This report famously contains various ring-fencing proposals which could be detrimental to capital-heavy fixed income trading businesses at European banks (take note Deutsche, BNP Paribas and SocGen). It also contains a well-flagged suggestion that part of bonuses ought to be paid in the form of so-called bail-in bonds. It revives the popular EU notion that bonuses should be capped – preferably at 100% of salaries. And it contains an all-new idea: bonuses at EU banks should be restricted to the value of dividends paid to shareholders.
Equating bonuses to dividends
It’s not clear where the bonus-dividend axis came from, but it could yet catch on. The notion that greedy bankers shouldn’t be paid more than long-suffering shareholders has simplistic appeal. But what would it mean in reality?
A brief look at the recent dividend/bonus history of Barclays suggests it would mean a massive reduction in bonuses.
In 2011 Barclays’s total bonus pool was worth £2.6bn. The bonus pool at Barclays Capital alone was worth £1.5bn (click thumbnail below for full breakdown). At the same time, Barclays spent a mere £728m on dividends. If the EU’s bonus-dividend arrangement were in place, Barclays’ bonus pool would have been 70% less than it actually was last year.
The situation would have been even worse at RBS, which hasn’t paid a dividend to its ordinary shareholders since 2008. Last year, RBS paid total bonuses of £785m and bonuses of £390m to bankers in its Global Banking and Markets division. Under the EU’s proposals, all of this would have been disallowed.
Bail-in bond bonuses
The EU’s suggestion that a portion of bonuses might be conferred in the form of bail-in bonds, which would be first in line to take losses in the event of a redundancy, has marginally more appeal – depending upon your opinion regarding the direction for banks’ share prices.
RBS bankers have been paid in a similar form of subordinated debt for the past three years. As a result, they’ve been protected from a more than 50% drop in RBS’s share price and have collected annual interest payments of 3% in the process.
“Being paid in a bail-in bond wouldn’t be too bad,” one banks analyst tells us. “However, it does depend upon the vesting period and how easily you could sell the bonds on after vesting – otherwise you’d be stuck with an illiquid credit instrument.”
As conceived by the EU, it seems bail-in bonds could indeed be quite illiquid: the Liikanen report suggests restrictions on who can own them, with banking organisations forbidden from purchasing the bonds in an effort to reduce systemic risk.
The clear downside of bail-in bonds is their removal of any opportunity to benefit from increases in a bank’s share price. This could be a shame. JPMorgan analysts think most European banks are marginally under-priced, with Barclays offering potential gains of 15% and BNP offering potential gains of potential gains of 12%. It’s not clear how the proposals would effect US banks’ subsidiaries in the EU, but US banks shares could also be conceived as a good bet – Morgan Stanley, for example, is currently trading at only 66% of total book value according to analysts at Alliance Bernstein. If Morgan Stanley’s London bankers were paid part of their bonuses in bail-in bonds they’d lose out on a potential 66% increase in the value of bonuses paid in equity.
Will it happen?
For the moment, it’s unclear whether the Liikanen Report will amount to much anyway. Peter Bevan, a partner in the financial regulation group at Linklaters, points out that it merely contains proposals. “The report contains a lot of recommendations that would need to be brought forward as legislation by the European Commission and Michel Barnier. Any legislation would need to pass through the European Council and the European Parliament, so we are some way off any of this coming into effect.”