Could removing bankers’ bonus caps lead to another financial crisis?

Partner Michael Barnett discusses a risk-taking culture as a factor contributing to the financial crisis in light of the imminent removal of the cap on bankers’ bonuses in Global Risk Regulator.

In 2013 the UK adopted the European Capital Requirements Directive, a measure brought in following the 2008 financial crisis and incorporated into the Financial Conduct Authority and Prudential Regulation Authority rules. These rules limit the ratio between bankers’ salary and bonus to 100%, or more with shareholder approval, and include other provisions designed to restrict the bonus element of bankers’ compensation.

To many who were scarred by the 2008 global financial crisis and the banking scandals that accompanied it, news of the possible abolition of the cap on bankers’ bonuses has triggered a response bordering on visceral. This reaction has been exacerbated by the news that, while most of the Government’s recent, beleaguered economic policies are to be reversed, that particular one may remain intact.

So why is it that of all features of the banking industry that have been subjected to critical scrutiny, the possible recall of uncapped bonuses should amount to the equivalent of shouting “fire” in a crowded cinema?

The causes of the 2008 financial crisis, and questions around whether it could or should have been anticipated and prevented, have been debated at length. Most commentators agree, however, that at its heart lay a complex spiral of regulatory and systemic failings in the global banking industry, culminating in a near-fatal case of over-leverage in financial institutions combined with balance sheets over-reliant on unchecked, risky assets.

Perhaps more than any other factor, however, the subject of bankers’ bonuses had become emblematic of an imploding banking industry that was fuelled by a culture based on greed and an unbridled pursuit of profit. Indeed, years before Lehman went down, the self-styled “Flaming Ferraris” set the tone, combining brashness, greed and risk-taking in a publicity-fuelled drive for… higher bonuses.

It was first and foremost that culture and under-equipped regulatory infrastructure, allowing profits and performance to be put ahead of market and customer protection, that facilitated the proliferation of increasingly complex, high-risk structured products in an environment where financial institutions’ risk and compliance functions were treated with contempt by many at the coalface.

In the post-2008 litigation that followed, bonuses and other financial incentives frequently came under the judicial spotlight, comprising a significant component of many claims in the English Courts. Whether it was trading desks selling risky tranches of structured credit derivatives to naïve European municipalities, restructuring departments seeking to maximise returns on distressed corporate customers or even other banks that lacked the “quant” capability to assess esoteric risks, those who lost their investments invariably pointed the finger at the “greedy bankers”. This flowed from a flawed belief on the part of many litigants that the motivation of a strong financial incentive might provide sufficient evidence of unlawful acts in the sale of the investment. Disclosure was sought from banks of internal documents revealing profits, HR records, bonuses and other financial incentives in the cause of vindication in the Courts.

But these efforts invariably proved unsuccessful, or at least seldom if ever amounted to the “smoking gun” that would establish mis-selling on the part of the bank. The English Courts tended to resort to strongly established principles of contract law, where “sanctity of contract” tends to prevail in favour of the seller, and where those who make a disadvantageous bargain cannot unwind the consequences by recourse to their own lack of vigilance. If anything, this led to greater resentment of the perceived perpetrators.

Unless, of course, that seller crossed the line into the realms of dishonesty. English law says that “fraud unravels all”, and a smart litigant might be able to weave a story of greed and financial motivation into a narrative framing allegations of fraud on the part of the bank. As more cases came before the Courts, the layers of complexity around structured financial products, their opacity, the asymmetry of information and sharp sales practices were increasingly peeled back, so that scales fell from eyes and many judges became wary of simply applying legal principle on a “one size fits all” basis.

And so there were some notable judgments which did condemn greed-fuelled conduct on the part of bankers – but invariably following findings of dishonesty after painstaking efforts by lawyers to disinter bank records, telephone calls, emails and texts. Some shocking practices were revealed around bankers hiding risk to get the deal done, as well as the bullying and misleading of risk committees for the sake of sales. However, these cases were largely outliers, with blame being attributed to a few “rotten apples” that did not necessarily poison the whole barrel. Indeed, one senior judge cautioned that one should be wary of “visiting the morals of the vicarage upon commercial contracts”.

A cold reflection on the years leading up to and following 2008 will remind all concerned that the pursuit of bonuses and other incentives was as much a symptom as a contributing cause (if in fact it was one) of the financial crisis and ensuing banking scandals. It is the systemic shortcomings that were sought to be addressed in the years following the financial crisis that are fundamental in that regard, not least of all with the ringfencing of investment from retail and commercial banking functions, and shoring up of regulatory capital requirements.

Abolishing the cap on bankers’ bonuses in the UK is very unlikely in and of itself to lead to another financial crisis (which was of course global, not localised), and a desire to increase the attraction of the City as a financial hub is well-motivated in principle. The reality is that banks have not been calling for bonus caps to be scrapped, and there are likely to be significant challenges around restructuring compensation packages and employment contracts, meaning that implementation may be cautious and longer term. Furthermore, there has been no suggestion that the rules adopted in 2013 around the deferring of payment of bonuses and clawback will be thrown out too, leaving significant fail-safes intact.

All that said, scrapping the cap on bankers’ bonuses is a move that must come with a stark health warning – that reintroducing one of the more insidious elements of a culture that no-one wants to see return carries risks that incentivising sales of financial products will always bring. And while there may now be a greater degree of transparency and wariness around many of the offending financial products themselves and the trading practices that underpinned the last financial collapse, “greed” is not confined to bankers, and the financial world continues to engineer complex products to satisfy investors’ needs. If restrictions are to be relaxed, it must be done with a great deal of care, based on sound economic rationale, rather than as an ideological symbol or means of gaining political capital.

This was published in Global Risk Regulator on October 28, 2022 and can be found here.