Martien Lubberink on cars cheating emissions tests, Europe's love of fast, polluting cars, solutions for executive pay issues, bankers and bonuses, Dilbert & more

Today's Top 10 is a guest post from Martien Lubberink, an Associate Professor in the School of Accounting and Commercial Law at Victoria University. He has worked for the central bank of the Netherlands where he contributed to the development of new regulatory capital standards and regulatory capital disclosure standards for banks worldwide and for banks in Europe (Basel III and CRD IV respectively).

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1) On Rewards and Punishments. 

Disappointing news for those of you who own a Cayenne, Touareg, or prestigious Audi. This week, the U.S. Environmental Protection Agency and the California environmental regulator published a notification that identified these cars as emissions test cheats. 

This new twist in Diesel-gate will surely add thousands of cars to the 11 million that rely on special “defeat devices” to pass vehicle inspection tests. 

This is a major scandal for sure. Early calculations, excluding the Cayennes, Touaregs, and big Audi's, show that it caused about 60 premature deaths in the U.S. alone. Another 130 lives would be saved If Volkswagen returned to compliance. Again, this research uses U.S. data, where only 3% of the cars use diesel. In Europe, about 50% of the cars use diesel, so the death toll would likely be much higher. 

2) “Take him to Detroit!” 

Given the scale of the scandal, one would expect U.S. authorities to pay heed to this quote from Kentucky Fried Movie and make an effort to extradite the two engineers at the heart of the scandal: Ulrich Hackenberg, Audi’s chief engineer, and Wolfgang Hatz, developer of Porsche’s Formula One and Le Mans racing engines. 

I mean, U.S. authorities last week managed to extradite former Rabobank trader Paul Thompson from Australia, and they are still after Kim Dotcom. Even the mere prospect of extradition would scare the engineers, as the case of former trader and LIBOR rigger Paul Hayes shows. He avoided extradition to the U.S., and instead serves a 14-year jail term in the UK.

Unfortunately, extraditing rogue car engineers from Germany is very different. According to Bloomberg, extradition is “not a given” and the extradition process can take years. So forget that. Thus far, the two Volkswagen engineers received punishment in the form of a suspension from work. 

3) For the love of fast cars.

The reason why this scandal involves European car manufacturers is not a coincidence. Europeans love fast cars. And fast cars pollute. 

The love for cars has become part of the the regulatory fabric. A telling example is motorway speed limits. In many countries 100 km/h is the max. However, in major European car producing countries the speed limits are significantly higher: 130 km/h in France and Italy. They are virtually non-existent in Germany.

It is known that the late Prince Bernhard of the Netherlands every now and then took his Ferrari to the German Autobahn for a ride, as it is pointless to drive a fast car in congested Holland.

4) The institutionalised love for fast cars has created dynamics of its own.

If you read this lament report from the European Parliament on the state of the car industry, then it is clear that there are many things not good: a lack of competition, a lack of innovations, poor labour relations.

In short, the European car industry bears many hallmarks of an industry that is too big to fail. 

5) It’s the economy stupid! 

The reason why the diesel emission scandal unfolds now is not a coincidence either. Back in 2011, the European Commission noticed that car manufacturers were “tweaking” their cars to meet emission standards. A 2013 letter from European commissioner Janez Potočnik notices that research failed to detect any improvements in air pollution levels, which one would expect given the millions of “clean diesel” cars driving on European roads:

Knowing that there was something really wrong with car emissions, Europe could have acted more decisively. 

But it didn’t … for an obvious reason: 

6) Soon after the scandal broke, the European Commission responded to Diesel Gate by posting a reassuring FAQ on its automotive policy website. 

But the official European response is actually quite shocking. Last week, Europe decided to allow car manufacturers to overstate test results by a whopping 110% until 2020, and from then on by 50%:

Note that currently the allowed overstatement is 400% on average. 

Such policies make me wonder: Is this the only item that car manufacturers are allowed to misrepresent? 

7) Will claw backs help?

Some of the bank regulations that entered into force after the Global Financial Crisis addressed excessive pay. Mark Carney, Governor of the Bank of England, is a big fan of bonus claw backs. This week, the Bank of England published a research paper that supports Carney’s view and demonstrates the virtues of clawback rules. 

Carney explains: ‘As a regulator, we like bonuses because of the flexibility to claw them back if an individual is found guilty of misconduct.’ Perhaps the car industry could learn something from bank regulation.

The clawback rules may work in theory, but will they work in practice? For prospective bank employees, the idea of handing back pay does not look great. They may apply elsewhere. But if they decide to work for a bank, they will certainly demand compensation to offset the clawback risk. And guess who pays for the extra compensation.

More worryingly, however, is this: What type of employee will banks attract as a result of clawback rules? There is a risk that it attracts careless daredevils who don’t mind losing large sums of money, or employees who do not really understand the risks of working for a bank. I don’t think any bank wants to hire either type of employee.

 8) On caps that become floors, and other solutions for executive pay.  

Carney’s stance on bonuses and clawbacks is at odds with European regulation, which merits bonus caps. The EU bonus cap will limit bankers’ annual bonus payments to twice the level of their basic salary. 

It is early days to comment on the EU bonus cap. In many cases, however, a cap creates expectations. Employees will regard the cap as a minimum entitlement, and expect their employer to always pay up to and include the cap. The cap thus becomes a floor and limits the flexibility that variable pay offers employers to manage their workforce.

In addition, there are many alternative ways to manage pay. Some banks use debt instead of equity to reward employees. This year, Swiss bank UBS paid bonuses partly in perpetual bonds. These bonds implode if capital ratios weaken, a prospect that creates incentives to think and act more long term. 

The trend towards mixing and matching equity, debt, and other elements into a pay packages is ongoing and confirmed by an academic study of professors Rangarajan Sundaram and David Yermack from the Stern School of Business at New York University. 

The examples above show that employers are able to develop their own solutions to manage pay. Not sure if regulation can contribute a lot. It is likely that imaginative minds will find ways to circumvent the bonus caps and the clawback rules, which may leave supervisors with empty hands. 

9) Regulating pay while alternative tools are available. 

When I worked in bank supervision, I noticed the respect that banks showed for capital requirements. Banks try very hard to keep capital ratios low. Imposing additional capital requirements (or capital add-ons) on banks to penalise undesirable behaviour has important consequences. 

Because of its leverage effect, every dollar of capital stands for ten to fifteen dollars of business. Forcing a bank to hold one dollar more of capital feels like taking away ten dollars of business. 

As a result of this leverage effect, banks generally respond well to the threat of capital add-ons. They tend to change their behaviour, often forthwith.

10) The other effective tool to control banks is disclosure.

Some weeks ago, the Reserve Bank closed the public consultation on its Regulatory Stocktake. I commented here at interest.co.nz on the proposal to scale back the off-quarter disclosure requirements. The National Business Review interviewed me on the RBNZ disclosure plans and used some colorful language to summarise my views. Fair enough. 

Whatever the Reserve Bank decides, decision makers may want to take a look at the disclosure plans of the European Banking Authority. 

In its work programme, the EBA demonstrates its commitment to improving the disclosure quality of European banks: 

This is from the 2016 work programme, which means that within the next year, we will have access to high quality bank data on a bank-by-bank basis, within and beyond Pillar 3 requirements. 

With the U.S. offering similar high-quality data through the Federal Reserve Bank of Chicago, it would be interesting to see how banks in other jurisdictions respond. 

Watch that space!