Tuesday, 14 February 2012

The Fred Goodwin memorial prize

Despite much harrumphing and hang-wringing (not at the same time, mind - that looks odd), the politicians have yet to come up with a coherent plan to tackle the problem of bonuses beyond appeals to responsibility and restraint. Even Labour's proposal to levy a super-tax on bank bonuses is weedy as it's a one-off tax, hypothecated to alleviating youth unemployment. A policy on bonuses should not have to use the latter as cover.

The simplest solution would be to bump up the top rate of tax. This wouldn't catch bonuses delivered as share options or LTIPS, but that in turn might stimulate broader discussion about tax rates on capitals gains and dividends. But before settling on a solution, let's clarify the problem.

Bonuses are typically justified as incentives and/or rewards. In other words, the promise of a reward can stimulate superior performance (the carrot theory), while exceptional performance (whatever the stimulus) deserves reward and recognition, if only pour encourager les autres.

There is a lot of evidence, both statistical and anecdotal, that bonuses do not work for executive, managerial and professional roles. This is because the value of the worker's product is rarely determined just by the quantity of effort - i.e. working harder does not necessarily produce better results, for reasons beyond your control.

Where effort does influence output value, bonuses tend to work in a clear and measurable way, e.g. sales targets. Bonuses are an efficient and effective mechanism for the other ranks, but not for the officer class. So why do senior positions in business attract bonuses, and hugely disproportionate ones to boot?

In the case of bankers, the historical roots go back to the partnership arrangements of merchant banks. At the end of the year, you got a share of total profits. This was justified as you, as a partner, were also putting up your own capital and were liable in the event of a loss.

The introduction of US norms post-big-bang in the 1980s, on the back of the Euromoney market growth in the 60s/70s, saw non-partner traders picking up a share of specific book profits (but not losses). As these trades grew in size, so did the bonuses. As bank executives needed to maintain their status relative to their traders, so the rising tide floated their boats.

This bonus culture in the City soon spread to those businesses and professions that dealt with it, such as lawyers, business consultancies, public relations and headhunters. It became an inevitable talking point for the boards of companies being floated (what else are you going to talk to an investment banker about?), with the result that the executive bonus culture spread more widely through UK business.

In reality, these bonuses were simply profit share. However, a bonus regularly paid is eventually treated as an entitlement, and may even be transformed into a contractual obligation.

In summary, the problem is that bonuses are increasingly ineffective the higher up the corporate tree you go. The higher up the tree you go the more the bonus is just disguised salary.

But a bonus isn't just money. It is a positional good in its own right, i.e. it's about status. It's worth bearing in mind that someone who receives a £1 million bonus is (usually) going to be someone who is already very rich. For them, the extra million is less significant (in terms of marginal value) than it is for most people. So in terms of incentivisation, money is probably not as efficient for senior roles as it is for junior ones - i.e. you get more bang for your buck on the shop floor.

So here's my idea. Implement a super-tax of 100% on discretionary bonuses above £52,000 (i.e. twice current mean earnings). This is high enough to provide the flexibility for bonuses that will have an effect. This tax will produce zero revenue as most companies will simply convert the excess for their executives either into salary or share options. This is no bad thing (greater transparency at least, and possibly some deferred gratification), however I suggest another option might be considered.

In this, I have been inspired by Fred Goodwin ...

Let's privatise the honours system. By this I mean let's allow businesses to buy honours. A honour is an ideal positional good in that it can be created out of thin air but commands a high price. To keep the price up, we'd obviously have to ensure exclusivity, but that (ironically) can be achieved by ... keeping the price up.

There would have to be a fit-and-proper-persons test, though considering some of the crooks that have been ennobled in the past, this would only blackball the most egregious. It would also make sense to debar individuals from buying honours - they should at least go to the trouble of setting up a shell company in Jersey.

All this does not preclude Betty Windsor from still handing out gongs as she and the PM see fit. Indeed, the cachet of an honour depends in part on being able to associate with people of actual talent and achievement, so this element should be guaranteed. I suspect that hereditary honours would be reserved as well.

Combined with a proper super-tax on income (e.g. 70% over £1 million), and a more sensible approach to share options (i.e. caps on the £ amount that can be allocated), this could not only change the landscape for executive remuneration but also produce a healthy revenue stream for government expenditure.

This could even be hypothecated (if Ed Milliband really wants it) to specific capital projects, such as hospitals or schools, with the bonus of a plaque and opening ceremony for the honoured whose fees funded it. Let's be honest, few of the names you see on a plaque mean much anyway.

You might think that this is all so much lunacy, and that business (the City in particular) will find a way of shovelling money around the rules, however this ignores the fact that what drives human behaviour beyond a basic level has nothing to do with money as a pure exchange medium and everything to do with esteem, status and power. Money is useful only insofar as it enables these.

And Fred Goodwin?

The pure free market position would be that, once awarded, we would have no right as a society to rescind the honour, as it was now someone else's property. One could argue that the honour remains the property of the buyer, RBS, i.e. they have merely awarded the "use" of it to Goodwin and can thus unilaterally rescind it. In either event, this would have neatly removed the government from the frame.

But what about the fit-and-proper-persons test? There would be occasions when we would, as a society, refuse to recognise an honour due to subsequently revealed misdeeds. But the sponsor (e.g. RBS) would be held responsible for the behaviour of the honoured, and would further be responsible for guaranteeing their suitability up-front, so we should have no qualms about keeping the fee as a fine for their lack of diligence.

So, if my cunning plan had been followed all along, we'd have had the pleasure of seeing Fred Goodwin stripped of his knighthood and we could have benefited by about £10 million or more (prices accurate at time of going to print).

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