06/03/2013 08:22 GMT | Updated 05/05/2013 06:12 BST

Capping Banker Bonuses Misses the Point

Brussels is wrong to cap bankers' bonuses, just as it was wrong to propose a financial transactions tax a few months ago. Its thinking, however, is along the right lines; having failed to manage their businesses responsibly, bankers need to be kept on a tight leash.

Brussels is wrong to cap bankers' bonuses, just as it was wrong to propose a financial transactions tax a few months ago. Its thinking, however, is along the right lines; having failed to manage their businesses responsibly, bankers need to be kept on a tight leash.

Under the current regulatory system, banks have been run almost entirely for the benefit of their employees. Important stakeholders such as the bank's owners (shareholders), their customers (depositors and borrowers) and their guarantors (tax payers) are treated with disdain.

Any other industry that had caused economic damage on the scale that the banks had caused in the last few years would bow their heads down in shame and take a lesson in humility, espeically when it comes to pay.

Bankers refuse to accept responsibility for the mismanagement of their assets. Governments, by continuing to stand ready to bail them out, have ensured that banks have little incentive to reform the dubious practices that got us into this mess. Unreformed, banks are likely to stumble into another financial crisis, the bill for which will land on hard pressed taxpayers again.

The bonus culture was one of the three main causes of the 2007 financial crisis. By creating a "heads I win, tails you lose" environment, bankers were encouraged to take excessive risks with depositors' money. Moreover, bonuses were paid on the back of profits which turned out to be fictitious because they were early estimates of gains on longer term transactions. These estimates turned out to be heavily biased, because the people calculating the gains were the same people who stood to benefit from them.

The second cause of the financial crisis was moral hazard. This refers to the situation where bankers know that they can gamble away our money, because the government will always be there to bail them out if they lose. Whereas the bonus culture allowed individuals to operate under a "heads I win, tails you lose" culture, moral hazard allowed banks themselves to operate under the same culture, ensuring that the normal rules of capitalism did not apply. Most markets are balanced by greed and fear. The problem with moral hazard is that it eliminates the fear, whilst fuelling the greed.

The third cause of the financial crisis was conflicts of interests. Investment banks act in their own interests rather than their clients' interests. Some of these conflicts have manifested themselves in misselling, market manipulation, money laundering and fraud investigations. One of the biggest conflicts of all is how universal banks handle depositors' money. Whilst most depositors expect their money to be invested in safe assets, bankers are incentivised to invest these deposits in risky assets, because risky assets generate higher returns - and therefore higher bonuses.

Governments looking to fix the banking sector need to tackle all three of these concerns simultaneously if they are serious about containing the next financial crisis.

Universal banks need to be split into retail banks and investment banks. The retail sector would have deposits guaranteed by the government; but the investment sector - which would not be allowed to take deposits - would have no such protection.

In addition, the investment banking sector would have to follow the Basel III guidelines on capital adequacy with immediate effect - rather than the leisurely 2019 timetable set out by the Basel Committee. The Vickers Report, commissioned by the British government, suggested a ring fencing of these two banking activities, but that leaves too much discretion to management. A full split would be cleaner, provide more accountability and would go some way to solving each of the three structural problems mentioned above. Moral hazard would be eliminated from the investment banking sector by this structural split. As a result, bonuses for investment bankers would be moderated. And the biggest conflict of all - bankers using deposits as cheap money to gamble with - would be outlawed.

Investment banks would then be free to pay whatever bonuses their shareholders sanction, subject to some sensible rules along the lines of the following:

  • No individual banker should get paid more than the CEO of the bank, whose remuneration should be sanctioned by a majority of shareholders.
  • Bankers' bonuses should follow the norms of best practice performance appraisal processes, namely they should be based 50% on individual performance and 50% on the bank's performance. That implies bonuses would be severely curtailed where a bank is loss making.
  • A "systemic banking crisis insurance fund" should be set up by the regulator with every retail bank, investment bank, hedge fund and shadow bank contributing an annual premium based on the size of their assets.
  • No bonus pool would be authorised by the banking regulator unless the bank has first:
  • (a) met the Basel II capital adequacy requirements
  • (b) made a profit after paying its annual premium to the systemic banking crisis insurance fund
  • (c) paid off all outstanding taxpayer bailout funds
  • Bonuses for investment bankers should be paid in the form of shares to be taken upon retirement.
  • Bonuses for retail bankers, given the job security effectively provided by a tax payer guarantee, should be capped at twice their salary and should also be taken in the form of shares upon retirement.

The standard argument used by bankers against keeping their remuneration on a regulatory leash is that banks need talent to prosper and talent needs to be rewarded. But this rationale ignores the nature of banks in the wider community.

Banks don't sell cars or iPods or hamburgers. Banks sell trust. You go to a bank; you hand over your money; and you trust that the bank will look after it. Forever. When you're in the trust business, you have to act honourably. And honour simply doesn't sit comfortably with short-termism and greed. So to those people who say that we need to reward talent with multi-million dollar bonuses, I say you're hiring exactly the wrong kind of talent.