Why Bankers' Bonuses Should Be *More*, Not Less

You may have noticed there has been a lot of indignation over the notion of bankers' bonuses - particularly since the financial crisis. Mention the two words "Bankers' bonuses" and most people you meet are likely to react as though you've told them they are being forced to spend a cold, rainy weekend in Bognor with Diane Abbott, Mehdi Hasan, Vanessa Feltz and Robert Kilroy-Silk. But aren't they onto something? Surely it makes perfect sense that bankers who make losses for the bank should not be given bonuses - it's the most obvious thing in the world, right? It might be the most obvious thing in the world, except for the fact that it is wrong.

For a lot of complex reasons that I won't bore you with in this Blog post (but on which I do elaborate in more detail here for those that are interested), if a bank can get away with apportioning some of the salaries in the form of bonuses, it is better than paying inflated salaries. So bonuses often aren't the financial bogey that people think they are - but let's get to the heart of it, though, with some questions:

Isn't it true that sometimes bonuses are a bogey?

Yes, but consider who's to blame.

Reckless bankers?

Sometimes, but the problem is underpinned by government interference. Consider that bankers were not regulated 100 years ago, yet banks were still full of profit-seekers. What changed is that a culture of recklessness came about primarily due to guarantees bestowed by the government.

But how do government guarantees encourage recklessness - bankers will only make deals they think are profitable, won't they?

The problem is, if depositors no longer benefit to the same extent by bankers' felicity, their incentive to look for prudence is diminished. When the government guarantees the losses of depositors, the depositors no longer have to monitor carefully whether the bank is a prudent lender. But as well, in such a culture, depositors are primed to favour riskier bankers, because higher risks increase the chances of higher rates of interest for their depositors in successes, whereas they only increase the chances of a government (i.e. taxpayers) bail out in failures.

Ah, so the government are the ones laying down a cushion for recklessness?

Primarily, yes.

What's the solution - stop the nationalisation and the bail outs?

It would have been better to never have started them. It's difficult to withdraw now as the State acts (among other things) to protect the capital of ordinary citizens whose money is tied up in failing banks.

However, as regular readers of my Blog probably hoped would be the case - I do have a solution. Scrap bankers' salaries and get them to work on a bonus-only culture relative to their success. This is not alien to many bankers anyway; a great many have variable pay in shares, or in a bank bonus, contingent on the share price. These are reliable indicators because share prices are a good measure of a bank's performance - but the system probably needs tweaking to give greater incentive against failure.

Which bankers are most likely to be attracted to such a pay structure? Fairly evidently it is bankers with the greatest ability to make lots of money for their bank. It is for that reason that the system of bankers selling their talents for pay-based rewards would work best. It's best for talented bankers with financial nous and business acumen, it's good for shareholders, and it's good for the economy too.

To see why it would work, consider a car boot sale as an analogy. With car boot sales sellers pay a few pounds for a pitch because they expect to make more than the pitch fee in items sold. A car boot sale with a £5 pitch fee is pretty standard in the UK. If all prospective car boot sale sellers in the UK were suddenly hit with a mandatory £15 sellers' fee you'd find people with lower quality items would be less inclined to bother buying a pitch. Those with lots of quality goods might still be tempted, though, because they would have confidence that their net sales would exceed the £15 pitch cost. Charging a pitch fee, be it £5, £10, £15 or whatever is a great way to organise a car boot sale, because the fee, and the effort to drive down and set up, attracts only sellers who think they have enough quality items to sell and return a profit.

Imagine what would happen if, instead of charging for a pitch, car boot organisers started to pay people to set up stalls. There'd be recklessness, as sellers would turn up in their droves, pitching lower quality items safe in the knowledge that they'll make a bit of money anyway.

Now apply that to bankers pitching for their own successes. Just as you don't need to pay car boot sellers with lots of quality goods to sell, you don't need to pay bankers with lots of business acumen and financial nous inflated salaries to perform well. To get them to make good decisions, you only need to give them share-based or bonus-based incentives to do what they do best, because their own wealth is tied up in their success.

The banking system would be much better if bankers' bonuses were more, not less, and their salaries capped at zero - because increased bankers' bonuses would mean increased revenue for the bank as a result of prudent investments, or increased revenue for the bank as a result of overseeing a profitable merger for which they receive a percentage of the bank's often very large fee.

* Photo courtesy of bbc.co.uk