Banks in the line of fire over bonuses

The latest proposals from the European Parliament to cap bankers’ bonuses at one times salary would wreak havoc at banks in Europe. Here are the banks most affected – and what they might do about it.

‘Oh Christ!’, was the response of one senior banker when asked recently about the latest crackdown on bankers’ pay with Brussels working on a plan to cap bonuses at one times salary.

This column has argued before that the politically motivated proposal is misguided in that it will be unlikely to reduce overall levels of pay (the chronic performance of investment banks means that bonuses are coming down by around 30% a year of their own accord). Instead, banks will find ways to raise the fixed element of remuneration to offset any enforced reduction in bonuses, raising their fixed costs and further reducing their flexibility. This is turn will limit their risk capacity, most probably leading to even less lending and lower liquidity.

The first question is which banks would be hit hardest. This chart shows the ratio of variable to fixed remuneration for the most senior staff at a range of US and European banks, based on their disclsoure to European regulators (note that for the US banks in the sample, the disclosure is for 2010 and refers only to their most senior staff in the UK).

On average, variable pay for senior bankers was three times the level of fixed pay in 2011 (a significant reduction from a ratio of nearly seven times in 2010). At the extreme, JP Morgan paid its 82 ‘code staff’ (a combination of senior management and highly paid staff) in the UK more than nine times in bonuses in 2010 as they received in fixed pay, according to regulatory filings. All in, they received an average salary of $265,000 and bonus of $2.4m each in 2010.

At the other of the scale, the 386 most senior staff at RBS received bonuses of just 1.6 times their salary last year. Assume that US banks have brought down this ratio in 2011 to around five times (they won’t disclose the actual numbers until later this year), and you probably have an average ratio between bonuses and fixed pay of around four times for senior staff.

Bridging the gap

This next chart shows how banks might address this problem if the cap on bonuses becomes law (it probably will, even if Denmark is currently working on a compromise proposal of a ratio of two-to-one). In summary, banks would either have to roughly triple salaries or reduce bonuses by more than two thirds in order to bring the ratio into line:

If we assume that US banks have not reduced the ratio of variable to fixed pay since 2010, they would have to slash bonuses by more than 80% to bring them into line, or they could increase salaries by more than 300%. The reality is probably somewhere in between: assuming a ratio of variable to fixed pay of four times today for senior bankers, bonuses would have to fall by 75% to bring the ratio into line. Alternatively, salaries could rise by 150%.

To put that in context, a banker earning $250,000 in salary and a $1m bonus would either have to be paid a bonus of ‘just’ $250,000, or their salary would have to rise to $625,000 in order to not lose out.

Of course, banks are unlikely to pursue such a simplistic route. Bonuses will continue to come down in line with performance, while salaries will no doubt edge up. The difference will be made up through higher pensions contributions, contractually agreed top-up payments or new hybrid bonus schemes that somehow get round the bonus rules altogether.

The other alternative, that becomes more likely with every new piece of legislation on pay in Europe, is that more and more bankers will be recalled to the US or posted to Asia, where the new bonus rules won’t apply.