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Should Bankers Be Capped or Caged?

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LONDON -- It hasn't been a good time to be a banker. 

On Tuesday last week, the European Parliament overwhelmingly supported plans to cap bankers' bonuses. The same day, Andrew Bailey, the head of the new Prudential Regulation Authority, told the Daily Telegraph that it was "more than odd" that chairmen and chief executives of failed banks had avoided formal charges.

Bailey said there was a flaw in the system if the trail of evidence didn't lead to the boardroom. Shadow Business Secretary Chuka Umunna went further, saying some bank bosses should go to jail. It signals a tougher regime.

Stick and carrot
So more stick and less carrot. Both will be popular, and bankers can only blame themselves for the popularity of banker-bashing.

But there's a danger in making bankers too risk averse. 

Banking is all about balancing risk and reward, and if the pendulum swings too far in the opposite direction, customers, investors -- and ultimately the economy -- will suffer. Especially vulnerable are the three banks most dependent on the U.K.: Barclays  (LSE: BARC  ) , LloydsBanking  (LSE: LLOY  ) , and Royal Bank of Scotland  (LSE: RBS  ) .

The bonus cap will bite first. The measure that George Osborne stood alone, Canute-like, to oppose will come into effect next year. Bankers' bonuses will be capped at 100% of salary, or 200% if shareholders agree.

The measure is aimed at investment bankers, who are egregiously overpaid. But that's the fault of price-insensitive finance directors who overpay for the safety of a big name. It's the customers who distort the market.

Law of Unintended Consequences
Regulation will fall foul of the Law of Unintended Consequences. Rather than reducing bankers' remuneration, base salaries will rise. That increases fixed costs, likely to hit hard at Barclays, with its big investment-banking operation. It may provoke RBS to shrink its investment bank even further.

The larger global footprints of HSBC  (LSE: HSBA  ) and Standard Chartered  (LSE: STAN  ) may insulate those two, but both could relocate. StanChart's boss has been vociferous about bonuses and has made muted sounds about relocation. HSBC ruled that out, but then it has form.

Captain Mainwaring
Sending people to prison for breaking the law sounds eminently sensible, but transporting bank management back to the 1940s, encouraging them to act like Captain Mainwaring rule-followers, could backfire.

LLoyds, always a conservative bank, was hammered most by the PPI mis-selling claims. Selling PPI to the wrong people is inexcusable, but the concept of creating a new product to protect customers from the risk of unemployment and generate a new revenue stream was a good one. The danger is that boardrooms will be too scared to pursue new initiatives.

But that's just what banks need to do. On their existing business models, increased capital requirements mean banks will struggle to earn enough to cover their cost of capital -- just achieving that is one of Barclays' new leader's objectives.

Still, banks remain in recovery mode, which gives them plenty of upside potential, but they're not without risk.

If you already hold bank shares and are looking for less uncertain stocks, I suggest you read "The Motley Fool's Top Growth Share for 2013." It describes a company that has increased or held its dividend every year since 1988. Among the banks, only Standard Chartered bears any comparison. You can download the report by clicking here -- it's free.

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