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Bank warns on City stars' big bonuses

The Bank of England is growing increasingly concerned about the potentially destabilising effect of the City's highest earning stars on the financial institutions that employ them.

Even before last Friday's announcement of a pounds 50m hole in NatWest Markets' options trading book, the Bank had become especially worried about the role big bonuses play in the risks traders are prepared to take with their employers' capital.

The publication by the Bank today of a report on "Remuneration and Risk" coincides with speculation that Kyriacous Papouis, the junior trader understood to be responsible for NatWest's catastrophic derivatives pricing error, is to be suspended by his current employer Bear Stearns, pending the completion of NatWest's internal inquiry into the affair. Mr Papouis left NatWest last December for the American bank, which yesterday refused to comment.

According to the Bank of England: "Remuneration policy has a broader role as a management tool. The amount someone is paid provides powerful signals to other employees about what is regarded as desirable behaviour. If large bonuses are paid to employees who make money but are perceived to have a cavalier approach to compliance, it is likely to encourage similar behaviour in others."

The report highlighted the need for effective controls on traders, only days after NatWest said it had suspended the manager responsible for Mr Papouis's trading activities. It warned that the potential imbalance between the risks and rewards that were considered acceptable by firms and by their employees could put any system of checks and balances under strain.

"Effective controls on risk-taking and measures to ensure the honesty of employees are essential, no matter how the bonus scheme is designed. But a remuneration scheme which gives perverse rewards to risk-taking behaviour may put the control system under great stress," said Daniel Davies, the report's author.

The announcement that a "mis-pricing error" in its interest rate option book would hit half-year figures to the tune of pounds 50m, came just three days after NatWest had announced figures for the year to last December and assured investors that its derivatives trading operation was tightly controlled. Concerns have been expressed about the risks being taken by relatively staid high street banking groups as they encroached on the more flamboyant trading areas of investment banks.

The emergence of problems at NatWest, so soon after fiascos at Barings and Deutsche Morgan Grenfell, came in the same week as a damning indictment of the City's "star" system and the bonuses that fuel it by Donald Gordon, chairman of Liberty International.

He said: "One unattractive feature of the rise in the dominance of financial markets has been a massive surge in over-incentivisation of personnel within the investment banking and capital market sectors leading to an excessively materialistic culture in big financial markets."