Why bonuses for bankers are a good thing

(breakingviews.com) -- Shoot-from-the-hip legislators are getting what they asked for -- the slow death of the Wall Street bonus. But that's not necessarily a good thing. While bonuses became something of a dangerous entitlement over the past few fat years, the incentive-based pay schemes common to the financial industry had many virtues.

These are now being discarded in response to regulatory and legislative measures. Much of the new policy agenda, such as the amendment to President Obama's stimulus package in February, has a clear populist bent. The amendment forces banks that tap the Troubled Asset Relief Program to restrict the bonuses of their biggest earners to no more than a third of total compensation.

Over in the UK, the Financial Services Authority has argued that "fixed pay should be a sufficiently high proportion of total remuneration to allow for a flexible bonus scheme".

The problem with these reforms is that they create an incentive for financial firms to raise their base salaries, to compensate for forgone bonuses. And that's precisely what's happening.

Late on Friday, Morgan Stanley (MS, Fortune 500) said the base salaries of its co-presidents would rise by a third to $800,000 a year, while those of its chief financial, chief administrative and chief legal officers would rise to $750,000.

Morgan Stanley is not the first firm to raise base pay. UBS (UBS) has also signaled to its bankers that their base salaries were going up. And Morgan Stanley's move is likely to trickle down to the salaries of its thousands of managing directors.

There is no doubt that Wall Street's incentives were skewed during the boom. Bankers and traders were often paid up front for deals that were later to cost their shareholders, and eventually taxpayers, dearly. Such bonus schemes should certainly be abolished.

But bonus is not a four-letter word. Ideally bonuses motivate and reward high performance by individuals and act as a sort of profit share, giving financial firms flexibility in how they manage their costs. When times are tough, overall compensation costs can be cut.

Salaries, however, are sticky and hard to amend. A shift to fixed from variable undermines some of better aspects of Wall Street's model. It would be better for regulators to focus on finding ways to link bonuses to genuine performance, judged over several years, before salaries go up across the board to the detriment of shareholders -- and, once again, taxpayers.