EDITOR'S TAKE: The fatal flaw in the new bonus systems

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If one phrase explains why banks got into so much trouble in the early noughties, it’s Chuck Prince’s assertion that Citigroup was “still dancing" in July 2007 despite the arrhythmic beat which left it with a nosebleed and as much as $3 trillion in nasty off-balance sheet assets.

Why did Citigroup keep on head banging? The simple answer is that its competitors were head banging too, and making big profits in the process. If Citi stayed at the bar drinking orange juice, it would have looked foolish. At the time, the share prices of rivals were rising fast: Goldman’s stock rose 60% in 2006; Lehman’s rose 22%.

The result was a rush to keep up, and not just at Citi. As Andy Haldane, the Bank of England’s executive director for financial stability said this week, “higher leverage became banks' only means of keeping up with the Jones's. Management resorted to the roulette wheel."

If risk taking is to be discouraged, keeping up with the Joneses should therefore surely be outlawed.

Instead, the opposite seems to be happening. Conspicuous on Morgan Stanley’s website is its 2009 compensation report, setting out how it’s adapting its compensation system to the “current environment.”

As well as boasting of its prescience in being the first major US bank to impose clawbacks, the report highlights Morgan Stanley’s new ‘multi-year performance-based programme.’ Under this, two thirds of the stock units awarded to its senior executives will be tied to the company’s ROE and total shareholder return relative to its peers.

Morgan Stanley isn’t the only bank operating this kind of system. Macquarie, for example, already imposes a performance hurdle on the options it issues to executive directors. The three year average return on its own equity must exceed the comparable return for a selected group of its peers if the options are to pay.

Is this really such a good idea? Principle seven of the FSA’s consultation paper on reforming remuneration in financial services says measures of long term performance must be risk adjusted.

By linking senior staff’s bonuses to the performance of rival firms, banks seem to be badly missing the point. Risk is disregarded, and the incentive is to keep up at any cost.

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