by Jonathan Eyal, Straits Times Europe Bureau

REACTING to mounting evidence that despite the global economic crisis, some banks are again promising their executives large pay bonuses, France's Finance Minister Christine Lagarde has condemned the practice as 'an absolute disgrace' and called on governments to tighten financial regulation.

French politicians are traditionally hostile to private capital markets. However, Ms Lagarde's anger is echoed even in Britain, home to Europe's biggest financial centre. A recent report commissioned by the British government recommends that if bankers are to be paid any bonuses, these should be spread over years.

But everything suggests that efforts to stamp out bank bonuses are failing. Financial institutions as diverse as Deutsche Bank, Citibank or Nomura are now again dangling huge payouts. And to make matters worse, these payouts are apparently unrelated to future performance: just wads of cash to those lucky enough to hit the jackpot.

So at first sight, the politicians' anger seems justified. The 'bonus culture', they claim, contributed to the financial meltdown. Bankers focused on their own performance, with little regard to the wider consequences. And none of these supposed whiz-kids accepted liability for the subsequent disaster.

Sir Fred Goodwin, for instance, the man who led the Royal Bank of Scotland to the biggest loss in British corporate history, walked away with a cool S$1.3 million yearly pension, leaving the taxpayer to bail out his bankrupt enterprise.

While everyone accepts that bonuses can incentivise and reward good employees, would a banking executive be more or less productive because he or she is paid just one million dollars instead of ten? Furthermore, what incentive is there in guaranteed bonuses?

Some countries - such as Netherlands - have already introduced limits on such payouts. But most other governments are hesitating, and for a good reason: Although bankers' bonuses arouse strong emotions, they remain a highly complex issue.

There is a big difference between guaranteed bonuses and those conditioned on performance criteria. The guaranteed bonuses are nothing more than a recruitment device, designed to poach employees from competitors. They have no direct impact on a bank's behaviour.

The bonuses paid on the basis of performance, however, may create problems, for they could encourage reckless behaviour.

Nevertheless, it is important to recall that the current economic crisis was not caused by bankers chasing fat bonuses. Rather, it was caused by the systemic failure of financial institutions to price risk correctly.

Despite all the mathematical formulas devised by lenders, measuring risk remains an art, rather than a science. Curtailing bankers' bonuses will do little to address this difficulty.

And although the banking sector does appear to offer mind-boggling rewards, this is largely because of its fundamental business model: Profits in the finance sector fluctuate; banks therefore need to control fixed costs. This means that their basic salaries are mediocre, but up to half of the yearly profits are paid out in bonuses. In effect, the bank transfers some of its operating risk to its employees. Their monthly salaries can be seen as just advances on an unpredictable final pay.

Furthermore, although bonuses for high-earners seem excessive, people below the executive level also benefit from the bonus pool, despite the fact that they have little control over the critical decisions. Depriving them of payouts merely leaves the cash to be distributed to a bank's shareholders. There is no evidence that shareholders are more efficient risk-assessors than a bank's employees.

This is not to suggest that matters should remain unchanged. Financial institutions currently propped up by taxpayers cannot pay astronomical figures. It is also important to ensure that good performance is assessed over a longer period than just one year.

Policy Exchange, a right-of-centre British think tank, has proposed a new bonus scheme which will give banking chiefs options on shares in their financial institution, but will prevent them from exercising these options for a period of five years. This means that everyone has a stake in ensuring long-term growth.

The recruitment of top executives certainly needs reform. People who sit on the boards of banks should know about finance. Too many executives failed in their duties simply because they did not understand the complex financial instruments which their employees handled.

And banks could appoint independent advisers to help them fix remuneration. That would ensure greater transparency.

Ultimately, however, the real job for governments is not to indulge in populist demands for revenge against well-paid individual bankers, but to devise proper supervisory agencies which can identify banks exposed to unnecessary or excessive dangers. And ironically, staffing these new supervisory agencies will require the creation of new, highly paid positions.

Dr Tony Tan, the deputy chairman and executive director of the Government of Singapore Investment Corporation (GIC), was the first to identify this challenge, when he warned participants at the World Economic Forum in February this year that any reform of the global financial architecture would have only limited success unless there were enough talented people to manage the reforms

The old adage, therefore, applies, to both bankers and regulators: If you pay peanuts, you are still only likely to get monkeys.

jonathan.eyal@gmail.com

This article was first published in The Straits Times.