Viewpoint: Why Capping Bankers’ Pay Is a Bad Idea

Why the proposed limits on banker pay being considered by the European Union are a misguided – if not dangerous – intrusion of government into the affairs of private companies.

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Jason Alden / Bloomberg / Getty Images

Canary Wharf, the business and financial district in London, Feb. 11, 2013.

I’ve come to dislike bankers as much as the next guy. How can anyone with a sense of justice and fair play not be angry at them? First they tank the global economy with their risky shenanigans, then they take taxpayer money in costly bailouts, then they unrepentantly continue to pay themselves gargantuan bonuses, then they complain about the big deficits and rising government debt that are a result of the recession they caused and the rescues they received. What’s to love?

Still, for me at least, the proposed limits on banker pay being considered by the European Union are a misguided – if not dangerous – intrusion of government into the affairs of private companies. On Wednesday, negotiators for the European Parliament and E.U. member states reached a preliminary agreement to cap banker bonuses at the same level as their salaries. (With shareholder approval, that can be increased to two times the salary.) There may be some wiggle room built into the rules – for instance, some sorts of long-term compensation may be counted differently and allow bankers to earn more money – but the restrictions the E.U. is proposing are still the most overbearing recently considered in the industrialized world.

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Such measures may soothe the public, but if they are finalized and come into effect, they have the potential to reshape the international banking industry – without making the finance industry any more stable. Ostensibly, the restrictions on pay are an attempt to force bankers to take fewer risks of the type that caused the 2008 financial crisis. Back then, bankers gorged on high-risk but high-return sub-prime mortgage securities that eventually caused the balance sheets of some of the world’s most venerable institutions to implode, rippling through the global economy and sparking the Great Recession. To prevent that from happening again, governments have tried various means to place more restrictions on or improve the oversight of the banking industry, such as the Dodd-Frank reform legislation in the U.S. The E.U. caps on banker pay aims to dampen the incentive of bankers to take excessive risks since they could only earn a certain amount of cash anyway.

Will that work? Not likely. First of all, banks will probably find ways around the rules – by, for instance, increasing base pay – so the link between profits and paychecks won’t be completely broken. (Nor should it be.) More importantly, bankers themselves aren’t the only ones interested in bank performance. Shareholders will continue to clamor for fatter profits and rising stock prices, meaning bankers will still be pressed to post better and better returns – and tempted to take the risks necessary to achieve them. The pay restrictions could also convince bankers to depart from commercial or investment banks and join hedge funds and other, less-regulated segments of the industry.

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Effective or not, the rules could impact the fortunes of the world’s largest banks. What the E.U. is forgetting here is that the financial sector is truly global. The E.U. doesn’t act in a vacuum; the policies it introduces can negatively impact the competitiveness of European banks versus American and Asian banks. Why, for example, would an aggressive banker work in London or Paris and face pay restrictions when he or she could fly off to New York or Hong Kong or Singapore and not have their income capped? Since the new rules are likely to apply to the operations of European banks all over the world, those departing Europe are also likely to depart European banks altogether. That will mean Europe’s banks will be stuck hiring the immobile or the incompetent (or both). And, since the pay caps will also probably be imposed on the operations of American and Asian banks in Europe, they will potentially chase away expert bankers from Europe in general. In the end, the E.U.’s pay caps will likely cause a brain drain out of its financial sector and into its international competition, scare away jobs from a continent desperate for job growth, and place its financial centers at a disadvantage to those in the U.S. and Asia.

We also have to question if capping pay is something governments should be doing at all. However you feel about bankers, you should worry about laws that control their income. How would you feel if the government stepped into your company and mandated limits to how much you should get paid? Chances are you wouldn’t be pleased. The job of allocating pay should be left to a private company’s shareholders. We can argue whether or not the shareholders and directors of banks have been properly doing their jobs, but that doesn’t mean the government should intervene and arbitrarily impose restrictions on the internal compensation decisions of a private institution. People should get paid based on their experience, productivity and results, not on the decisions of politicians or bureaucrats.

The E.U. proposal is effectively a response to the moral hazard governments around the world have created. By treating big banks as “too big to fail,” governments have encouraged risky banker behavior. Why not take a chance and gorge on risk when you know the taxpayer will step in if things turn ugly? Having bailed out the banks, now politicians are looking for other ways to keep them under control. Perhaps the best way to ensure bankers don’t play risky games that threaten national economies is to both allow them to profit from their activities – and suffer for their mistakes.

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