Bookmark and ShareSargon Nissan is a researcher in nef‘s Access to Finance team.

Listening to the debate on bankers’ bonuses over the past week is enough to make anybody seasick. It veers terrifyingly from righteous vengeance to doom-laden warnings.  The Chancellor says he “won’t be held to ransom” by the RBS directors.  Then we hear that taxing wealth-creators is bad and counter-productive.

Rather than being dogmatically for or against bonuses, we should take a step back and ask: what is the point of a bonus?

Bonuses are incentives. And we know that incentives are powerful and do work. So while there is a question about size – City bonuses are obscenely large and out of all step with pay in the much vaunted “real world” – the most overlooked question seems to be: are we using bonuses to incentivise the right kinds of actions and behaviours in the City?

Put like that, it is obvious that there are fundamental flaws with the City bonus systems.  The current bonus system in the financial sector encourages the behaviour that wrecked our economy. My own experiences as an investment banker echo the observation by Lord Turner and now many others: much of it is indeed socially useless. It also has the potential, as we’ve seen, to bring the economy to its knees. It is dangerous and useless primarily because the opaque bonus system breeds short-termism and speculation.  It pushes bank staff into overstretching their institutions’ capacity to bear risk. My experience is that even if traders want to invest long-term, they find they can’t because they are not paid to. When I traded shares for an investment bank, the managers’ patience for losing money was counted in days, not weeks or months.

A recent Harvard Law School study documents how executives from America’s two biggest failed banks were rewarded hugely for their efforts in the years leading up to the crisis.  We now know that they were being paid so handsomely to bankrupt their own institutions and threaten the world economy.

I have just taken part in a Royal Society of Arts debate about whether the bonus system could possibly exist in an effective finance sector. The City insiders who defended the system inadvertently revealed the two reasons why this debate continues going in circles.  First, they over-estimate the contribution of the sector’s high-paid.  Second, they believe,  wrongly, that bonuses reward good performance.

Even the Bischoff Report, commissioned by the government, makes this same mistake.  It assumes that because the financial sector is vital that the bonuses must be vital and, crucially, that there is nothing wrong with the way bonuses are structured.

In reality, the sector’s contribution to the economy is not dependent on the bonuses likely to suffer from a windfall tax. Most bonuses that non-bankers receive (including doctors, teachers and many other private sector employees) are no more than a portion of overall annual pay.

A windfall tax will send a strong signal that bonuses have gotten too big. But a windfall tax is not enough. Incentives, rules and regulation are not encouraging the behaviour our businesses and economy need.  They have encouraged the banks to become casinos and their staff to bet the house and our economy.

For banks, just as for bankers, it isn’t that incentives are the problem.  Bad incentives are the problem.