Bankers and their bonuses

Are banks still paying bonuses?

Yes. In the year to last April, a period encompassing the nationalisation of Northern Rock, the collapse of Bear Stearns and multi-billion losses on subprime-linked investments, they paid out £8.5bn, much the same as during the boom year of 2006-07. Payouts will fall this year, but London bankers still expect to scoop £3.6bn. Yet that figure is dwarfed by the payouts on Wall Street, where bonuses in the six largest banks are forecast to top $70bn – a tenth of the US government's $700bn bank bailout. Almost all the $25bn that Citigroup is to receive in state capital will be spent on salaries and bonuses. Lehman Brothers finalised a $6.12bn pay plan just days before it succumbed to bankruptcy.

How important are these bonuses to bankers?

Very. They account for at least 60 per cent of their pay. A divisional managing director at an investment bank, on a basic salary of £150,000, would expect an annual bonus of at least £1m; "rainmakers" (traders who drive a bank's profits in lucrative new markets) would expect far more, with bonuses calculated as a generous percentage of the cash they bring in. The rule of thumb at most banks is to channel 45 to 50 per cent of net revenue into salary and "discretionary bonuses". The exact sums are often clouded in secrecy: though directors of publicly quoted banks must disclose earnings, they don't have to reveal what they pay star traders. The biggest disclosed bonus in the City last year was paid to Barclays' investment banking chief, Bob Diamond, whose £21m package dwarfed the £3m earned by its chief executive, John Varley.

And what are the alleged dangers of this bonus culture?

Some claim that bankers spend so much time politicking over bonuses that business at investment banks virtually grinds to a halt towards the end of each year. Others say that the huge City payouts inflated the top end of the housing market, while contributing to a socially corrosive widening of inequality. But the biggest charge against bonuses is that, by encouraging bankers to take huge risks, they were a key factor in destabilising financial institutions and may even have precipitated the current crisis.

Why does the system fuel extravagant risk-taking?

Because it handsomely rewards strategies that focus on short-term profit-making, with no regard to long-term consequences. If traders pocketing mega-bonuses lost billions a few years later, tough luck: the bonuses were paid and consumed long before they could be held accountable. And banks rarely, if ever, took steps to claw them back. For the individual trader, the potential downside of engaging in excessive risk is thus far outweighed by the potential upside. In this perverse heads-I-win-tails-you-lose scenario, it was left to shareholders and, ultimately, taxpayers to shoulder the losses. The traditional capitalist balance between personal and corporate risk had been blown away completely.

How did this system come about?

Some date it to the early 1970s when a mass of Wall Street banks transformed their legal status from partnerships to corporations and then floated on the market. Until then, a bank's partners were paid a percentage of the pre-tax profits but, crucially, their agreements also contained shared liability clauses. If one partner screwed up, they would all suffer. That natural brake was removed once the bulk of a bank's capital was owned by external shareholders. And the emerging bonus culture received a further boost during the deregulatory splurge of the 1980s and 1990s.

What happened then?

London's 1986 "Big Bang" saw the abolition of fixed commissions on trades; it also opened the doors to US brokerage houses with their more aggressive attitudes to risk and reward. The stakes became higher still following the 1999 repeal of the US Glass-Steagall Act, which had enforced a rigid separation between investment and commercial banking: suddenly bonus-driven investment bankers had giant balance sheets to play with. Ominously, this coincided with the development of ever more complex debt-based derivatives products which multiplied the scope for booking instant profits.

And why did the authorities play along?

Although the cult of the bonus was cited as a contributory factor in the 1987 stock market crash and the dotcom bubble, the rewards of light-touch regulation were felt to be greater than the risks. This was particularly so in London, which took advantage of America's regulatory clampdown following the dotcom bust to challenge New York as a global financial hub, particularly in the booming derivatives market. By 2007, Britain's financial services sector accounted for nearly 10 per cent of British GDP, generating crucial tax revenues for the Treasury. The then Chancellor, Gordon Brown, declared a "new Golden Age" in the City.

Has Gordon Brown changed his tune?

Yes. The PM is leading the backlash against the "irresponsible" bonus culture and the "excessive risk-taking" it has spawned. Reform now looks inevitable, not least as it's seen as a crucial step in restoring public confidence in the banking sector. The Financial Services Authority has already outlined some of the short-termist practices it would like stamped out. They include: linking bonuses to one year's performance rather than average performance over a number of years; paying bonuses entirely in cash rather than in shares or share options; and allowing traders to assess the value of their own positions when bonuses are calculated. The City watchdog will also demand that banks which continue promoting risky incentive structures will be required to hold more capital. Yet the authorities are only too aware that they must tread carefully or risk hobbling the City permanently, particularly given rising competition from the new financial centres of the East. ·