Hester, bonuses and the perils of payment by results

I have just listened to Stephen Hester of RBS explaining that salaries must "reflect worth".  He is quite right, he is turning RBS round, he has reduced the absolutely obscene pay and bonuses there to simply obscene.  He is an honourable man who remains unfortunately profoundly wrong - banking salaries are still corroding the economy, creating house price inflation, heaping ridicule on the efforts of the middle classes and cheer-leading the destruction of UK manufacturing.  

He is profoundly wrong because he does not yet see - any more than the political establishment sees - that the financial sector is not dysfunctional because of its operating mistakes.  It is dysfunctional because, even when it has been operating as designed, it has been undermining the economy, corroding our national life.

The central economic task before this government and the next is not to rebuild the financial sector in its current model; it is to create an effective local lending infrastructure.

Does Hester get that?  Obviously not.  Does George Osborne get it?  No.  Do the Lib Dems get it?  They are beginning to (but I may be being hopelessly optimistic).

Which brings is to the UK's backward position on the European Union decision to cap bankers' bonuses.  Bonuses need capping not just because they are a waste of shareholders' and taxpayers' money (though they are), nor because they unfairly privilege the richest (though they certainly do), but because they are actually glorified targets. They have exactly the same perverse effect on companies and organisations that they do on public services.

Just like targets, bonuses persuade staff to focus on reaching simplified numerical targets which can't possibly sum up the complexity of the broad objectives we want them to strive for.  Like targets, bonuses narrow complex objectives down to impoverished output figures. They sacrifice broad objectives for narrow outputs. You might as well replace highly paid human beings with extremely expensive machines.

Whether they are public or private, organisations in which senior staff get major bonuses are therefore organisations dominated by targets, and they resemble the target-driven public sector in many ways. They tend to be characterised by the headlong pursuit of narrow measures, gargling with highly inaccurate figures, and what can sometimes look like the dereliction of duty. Hospitals where older patients were seriously neglected were those that pursued targets hardest.

"As an investor, I have no interest in how much a manager is paid," said the investor Terry Smith, "but I have a great deal of interest in how that pay is calculated" (I do have an interest in how much they are paid, but you get the point).

Anyone who wants to see what bonuses can achieve in financial services should read Michael Lewis's book The Big Short, his brilliant exposé of the sub-prime mortgage crisis.  At every level, in the disaster that destroyed the world's banks, the behaviour of staff was dominated by bonuses related to narrow targets.

The mortgage sales teams were only interested in how many mortgages they could sell, not whether they could ever be repaid. The bond departments were only interested in packaging up new bonds, packed with mortgage debt, rather than whether or not the debts were sound.

Even the ratings agencies were dominated by targets, by how much they could earn from the bond departments, rather than whether they were accurately rated. When a handful of ratings officials finally suggested downgrading some of these toxic CDOs, Lewis described how they were overruled by managers.

The banking system has been hollowed out by these targets, but turbo-charged by obscene bonus amounts – a perverse Payment By Results system.  The interests of our economies, and our banks, are best served – not just by capping bonuses but by taxing them at 90 per cent.