Bonus cap blues

Craig Coben is a former senior investment banker at Bank of America and now a managing director at Seda Experts, an expert witness firm specialising in financial services.

Investment bankers are having a difficult time. Dealmaking collapsed in 2022, job cuts are savage and remuneration is being chainsawed. The recent market recovery has given some cheer, but business remains slow.

Now a new danger lurks for senior bankers in the City: the prospect that the UK government will rescind the cap on bonuses later this year. Because contrary to public and media perception, most investment bankers like the bonus cap, and many don’t want to see it eliminated. They just can’t openly admit it.

Adopted in 2014 by the European Union, the so-called banker bonus cap limited the variable pay of a “material risk taker” (MRT) to 100 per cent of fixed annual pay or 200 per cent with shareholder approval. This means in practice that a banker earning, say, £250,000 a year in fixed pay can receive a maximum bonus of £500,000.

The rationale for the cap was that the lure and lucre of a big bonus encouraged excessive risk-taking, resulting in windfall gains for bankers if the bets went well or potentially taxpayer losses if they turned sour. Proponents argued that if you put a ceiling on their bonuses, bankers will have less incentive to take on huge risks and will instead focus on building strong customer franchises.

In late December, the UK Prudential Regulation Authority and the Financial Conduct Authority announced a joint consultation to be concluded in March 2023, and it’s clear they want to eliminate the bonus cap.

The proposals to remove the current limits on the ratio between fixed and variable components of total remuneration aim to strengthen the effectiveness of the remuneration regime by increasing the proportion of compensation at risk that can be subject to the incentive setting tools within the remuneration framework — including deferral, payments in instruments, and risk adjustment. Over time, the regulators consider that the proposed changes should also help remove unintended consequences that have arisen as a result of the bonus cap, namely growth in the proportion of the fixed component of total remuneration, which reduces firms’ ability to adjust costs to absorb losses in a downturn.

In other words, banks had responded to the bonus cap by jacking up salaries and introducing generous “role-based allowances” for its senior bankers. Fixed pay rose sharply, and overall compensation was otherwise mostly unchanged. In fact, Bank of England researchers found some evidence that a lower proportion of bonuses were deferred.

Thanks to these changes, senior dealmakers are now the beneficiaries of a kind of UBI-on-steroids. They not only have a high guaranteed minimum income, but it is in cash, paid upfront, and not subject to clawback. After a miserable performance year like 2022, senior bankers can take shelter under the umbrella (ella, ella, eh, eh) of high fixed pay.

Meanwhile, the bonus cap rule has failed to achieve its most basic objectives. It curtails pay in few, if any, cases, with only about 4 per cent of MRTs even coming close to the regulatory limit (bonus of 175-200% of fixed pay) in any given year. Moreover, another group of researchers could find no evidence that the bonus cap reduced risk-taking by banks.

In other words, the bonus cap has proven at best ineffective, at worst counterproductive. It has succeeded in safeguarding senior bankers’ income, but not the financial system. That wasn’t the intention of the regulation, to put it mildly.

If UK regulators nix the bonus cap, it will probably prompt banks to reconsider the level of fixed pay. According to press reports, Goldman Sachs, Morgan Stanley and JPMorgan are exploring the possibility of eliminating allowances, and other banks will surely follow suit if the UK removes the cap. In many cases the allowances were drafted in a way to allow them to be withdrawn, and even if not, it would take a brave or foolhardy banker to refuse to consent to their elimination, not least given that unfair dismissal awards are capped at £93,848 in the UK.

Removal of allowances will affect two categories of bankers in particular: (a) the Big Cheeses and (b) the Struggling MDs.

Big Cheeses: under current rules the bonuses of the most senior bankers are subject to a seven-year vesting period. Others with managerial or supervisory roles have five-year deferrals. These awards can be cancelled or reduced if something goes wrong in future and the banker is deemed (fairly or unfairly) to be at fault. Such back-ended compensation means that the fixed pay is a valuable backstop. The media have played up the salaries and allowances paid to the London-based banking heads of Citigroup and JPMorgan, but they are overseeing complex organisations in which a lot can go wrong even with the most active vigilance. A clawback or “malus” of their (generous) variable compensation packages is unlikely but by no means impossible or implausible.

Struggling MDs: managing directors at several banks have reportedly received zero bonus this year due to low personal revenue production or the poor profitability of their business group. In every case their area had suffered a massive slowdown in activity. The higher salary and role-based allowance provided a floor that limited how much their compensation could be reduced. But for that floor, their compensation would likely have been quite a bit lower.

The disquiet about the removal of allowances also extends beyonds these two categories. (Warning: I’m about to make sweeping generalisations about investment bankers. Exceptions abound.) Contrary to popular belief, most senior dealmakers are risk-averse; they have worked in investment banks for 15, 20 or more years. They praise entrepreneurialism more than they practice it. Their priority is to earn enough to maintain the (expensive) standard of living associated with a certain segment of the London professional class.

Bankers also know their careers operate on borrowed time. Although outwardly optimistic, they know that recessions and restructurings happen, competitive threats are omnipresent and ineradicable, and bull markets can end without notice.

That’s why these bankers appreciate a lifeboat of role-based allowances in case business hits rough seas or a few deals just don’t go their way. Removing the role-based allowances plunges London bankers into the icy waters of performance accountability.

Of course, you can’t say openly you want to keep your allowances. Investment bankers present themselves as hard-working hunter-gatherers of new business, not rent-seeking apparatchiks. Senior financiers know they’re supposed to be cutting deals, not clipping coupons.

So if allowances are withdrawn, many senior bankers will be unnerved but silent. In the City of London, as in space, no one can hear you scream.