Dr Dread: Bonuses are rotten, but necessary

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Mervyn King's scathing attack on bonuses would be easy to dismiss as the naïve whining of an underpaid regulator, were it not for the stench coming from the system.

The investment banking world, or the 'Shadow Banking System' - let's call it SBS, is a different world and a law unto itself. It exists in the real world (RW) and yet is distinct and apart - like oil on water. It offers opportunities to a wide variety of professions at huge premiums to those available in the RW - IT professionals, lawyers, economists, HR personnel - even the service industry servicing the SBS charges a premium.

The 'culture' King is referring to is at the core of this phenomenon. The compensation structure in the SBS is based on a ruthlessly capitalistic 'efficient frontier' mechanism - the higher the risk, the higher the reward.

The flaw in this model is the measurement of risk, and who is taking the risk. At one end of the spectrum, prop traders take the highest level of risk and demand the highest return - the risk however to the prop trader is the loss of his/her job, while return is theoretically infinite. In such a system, it is only rational that everyone in the SBS (traders, salesmen, business managers, etc) maximise the risk to the institution to maximise their own personal return. This asymmetric risk return profile is at the heart of the 'bonus-driven culture'.

In the boom years of the last two decades, risk-taking reached obscene levels. An unprecedented amount of money was injected into the system and innovative derivatives designed to maximise leverage and facilitate risky behaviour pushed personal gain at the expense of the institution. Regulators, rating agencies and governments were all complicit.

Greed, arrogance, hypocrisy and moral hazard

In the process, a generation of business managers and CEOs were born who understood nothing about the concept of risk but everything about the concept of return. Lip service was paid to teamwork and working for the good of the whole, but the entire model was created, maintained and serviced to reward excessive greed, arrogance, hypocrisy, lack of personal responsibility and moral hazard.

Nevertheless, King's idea of regulating compensation, while a courageous stab at a complex problem, is misguided.

A culture evolves over many, many years and cannot be changed overnight. It definitely cannot be changed by exogenous regulatory forces. Any attempt at regulation will simply cause an exodus to hedge funds, which will selectively continue to thrive as long as the demand from wealthy clients is there, or to countries where such Soviet-style Marxist regulations do not exist.

This exodus is already happening - to Dubai, Singapore, Hong Kong and Mumbai - these cities are providing enormous incentives (regulatory, taxation) and lower barriers to entry, along with a lifestyle and standard of living unavailable in London.

An attack on the SBS culture - no matter how cancerous and inequitable it may seem - will fatally wound London as a global financial centre. This culture, born of market forces, maintained by market forces, can only metamorphose into something better and different under the influence of market forces. The market cleansing tsunami sweeping the SBS and the real economy will force changes upon the industry - only those that adapt to these changes will survive.

Are you overpaid? Should bonuses be reformed? Click here to have your say via the eFinancialCareers bonus survey.

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