European bonus caps won’t see the light of day

FORTUNE — The European Union and Switzerland would be wise to rethink recently proposed policies restricting bonus payouts. The new rules, which cap bonuses for banking employees in the EU and for all employees of publicly-traded companies in Switzerland, could have dire economic consequences that could ultimately gut the profit centers of banks across the Continent. Banks from London to Berlin to Zurich are now scrambling to find ways to circumvent the new rules, but it may be easier to simply abandon Europe altogether and move their operations to Wall Street.

The new rules restricting banker pay seem so harsh that many on Wall Street and in the City of London — Europe’s financial hub — have a hard time comprehending them. In an effort to “curb excessive risk-taking,” EU ministers voted last week to restrict “banker” bonuses to a ratio of 1:1 (100%) to their base salary, with a maximum salary-to-bonus ratio payout of 1:2 (200%) if approved by a supermajority of the bank’s shareholders. Then over the weekend, Swiss citizens delivered a surprisingly callous blow by voting overwhelmingly in favor of a referendum, which among other things, restricts bonus payouts of almost any kind — from signing bonuses to so-called “golden” parachutes — across all industries, including its legendary banking sector, to no more than 200% of base pay.

Adding extra salt to the wound, EU bureaucrats have designed the new bonus caps to reach far beyond their jurisdiction by forcing both foreign banks operating in the EU, as well as EU banks operating abroad, to adhere to the policy — regardless of the nationality of the employee. So the rule will apply to an American citizen working for Deutsche Bank (DB) on Wall Street as well as a French citizen working for Goldman Sachs (GS) in Frankfurt.

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“There will be no exceptions,” Othmar Karas, an Austrian member of the EU parliament, who helped draft the new rule, told reporters last week in Brussels. “It goes for all banks inside and outside the European Union and for all foreign banks inside the European Union.”

It appears that the Swiss law will impact all public Swiss companies as well as their foreign subsidiaries. That includes pharmaceutical giants like Novartis (NVS) but also the big banks like UBS (UBS) and Credit Suisse (CS), which have extensive operations on Wall Street and across the globe.

There are a lot of unknowns here, but it is really hard to see how these rules could get any worse for the financial industry. The EU rule as written seems to just impact “bankers,” which is defined as anyone who is a “risk taker” at a bank. But the EU isn’t stopping there. They are now looking to extend the bonus-busting rule to cover the entire financial sector, including hedge funds and private equity firms, in legislation to be taken up later this year. As for the bankers, EU finance ministers are meeting Tuesday to hash things out with a final vote slated for the EU parliament in April. The law is expected to go into force in January of 2014.

The Swiss law appears to just impact firms that are publicly traded (on both Swiss and foreign stock exchanges), so private companies and small investment houses look immune. The Swiss government needs to draft a resolution based on the referendum, which will then be voted on by the Swiss Parliament. A lot could change there, but a draft law needs to be presented in one year’s time. Implementation, though, could stretch out to as late as January 2016, according to a person close to the situation in Bern.

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Finance ministers from the EU debated the rule in Brussels, with George Osborne, the U.K.’s finance minister, arguing that such a cap, if implemented, would be highly destructive to Europe’s financial industry. London has a lot to lose here. The bonus blocking by the Continent threatens its financial industry, which at last count contributes around 10% to Britain’s GDP and 12% to its tax revenues. But only a simple majority is needed for this law to move forward, which it seems certain to do.

The U.K. is taking this all very personally — and they should. Instead of trying to support London’s nascent banking recovery, the EU, led by, of course, France, is effectively trying to smother it in its crib. So, yes, while the City’s bonus pool is but a shade of what it once was (11.5 billion pounds in 2008 vs. 4 billion pounds last year), it could have rebounded at some point in the not-so-distant future, breathing new life in the City, which has lost a third of its workers since the crisis started in 2008.

“This is possibly the most deluded measure to come from Europe since Diocletian tried to fix the price of groceries across the Roman Empire,” Boris Johnson, London’s colorful mayor, who studied the Classics at Oxford, said in a statement. “Brussels cannot control the global market for banking talent, Brussels cannot set pay for bankers around the world.”

What the French and their allies in Brussels don’t seem to understand is that this will also have a major impact on their own banks as well, especially firms like Société Générale, BNP Paribas and Calyon, all of which have extensive trading operations that depend heavily on bonuses to drive performance. Sure, you can raise the base pay of many employees at the banks to cover for the lost bonus pay (which presents a whole new set of incentive issues), but it is impossible to do that for traders who live and die by their bonus.

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So what’s going to happen now? The fear is that this will cause the banks to relocate abroad to Wall Street or to tertiary financial hubs in places like Singapore or Hong Kong. The big winner in the relocation game is clearly Wall Street, not just because those other financial hubs are located far away from most European bankers’ home countries in the northern hemisphere, but because investors trust the U.S. capital markets above all others.

To be sure, if the bonus cap is implemented, the financial industry in Europe won’t go away overnight — just the real profitable part of it, the investment banks and the broker-dealers. You can pay a credit analyst a big salary with no bonus, but you can’t pay an investment banker, who is basically a travelling money salesman, a big salary — where’s the incentive to hustle? That also goes for traders who will basically have zero incentive to ramp up the risk to make the big bucks. EU regulators would say that kind of behavior is exactly what they are trying to stamp out with the new rules, but it is also where the bank makes almost all of its profit.

Like it or not, the traders who “gamble” and “front run” their clients provide the bulk of a bank’s revenue. The banks like to hide this dirty fact by presenting investors and regulators with black box financial statements that reveal everything except how they make their money. But it is largely understood, at least among people in the financial industry, how the sausage is made. Take away the employees’ bonus-motivated parts of the bank, and you will be left with tellers and back-office staff.

Given this reality, it is hard to see how either the EU or the Swiss bonus rules will ever see the light of day. They would cause the slow death of what continues to be, despite overregulation and higher taxes, a very profitable industry for Europe. Businesses linked to the banking sector, especially the high-end property markets, could take a dive. In London alone, 27 billion pounds ($42 billion) worth of banker bonus cash has been spent on real estate in the last decade, according to data compiled for Reuters by property firm Savills. It’s hard to imagine what would happen to the U.K. economy if property prices would (again) collapse in London.

Furthermore, what would French tax rolls look like after its major banks spin off their trading desks and their bankers, those that are left, relocate to New York. And what would Switzerland be without its legendary banks? Chocolate, cheese, and watches won’t keep its obnoxiously coddled population warm on all those cold nights.

“The European Commission has come up with a vengeful piece of retribution against the continent’s banking sector that will have New York, Tokyo, and Singapore rubbing their hands in glee,” Andrea Leadsom, a Conservative member of the U.K. Parliament and a former banker, wrote in the Financial Times last week.

Representatives from Goldman Sachs, Morgan Stanley (MS), Barclays (BCS), Credit Suisse and UBS all refused to comment on how they are dealing with the news. Sources inside the banks, though, tell Fortune that the EU law is of “major” concern and that they fear that all the uncertainty could “crush” employee morale. As for bankers on Wall Street “rubbing their hands in glee,” that remains to be seen just yet.

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