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The Telegraph - Give bonuses for long-term performance not for taking short-term risks

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This week the Financial Services Authority published its draft code on remuneration in the financial services sector and ran straight into a firestorm of complaints that it was back-tracking and allowing a return to the bonus culture, which some would claim was the root cause of the credit crunch.

As Michelle of the Resistance used to say in ‘Allo ‘Allo: listen very carefully, I shall say this only once.

Hector Sants, the chief executive FSA, is right.

The FSA’s proposal seems to go a long way towards ensuring that bonuses will work as I would want them to work from all three of my perspectives. It is seeking to ensure that bonuses for senior executives are based on profits and not guaranteed for years without any link to performance. It should reward long-term performance not short-term results that may store up longer-term risks.

So why has there been such a row about the FSA’s proposals? Because they don’t satisfy the populist notion, which is being fanned by politicians, that bonuses were to be eradicated. As Hector Sants pointed out forcefully in a Radio 4 interview last week, if the Government wants to engage in social engineering by banning bonuses for bankers, or pay for bankers that is more than doctors, or that is more or less than footballers and C-list celebs, then it should have the guts to legislate.

However, we must be careful what we wish for in this regard since we are dealing with a government that thinks that passing new laws is the answer to almost every problem.

For example, it passed the Violent Crime Reduction Act of 2006, yet we are all aware that violent crime has not decreased. I seem to recall that violent crime was already illegal before this new legislation. Maybe enforcing some existing laws might be the way forward.

The populist assault on bonuses has already produced some bizarre results, such as some banks increasing basic salaries in expectation of not being able to pay bonuses. This unintended consequence of the bonus assault is ridiculous. Staff are the biggest non-financial cost in most financial services businesses and retaining a flexible-cost staff base is one of the few protections against a downturn in revenues. Increasing basic pay not only reduces that flexibility, it also reduces the incentive to perform.

As the FSA points out, financial services are an international market. UK financial services firms compete with those from other EU countries, Switzerland, the United States and, increasingly, Asia. None of these other countries has yet put forward any proposals for curbing bonuses or linking them to capital adequacy requirements. Maybe they will, but at the moment the FSA’s proposals, let alone any curbs which might be brought on by legislation, stand alone.

So what are we to do? My own business, Tullett Prebon, is in a sector dominated by five major companies. Of these, only two are headquartered in London. Are we supposed to change our employees’ bonuses (which by the way are mostly contractual and formulaic and cannot just be altered unilaterally) and then lose them to our US and Swiss competitors who face no such curbs? If, as the FSA suggests, this experiment is abandoned after a year if other countries do not follow its lead, maybe we can hire our staff back. For more money.

Lastly, there is the subject of bonuses at the banks in which the state has a significant shareholding. This has produced the predictable response from George Osborne that “Banks need to be told that the support provided by the taxpayer is there to rebuild their balance sheets and resume normal lending; it is not there to help with mega-payouts to bankers.”

The concept of operating these banks on a different commercial basis to banks that have not been forced to accept capital and a shareholding from the Government is a dangerous one. The staff in those banks perform the same tasks as in banks that have not become government controlled; if their bonuses are curbed there will surely be a migration to the better pay in competitor banks and, as with all such migrations, the best will be most able to make the move.

As a taxpayer-shareholder in those banks, I would like to see the Government exit the stakes it has taken in The Royal Bank of Scotland and Lloyds at a profit and the only chance of this happening is if these banks are able to retain the key staff who are able to make those banks viable once again. That will require performance bonuses.

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Terry Smith 

The Telegraph