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Bail-inable bonuses: a step in the right direction

A proposal in the Liikanen report that bankers should be paid partly with bail-inable debt is intended to build on existing attempts to align decision-making with long-term performance. At first glance, the idea might appear unfair, but it could help keep management on the right track in times of crisis.

Tuesday's banking stability report from Erkki Liikanen's expert group suggested that in addition to being paid in shares, bankers' bonuses should be paid in bail-inable debt.

The Capital Requirements Directive III already states that at least 50% of a bonus should be paid in shares or other instruments. That is expected to rise to a minimum of 50% equity under CRD IV. Liikanen’s report says that senior management should receive a portion of their bonus pay in the form of bail-inable debt. That would "align decision-making with longer-term performance in banks”, he says.

Some might think this is the wrong incentive, as it makes it look as if there is no longer much upside to be gained from exceptional performance.

And in bad times, so long as the bank just avoids the trigger, a banker paid in bail-in notes will still get paid — even though his employers, the shareholders, could be all but wiped out.

But it’s better than the alternative. Equity in a troubled bank is a call option on survival — and owners are therefore incentivised to take on even more risk and increase volatility. On the cusp of solvency, doubling up on risky bets might suit shareholders but brings only additional risk to bondholders.

Shareholders might not like the idea, but giving management interests in both sides of the coin could balance out some of the short-termism that regulators and the public complain is afflicting our banking system.

There might be some perverse results. Management figures that lead a bank close to failure could still end receiving an award as bail-in is supposed to only be enacted once equity has been wiped out, and if not all of a bank’s bail-inable funds are needed, holders of that class of debt could still get some money back, rather than losing everything.

But bankers with a bonus in deferred equity and bail-in debt would be more minded to look after the interests of investors across the capital structure in a stress situation.

The proposals need some work, but Liikanen’s report is not a directive — its job is to promote discussion. But when the European Commission gets round to discussing it, it would do well to bear in mind that such a structure would actually penalise bankers if government money were ever needed to help a firm.

And if that isn't encouragement enough, someone should remind the policymakers that payment in equity could promote gambling the firm. After the subprime crisis, that ought to do the trick.

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