If Britain waives the rules, US banks could benefit
Removing bonus caps in the UK and undermining the Bank of England could exacerbate a sterling crisis while entrenching US dominance of investment banking.
A likely move by the new UK government to lift a cap on bonus payments to bankers has puzzled allies and enemies of prime minister Liz Truss and her chancellor Kwasi Kwarteng.
European Union rules that limit year-end bonus payments to twice a banker’s base pay remain in place in the UK, despite the formal implementation of Brexit at the start of 2020.
The cap is unpopular in the City of London, especially with the five big US banks that dominate European investment banking revenue generation and would prefer to use Wall Street compensation practices that are weighted towards bonus payments for high-earning employees.
The European rule has been in place for eight years, which gave banks of all types ample time to adjust. A relaxation of the limit in the UK might provide a marginal hiring boost to Barclays, which has gained some market share in recent years without quite cracking the top five for trading and dealmaking revenue.
However, it would have little impact on EU-based banks that still compete with the US majors for investment-banking income, such as BNP Paribas and Deutsche Bank.
And a bonus-cap removal that coincides with a market perception that the new UK administration is undermining the credibility of the Bank of England (BoE) could exacerbate the current slump in sterling.
An open attempt to undermine the central bank’s ability to set interest rates independently is unlikely. However, there is plenty of scope for conflict between the BoE and the new government
The currency broke below a floor of $1.14 that had held since 1985 on September 16, prompting a wave of predictions that sterling could fall to parity with the dollar.
Sterling is not alone in declining against the dollar as the Federal Reserve leads a belated global assault on high inflation with interest-rate hikes, and an energy crisis hits Europe and Asia harder than the US.
But by late September, sterling had fallen further in 2022 against the dollar than the 16% dip seen in 2016 after the vote for Brexit and was closing on the 19% decline seen in 1992, the year of Black Wednesday, when the UK was forced to withdraw from the European exchange-rate mechanism.
The current volatility in leading currency trading pairs is giving a boost to all banks that remain active foreign-exchange dealers, though any notable market shifts can come with unexpected consequences. For example, Barclays will face a higher bill in sterling terms this year for bonuses paid in dollars to its New York-based dealers.
A rise in FX volatility can also turn into too much of a good thing for banks. Many corporates have been forced into emergency hedging of FX risks by the price swings that have accompanied the strengthening of the dollar against other currencies.
However, some of the most sophisticated corporate end-users of hedging strategies are starting to balk at the prices they are offered by banks for currency derivatives.
The combination of a surge in trading volatility with a decline in cross-border corporate dealmaking is also unfortunate for banks. Niche derivatives trades such as contingent FX and rates hedges for companies that are making foreign acquisitions have been a welcome source of profit for banks in recent years, as they are often conducted at relatively generous bid/offer spreads on large nominal takeover amounts.
That business has fallen this year, despite interest from some foreign buyers in taking advantage of the relative cheapness of assets in countries including the UK, given the decline in sterling.
Daniel Pinto, president of JPMorgan, warned in September that investment-banking fees for the third quarter for his firm – the global leader by revenue – could be down by 50% compared with the same period last year. Merger advisory work is holding up better than some contributors to the investment-banking fee pool, such as IPOs, but relatively few cross-border deals that need accompanying FX and rates hedges are being completed.
UK-based investment bankers in most business lines may accordingly be happy to have 2022 as a year when they can rely on their high base salaries to cushion the blow of lower performance-related bonuses, even if compensation practices change from 2023.
The bigger question is whether a broader push to reduce the regulatory burden in the UK will deliver a meaningful boost to financial market volumes – and related tax revenue – or further undermine confidence in an economy that is looking very shaky.
Truss and Kwarteng are longstanding political allies who first drew widespread attention in 2012 when they were among five co-authors of a book called Britannia Unchained, which recommended lower taxes and lighter regulation as a path to growth.
The short book is best remembered for a line condemning British workers as “among the worst idlers in the world”. When Truss was asked about the quote during the recent campaign to succeed Boris Johnson as UK prime minister, she blamed one of her co-writers – her friend turned rival Dominic Raab – for its inclusion, in a demonstration of the ability to deflect responsibility that is necessary for any successful political career.
Truss also used the Conservative party leadership campaign to say that she would review the BoE’s mandate if she became prime minister.
An open attempt to undermine the central bank’s ability to set interest rates independently is unlikely. However, there is plenty of scope for conflict between the BoE and the new government.
The central bank’s supervisory arm, the Prudential Regulation Authority, is due to publish details in the fourth quarter of its plans for implementation of the Basel 3.1 package of banking capital reforms that has been moving slowly towards adoption since being agreed in principle after the 2008 financial crisis.
An attempt to water down aspects of Basel 3.1 implementation in the UK would fit well with the new government’s goal of establishing the country as a haven of light regulation, while making life difficult for the BoE officials who have been working for years with their counterparts in other regimes to agree the details of new standards.
The BoE could also find itself in a strained relationship with the UK government over the impact of likely tax cuts and borrowing increases on inflation, as it joins other central banks in attempting the challenging task of tightening monetary policy without exacerbating a likely move towards recession for major economies.
Another fall in sterling after the Fed delivered a 75-basis-point rate rise on Wednesday indicated that the BoE will have to match US hikes or see a further slump in its domestic currency.
Removal of the cap on bonuses for bankers will not have a meaningful impact on the UK’s finances, but it does seem likely to have a side-effect that its beneficiaries may not welcome: a return to the spotlight.
Truss described her agenda of cutting financial regulation as “a key part of the levelling up agenda” for the UK economy in a speech in New York on Wednesday. That virtually ensures that bonuses for bankers will regain a prominence in the national political debate that had faded along with memories of the impact of the 2008 financial crisis.
It is almost enough to make a City of London banker brave the higher cost of foreign travel in sterling terms and spend some of that bonus money outside the UK.