How To Fix The Bonus Culture

The bonus culture is back, with the bank awarding mega-bucks to their staff again. That seems crazy. But how can you fix it without legislating for top pay. In my Money Week column this week I explain how. Here's a taster.


Any reasonable person listening to the increasingly furious debate over City bonuses probably finds themselves in the odd position of agreeing with both sides of the question, even though they are miles apart.
It is bonkers that only a year after the financial system virtually collapsed, and with many banks still effectively on life support, that big bonuses are back, say the critics. And most of us nod and say, yup, sounds crazy.
Against that, plenty of voices from the City pop up to say that you can’t legislate for pay. That isn’t so much a slippery slope as a one way ticket back to the Soviet Union. And again, most of us will nod and say, yup, that does sound like a bad idea.
We end up agreeing with two contradictory arguments. But actually, there is a way out of this dilemma.
True, it doesn’t make any sense to legislate for pay. But it does make sense to legislate for the structure of financial firms. Indeed, we have done for decades. And if we got the structure right, we could start bringing bonuses back under control again.
It isn’t hard to see why the debate on bonuses has become so heated.
A year ago, following the collapse of Lehman Brothers, the financial system went into meltdown. Banks started collapsing all over the world. Billions had to be poured into the system to keep them afloat. And yet the people who had created the mess had been being paying themselves vast bonuses over many years, usually on top of salaries that were already extravagant by comparison with most other careers. Even worse, it seemed to many people even within the financial system that bonuses – particularly the ‘heads-I-win-tails-you-lose’ bonuses that were rampant in the City – had played a big part in encouraging the excessive risk-taking that had created the collapse in the first place.
Now, less than a year later the bonus culture is back in full swing again. For the left, that is an opportunity to attack high pay in general. The centre-left Compass Group has just launched a campaign for a High Pay Commission that would regulate wages at the very top of the ladder in much the same way that the Low Pay Commission regulates pay at the bottom. Both the Chancellor Alistair Darling and the business secretary Lord Mandelson have said they might legislate to curb bonuses.
But it is not just restricted to the left. The shadow Chancellor George Osborne has said it is wrong that banks with any state support should be paying out huge bonuses. Nor is the argument restricted to this country. Proposals to cap bonuses have been put forward in France, Germany, and even in the United States.
In truth, this isn’t a right/left, free market/regulation argument. The banking sector has just effectively exempted itself from the free market. Plenty of banks are still being effectively proped up by the governments, either through direct shareholdings, or else through schemes to insure toxic assets. Even when the support isn’t explicit, it is still implicit. After all, how many of us would be willing to put our money into a bank any more if it weren’t for the fact the state ultimately guaranteed the deposit? Probably none of us.
Bonuses are, in reality, the one bubble that didn’t burst. No one can explain why they are so huge, nor can they provide any convincing economic rationale for them – there are as much as bubble as dot com stocks in 2000 or house prices in 2007.
So how should we bring them back under control again?
In fact, the answer is very easy.
It doesn’t make any sense to legislate for pay. There is no way any regulator can know what the right level of remuneration might be. You will drive firms offshore. And, for those firms that remain, innovation and competition will be stifled. Salaries are a price, and we know from a hundred years of experience that any form of price control ends up doing more harm than good.
But we can legislate for the structure of the firms that operate in the financial markets. That has always been the case – and if we have the wrong structure then it makes sense to change it.
The problem with bonuses are the way they encourage bankers to take big risks with other people’s money. If you were given a stack of free chips, told to go to a casino, and told you could keep any money you won in the next hour, whilst not having to bear any of the losses, you’d make some pretty wild bets as well. That, in effect, is what the bonus system does.
Two things need to be done to stop that.
First, there needs to be a division between investment banking and retail banking, as there used to be on Wall Street, and in the pre-Big Bang City of London. It is the retail banks that can’t be allowed to fail, since the consequences for the rest of the economy are too severe. It is the investment banks that take the big risky bets and pay the big bonuses. The two should be split up again.
Next, the investment banks should be turned back into partnerships, or, at the very least, companies that were majority owned by their staff. Just take a look at the hedge funds and the private equity houses. Despite all the warnings of instability, they didn’t blow up in the crisis. That is because they operate much more as partnerships. The staff have their own money tied up in the firm, and their long-term wealth is bound up with its future.
Instead of taking short-term bets with other people’s money, they are taking long-term bets with their own. That instantly creates a very different attitude – and a far healthier balance between risk and reward.
What you would end up with, of course, is a City that looked a lot more like the one that existed before the reforms of the mid-1980s. But maybe that would be such a bad thing.