The EU's New Limits on Banker Bonuses May Not End Excessive Risk-Taking

Europe's parliament on Wednesday approved the toughest limits on bankers' bonuses that have been adopted anywhere in the world, a move likely to fuel demands for similar curbs in the U.S. But are these measures enough to limit excessive risk-taking at too-big-to-fail financial institutions and avert another meltdown?

Michel Barnier, the European Union's financial services commissioner, says he believes the new European rules will change banker behavior. "Banks will need to change radically their practices and the mentality that has led in many cases to excessive risk-taking and contributed to the financial crisis," he says.

But limits on banker bonuses have been in effect for a year already in Britain, and there aren't many signs that they've brought about any meaningful changes in the way banks operate there.

John Van Reenen, director of the Center for Economic Performance at the London School of Economics, says that while there have been some positive changes, such as a move toward more deferred compensation rather than cash in bankers' bonus packages, he worries that the shift in behavior doesn't go far enough.

"I think that one of the main problems is that banks know that it is pretty much for sure that they will be bailed out in the future, and that by itself gives banks incentives to behave in a very risky way," Van Reenen says. "It's not surprising to see banks have these annual bonus schemes because they know they have some protection on the downside if things go wrong. It's not until you take away that safety net that you can credibly say to them 'if you screw up, you really are going to go bankrupt.'"

Wider Scope Than Previous Proposals

The new European rules will force bankers to take between 40% and 60% of their bonus over a three- to five-year period, though it will be up to individual national governments to set the exact deferment periods. Bankers with "particularly large" bonuses will have to defer more than other bankers, but the exact point at which a bonus crosses that threshold hasn't been determined yet. Half of the bonus has to be paid in company stock, which is a way of linking compensation to the firm's performance.

The legislation uses the term "investment companies," which could mean the new rules would also apply to securities firms, hedge funds, private equity firms and insurance companies.

The new law has a far wider scope than the proposed rules on compensation that were adopted at the Pittsburgh G-20 summit in September 2009. Those rules, which are not binding, only suggested that banks avoid guaranteed multiyear bonuses and that a significant portion of pay should be deferred.

In the U.S., limits on banker bonuses were left out of the final version of the financial regulation overhaul bill that came out of the congressional conference committee last month, though that bill does call for shareholders to have more say on executives' pay packages.

Tight Rules Risk Institutional Flight

The British Bankers Association says the new European rules include "unnecessary complications" because they seek to force bankers to take part of their pay in so-called "contingent capital" -- bonds that can be converted into equity if a bank is in distress. The BBA says that shouldn't be part of the pay discussion until the capital requirements issue is resolved at an international level.

"It's not just about bonuses but about capital and liquidity as well," says Irving Henry, policy director for prudential capital and risk at the BBA. "If some countries have tighter rules, then the business may move. There's always that danger."

There was an uproar in Britain when Alan Howard, co-founder of Europe's largest hedge fund, Brevan Howard Asset Management, announced that he was moving from London to Switzerland following the introduction of a 50% tax rate on executives earning more than $225,000 a year. The British government also imposed a 50% tax on bankers' bonuses for this year.

Van Reenen says that while it remains to be seen how the new European rules will be implemented, banks have a history of getting around regulation. "Usually the government is outgunned by the lawyers and tax accountants on the other side," he says.

Excessive Risk Will Still Be Rewarded

Even with more pay being deferred, Van Reenen says, the bonus system creates powerful incentives to take excessive risks. A high-risk strategy that will give a banker a huge payoff one year, but huge losses in the next few years, is still attractive, he says, because in losing years the bankers don't have any salary taken away. All that could happen is they get fired, but they will still make huge amounts of money in the good years.

"It is reasonable to think that part of the crisis we went through was related to the remunerational structure of these extraordinary, high-powered incentives which caused executives to get out of line with the interests of shareholders and the taxpayer," Van Reenen says.

Evidence of this kind of thinking emerged at a Paris court Wednesday, when Jerome Kerviel, a former trader at French bank Societe Generale who lost $7.22 billion of the bank's money, testified that his bosses knew he was taking wild risks and encouraged him to do so.