There are good fires and bad fires. The good ones are those that burn where you want them to burn – in the fireplace for instance – keep you warm and cosy. And there are bad fires. Those that generate a massive flame and a lot of sparks very quickly, spread to the carpet and curtains, and set the house on fire. Chancellor Kwasi Kwarteng thinks his economic strategy will provide the former. In reality, he is about to ignite the latter.
In a sign of how desperate the new government is to finally deliver to the British public some of the Brexit benefits we were promised but the Johnson government repeatedly failed to find (after various unsuccessful attempts, see e.g. this post), has announced a post-Brexit shake up of the UK’s financial sector – dubbed Big Bang 2.0 in reference to Thatcher’s deregulation of the city in 1986. Not much is known about that reform plan at the moment. Yet, it has transpired that Big Bang 2.0 may include the scrapping of a cap on banker bonuses introduced by the EU in the wake of the 2007 Global Financial Crisis (GFC), which limited the amount of bonus payments to twice the annual salary.
To those who object that such a move would be politically controversial at a time when most other professions face real-term wage cuts, people close to the Chancellor reply that he is being unashamedly pro-growth. Indeed, removing the cap, Kwarteng hopes will boost the City of London and the UK financial sector in general, leading to a new boom in financial services - and that is the fire he hopes will keep us warm.
That is where arson comes in. To Kwarteng and others in the Truss government, being ‘unashamedly’ pro-growth seems to mean unlearning the lessons learned from past crises and renewing the blind and naïve belief in the efficiency of markets and the evil of regulation. In other words, unashamedly pro-growth is equated with ‘unchaining’ businesses in the UK from any constraints the state or society may impose on them. Indeed, Kwarteng is clearly in line with the PM herself who is expected to announce a series of radical deregulatory measures in the coming weeks to show that she is serious about ‘unchaining’ businesses. It seems safe to predict that this approach to the economy will set fire to the house.
Bonus caps: symbolism or substance?
Some bankers – especially US investment bankers – have welcomed the news about the removal of the bonus cap; but others in the industry voice their scepticism, questioning whether the change makes any substantial difference to the sector. One banker reportedly called the planned move tokenism compared to the long-term damage done to the City of London by Brexit.
The Bank of England and its Prudential Regulation Authority, in turn, are in favour of the change, as they consider the banker bonus cap a ‘blunt instrument’ that does not achieve its goal of reducing bankers’ willingness to take excessive risks.
There is certainly some truth in claims that the bonus cap was introduced in 2013 as a populist measure to show the public that European governments were doing something (although the UK government was opposed at the time and even sued the EU over the bonus cap). As such, the cap was a symbolic measure that may not have made a massive difference in terms of overall pay in the sector.
Systematic evidence is hard to come by, but it would seem that the bonus cap may have had an important effect on the very top end of the pay scale in banks. Indeed, this year has seen the highest banker bonuses being agreed since before the GFC of 2007, but it would appear that pay practices in the City have significantly changed among other things due to EU regulation. Thus an article by an industry insider on the eFinancialCareers platform recounts a story of top bankers complaining about the fact that very few in the industry now earn eight digit salaries and estimates that top pay may have halved since the GFC. Similarly, further down in the banking hierarchy, expectations also seem to have changed according to the same source who states that: “the regulation of compensation in Europe has affected norms across the industry, with a multiple of 100% of salary now being seen as an aspirational goal for top performers at most levels, rather than the baseline expectation for a competent year’s work.” Luke Hildyard, director of the High Pay Centre told the Guardian the cap has probably slowed down the rise of banker pay somewhat.
Yet, despite the dampening impact on the very top of the scale, overall bankers pay does not seem to have declined after 2007. Thus, a report by the European Banking Authority from 2016 – three years after the introduction of the cap – showed that the number of high earners (bankers earing EUR 1m or more a year) in Europe increased by 22% between 2013 – the last year before the cap came into effect – and 2014. What had changed was the composition of pay packages: The fixed pay bankers took home every month in cash had increased, while that variable pay – including bonusses – had decreased. While that may not satisfy concerns about absolute pay levels, it may have changed the incentives bankers have to take excessive risks to maximise bonuses at the end of the year.
