Banks Should Abolish Bonuses

Bonus For Failur

It will only take one bank to ban bonuses to open the floodgates.

By Professor Moorad Choudhry

What makes otherwise law-abiding people mis-sell insurance products or derivatives to their customers ? Or manipulate market rates to their advantage ? Or cover up loss-making trades in order to buy time to move their trading book back into profit again ?

Probably a whole series of factors, I imagine. But in the financial services sector there is a common thread running through all of these recent examples of bad practice, and that is the bonus system of remuneration.

Incentivize individuals by promising them a bonus at the end of the year that may be many multiples of their base salary and it can hardly be surprising that some of them start cutting corners to maximize said bonus. And of course when one gets up to sufficient size, it becomes a fine line between cutting corners and outright law breaking.

We are familiar with all the supposed benefits of the bonus system. "We must be able to attract the best"... "its important to minimize fixed costs and move as much of the remuneration into variable costs"... "how else should we incentivize our staff to sell more ?!"

More and more these look like spurious arguments. The point of the bonus system was originally to reward staff for above-average or above-expectations performance, once the company had reported profits and the partners had taken their share. That's the key point here. A bonus would only have been paid after the firm, and its owners, had actually made money at the end of the year. Hands up everyone who knows of loss-making firms still paying bonuses to staff ?

The fixed- versus variable-costs argument is rubbish too. Many employees join on a "guaranteed" bonus, although post-crash that word is no longer used. But an "expectation" is still common. That makes the bonus part of fixed costs. And commercial business, be it in the financial services industry or any other industry, is not brain surgery. There isn't a dire shortage of people able to undertake these roles.

In an era of globalization, high levels of freedom of movement and increasing competition, it is not necessary to offer an inflated bonus system in order to attract "the best". (By the way "the best" was the expression often used to describe the same people who later helped drive the banks they worked for into government bailouts).

Or indeed any bonus system at all. Would staff leave their firms overnight if the bonus system was abolished ? Not enough of them to make a difference. And for every banking job vacancy advertised today in the City, Wall Street, Singapore or Shanghai, there will be at least 500 applicants, if not 5000.

The bonus system is no longer fit for purpose and should be scrapped. No bank will ever be brave enough to do this on its own, but it would only take one to open the floodgates. And if certain people decided that that was too much of a change and left, we should be under no illusion that others, equally capable, would fill their place.

Who knows, people motivated not solely by money and greed may even improve the industry's culture such that we have fewer mis-selling scandals.

Professor Moorad Choudhry is at the Department of Mathematical Sciences, Brunel University and author of The Principles of Banking (John Wiley & Sons 2012)

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