The G20's compensation agreement is irrelevant. The agreement states regulators should limit bonus payments "when it is inconsistent with the maintenance of a sound capital base." In other words, if banks don't have enough capital, then regulators can limit payouts. The second part of the compensation agreement decrees that a substantial part (40%-60%) of senior bankers' bonuses will be deferred. This part of the agreement is equally worthless because it is already standard practice at most banks.
But it is much more important to address the mechanics of regulatory arbitrage that can take advantage of "risk-based" capital. Regulators must address the arbitrary calculation of tier I capital. Allowing banks to judge the riskiness of their own assets will never be adequate because risk can easily be mispriced. The FDIC's Sheila Bair criticized Basel II in 2007 for this exact reason::
(I wonder if European emphasis of executive compensation versus capital requirements is driven by a different societal perspective or industry structure. European banks generally have much lower capital ratios than American ones. Furthermore, this capital is often hybrid debt with no real ability to cover losses, as capital is supposed to. Some European banks even include certain deferred taxes in their tier 1. How can deferred taxes ever be used to cover losses?)
Finally it is crystal clear: bank regulation after the greatest financial crisis since 1929 will focus on higher, risk-adjusted capital requirements. The general consensus is that regulators will increase capital requirements from 4% of total assets to 8% and hasten the implementation of Basel II.
But it is much more important to address the mechanics of regulatory arbitrage that can take advantage of "risk-based" capital. Regulators must address the arbitrary calculation of tier I capital. Allowing banks to judge the riskiness of their own assets will never be adequate because risk can easily be mispriced. The FDIC's Sheila Bair criticized Basel II in 2007 for this exact reason::
Bair is right. Lehman had 11% tier 1 capital when it failed, more than twice the requirement. Its total capital ratio was at 16.5%, well above the 10% regulatory threshold (see here). Under the new compensation and capital regulations, Lehman right before its collapse would be able to pay its executives whatever they liked, as long as they paid 50% of it in stock. It would also have sufficient capital.
There are strong reasons for believing that banks left to their own devices would maintain less capital -- not more -- than would be prudent. The fact is, banks do benefit from implicit and explicit government safety nets. Investing in a bank is perceived as a safe bet. Without proper capital regulation, banks can operate in the marketplace with little or no capital. And governments and deposit insurers end up holding the bag, bearing much of the risk and cost of failure. History shows this problem is very real … as we saw with the U.S. banking and S & L crisis in the late 1980s and 1990s. The final bill for inadequate capital regulation can be very heavy. In short, regulators can't leave capital decisions totally to the banks. We wouldn't be doing our jobs or serving the public interest if we did.
(I wonder if European emphasis of executive compensation versus capital requirements is driven by a different societal perspective or industry structure. European banks generally have much lower capital ratios than American ones. Furthermore, this capital is often hybrid debt with no real ability to cover losses, as capital is supposed to. Some European banks even include certain deferred taxes in their tier 1. How can deferred taxes ever be used to cover losses?)
