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The Economist: Bonuses? That's rather bad form ...

Especially so given the subsidies big banks receive. Here's a way to fix things:

By FROM THE ECONOMIST

Last update: October 22, 2009 - 8:49 PM

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Watching an industry committing political suicide is ugly. That is what investment banks are doing by paying bumper bonuses a year after they were saved by state intervention.

Goldman Sachs is set to award staff a near record $20 billion this year. Firms making losses for shareholders, such as Citigroup and Bank of America, are still paying hefty bonuses.

Such rewards, in the face of public protest, feed the impression that banks are victims of what some call "employee capture." The top 10 investment banks (as of the start of 2008) made an average return on equity of just 8 percent between 1999 and 2008. Four made cumulative losses. Staff got four times as much as shareholders did in profits.

Normally, that would be a problem for shareholders alone. But Merrill and many others got bailed out by government. The new bonuses make a mockery of banks' claim that higher equity buffers are too expensive to contemplate. Some governments still own stakes in banks, so decisions on pay are directly theirs.

Worst of all, bonuses are being paid in part from subsidies. This is not a free market, but a perversion of it.

It is worth revisiting how much policy has been skewed in banks' favor. It is not just that they were saved from destruction. They got public capital (much of it now repaid), short-selling bans on their shares and rescues of counterparties, such as American International Group, which the public otherwise had no interest in saving. Today they enjoy laxer accounting, loose collateral rules at central banks, explicit debt guarantees and asset-purchasing schemes.

And, critically, they can borrow cheaply because they are deemed too big to fail. All of them -- from comparatively healthy Goldman to the nationalized weaklings -- are being subsidized by the rest of us. As a way to keep cash flowing to the wider economy and help banks rebuild their capital, this subsidy made sense; nobody intended it to go to employees.

In the longer term, the bonus mess underlines the importance of getting the state out of finance -- setting a time limit for the explicit guarantees and finding ways to lessen the implicit promise of support. In the shorter term, the political provocation of the bonus payouts is likely to increase demand for a windfall tax on bonuses or salary caps. Both look mistaken.

Retrospective taxes are usually bad news. They distort incentives and scare investors in other industries, who fear they may be next. A wholesale cap on pay would lead regulators further into the swamp of micromanagement. And symbolic caps on a few top executives, as the White House is threatening, are too feeble a response.

A better alternative would be to claw back the subsidy banks get through being too big to fail. Assume that America's top five investment banks would pay 2 percentage points more on unsecured borrowings without an implicit guarantee. On that basis, the subsidy is $36 billion a year (compared with pay this year of perhaps $120 billion). Providing banks have built up adequate capital, they could face a funding "premium" in much the same way that they already pay premiums for deposit insurance. This would have to be paid before bonuses.

Regulators should cap bonuses only to the extent that they cause losses that erode capital, but assuming that shareholders, including governments, show some spine, pay would be squeezed at profitable banks. If some traders left weaker banks to join unguaranteed hedge funds, so much the better for the taxpayer.

That still leaves some tricky questions. Some banks might be unable to afford the annual subsidy premium. They could be permitted to defer its payment, but if it were for more than a couple of years it would be a good indication they should be wound down. There would be hellish choices about which banks are perceived to be too big to fail, and whether lower-risk retail banks should be charged less. Still, these are dilemmas capital regulators are already grappling with. A funding premium could piggyback off their work.

Ideally, investment banks would have no public guarantee, their profits would reflect private endeavor alone and their pay would be decided by their owners. But the opposite exists today -- which is why any right-thinking capitalist should want to see that subsidy clawed back.

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