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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.

Bookmark and Share David Boyle is a nef fellow, a writer and the editor of nef‘s newspaper, Radical Economics.

Vince Cable was quite right on the Today programme. The response to the RBS director’s threat to resign if they are not allowed to pay the bonuses they want to their failed, cash-strapped, state-owned bank should be to say: go ahead.

But we need to look a little more closely at the business of banking bonuses. They are paid out of a percentage of the profits of the investment divisions, sometimes up to fifty per cent. The money would otherwise go to the shareholders – the same ones who failed to exercise proper control over the bank they owned.

There are some, and Fortune magazine is among them, who would say that they are better shared with the staff than shovelled at the owners – and that’s right as far as it goes.

But the real question is not why the bonuses are so high. It is why the profits are so high. They come, after all, out of all of our pension investments, or the debt that goes to build productive business, or capital investments in public infrastructure. The real scandal is that these bonuses are paid out of fees which ought rightly to stay with the small investors who are watching the value of their pensions falling.

The fact that the banks are able to award themselves such hefty fees is purely because we have allowed a semi-monopoly to build up in banking, both domestic and investment banking. So here is the real solution: slash the bonuses, accept the resignation of the directors, put in their place bankers who are prepared to do what is necessary to break up RBS into its constituent businesses and regions.

Bookmark and ShareAndrew Simms is nef‘s Policy Director and head of nef’s Climate Change programme.

Levelling out: The maximum wage isn't just for equality: it helps firms – and big earners – to function happily

Levelling out: the maximum wage isn't just for equality: it helps firms – and big earners – to function happily

Whether it is bankers, doctors or dentists pulling in excessive pay, people are left wanting to spit at their greed. But John Varley, Barclays chief executive, reacted in horror this week to the suggestion of a Radio 4 interviewer that some parameters should be put around pay and bonuses awarded to bank staff. It would “interfere with the market”. This, it should now be clear, was a deeply strange thing to say.

Extraordinary powers of compartmentalisation may be a key skill for any banking chief. Yet this breathtaking adherence to doctrine in the face of real-world evidence is worthy of the officers of 1916 who ordered soldiers to slow walk against machine guns.

Had the banking market not been interfered with, to the tune of hundreds of billions in public largesse, it would not have survived in its current form. Something for which Varley, if not the rest of us, should be deeply grateful, and for which there must be a serious quid pro quo. And why should the market not be interfered with when it doesn’t think twice about interfering with life, the universe and everything else?

Six years ago, I proposed a maximum wage in an article for the Guardian. At the time it seemed a logical complement to the minimum wage, one of the key achievements of New Labour’s first term. The signs of the crash to come, in terms of ludicrous executive pay expectations, were already there. As Richard Wilkinson’s work in The Spirit Level has shown, inequality really is at the root of most social, and by implication, environmental problems. A maximum as well as a minimum wage would tackle income inequality from both ends of the scale.

The defence of high pay is that it is needed to attract and motivate senior executives, and give mid-level executives something to aspire to. Yet, as with so many facets of the failed neoliberal economic model, it is a triumph of self-serving assertion over reality.

The unintended consequences of that argument lie all around us in the landscape of the recession. But, more than that, the existence of an inverse relationship between pay and performance has been demonstrated for FTSE 100 companies. One of the fathers of modern banking, JP Morgan, believed that to motivate people you didn’t need a ratio of more than 10 between the highest and lowest paid. This is common knowledge in management school, but seemingly ignored in the workplace.

We know now all too well how destructive are the forces of seeking profit and pay maximisation for their own sake. Another benefit emerges of capping high pay or setting a maximum ratio between highest and lowest paid: beyond that level, an executive’s performance has to be judged against achievements other than personal accumulation. So, instead of status derived from higher incomes, the desire to excel can instead be directed toward the social contribution and environmental performance of the bank or company involved.

In an efficiently functioning market, there should be no exorbitant pay or profits. Competition is supposed to deal with that. There should always be someone or some business prepared to offer the same goods, skills or services and do the job for less. The pressure at the top should be down, not up on salaries.

Varley is fond of using the example of footballers pay to defend bank bonuses. But football managers get sacked. Varley himself earned more than £1m as the banking system crashed around him in 2008. Time to blow for a foul and show a maximum-wage card to those bringing the economic game into disrepute.

Bookmark and ShareVeronika Thiel is a researcher and project manager on nef’s Access to Finance team.

A light at the end of a tunnel - or is it an oncoming train?

A light at the end of a tunnel - or is it an oncoming train?

Barclays is said to be already recovering from the credit crunch whilst most of its clients, and the population at large, still are not even seeing a sliver of the light that could indicate the end of the tunnel is in sight. Small businesses still face cuts in their existing overdraft and credit facilities despite of the fact that their businesses are structurally sound. People with consumer debt still face increased interest rates. Personal insolvencies, as a result of redundancies, are at an all time high (link to insolvency services). Mortgage holders see their interest rates rising. Banks reposess houses more quickly than ever, and debt collectors are also becoming more aggressive.

So what does this increase in banking profits actually mean? Are we seeing a rehabilitation of our broken financial system? Or are we simply on the way to returning to business as usual, with the toxic loans written off?

