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It is economically sensible and morally imperative to talk of weakening the link between compensation and profits in banking, for example through the use of caps on bonuses. It will also help tackle some of the most pressing problems in the banking system.
Whatever one might think of base salary levels in finance, it is the possibility of large bonuses that has been a major driver of many of the most pernicious problems in banking. The risk-reward landscape faced by bankers is highly skewed. Traders and deal-makers, in particular, can earn multiples of base salary on the upside. Retail banking has also seen a proliferation of performance-linked pay, where selling large volumes of products, such as payment protection insurance, is highly rewarded. The downside, if things go wrong, is limited to getting fired and losing one's salary. Criminal prosecution and prison, no matter what the degree of malfeasance or irresponsibility, remain an exception. The costs of things going wrong are often borne by taxpayers.
These skewed incentives drive excessive risk-taking among traders, promoting marginal and sometimes "value-destroying" mergers and acquisitions by investment bankers, and the sale of inappropriate financial products by retail bankers. All else being equal, larger, riskier trades, bigger mergers and higher volumes of products sold are more profitable. As the Libor scandal, the widespread mis-selling of financial products and support for dubious tax-evading activities all show, the starry-eyed pursuit of ever-larger bonuses also drives bankers to cut corners with the law.
It is the prospect of large bonuses that makes the culture of excessive risk-taking and bending rules endemic to banking and it can only be tackled by capping rewards. Increasing the risks of prosecution will also help.
Half measures, such as being able to claw bonuses back when losses arise, are mostly ineffective. They fail to account for the fact that, under most circumstances, risks taken by bankers do not materialise into losses. Betting on house prices continuing to rise, for example, is risky, but will generate handsome rewards in most years. The bending and breaking of rules often goes undetected.