New bankers’ bonuses regulation “destined to fail”

New European Union (EU) rules aimed at curbing bankers’ bonuses have sparked alarm in the City’s hedge fund industry which says there is no need for reform in their part of the banking sector.

The outcry follows plans to introduce a new EU later this month in a bid to curb excessive bonuses amidst public anger over huge payouts by the banks – many of which were bailed out using taxpayer money.

EU banking supervisors are to introduce binding rules on the balance between fixed salary and bonuses in a banker’s pay packet.

The City is home to 80% of Europe’s hedge funds companies who say that if the legislation goes through as it stands they will be being punished for the mistakes of a different part of the banking sector: those banks which look after people’s money and had to be bailed out, whereas the hedge fund industry, which deals primarily in investment and with the private sector, already has sufficient regulation.

Although exact details are yet to be announced, David Gale of Sloane Robinson Hedge Fund & Management Assets believes that any attempt to apply the regulatory mechanisms to hedge funds as currently proposed is destined to fail: “There’s a general lack of understanding by the public as to what a hedge fund actually is. The problem is that it’s a very generic term and different companies can approach it differently. It depends how you invest.”

He said: “Hedge funds are investment banks and are private companies, whereas it’s normal banks who are expected to look after your money rather than invest it.”

According to Mr Gale, for over 80% of the hedge fund market the need to manage bonuses relevant to risk-taking is “somewhat an irrelevance”. He does admit a small portion of the industry may take imprudent risks.

Currently there is no mechanism to tie in long-term success with short-term success explained Mr Gale: “Bankers aren’t paid ‘real cash’ when they receive their bonuses, they’re instead paid for successful short-term risk-taking that two or three years down the line is failing.”  The end result is huge long-term risk for banks.

Investments are similar to betting on a horse; you can pay a little and get a lot in a high risk bet, or pay a lot and get the same amount out of low risk bets. This is directly linked into the remuneration system with hedge funds, but with banks there’s a huge difference.

Mr Gale takes the example of his own company to explain further: “We use watermark principal that means clients get money back when we make more than they invest, but they don’t pay out when we make back less, which means we get paid less when that happens, so the incentive is there not to take too much risk on: the main benefactors are the hedge fund managers themselves so it’s strongly in their interest to make good decisions.”

He believes the rest of the banking sector can learn a lot from hedge fund companies and says they need to tie in risk-taking to remuneration with longevity. He said despite what people think there’s no need to cap bonuses, but rather look at how it’s paid to the individual –which is what new EU banking regulators are now beginning to do.

Mr Gale said they’re heading in the right direction: “Link pay to the wellbeing of the company as with hedge funds: introduce a claw-back mechanism for when the company does badly, and part of their pay should be in company shares rather than actual cash.”

He said hedge fund companies needn’t be worried about the new legislation: “What we’re more likely to see is a much-watered down version of the regulation applied to the banks being applied to hedge funds. The proposed regulation is simply not possible to apply because of the very nature of hedge funds. Risk-taking is already linked to long-term gain rather than short-term risk, so the risk-taking profile of hedge funds is much more sound than with other banks.”

He also said that going forward the banking system’s capital needs to reflect risk. But again, due to the nature of hedge funds companies (who have all their capital up front) this isn’t an issue they need to be worrying about.

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