Why government can't stop big bonus payments

BBC business editor Robert Peston on a headache for the coalition

The third commitment in the coalition's programme for government is to:

"Bring forward detailed proposals for robust action to tackle unacceptable bonuses in the financial services sector; in developing these proposals, we will ensure they are effective in reducing risk".

Has that happened since the general election in May?

Well as a result of new European Union rules and earlier action by the UK's Financial Services Authority, the way that bonuses will be paid has been significantly reformed.

At least half has to be paid in shares and between 40% and 60% can't be cashed in for years.

Also, it is highly likely that for the top earners at the UK's leading banks, more-or-less 100% of payments will be made in shares or in subordinated debt (IOUs from the banks that can incur losses if the bank gets into difficulty).

Which should remove two elements of risk from the bonus payments, namely that they would deplete banks' precious capital and liquid resources, and that they would encourage bankers to take crazy short term risks.

If bankers are forced to hold shares and subordinated debt in their banks for years, then they should have less of an incentive to make dangerous bets to maximise short term profits - in that they would suffer if the bets go wrong.

That's the theory - though it didn't work at Lehman Bros, where employee share ownership was higher than it will ever be at Royal Bank of Scotland or Barclays.

But many, especially Lib Dem supporters, will be infuriated by the huge absolute size of bonus payments - millions of pounds for some individuals. Whether they are paid in shares or cash, these bonuses are immensely valuable.

And even if the bonuses or variable payments fall a bit, there have been increases in fixed salaries of between 20% and 40% for many investment bankers over the past few months.

So at a time when the incomes of most British people are being squeezed by low nominal pay rises and inflation, some will doubtless argue that bankers' bonuses remain "unacceptable" (to quote the coalition agreement) - especially when all big banks benefit from a guarantee provided by taxpayers that they won't be allowed to fail.

Even the Bank of England takes the view that big bonuses are inappropriate at institutions in effect subsidised by the state (to the tune of £100bn or so in 2009, according to Bank of England calculations).

As a consequence, the thrust of government policy - via international negotiations on reforming the banking system and the work of the government's own Banking Commission - will be to remove that implicit subsidy and support provided by taxpayers.

As readers of this blog will know, that means allowing banks to fail, or putting in place arrangements such that when banks get into difficulties, huge losses fall on investors and institutional creditors, while depositors cash and the bits of banks vital to the economy are protected.

Easier said than done. It is by no means certain the implicit support of taxpayers can be completely removed.

Which begs the question why ministers haven't simply ordered banks to slash bonuses, especially at the largely nationalised Royal Bank of Scotland.

Well, it is because slashing bonuses in that way would be tantamount (the banks warn) to closing down the investment banking operations of Barclays, and RBS and HSBC - in that their internationally mobile banking superstars would simply move to overseas competitors.

That is not a risk the chancellor wishes to take, because investment banking (whether you like it or not) has over the years generated significant revenues for the Exchequer and creates a good deal of employment in the UK (even if some would also argue that the proliferation of highly paid bankers in London distorts the economy and housing market of the capital).

To state the obvious, the payment of billions of pounds in bonuses will cause something a headache for the Liberal Democrat Business Secretary Vince Cable and the Lib Dem Deputy Prime Minister Nick Clegg - both of whom put the banks on warning before Christmas that the payment of massive bonuses would be wrong, especially if the banks were perceived to be doing too little to support the UK's economic recovery.

That's why ministers are now pinning all their hopes on the second strand of negotiations with bank chief executives, which are aimed at persuading banks to provide more and cheaper credit to small businesses.

To be clear, even reaching agreement on business lending isn't easy. For example, shareholders in HSBC might well query why on earth that bank should allocate precious capital to what they would see as relatively risky and low-return lending to small British companies, when there are arguably far better opportunities for a bank with global reach in India, or China or the Middle East.

All that said, I would be staggered if the banks don't come up with promises of new finance for smaller businesses, perhaps as soon as the end of next week.

Because if they failed to do so, the political pressure on ministers to punish them - perhaps through the implementation of a new tax - might become impossible to resist, even for the chancellor (who doesn't want a new bonus tax).

You can keep up with the latest from business editor Robert Peston by visiting his blog on the BBC News website.

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