Chancellor Kwasi Kwarteng’s scrapping of the banker’s bonus cap is audacious. While the cap was particularly popular, capitalising on the tarnished image of financiers following the Great Recession, it made little economic sense.
Under the EU Capital Requirements Directive, bankers bonuses are limited to 100 per cent their fixed salary, or 200 per cent if shareholders approve. The thinking behind the cap was to discourage excessive risk-taking by limiting bonus potential, and to reduce income inequality by bringing down banker renumeration.
The measure was heavily criticised at the time of introduction. The then-Chancellor George Osbourne called the cap “entirely self-defeating”. The now-Governor of the Bank of England decided it was “the wrong policy” since it interfered with “appropriate incentives”. Capping bonuses restricts banks from remunerating their top talent commensurate to their individual, and the wider business’s, performance.
The limit on bonuses resulted in banks increasing their base pay substantially in order to compensate their staff, creating a wash of bankers with weaker incentives to perform. And with higher base pay, bankers are better insulated from risks since they have less to lose in terms of potential bonus payments. Additionally, increased base pay presents banks with higher fixed costs, another unwelcome unintended consequence. Since the cap does not apply to other financial firms like hedge funds and fin-techs, it opens the door to a banking skills brain drain.
The biggest advocates of keeping the cap focus solely on income disparities. While bank bonuses as a share of pay have remained below 2008 levels, banker base pay has continued to grow. Putting aside the failure of this policy to half growing wealth inequality, advocates of the cap fail to recognise what Thomas Sowell once put so well: “most income is not distributed: it is earned”. When private banks bestow their top talent with bonuses – even those deemed lavish by outsiders – the man on the street is not made worse off. Private funds, rather than taxpayer funds, are the source of the renumeration. The moral justification for capping renumeration for any private corporation is just as weak as the economic case.
That said, it will take some years for the effects of the cap’s demise to show. Incoming junior bankers will likely face lower base pay and higher potential for bonuses, but it is questionable whether banks will be able to renegotiate contracts with more established staff accustomed to years of higher fixed pay.
Whilst binning the cap gifts the Truss government with a tangible benefit of Brexit to brandish on the airwaves, it is a politically unpopular trophy to wield. There is strong public support for caps to top pay. Polling suggests that over half of the public may believe British executives should receive renumeration no more than 10 times higher than low-to-mid ranking employees.
Furthermore, it is contested whether reforms such as axing the pay cap will compensate for the shock to the City engendered by Britain’s departure from the EU Single Market. Whilst the 100,000 lost jobs envisaged by ‘Project Fear’ never materialised, over 7000 staff are estimated to have relocated to the continent.
Prime Minister Truss and her buccaneering Chancellor drew a clean break with the past last Friday, casting aside a focus on distribution and placing economic growth front and centre. Ordering the Prudential Regulation Authority to jettison “poorly designed EU rules” like the bonus cap are sensible steps in this direction.