Those who are in favour of the scrapping of bonuses consider, however, that there are more effective instruments to curb such undesirable behaviours. They point to other regulatory changes that have taken place since the GFC and are said to be more effective in curbing unreasonable risk-taking. Here, the malus and clawback clauses in the Corporate Governance Code (CGC), which allow it employers to respectively reduce a bonus before it is paid-out or to recover a bonus after it was paid out, are often mentioned. These are legitimate arguments that deserve thorough consideration, although it has to be noted that the CGC only applies to listed companies and operates on a ‘comply or explain’ basis, i.e. companies can choose not to comply with the rules, but have to explain in their annual report why. So, more evidence would be needed to understand whether malus and clawback clauses really work.
Beyond these legitimate arguments, Kwarteng’s announcement has also given rise to a great deal of very questionable arguments, which are concerning in terms of what conclusions regulators, politicians, and the general public may draw from them if they remain unchallenged. A few of these arguments require particular attention.
Flexibility
The most basic argument why bonuses should be uncapped is that it would allow banks to reduce the fixed part of the pay package and thus reduce the banks’ fixed costs, making it easier to navigate difficult periods. The Financial Times seems to accept this argument writing that “[i]t is harder or impossible to reduce an employee’s salary compared with a discretionary bonus, which can be entirely withdrawn.” That may be broadly true. At the same time, with or without clawback clauses, withholding a discretionary bonus may not be as easy as those arguing against the cap may suggest. As one legal expert writes, an “employer may find it difficult to withhold a bonus if it has by custom and practice, regularly paid previous bonuses to employees who have performed to a similar standard each year.” In several cases, bankers have successfully sued their employer over withheld bonuses, the most high-profile case perhaps being former Lloyds CEO Eric Daniels.
Moreover, some in the industry are warning that it will be difficult to reduce fixed salaries now that bankers have gotten used to them. Uncapped bonuses may simply be added on top of them. This would lead to further pay inflation in the financial industry. Perhaps, if we were serious about fixing the problem, it would be important to discuss the possibility of a cap not just on different parts of pay packages, but on overall pay?
Regardless, even if we accepted the argument that paying higher bonuses but lower fixed salaries reduces banks fixed costs and increases their flexibility, it is doubtful how much that matters materially. The European Banking Authority, for instance, estimates that the costs of fixe salaries are less than 1% of banks’ own funds and hence negligible in terms of the banks financial stability or profitability. Limiting that flexibility should not matter much in reality.
Peanuts & Monkeys
Another often-made argument not just against the bonus cap, but more generally in favour of high banker salaries, is summarised in the famous saying ‘if you pay peanuts, you get monkeys.’ This argument was made most clearly this week by ‘acid capitalist’ Hugh Hendry. On the News Agents post cast he crudely argued that the lack of talent in politics was due to low pay in politics.
At the face of it, this may seem like a plausible argument: The smartest people with the best skills have options and will work for whoever pays the most. However, it is based on a fundamentally flawed basic assumption about human behaviour, namely that the only thing that determines people’s career choice is money. That assumption is of course untenable. Talented people may prefer jobs that allow them to use their talent in a way that they consider meaningful, that allows them to achieve a good work-life-balance, or simply that provides them joy. Therefore, taltented people may not be running after the best-paid jobs. Consequently, ‘talent’ is not the main reason why people make a lot of money; greed is. Indeed, if the past forty years have taught us anything, it is that paying absurd amounts of money does not generate a work environment teeming with talent, but rather one packed with greedy psychopaths like Jordan Belfort – depicted (some say glorified) in the Scorsese film the Wolf of Wall Street – or former Lehman Brothers’ CEO and chairman Dick Fuld. The latter has been filmed explaining what he would like to do with ‘short sellers.’ The explanation contains the sentence “I’m soft. I’m loveable. But what I really wanna do is I wanna reach in, rip out their hearts, and eat it, before they die.” That’s the sort of people that paying absurd amounts of money gets you. Not talent.
