Fraud must be stamped out – but bonus reforms will backfire

Allister Heath

BONUSES are not the source of all evil. Sorry, I know I’m not meant to say that, but it’s the truth.

Some of the Bank of England’s proposed reforms to bonuses make a lot of sense – crime, fraud and misselling need to be ruthlessly stamped out, and incentives need to be correctly aligned – but others will weaken, rather than strengthen, the financial system and the rule of law. The Independent Commission on Banking’s proposals will also backfire.

Should some payments be delayed to make sure that short-termist behaviour is discouraged and that performance can be properly assessed over a decent period? Absolutely, and that is pretty much what is happening now, with bonuses deferred over three years. But while this sort of approach will weed out some problems, it won’t stop many other bad decisions. Lehman Brothers’ employees were partly paid in stock and owned significant stakes in their bank; yet they still took decisions that led to its collapse. Many lost fortunes when the firm went bankrupt.

Deferring bonuses prevents fraud but doesn’t stop mistakes, manias, irrational exuberance and the rest.

But extending this principle to ten years is absurd. There is too much uncertainty over such a long period of time. Imagine the scene: the boss walks over to a hard-working employee, who is desperate to do well and better herself – but tells her that she will be getting her bonuses in tranches over the next decade. For people trying to get on in life and save up for a deposit on their homes, this sort of thing would be almost useless and in some cases downright insulting. Three years is one thing – the length of a university degree, a comprehensible period of time – a decade another thing entirely. Bonuses would start to feel more like pensions, albeit uncertain ones. Nobody can know what their lives will look like in ten years’ time. Some recipients will even have died.

A much more realistic outcome under these rules is that high-performing employees would get a pay rise, which isn’t deferred and isn’t subject to any clawback, and the use of variable pay will dwindle.

Rewards would thus become shorterterm, and saddle banks with ever-higher fixed costs and an inflexible pay structure, making them more likely to go bust in downturns.

Variable pay is generally best viewed as a revenue sharing system between employees and owners in a highly cyclical industry. If revenues go up, so does pay; if they fall, so does pay. Bonuses are not especially closely related to profits but are closely related to turnover. Anything that ruptures this system by reducing the role of variable pay – either EU bonus caps, or extreme deferral proposals – will increase risk. Sacking staff will become the only way firms can reduce costs in a downturn.

The Bank’s proposal to allow bonuses to be clawed back for up to six years after they were awarded is partly right – but not entirely.

If this were only about recouping illgotten gains, that would be fine – for example, staff that benefited from misselling, incorrect statements, lies or fraud. There should also no longer be any more Fred Goodwin-style rewards to CEOs who bankrupt organisations.

However, the Bank’s clawbacks will apply to a very large number of people, will kick in if there is “reasonable evidence of employee misbehaviour or material error” (good if the burden of proof is sufficiently strict), if there is a “material downturn” in the firm’s performance (dangerous, as could simply be caused by a change in economic conditions), if the relevant unit suffers a material failure of risk management (depends), and will apply not just to those directly involved but also to those that should have been aware of the failure but weren’t or failed to act (again, depends).

Clawbacks are a great tool when applied properly, fairly and sparingly – but these proposals, and those for 10-year deferrals – are too extreme.
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