Are bonuses to blame for banking’s downward spiral?

To some people, the world financial crisis is all the fault of city bonuses

Prime minister Gordon Brown has denounced them for stoking an “age of irresponsibility”; unions accuse them of encouraging a culture of greed; and, if the tabloid press is to be believed, they are the motivation for the “spivs and speculators” that have brought Lehman Brothers, Bradford & Bingley and others in the banking sector to their knees.

So are the banks’ reward strategies partly to blame for the situation they find themselves in? Or are extravagant city bonuses merely an easy target to whinge about in bad times?

“At times like this people look for easy answers and this is the latest scapegoat they have seized upon,” says Charles Cotton, CIPD adviser, reward. “Of course, it would be wrong to say that anything is solely to blame, and this aspect has probably been exaggerated. But that’s not to say there’s not something there.”

The problem, Cotton says, is not the principle of awarding a bonus for individual profit-making but poor appreciation of risk by managers who judge bonuses purely on annual figures. Such judgments are made in good faith (“No one is deliberately setting out to trash their organisation,” he points out) but it is often simply not possible to measure the effects of an individual’s trading over a one-year period.

For this reason, there is a growing consensus that bonuses should be risk-adjusted to reflect how profits have been made; that they should be deferred and spread over several years rather than paid at once; and that they should be paid in shares or options rather than cash.

The chairman of Deutsche Bank, Josef Ackermann, spoke out earlier this year in favour of such changes, but the idea of multi-year, risk-adjusted bonuses is not new. Nomura and Salomon Brothers attempted similar reforms in the 1990s without much success. Cotton says the unpopularity of reform with bank staff made it a non-starter in better times, but now that the crisis has left employees fearing for their jobs, such reforms may be back on the table.

“Bonuses have become a recruitment and retention tool rather than a reward for good performance,” he says. “There are so many corporate governance issues around permanent salaries that the only ‘wriggle room’ has been bonuses. That’s why in recent times there have been sums that have been seen as excessive, and the phenomenon of people asking for guaranteed bonuses – degrading the principle of paying for performance.”

These concerns were echoed in a recent report, Strategic Risk and Reward, published by the International Financing Review. It claims banks have focused too heavily on cash bonuses and neglected all other aspects of the reward package – resulting in a workforce shorn of loyalty.

The report’s author, Philip Whiteley, says the bank crisis represents a huge opportunity for HR. “What has happened is the biggest repudiation of the orthodoxy that people are just another resource,” he explains. “It’s been too easy for many firms to patronise and sideline HR over the years, but they won’t be doing that anymore.”

Whiteley contends that Goldman Sachs has gone further than other investment banks in developing a multi-dimensional reward strategy and in emphasising loyalty through its culture, which might explain its relative resilience compared with rivals Lehman Brothers and Merrill Lynch. He also talks of the need to establish a “more mature employee profile” on trading desks, which are dominated by less experienced people. Many aspects of the current crisis have parallels with previous ones, highlighting the value of experience and learning from the past.

Of course, employees in finance are likely to be forced to look beyond the bonus, next year at least, for the simple reason that many of them won’t be receiving one. The combined bonus pool for the UK finance sector in the first quarter of this year was £28 billion, a record high; at the top end, bonuses can be more than 100 per cent of salary. But it could be very different next year, says Alastair Hatchett, head of pay and HR services at Incomes Data Services.

“I would expect the bonus season in banking is going to be down to almost zero in the first months of 2009,” he says. “Basic salaries may also be frozen in the short term, although over time they will be under pressure to rise if they begin to take the place of bonuses.”

The “bonus culture” that has grown over the past decade was partly a response to tax and national insurance loopholes that have since been closed, says Hatchett. This suggests there is no reason that firms should not start to adopt a reward strategy focusing more on basic salary and total reward.

But will change, in fact, be forced on banks? Up until now, strong words from politicians and the Financial Services Authority (FSA) have been little more than rhetoric, with the FSA not having the power to intervene in reward practices, said Hatchett. However, banks that are part-nationalised under chancellor Alistair Darling’s bail-out plan are now in a different boat and will come under direct government influence.

Peter Christie, director of reward consulting at Hay Group, points out that the US bail-out plan includes measures for the US government to regulate the reward packages of the top handful of earners in each of the banks assisted. The UK’s banks may now have to submit to a similar approach, especially in institutions where the taxpayer has a stake.

Christie says the most important reform required is that bonuses are linked to risk and ongoing performance. Purely deferring a bonus or paying it in shares will not necessarily change employee behaviour.

“A huge amount of bonuses at Lehman Brothers were paid to staff in the form of stock, but it didn’t stop a small number of them trading in risky instruments,” Christie says. “Organisations have tried to engender loyalty and commitment, but it’s a difficult concept in that environment.”

He agrees this should be a time when HR bosses can make a real contribution to their firm’s fate, but says many are not in a position to do so. “Sadly there are many organisations in the City where HR is still seen as an overhead and a mere admin function,” he says. “There are some highly capable individuals working in HR who are not being allowed to show what they can do.”

So it seems some reform of bonuses may be inevitable. And it looks increasingly likely that banks will be unable to do it on their own terms.

And as we went to press…

  • Lehman Brothers has so far made 750 staff redundant, and about half of the bank’s 5,000-strong workforce are likely to be laid off as the bank has gone into administration and part of it sold to Nomura.
  • HSBC has cut 500 UK jobs, the majority from its Canary Wharf headquarters in London.
  • Bradford & Bingley cut 370 jobs prior to its part-nationalisation, and more are expected.
  • Northern Rock, nationalised in February, has slashed 1,300 posts this year, a quarter of its workforce.
  • HBOS and Lloyds TSB have admitted that job losses will be an inevitable consequence of their merger. The two banks have a joint workforce of 150,000 people.
  • UBS announced 2,000 job cuts this month, but its UK losses weren’t confirmed as PM went to press.