Study: Cap each bank’s bonus pool to cut risk

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An Oxford University economist says a cap on each bank’s bonus pool in relation to their balance sheet would limit bankers’ pay and thereby reduce bank risk.

In a new study, Dr John Thanassoulis argues that an adjustable cap at the balance sheet level of each bank would affect weaker financial institutions most, and result in bankers commanding lower rates of pay.

The study, to be published in the Journal of Finance, shows that a cap that reduces the bonus pool by between US$1 billion and US$3 billion every year for each major financial institution would be at a level which minimises bank risks and maximises bank values. This calculation is based on the financial data of 20 global banks.

The study notes that just before the financial crisis, staff wages and bonuses in one year at Merrill Lynch and at Morgan Stanley were the equivalent of half of their entire stock of shareholder equity (equivalent to tier 1 capital). Analysing data from the last ten years on the banks and financial institutions traded on the New York Stock Exchange (NYSE), the study finds that in about 10 per cent of cases, bankers’ pay (including bonuses), was worth more than 80 per cent of total shareholder equity.

There have been widespread calls for curbs on bankers’ earnings with the EU, the US and individual countries already implementing or proposing policies that limit bankers’ pay.

Dr Thanassoulis says that the level of bankers’ pay is a legitimate cause for concern and poses a significant risk factor for banks. He argues, however, that bonuses have better insurance properties than fixed wages as bonuses are linked to investment returns. If current proposals remain unchanged, Dr Thanassoulis argues that banks would have to pay the market rates in fixed wages, regardless of whether the bank was experiencing good times or bad. This would raise bank risks significantly as pay is such a large fraction of shareholder equity, says the study.

Dr Thanassoulis, from Oxford University’s Department of Economics, said: ‘An adjustable cap on the proportion of the balance sheet which can be used for bonuses will lower the market rate of bankers’ pay, will lower bank risk, and will raise bank values. The level of the cap would need to be determined by bank regulators, such as the Bank of England. The more this model is applied across the banking sector, the larger the benefits for banks, thereby reducing the level of risk to the sector as whole.

‘A cap at the balance sheet level targets the risk to banks directly, but still leaves banks with flexibility as to how they motivate and reward individuals. Such a cap hits weaker financial institutions harder, prevents them driving pay up excessively, and so lowers the overall market level of bankers’ pay. As the banks can retain their staff with lower bonuses, and are not forced to use fixed wages, the good insurance properties of bonuses are preserved.’

The study also argues that a policy, followed in the UK and in France, to tax banks on their bonus pools, is ‘ineffective’ in reducing bank risk as banks still bid for bankers up to the market rate, leaving the risk to banks unchanged. The study points out that the government is the main beneficiary of this policy, raising money for the Treasury from the tax.

The cap should be ‘the most stringent cap on the proportion of the balance sheet which can be used for bonuses without resulting in banks moving to increased fixed wages’, advises the study. The study warns, however, that ‘very stringent’ bonus caps, or a requirement to pay wages rather than bonuses, would increase the risk of the bank defaulting.

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