Bankers' bonuses: can they be justified?

Bankers bonuses are on the political agenda once again, with Oxfam issuing a new warning on economic inequality as the world's business elite prepare to meet in Davos later this week.

Against that backdrop, Britain's financial institutions have been revealing how much they will be doling out in bonuses in the "biggest week in the City's calendar".

In light of the countless scandals, bankers' bonuses remains highly contentious. Can the dizzying amounts being handed out be justified by the results they produce, or are they still encouraging dangerous risk-taking within the financial sector?

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Are bankers still receiving big bonuses?

Yes. On Friday, Goldman Sachs revealed that its senior employees would receive the same bonuses they did last year: payouts that averaged out in excess of £2.5 million each.

However, regulators have been trying to crack down on such payments by introducing tougher regulation since the financial crisis. In 2013 a cap limited bonuses within the EU to 100 per cent of an employee's salary. "Bonuses aren't what they used to be," says the Evening Standard's James Ashton. "For many, the good times that rolled pre-crisis are unlikely to return."

This cap can, however, be increased to up to 200 per cent with shareholder approval and, according to the New York Times, some banks in Europe have responded by getting "creative." Among tactics used to sidestep the regulations are generous "allowances" and "role-based pay" it reports.

How important are these bonuses to bankers?

They can account for at least 60 per cent of their pay, reports suggest. A divisional managing director at an investment bank, on a basic salary of £150,000, would have expected an annual bonus of at least £1m under the old system. "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.

Why has the bonus culture come under attack?

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 2008 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.

So why are bonuses still paid?

Now, more than ever, banks want to keep their best staff in order to maximise earnings and rebuild battered balance sheets. Offering key traders a fat bonus is the most powerful way of doing that.

Those in the banking sector argue that bonuses are also an important mechanism to retain executives who 'know where the bodies are buried'. These individuals are vital for identifying how to move a firm forward after it has suffered problems, or in some cases for keeping information out of the public domain.

Often the term 'bonus' really refers to the 'commission' that a broker has earned bringing business to the firm. Defenders of the bonus system argue that the payments have been earned: if a star broker has brought in revenues as agreed, why should he or she be penalised just because traders in another part of the group have lost a packet on sub-prime mortgages? The promise of a share of profits is really the only effective way of providing an incentive for workers to go the extra mile when money is tight and salaries capped, they say.

Could banks stop paying bonuses, even if they wanted to?

Many banking executives say that their companies would lose talent if they reduced or ended bonuses. And in any case, discretionary bonuses have become contractually binding in recent years, meaning that even if companies' profits are falling, they are still legally compelled to pay them. Despite the current public outcry, in many cases there is nothing firms can do to stop giving guaranteed pay-outs.

Is there an alternative?

Shareholders should consider scrapping fancy pay packages and bonuses altogether, says Richard Lambert in The Financial Times. The empirical evidence suggests they don't improve performance and may prompt managers to waste energy manipulating the performance criteria. Non-material rewards such as awards and recognition are a better way of motivating executives, adds Lambert. And let's not forget, "no one is irreplaceable".