Related to that, an interesting unintended consequence of Kwarteng’s plan might be to create a real divergence between UK banks and European ones, which may lead to a self-selection bias in terms of recruitment. An industry insider suggests that even if removing the bonus cap may lead to overall higher pay – possibly a return to the excesses of the pro-2007 era – some people working in the industry prefer the certainty of a higher (monthly) fixed salary over an uncertainty, but possibly exorbitant end-of-year bonus. This may mean then rather than struggling to attract ‘talent,’ European banks – who remain subject to the EU cap – will be more appealing to the sort of bankers who prioritize stability and predictability over volatility and risk. In other words, they will get more risk-averse people, but fewer Fulds and Belforts.
This also relates to another argument made against the cap, namely that the cap “skews the performance elements of pay as it means you have to pay a high basic salary that doesn’t have incentives attached.” This seems like an odd argument, given that the cap was introduced precisely because bonuses – especially cash bonuses – were considered to create the wrong kind of incentives, namely, to take excessive risks. Given the complexity of human psychology, getting incentives right is notoriously difficult as a huge literature on so-called long-term incentive plans (LTIP) shows. It is much more likely that bonuses incentivise greed, short-termism, and risk taking, rather than good long-term performance in the interest of the company and society.
Regulatory fatalism
A final argument against the cap I want to discuss is what I would call regulatory fatalism. Here, the argument is that bankers will always outsmart the regulator and find ways to pay themselves and their colleagues the salaries they want. On the News Agents podcast, Emily Maitlis summarised that argument in the words of one banker: ‘Money is like water – it always finds away.’
There is definitely some truth in the notion that regulating the economy is like an arms’ race, with new undesirable practices emerging as regulation makes old ones impossible. Yet, the implied conclusion that there is no point regulating in the first place is flawed and dangerous. Even if no regulation will ever be perfect, or anticipate all the ways the regulatees have to circumvent it, regulation is still crucial to avoid economic disasters. This can be illustrated for instance by pre-GFC financial regulations in different countries. Even among the Anglo-Saxon countries Australia, Canada, the UK, and the US, which traditionally all adopt relatively liberal economic policies, considerable difference in their regulatory approaches existed. And this mattered. While none of these regulatory regimes were perfect, the more prudential regimes of Australia and Canada meant that these countries fared a lot better during the crisis than the US and the UK who had adopted more ‘soft touch’ regulations. So, regulations certainly do have blind spots and create unintended consequences, but we certainly should not buy into the fairy tale that regulations are powerless and therefore should be scrapped.
The bigger picture: economic structure and inequality
The most important shortcoming of the debate about banker bonuses, however, is that it is mostly about how bonuses affect banks’ ability to perform or recruit talent and about the competitiveness of the UK banking sector compared to New York, Paris, Frankfurt, or Singapore. What is being completely ignored is the role that the financial sector plays in the UK economy. This is where Kwarteng’s plan is most concerning.
Last year, the UK financial services industry contributed 8.3% to the total economic output of the UK economy. That may not sound like all that much, but it means the UK’s financial sector is the fourth largest amongst OECD countries (p.11), behind Luxemburg, Switzerland, and the US. Taken in isolation that may be seen as good news, given that financial services companies create a lot of jobs and tax revenue. Thus, HRMC estimates that the banking sector contributes 4.1% to the total tax receipts, although the City claims it is much higher than that (10%).
Yet, the question is what impact does such a large financial services sector have on the UK’s society and the rest of the UK economy.
Regarding the former, research into income inequality in the UK clearly shows that banker bonuses are part of the problem. It is no secrete anymore that the UK – together with the US – are the most unequal countries of amongst the advanced nations. In a striking article, the Financial Times’ John Burn-Murdoch writes that “last year the lowest-earning bracket of British households had a standard of living that was 20 per cent weaker than their counterparts in Slovenia.” Furthermore, “[i]n 2007, the average UK household was 8 per cent worse off than its peers in north-western Europe, but the deficit has since ballooned to a record 20 per cent.” At the other end of the income distribution, however, Britons are among the world’s top earners. Burn-Murdoch writes that the top-earning 3% “took home about £84,000 after tax” putting “Britain’s highest earners narrowly behind the wealthiest Germans and Norwegians and comfortably among the global elite.” The UK has hence amongst the world’s wealthiest people but also amongst the advanced countries’ poorest ones and as such can be classified as a poor society with pockets of rich people.
