Bonus please Darling...

The Christmas lights have gone up in Bond Street and London's investment bankers know that we're entering bonus season. Luxury retailers and banker's mothers wait alongside expectantly to see whether it's Asprey or Asda this Christmas. By all accounts its been a bumper year across the city, with all parts of investment banking operations posting record profits. In any "normal" year the expectation of big individual payouts would be bordering on uncontrollable. This year though it is likely to be considerably less predictable than has been the case in the past. The poor souls, god love them in this uncertain time.

All of the big banks in London will be under pressure to conform to the G20 principles on bonus payouts, but the banks with continued government involvement will be most at risk of having to pay their staff "unsatisfactory" (i.e. low) amounts. In this realm, RBS has been the subject of most discussion. The UK government owns 70% of the ordinary shares and £13bn worth of B-shares, comprising an economic interest that will rise to about 84% upon conversion of option rights. That effectively gives the Treasury the right to interfere in whatever it wants. Given the political ramifications of allowing "excess" at RBS, the Treasury has predictably warned the board off awarding bumper bonuses this year.

There is a strong political imperative behind this veto. The general public - who are facing large scale public sector cuts, tax increases, and an election next year - cannot see why traders at the UK's busted banks should be granted lavish bonuses so soon after their multi-billion pound collapse. It's hard to argue against that point of view - without the taxpayer lifeline in the UK and around the world, the domino effect that Lehman Brother's collapse started would have taken out all but the very strongest of financial institutions. In that context bonuses would have become a fabled relic of an indulgent past. "The fact is that we have gifted vast profits to the banks as a result of our actions," said one MP. "If they were using those profits simply to strengthen themselves that would be okay. But what we can't accept, and what society can't accept, is that they are using those profits to pay enormous bonuses."

The hard line being taken by the Treasury has prompted RBS directors to consider their options amidst concern that it will be tricky to retain key staff if they aren't paid their "market rate". As the Sunday Times reported yesterday, more than 1,000 investment bankers have quit RBS to join rivals in the recent past on the basis of better financial prospects; and a London based headhunter told me a couple of weeks ago that she has been inundated with CVs of RBS staff who are looking to jump ship. The 1,000 who have already left were said to have contributed between £600-£700mm to the bank's coffers last year - funds that the taxpayer would presumably like to be earned in future years as it seeks a nice return on its investment.

As a lawyer friend of mine has pointed out - it seems that corporate governance has come full circle. If RBS lose their top producing staff because the government prevents them from paying them what they need to pay them, then are the board in breach of their fiduciary duty to protect the interests of shareholders? There are reports that lawyers representing board members at RBS have advised the board to resign en masse if the government intervenes to block or cap bonus payments. The argument goes that if the board did accept any restrictions which could be perceived to make RBS uncompetitive then they would be breach of their statutory responsibility, which could have legal implications for each member of the board.

Given that the government owns more than the 75% shareholding required to force a "special resolution" in theory they can force through whatever bonus related concerns they have. In practice, however, if the board still think that this is not in the best interests of these same shareholders they, as i understand it, are not obliged to follow the special resolution. In which case the only option for the government would be to remove the board. Do-able, but it would certainly be a little on the messy side of things.

Presumably the complexity of reducing the bonus payments at RBS is one of the factors behind Alistair Darling contemplating the "nuclear option" of a windfall tax on investment bonuses across the City of London, which would not just apply to the state owned banks, but all international banks operating out of London. This is rumoured to be a central tenet of his pre-budget report due this Wednesday, which will need to outline a host of ways in which the government can increase tax revenues and reduce expenditures. It's thought that a windfall tax could generate £1bn per year - a useful contribution, but unfortunately more of a political ploy than a significant revenue generator. In reality, the transient nature of the the London investment banking community would mean that other jurisdictions will quickly pull workers away from the City. As a consequence the current corporation and personal tax raising capacity from the financial services sector may ironically diminish as a result of the windfall tax.

What is clear to me is that solving for the false incentives that cash bonuses create cannot be isolated to one bank, let alone a city. If RBS can't pay, or there is a windfall tax on investment bankers bonuses in London, the bigger picture issue will not be solved. The financial system needs to be set-up to reward for performance that is real, and not short-termist. It's been acknowledged by the G20 leaders in the past that solutions to the financial crisis, in terms of better regulation and greater transparency, need to be global in nature. If the UK government is acting in an aggressive way, but nobody else is following, it might be good political capital for a baying public, but the real systemic issue of skewed risks and rewards in the financial system will remain, just at a different bank or in a different city.