A misguided cap on Bankers’ bonuses

Alexander Pannett 3.30pm

And so they are marching again. The restless European Parliament is finally getting its revenge against the unscrupulous “Anglo-Saxon” capitalists in London. It has voted to reign in bankers’ bonuses, reducing permitted amounts to the base salary of bankers.

The rules would apply to Europe-based employees of any bank, as well as to staff of European banks wherever they are located. That means a Barclays trader working in New York would be subject to the cap, as would a Goldman Sachs banker based in London.

I am sceptical of the bonus cap’s effectiveness. The reduction of bonuses will mean that remuneration will be granted in the form of higher salaries.  This adds inflexible costs to financial institutions which, in a crisis, will have to reduce head-count rather than being able to cancel bonuses in order to preserve capital levels. It will lead to the increased use of temporary contracts as banks seek to maintain flexibility.

Increased salaries, rather than bonuses, also moves the City away from performance related pay. Bankers will receive salaries despite the poor risks and mistakes they make. Failure will be rewarded. This is also unnecessary as recent claw-back regulations have been introduced which are designed to ensure remuneration is performance linked. Bankers whose trades made losses in the long-term would see their bonuses reclaimed, which incentivises bankers to consider long-term risks. Higher salaries do not ensure that bankers mitigate risks.

I also have an intrinsic revulsion at politicians who interfere with business for political or even emotive reasons. Do these politicians understand or even care about the effect that these changes will have on London’s financial services, which is a considerable European strategic asset? I suspect they do not.

Despite my above concerns, we must not ignore the considerable antipathy that the British public holds for the financial sector. It is almost satirical that RBS, which was saved with taxpayer’s money, has posted 2012 losses of more than £5 billion whilst paying out £600 million in bonuses last year. This European cap on bonuses may be mis-guided but that does not mean the City now smells of roses.

A reform of the bonus culture may indeed be needed, such as substituting locked-in equity for current bonus structures or changing the criteria for awarding bonuses so that they are more strongly linked to the overall performance of a financial institution. However, this European cap on bonuses is not helpful and will be counter-productive as it harms the international competitiveness of one of Europe’s few remaining engines of economic growth. The prime minister is right to resist.

Follow Alexander on Twitter @alpannett

Dark Satanic Mills or Green and Pleasant Land?

Matthew Robertson 10.30am

If I asked you to describe a generic duck, you would probably say it had a white covering, yellow feet and a beak. 

Let’s imagine that there are rules for what a duck is and that those rules are the above. By this definition a dog covered in white with painted orange feet and a beak planted on it would be classified as a duck. Everyone knows it is a dog but the rules state that it’s a duck.

This illustrates how misguided playing by the rules can be. It is from ‘The Smartest Guys in the Room’, a book about the rise and fall of Enron. I will not go into the intricacies of the Enron scandal but it was their ability to manipulate the rules that led to their downfall, in particular accounting ones.

You don’t need to be a comedian to know that there are many ways individuals and companies can use tax rules to minimise their liability but there is less understanding of how national governments can ‘bend’ the rules to show a better position.

International companies adhere by International Financial Reporting Standards (IFRS), the main bedrock of these standards is a principal called ‘Accruals Accounting’ where economic events are recognised by matching revenue to expenses at the time in which the transaction occurs. As opposed to when it was paid or received.

Governments are not obliged to use accruals accounting and so are more susceptible to manipulation and because they do not have the same audit regulations, there is a lack of transparency. It is this lack of transparency that allowed the Greek government to hide its liabilities which were only revealed when the new government came in. In austere times the incentive to reduce the deficit is higher than ever.

One of the key methods to reduce a reported deficit is to keep liabilities off government books. The IMF mentions that when Eurostat (the statistical office of the European  Union) went through Greece’s accounts, it reclassified transport and other companies as belonging to the general government and so increased Greece’s reported debt by  €18.2 billion. It is not clear whether the difference would have been a deciding factor in allowing Greece to join the common currency area but it is clear that false reporting allowed the government to borrow more than it should.

Which is why I have been interested in the latest release of Whole Government Accounts (WGA) which were published on July 12th for the year ending 31 March 2011. As described by the Treasury:

'WGA is based on EU adopted International Financial Reporting Standards (IFRS), the system of accounts used internationally by the private sector, as adapted or interpreted for the public sector context, and is similar in presentation to private sector accounts. It complements the National Accounts figures, produced by the Office for National Statistics (ONS), by providing a set of financial statements based on standards familiar to users of private sector accounts.'

The release of the accounts to 31st March 2011 is only the second set of financial statements of this kind and so this is the first time that a comparison can be made between 2009/10 when Labour were in power and 2010/11 when the coalition came in.

The biggest number that hit me was that government borrowing and financing increased £126bn which reflected the need for higher borrowing whilst tax receipts fall short of public spending. Because of this, debt interest increased by £13bn to £44bn in the year. Despite the rhetoric of trying to tackle the deficit, these figures show how little was achieved in this respect in the first year of the coalition.

Most of that analysis has been well documented in the financial press but what about the dogs dressed as ducks?