Banker bonuses contribute to this problem. In their academic research, Brian Bell and John van Reenen found that “[r]ising bankers’ bonuses accounted for two-thirds of the increase in the share of the top 1% after 1999” and that “[s]urprisingly, bankers’ share of earnings showed no decline between the peak of the financial boom in 2007 and 2011, three years after the global crisis began.”
In this respect, it seems clear that what Kwarteng’s plan will do is to aggravate a serious problem that is increasingly dividing UK society.
Too large a financial sector is not just bad for inequality, but also for the rest of the economy. Indeed, an often-cited argument in favour of an expanding financial sector is that it will have positive effects on other sectors too due to the availability of financial capital for businesses. Again, there can be no doubt that a developed financial system is an important pre-condition for economic growth. That does not mean, however, that the larger and less constrained the financial sector the better for growth in other parts of the economy.
For two reasons, that idea seems particularly unwarranted in the British case. Historically British banks have been notoriously bad at lending to British non-financial firms. Contrary to countries like Germany and Japan where banks have played a crucial role in financing the industrialisation of the country, UK banks have always focussed on financing trade and more speculative activities (see for instance my paper with Philipp Kern in Business History). This has led to several official investigations going back as far as the 1920s, (unsuccessful) attempts by the government to make banks to lend more to UK business (most recently the so-called Project Merlin), and the launch of the British Businesses Bank by Vince Cable as an alternative source of finance for SMEs. This is not to deny that UK banks do provide vital services to British business in other forms – including issues stocks and bonds – , but their impact on financing companies directly is limited.
This has gotten worse with financial liberalisation of the 1980s. Since then, the nature of financial services has changed radically and fundamentally. Rather than a support service for productive companies, financial service companies use the new leeway to invent ever new products – such as financial derivatives – which they then market and sell like any company in any other industry would do. The focus, therefore is no longer on the crucial service of providing finance to companies, but on acquiring new customers, innovating, and growing. Jan Toporowski calls this epochal shift ‘the end of finance,’. The problem is that the competition in the liberalised market place leads to the innovation of financial products that is not always functionally justified, but rather driven by the logics of competition and marketing. This has detached banks from their crucial fundamental function in the economy, and made them ever more risky and speculative entities. Their value for the ‘real economy’ has decline correspondingly, and the case for “un-ashamedly” promoting its growth seems very weak indeed. Truss recently called City “the jewel in the crown” of the British economy. That is quite accurate in the sense that like a jewel it sparkles and shines, but it is pretty much useless.
Kwarteng’s Big Bang 2.0 and the removal of the bonus cap may very well lead to spurt of growth in that sector, possibly providing some positive headlines, but it will hardly be more than a straw fire that generates a lot of heat but will not provide much light for most of the country. Rather deregulation will once again risk burning down the house in a next financial crisis.
It is somewhat puzzling that the government would risk a popular and political backlash against what is likely to be a rather unpopular policy when the economic gains are very doubtful. Part of it may simply be ideological blindness. The “Britannia Unchained government” simply believes that deregulation is the best economic policy and divergence from the EU is intrinsically good for the UK. The other part of the explanation may be that the Truss government is distinctly less ‘populist’ than the Johnson government. Kwarteng’s and Truss’ approach may be aimed at showing resolve and an un-compromising deregulatory approach which will please the libertarians in the European Research Group (ERG) and the rentiers who have become the main source of donations to the Tory party. The flip side of this attitude is that remedying the huge geographical disparities that increasingly divide the country economically, culturally, and politically are not high up on Truss’ priority list – at least not until the 2024 General Election campaign draws closer. Once again, Brexit seems to be taking a Saturnian turn: Those who voted for Brexit in the hope that it will rid them of the economic policies that undermined their living standards, will have to realise that the Brexiters in charge use their grip on governmental power to double down on those very same policies. This political strategy is nothing short of pouring Kerosene on the fire they lit.