Bankers' bonuses and all that

For now, it looks as though the US and UK have seen off pressure from other G20 governments to impose stringent limits on bankers' compensation, especially bonuses. France is threatening to go it alone, but investment bankers in Paris are already threatening to move out, so it remains to be seen how tough the Sarkozy government will eventually be.

There still seems to be a visceral desire among the public and politicians alike to "do something" about the bonus culture in the financial sector. Given what we've been through in the past two years, this is understandable. However, bonuses were only a small part of what brought the financial system to its knees, and curbing them can only be a small part of the solution. I'm still far from sure of what needs to be done to strengthen the system, partly because there are so many parties to blame for what went wrong. For instance....

* Certain Central Banks (notably the Fed and the Bank of England) were far too willing to believe their own press releases about defeating inflation. Stability in consumer prices owed much more to the flood of cheap goods from Asia than to any new monetary paradigm. Lax monetary policies fostered both soaring asset prices and the explosive growth in financial institutions' balance sheets.

* Governments (the US and UK again in the van) were willing to turn a blind eye to the explosive growth in personal debt as long as it preserved the illusion of healthy growth in their economies.

* The public and the media showed no appetite for reining things in before the crisis hit. The debt-fuelled housing booms in the US, UK, Spain, Ireland and elsewhere were almost universally lauded as a "good thing" until the house of cards collapsed.

* Regulators entirely failed to understand the risks posed both by the growth in FIs' balance sheets and by the increasing complexity of the financial instruments that the banks were employing. In particular they underestimated the significance of growing reliance on wholesale funding and the resultant risk that the whole system could freeze up almost overnight.

* Ratings agencies threw around AAA ratings for new products like confetti while failing completely to understand the risks. No doubt many of the derivatives they were asked to opine on were complex, but some sort of macho unwillingness to admit that they simply didn't understand the products seems to have got in the way of proper due diligence. No banker, or at least no lender, would have been in any way surprised by the ineptitude of the ratings agencies, which has been repeatedly demonstrated over many decades. However, investors, even big ones who should have known much better, continued to rely on their opinions right up until the crisis hit.

Which brings us, finally, to the banks themselves. Take lax regulation, complacent-to-irresponsible monetary policy, debt-happy governments and citizens, and add smart, greedy, Type-A financiers, and what other outcome could you possibly expect? I'm not sure it's correct to assert that none of the banks could see the problems building up; rather, I think there was something of a fallacy of composition. Each bank assumed that its own position was manageable, without considering the implications of the fact that every other major institution was facing a similar risk profile. Sure, there were some abuses going on: "guaranteed bonuses", upfront rewards for assumed long-term profits and such. But these were symptoms of the excesses throughout the financial system or indeed the whole economy, rather than the causes of the crisis.

So what does this all mean for attempts to curb bonuses? Well, it seems to me that if Governments can agree on better regulation (including higher capital requirements) and central banks can resist the temptation to play the good guy by keeping monetary policy excessively lax, then the excess or illusory profits that encouraged the payment of monster bonuses would largely disappear. You could throw in a few steps like restricting "guaranteed bonuses" and requiring bonus payouts to be spread over a longer period or tied to stock prices, though those would mainly be for the purpose of playing to the gallery of public opinion. It's just a matter of restoring common sense, boring as that may be. Sadly, however, that's been in such short supply over the past decade that I'm not optimistic that the G20 meeting in Pittsburgh at the end of the month will do anything worthwhile.