The biggest differences between the government accounts and the WGA relates to public service pensions and Private Finance Initiatives (PFI).

Note 1.47 in the WGA:

"WGA is prepared on an accruals basis in accordance with accounting standards. It takes into account all future pension liabilities from the service already provided by past and current public servants. Therefore, WGA net liabilities include the net public service pension liability for public sector pension schemes. “

“There are similar differences between the WGA net deficit and the National Accounts current deficit in relation to: interest on pension liabilities of £47 billion which is included in WGA but not National Accounts.”

The other big difference is in the treatment of PFI, WGA records more PFI contracts as liabilities of the public sector than the National Accounts do. This is primarily because of the inherent subjective way of measuring PFI contracts. The main objective of PFI contracts was to transfer risk from the public sector relating to the operation of certain assets. Naturally, there will be judgements involved in determining the balance of risk and reward from each contract. One of the criticisms of New Labour was that they changed the calculation of comparing PFI to public sector procurement so that the risk assessment became far more subjective and arguably easier to manipulate.

The WGA tries to overcome this difficulty by recognising PFI contracts by judgements on the balance of control, as the subjectivity of control is a lot less than the subjectivity of risk.

The WGA accounts are far from perfect and they do not provide a complete assessment of the UK government’s fiscal position. It is not beneficial that the March 2011 accounts have only just been released and there will be probably be a number of adjustments once these figures have been audited. But they are an attempt at providing a greater level of transparency and to subject government to the same accounting rules that worldwide corporations adhere to.

The measurement of government success should never be restricted to how it performs on accounting/financial measures, a problem inherent in GDP statistics. But there has to be a consistent and reliable basis on which to judge how much money a government can raise and spend.

The UK is the first to try and attempt to consolidate the whole of the public sector on an accruals basis and it will be interesting to see how this will be received internationally. After all, no one wants to see a dog dressed as a duck.

Follow Matthew on Twitter @FlatFootTory

A Reply to Charles Moore…

Daniel Cowdrill 6.40am

The collapse of the banking system and the recent phone-hacking scandal have led some to question the wisdom of market forces.  In a now famous piece in the Telegraph, Charles Moore considers whether the Left were right all along about the free market being a ‘set-up’ designed to benefit only the rich. After recent events, ‘Everything is different now’ - but is it?

 In the post-war period the Conservative party was haunted by the memory of the ‘hungry thirties’ - a period of mass unemployment. This was compounded by election defeat in 1945, viewed by many on the Right as a delayed verdict on their economic policies during the wars.

Across public policy, but especially with the nationalised industries, industrial relations, and economic management, the Conservative party ceded ground to the left. Churchill focused his fading energies on establishing his position as an international statesman. The grand old man was not prepared to risk his reputation over a battle with the unions, and every effort was made to avoid confrontation. Tories fond of State planning, like Harold Macmillan, sidelined before the war yet profoundly affected by his time as a MP in the industrial north-east, were now promoted.

But had things really changed that much? As Andrew Roberts has argued, instead of treating the 1945 election as the freak result it was, Tory politicians were emasculated by it. They drew the false conclusion that it represented a turning tide which they were unable to hold back, even if they had wanted to.

There is a danger of the same happening again. Most Conservatives still believe that spontaneity is preferable to state direction, and that variation and competition lead not just to higher productivity but to a richer society. I assume that Charles Moore still believes these things. What disappoints me is his willingness to buy into a left-of-centre narrative of recent events.  We need to beware the false conclusion that confidence in the free market has collapsed.

 Some of those who benefited the most have certainly abused their power. Rupert Murdoch, once the heroic defender of a free press versus union intimidation, has presided over (unknowingly or not) allegedly corrupt and illegal practices at some of his newspaper titles. Bankers made reckless investments tied to the US subprime market. Some of our largest banks have been humbled. These are indelible stains on capitalism’s record but the lessons of the post-war period stand.

Between the end of the Second World War and 1980 the British economy was in relative decline. Harold Macmillan’s claim that we had ‘never had it so good’ and Harold Wilson’s ‘technological revolution’ belied lacklustre productivity, rising inflation, and deteriorating industrial relations. Mrs Thatcher’s governments changed course and Britain began to gain some lost ground.

Relatively unfettered markets and a relatively light, normative tax regime are a source of much higher growth and technical innovation than nationalised industries and are more compatible with democratic values than centralised bureaucracies.  The free movement of capital allows for the more efficient allocation of resources in an economy.  This allows for more entrepreneurship, innovation and job creation.  In a globalised market, those economies that are uncompetitive and protectionist will spiral into high unemployment and low growth, leading to sovereign debt difficulties, as Southern Europe is discovering today and Latin America discovered a decade ago.

In the 1970s, a new generation of economically liberal Conservatives made a vigorous case for de-regulated markets. As the economy struggles to adjust to recent hardships, this is the worst possible time to cede ground to the Left and thus allow the state and not the market to direct the economy.

Read more on this subject:

'I'm starting to think Charles Moore might be right, but not quite', by NIk Darlington (25 July)

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