City bonus system: an operational risk?

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LONDON – The City bonus system is constantly under fire by the UK press, but this time top economist Joseph Stiglitz is blaming investment banker bonuses for exacerbating the credit crunch.

The number of tales of investment bankers knowingly overvaluing products to ensure they meet their bonus targets, and pocketing their million-pound gains before being found out and sacked, are growing in the city. Answering reader’s questions in The Independent, Stiglitz commented that even knowing they will be sacked once their methods have been discovered does not deter some unscrupulous bankers because by that time they will already have been paid. “It was predictable that this system would lead to problems,” he said.

The bonus system encourages bankers to take risks because high returns are rewarded with big bonuses but, when their gambles fail, bankers do not share in the losses. Subprime writedowns are currently estimated to be more than £60 billion but city bonuses are expected to top £6 billion this year. Although this figure is the lowest since 2003, the average staff bonus will be around £200,000. Stiglitz does not advocate removing the bonus system altogether, but rather says it should be pinned to long-term success. So instead of capping bonuses, banks should ensure their bankers share in the losses as well as the gains by using methods such as holding bonuses in escrow for 10 years. If there were losses in the second, third or fourth years, the bonuses could be reduced appropriately.

In Stiglitz’s opinion, the regulators have not been doing enough to monitor the situation, and have not been keeping pace with innovations in the financial markets.

To keep the regulators out, the industry needs to come up with its own way of rewarding staff that cannot be tailored by unscrupulous bankers for their own needs. Human resources risk is a key area for op risk managers – should this abuse continue, the responsibility might ultimately fall into their hands.