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How to Cap a Banker's Bonus

Europe gets it just about right by not strictly capping pay but regulating how the payout wends its way to a banker's pocket.

A week or so before the U.S. Senate passed the biggest Wall Street overhaul since the Depression, the European Parliament voted for some of the world's strictest rules on bankers' compensation. These "bonus caps" should be imported quickly to Washington, while the spirit of reform is still fresh.

Next year EU bankers will start taking home an up-front limit of 30 percent of their bonuses, deferring the rest for three to five years. They risk losing some or all of the remaining compensation if their investments go sour, or if their banks go bust. (Some large bonus packages will be limited to 20 percent payouts up front.) The idea is to tie the financial industry's exorbitant bonus packages to performance — to keep bankers from gambling the health of a bank itself, then walking home with the loot.

Limits are a good idea because the culture of outrageous bonus payments encouraged the sort of high-risk speculation that brought down so many major banks — and nearly the Western credit system — in 2008-09. "The current bonus system in the financial sector encourages the behavior that wrecked our economy," writes researcher Sargon Nissan at the U.K.'s New Economics Foundation. "[It] breeds short-termism and speculation. It pushes bank staff into overstretching their institutions' capacity to bear risk."

The main argument against limits, of course, is that ham-handed government interference in the free market of bankers' pay will drive talent to more lawless frontiers, like Asia or Switzerland. Sharon Bowles, chairwoman of the Economic and Monetary Affairs Committee in the European Parliament, gave a tart retort to this notion. "I say good riddance," she wrote recently in Bloomberg Businessweek. "Go play poker with the Swiss franc, but not anymore with the livelihoods of 500 million European citizens."

The subtlety of the EU solution is that it's not a true limit. Banks can still pay traders and executives as much as they care to fork out — the rule just spreads those millions over several years in a kind of escrow account. It has the beneficial side effect of ensuring that a bank will maintain a larger bundle of cash in case its investment arm (or the whole credit system) tanks. Billions of euros in withheld bonuses will therefore offer precisely the right insurance against the day when a government might be called on — again — to pour massive amounts of "liquidity" (read tax money) into a stumbling finance industry.

There's nothing wrong with bonuses: They're just incentives, which can be organized by a firm, an industry or a government to nudge individuals toward the productive and the good instead of the suicidal.

So far America just has toothless "guidelines" from the Fed that more or less agree with the European ideas. And the ideas aren't un-American: A Harvard study, "The Wages of Failure," from late last year argued that executives working for Lehman and Bear Stearns had solid bonus incentives to run their banks to collapse in 2008. "Firms and regulators would do well to devote considerable attention to examining how the design of performance-based compensation can better link the payoffs of executives with long-term results," write the authors.

Europe has listened, and the new regulations could change the banking landscape in an unexpected way. They won't send Frankfurt or London traders to Wall Street in search of strictly fatter bonuses, though it might send them to Wall Street in search of quicker bonuses. President Obama has toned down his rhetoric about financial compensation since his flash of anger in early 2009; now he'll have to decide whether America wants those sorts of people moving to Manhattan.