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Bankers' Pay Caps Didn't Work Here, They Won't Work in Europe

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The news that European fund managers’ incentives may be capped at one times salary comes hard on the heels of earlier news that top traders and senior managers in banks will have their bonuses capped at the same level as their salary, or at two times salary with specific shareholder approval. The latter policy will only be allowed if at least a quarter of this larger bonus is deferred into loss-susceptible securities for at least five years. The bank rules will affect all senior traders and managers working for banks based in the 27 nation bloc, including EU and non EU-based employees, as well as employees of non-EU banks working within the EU. The same “no exception” rules are likely to apply to fund managers. These changes will cover mutual funds, which have about 6 trillion euros under management, but not hedge funds or private equity investors, because they are governed by different law. On the other hand, it seems likely that wider restrictions on pay in finance are ahead; and these will cover hedge funds.

“The rules as voted would be an important step toward ending the gambler mentality in the investment fund sector,” said German lawmaker Sven Giegold.

The moves have stimulated a great deal of “no comment” from banks and fund management firms and an enormous amount of comment from trade associations and rebellious governments, specifically the U.K. For example, U.K. Chancellor George Osborne said, during a broadcast section of the meeting discussing the banking curbs, that:

"It will push salaries up, it will make it more difficult to claw back bankers' bonuses when things go wrong, it will make it more difficult to ensure that the banks and the bankers pay when there are mistakes, rather than the taxpayer."

Unusual though it may be for me to agree with a Conservative chancellor, I have to concur.

These rules are not so very different from the mistaken limits on bank pay that were imposed by TARP and U.S. Pay Czar Kenneth Feinberg while banks were being bailed out. These resulted in massive increases in base salaries for all senior managers.

Limits were set on bonuses of one-third of total compensation, to be paid entirely in stock. Limits were set to cash base salaries, but not to salary paid in stock. The consequence? Increases in base salary of up to 600 percent at most banks. For example, base salaries for senior executives rose from $600,000 to $2,000,000 at Goldman Sachs, while for John Stumpf, CEO of Wells Fargo, his salary rose from just under $900,000 to $5,600,000. If you wanted an example of unintended consequences, you could hardly look for a better one.

Some of the European banks already underwent this exercise, though with less excess and with a concomitant reduction in incentives. That is unlikely to happen this time around.

Banking compensation is like a geyser. Stop up one hole and the pressure will burst through somewhere else. You cannot simply cap one form of pay, or the other forms will explode in consequence.

So we are left with three alternatives. Keep government out of pay setting. Cap all forms of pay. Force through reform of pay structures.

Frustratingly enough, the pay changes in European banks – more deferred pay, more pay based on long-term performance, more pay significantly at risk – that are partly due to initial reforms mandated by the EU, which have pushed European banking pay to even greater levels of sophistication are likely to be scrapped because of the pay caps. Europe is already moving to better pay governance, and the governments would do well to allow these to settle in before further reforms were pushed through.

The country that really needs the impetus towards pay reform is the U.S.. Some reforms have been instituted but those are still far behind Europe, and base salary remains excessive, meaning that executives are paid handsomely whether they have led the bank successfully or not.

But should those reforms come from the U.S. government or from the owners of the businesses? The answer should be obvious. Shareholders have the perfect avenue to effect reform through the Say on Pay vote. It’s about time more of them used it effectively. Any naysayers who point out that the vote is not binding have not been studying the pay reforms at the well over 100 companies that have already received a majority vote against their pay policies. It works.