Why banking bonuses matter

It’s bonus season again in Britain’s financial sector, time for the bankers to collect their annual cheque for turning up to work. And as usual, the indignant headlines from the popular press and impotent muttering from politicians are back too, an annual tradition.

Bonus season has been contentious for a little while, and big bonuses were being paid well before things started to come unstuck in 2007. Some 4,200 city traders took home a million or more in 2006. It was good news for sales of luxury yachts and cars, but among the more negative effects were a spike in the price of rural land. The rush of easy cash priced farmers out of the market and handed some of Britain’s best farmland to ‘lifestyle’ owners.

Bonuses have become more controversial since the financial crisis. As performance bonuses, it was understandable that they were paid in the good years. When the banks still paid out after making a loss, it was clearly no longer performance related. Some banks protested that they were contractual and began calling them ‘retention bonuses’ instead, but since the banks had been bailed out by the state, the taxpayers were funding the bonuses either way, and weren’t happy about it.

In response, politicians threatened discipline. “I am angry at irresponsible behaviour,” said Gordon Brown in 2008. “The days of big bonuses are over.” But then he did nothing, which meant that in 2009 all he could do was say that he was “very angry” again.

Needless to say, the opposition made political hay out of the situation, and both the Conservatives and Liberal Democrats promised action on bonuses during their campaigns. So did Gordon Brown in fact, come the election, although there was no reason to believe him. Cameron suggested no bonuses should be paid at all by banks bailed out by the taxpayer, and told the government to “wake up and smell the coffee.” The coalition agreement agrees “robust action to tackle unacceptable bonuses.”

I suppose it was inevitable that the tune would change once the Conservatives were in power and the force of the City’s lobbyists turned on them. Bonuses are necessary to motivate staff, they argue. If UK banks don’t pay out, the City’s best will go to New York or Frankfurt. Bank profits would fall, and where would your tax revenues from the banking sector be then, they insinuate in a tone just short of blackmail. So the government relents, expresses hopes that restraint will be shown, and does nothing.

The fact is, bonuses do matter. For one thing, the banks need to recapitalize, so it’s not a great idea to drain billions out of them every year. Fund manager Michael Lewitt admits as much:”The payment of huge amounts of cash compensation severely weakens the balance sheets of financial institutions,” he warns. That’s money that could be either capitalising the bank or paying investors.

More importantly, big bonuses incentivise risk. Obviously the idea of a bonus is to reward bankers that turn impressive profits for their employer. Nothing wrong with that, except that the bankers still drew bonuses when the banks made a loss. Detached from actual performance, the bankers have nothing to lose. If they generate a big profit, they get rewarded generously. If they make a loss, they still take home the bonus. Since the banks are too big to fail, the taxpayer can always pick up the bill. Bank staff take home all the rewards, and the government underwrites the ultimate risk. With nothing to lose, banking bonuses encourage reckless, debt-based risk-taking in the City, and we all know where that leads.

“Public company executives have a one-way ticket to earn cash compensation with no return ticket to put any of that cash at risk” says Lewitt. “This is the real objection to the sky-high bonuses that were paid on Wall Street.”

David Cameron understands this. “For the past decade, the incentives have been distorted. The bonus culture encouraged short-term risk-taking instead of rewarding the long-term interests of shareholders and the public.”

Lewitt argues that bonuses should be paid in stock, which is something the Lib Dems have argued for. Joseph Stiglitz disagrees. Paying in shares, he argues, creates an incentive for executives to do “everything they could to get their firms’ stock price up – including creative accounting.” As we’ve repeatedly seen on Wall Street, reported value can be very different from actual value. Giving bonuses in shares discourages transparency.

So is it possible to have a fair bonus system? Sure. There are still reasons to object on the grounds of equality and the gap between rich and poor, but setting those aside for a second, it is legitimate to reward those who make the most money for the bank, if that’s the game. A safer way to pay out bonuses would be to tie them performance. Forget the idea of contractual or retention bonuses, you get paid a percentage of the profits made, no more. Further, it should be calculated on a longer time frame. Instead of getting a bonus on the year’s profits, you would be paid over three years’ performance. You should get more in bonuses for consistently bringing in $5 million a year, for example, than making double that one year and a loss the next. It would incentivise longer-term, more stable investments, rather than winner-takes-all risks.

In summary:

• The bonus culture matters because it encourages risk taking and debt.

• Bonuses should be performance related by law, so that none are paid if the bank makes a loss.

• Performance should be assessed on longer time frames to encourage stability.

• To protect bank bottom lines and shareholder interests, the bonus pool should be capped at a certain percentage of bank profits.

• In the interests of an equal society, bonuses should be taxed, and could be subject to an absolute cap to prevent runaway earnings for executives.

• To redress the balance of power between finance and government, bonus culture should be addressed internationally.