The justification for capping bonuses is to limit risk taking by banks.
At best, capping bonuses is a one off solution for reducing risk taking. The thinking behind why capping bonuses will work to reduce risk taking going as follows: if bankers can earn less, then they have an incentive to take less risk and as a result they will take less risk.
Forgive your humble blogger for not having a lot of faith in this reasoning as its success if dependent on the combination of complex rules and regulatory oversight.
Don't kid yourself that the rules on banker pay are not going to be complex. Bankers receive compensation in many different forms including base salary, short-term cash bonus, long-term cash bonus and stock.
Simply changing one component of banker compensation is not going to change their incentive to take risk. Bankers will still take risk and privatize the gains while socializing the losses by simply changing where in their compensation they are awarded for taking risk.
Regular readers know that you humble blogger despises any solution that relies on the use of the combination of complex rules and regulatory oversight when there is a better, simpler alternative.
In this case, the better, simpler alternative is to stop focusing on banker pay and instead focus on limiting their ability to take risk.
The way to limit their ability to take risk is to require the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.
With this information, market participants can assess the risk each bank is taking and adjust the amount and pricing of their exposure to each bank to reflect its risk. When risk and cost of funds are linked, banks are subject to market discipline to reduce their risk profile.
For example, banks are subject to market discipline at the proprietary trading level. When all market participants can see what a trader is gambling on, they can trade against the trader in such a way as to minimize the potential upside of the trade while maximizing the downside. Market discipline acts to restrain, if not eliminate, proprietary trading.
"For the first time in the history of EU financial market regulation, we will cap bankers' bonuses," said the European Parliament's head negotiator, Austria's Othmar Karas, in a statement.
"The essence is that from 2014, European banks will have to set aside more money to be more stable and concentrate on their core business, namely financing the real economy, that of small and medium-sized enterprises and jobs."
The bonus cap was part of a package of financial laws hammered out between EU officials, the European Commission and representatives of the 27 member states in negotiations led by Ireland's Finance Minister Michael Noonan.
The goal is to prevent bankers from taking excessive risks, which can shake the financial industry.
"This overhaul of EU banking rules will make sure that banks in the future have enough capital, both in terms of quality and quantity, to withstand shocks," Noonan said. "This will ensure that taxpayers across Europe are protected into the future."It is far from clear that capping banker bonuses will achieve this outcome.
What is clear is that requiring banks to provide ultra transparency would achieve this outcome.