The simple answer is – no-one knows for sure. There was certainly a gradual return of confidence, meaning that people will want to invest again. But there remains also a certain amount of question marks. As Robert Peston from the BBC argues, banks are reducing the amount of money they lend, so that they simply have more on their books.

In addition, however, the way that banks post their profits can change quickly as they can use different methods of valuing their assets. Asset valuation is not an exact science, and there are various ways of doing so.

Be that as it may, everyone is sighing a breath of relief that at least two banks don’t appear to go the way of Northern Rock (although there are interesting ideas around to breathe new life into it. That relief could be (and in certain quarters, is) giving way to complacency and a return to BAUBAB: Business As Usual and Bonuses Are Back. Despite Barclay’s assurances that bonus payments are reformed, an average of bonus £100,000 for staff at Barclay’s Capital still makes me think that this is more cosmetic.

We probably will have to repeat this until we’re blue in the face – but banking reform has not gone anywhere near enough to create a stable financial system in which systemic crises such as the current one are less likely to happen. And anyone who thinks that the crisis is over forgets that for the millions of unemployed, and those steeped into debt, it’s only the beginning.

Bookmark and ShareVeronika Thiel is a researcher and project manager on nef’s Access to Finance team.

Remember to think happy thoughts!

Remember to think happy thoughts!

As promised yesterday a short summary of thoughts on the Government White Paper: Reforming the financial markets.

Unsurprisingly, but sadly, the bigger picture has been missed. There are many reforms that tweak the system here an there, but few that will change the overall picture. The paper isn’t really committing the Government to do too much whilst trying to give the impression that decisive action is being taken.

Most disappointingly, Darling will not move to break up the bigger banks, following the concept of: if it’s too big to fail, it’s too bit. Zero points for this.

The second biggest problem is the lack of immediate reforms. Many of the proposed measures will not be implemented immediately, giving the opposition (i.e. most of the financial industry) plenty of time to mount a counter-offensive. The City has one aim to restore business as usual and that bonuses are back (or BAUBAB as I like to shorten it). One journalist likened the current atmosphere in the City to the end of Terminator 2 – just when you think that that horrible robot has been smashed to smithereens, it is reassembling. It is thus crucial to work fast and seize the opportunity to reform the financial system in a meaningful way. Unfortunately, party politics and bickering defuse the potential of decisive and effective action that would reduce the influence of finance on UK politics and economy. It appears that no-one at the top of either banking or politics has understood that finance should be subservient to the needs of the economy, not the other way round.

Also zero points on the issue of bankers’ bonuses: Darling talks the talk, but certainly does not walk the walk. The short section on pay suggests to draw up a code of conduct buy February and banks will have to report on their compliance with this code yearly. However, there is no indication yet what will happen to the banks if they fail to adhere to the code. Basically, we’ll be none the wiser until then.

The paper scores slightly better on the issue of pre-funding. Basically, pre-funding would mean that banks have to pay a part of their money into a pot as insurance against their potential collapse. This pot of money would then be used to repay depositors. There are some obvious advantages to this: instead of the Government having to cough up vast amounts of money at a moment’s notice, there is already some earmarked for it. A bank collapse will still be unpleasant, but it will be slightly less painful. Also, from a behavioural point of view, a levy on banks would remind them regularly of the potential of failure. Banks are, unsurprisingly, against this levy, as it reduces the amount of money they can use to invest. In addition, they say it’s expensive and puts an additional burden on them when they are trying to get back on their feet (needless to say they fail to point out that they stumbled over their own feet in the first place). But there are other factors at play: banks, as we all have learnt over the past year, rely very strongly on trust. So banks have to be trust-worthy institutions in order to attract clients and make investments. That’s why individual banks cannot say that they will insure themselves against failure – that would be paramount to suggesting that they are not sure that their bank’s strategy is foolproof. Bankers might say that banks in general collapse once in a while, but they would not be able to concede this possibility for their own bank – investors would be scared away (I personally would trust a bank that was a bit more realistic and didn’t pretend it would know everything, and hence took out insurance against failure. But then, that’s just me….)

To get over this dilemma is simple – make it compulsory for every bank to have insurance. Of course, this may still tar the reputation of the whole of the banking sector a bit, as it indicates that banking collapses are not as rare as some would have you believe. That again could be a good thing: prudence is also required on the side of the consumer. So, if Darling really introduces this levy, that would be a step in the right direction.

There are also some great ideas on counter-cyclical measures: make sure that banks build capital in the good times to use them in the bad times. That kind of thinking is definitively the clever one, and if the regulations are strong enough to prevent banks from getting around them, then they will do more for financial stability than many other suggested measures. The question-marks are around the how and when – and especially the ‘when’ is urgent because of aforementioned efforts to reinstate the previous state of affairs.

If you want a digested read digested: we don’t know what will happen until it may be too late.

On that cheery note, I recommend you read some something relaxing now – such as our suggestions on five ways to well-being. Money, after all, isn’t everything.

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nef employees blog in their personal capacity. The opinions expressed here do not necessarily reflect those of the new economics foundation.