Margareta Pagano: Diocletian needn't worry us, but Henry VIII should

The flawed, but rather good, EU proposal to cap bankers' bonuses could lead to a European rupture akin to the Tudor king's fallout with Rome

Here's a heretical thought for you; as a way of controlling bankers' pay, isn't the EU's plan to cap bonuses actually a rather good one? You wouldn't think so from all the hot air that is now steaming out of the City and, interestingly, from politicians of all persuasions but that's because of a visceral hatred of being told what to do by anyone, let alone European bureaucrats.

Here's why it's a better idea than at first glanwce. What the EU is suggesting is that the banks should make sure that the variable pay – the bonus – part of the package they pay to staff is limited to their salary at a ratio of 1:1. However, this can be raised to a 2:1 ratio or even higher with shareholders' approval.

Such a plan could introduce more transparency into how bankers' are paid and could benefit the industry long-term. So far, most of the opposition to the cap is that fixed costs will be pushed up because banks will pay staff more to make up for less bonus. Is that such a bad thing? If the top risk-takers in a bank are so good, why wouldn't the bank pay a higher base or maybe more in commission?

You could argue that higher fixed costs will make the banks take smarter decisions about the staff and keep a closer eye on their activities. For the problem with variable pay is that the risks shared by the bank and the employee are asymmetric.

Bad bets taken by the individual can cost the bank a fortune in losses but cost the employee nothing. Good bets are always favourable to the employee because he or she has a built-in bias towards taking risk.

Investment banks will always be highly cyclical. In good times, employees earn astronomical pay; typically total pay has been 60 per cent or more of overheads. This didn't matter when investment banks were run as partnerships but now most are part of retail banks. Old habits die hard and the investment bankers continue to earn too much as the bonus figures from RBS and Lloyds showed last week; even though the banks lost money.

So the EU's new proposal strikes right at the heart of this conundrum; how to balance risk and reward more fairly. Yet it's a flawed plan: the EU shouldn't be able to tell companies in the UK – or in any other country for that matter – how much to pay their staff either here, or in overseas offices such as New York or Singapore. How they must be rubbing their hands.

The UK is partly to blame. If investors had been quicker to lobby the bosses of banks to cool down sky-high bonuses after the crash, we might not be in this mess. If George Osborne and his Treasury team had been sharper in their diplomacy behind the scenes we might have won over more of our allies such as Sweden and the Netherlands to help negotiate a better deal.

Once again, the UK's diplomatic skills have been shown to be wanting when it comes to managing our European affairs. If the proposal does go through, the City – as big as all the financial centres in the EU put together – will lose some business. But the more lasting impact is likely to be on our relations with Europe and it will be intriguing to see how George Osborne gets on at this week's finance ministers' meeting.

Boris Johnson, London's Mayor, described the plan as the most deluded measure to come from Europe since Diocletian tried to fix the price of groceries across the Roman Empire. It could prove worse than that: Henry VIII broke with Rome over a Queen's head.

Who knows, maybe this time it's a bankers' cap that triggers the UK to up sticks and march out of Europe once again.

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