As most of you will know, the FSA has issued a consultation paper on Reforming remuneration practices in financial services. We have spent the past few weeks preparing a response. What follows is a summarized version of our document.
Having spoken to risk managers, traders, and academics, we can categorically say that not one person did not consider the FSA proposals damaging, some using harsh language.
Any policy that reduces London's attractiveness to senior executives is certain to cause damage. Compared to other financial centres, the City is particularly at risk because a high proportion of business that takes place here is not tied to the UK and could easily move to New York, Hong Kong, Paris, or other locations with more attractive tax systems. It is not easy to define in which country risk decisions are made, leading to regulatory arbitrage.
In the 1970s and early 1980s it appeared unlikely London would become Europe's leading financial centre. Frankfurt, Switzerland and Paris were favourites. Unfavourable regulation in France and Germany, combined with hostility to 'Anglo Saxon' finance ensured the City's ascendancy, and we now risk going full circle.
The question must be whether the potential damage from new regulations achieves a valid goal at a necessary price. This is disputable. If the FSA acts independently of other regulators, it risks suffering first mover disadvantages. We accept that the FSA must tread a difficult line between the howls of populist politicians and economic reality, but unilateral action will simply export jobs to financial centres who either do not regulate this, or as is so common in the EU, "work with the industry", and ignore the rules.
Clawbacks and higher base pay could increase risk taking
If a position has gone seriously toxic, risk takers may come to the conclusion that "all is lost", and thus be incentivised to play "double or quits". Since their bonuses from previous years have been put at hazard and extinguished by later losses, they may literally have nothing to lose. This of course will not a frequent response, but analyses of several rogue traders supports the thesis that this is a risk to be minimised.
The FSA also implies that bonuses account for a lower proportion of future compensation, and salaries rise. This too could increase the appetite for risk. In the absence of large bonuses, the emphasis will be on moving to the next salary level, creating an impetus for "radical" outperformance, in order to impress more senior management. The effect may be to increase risks taken above the ideal, given that ordinary risks may have limited or no effect on pay.
The FSA also recommends risk departments assume a greater role in setting bonuses, and bonuses be adjusted for risk. This is desirable, but at present risk professionals and remuneration committees are ill equipped to do this. In calling for risk adjusted bonuses, the FSA may be asking for techniques that do not yet exist. Bonus systems are so opaque they are not really understood by anyone at large firms, let alone people in risk.