Andreas Whittam Smith: Separate 'good' and 'bad' bonuses to clean up City

Banks don't pay a single penny for insurance provided by the tax payer

The moral case for levying a special tax on bankers' bonuses is strong. You can come to this conclusion by way of righteous anger or by showing that banking profits are illusory.

The argument from indignation starts by observing that reckless overtrading by the banks caused the crash of 2007-2008. So why should their executives carry on as if nothing had happened and take home bonuses (for what exactly?) that often reach into six figures and even into seven? By way of contrast, take the North East steelmaker, Corus, which has just announced 1700 redundancies. Without the recession induced by the banking crash, how many of these jobs might have been saved?

It is not that anybody doubts that the banking system is more important than a Teesside steel plant. No, what enrages is the feeling that somehow, in the final analysis, taxpayers are financing undeserved bonuses.

I say that the profits of banks are illusory even though they publish accounts signed by respectable firms of auditors that show they are in surplus on their day-to-day activities. These figures, however, are make-believe in this sense. Banks enjoy an unofficial guarantee from governments that they are too big to fail. This has allowed them to overtrade with impunity. Yet they pay not a penny for this insurance. If the full cost were charged to the banks, their apparent profitability would shrink substantially.

Moreover they benefit from extremely low interest rates. For their raw material is the deposits they attract. And these rates are, if you like, a gift from the Government, a necessary measure to bring us out of recession. Imagine telling Corus that it need pay hardly anything for coal, coke and ore. Its staff would think they were in steel heaven. That is where the bankers are – enjoying the best of times while the country struggles to recover from their mistakes.

As it happens Alistair Darling, has chosen a clever method of attack. It is not individual employees who will pay the one-off levy but the banks themselves. If a bond trader, say, has 'earned' a £1 million bonus from his bank and the bank decides to pay it – as it almost certainly would – then nothing has changed for the bond dealer. He or she will simply pay income tax in the usual way. For the bank pays the one-off levy, not the individual. There is, therefore, no reason for bankers to flee to overseas financial centres to improve their tax position. And for the British-based banks as a whole, the £550m that the levy is expected to bring in is a small amount when compared with, say, aggregate losses of £80bn recorded last year.

Thus the Chancellor's bonus levy will neither diminish the value of the taxpayers' stakes in banks that have been rescued by the Government nor significantly harm London's standing as a financial centre.

Oh, say the critics, but the levy can be so easily avoided by turning bonuses into salary. But banks wouldn't rush to do this. It would transform a variable cost into a fixed cost and thus require more capital. And anyway, why make an irreversible change of this nature when the levy has a duration of just four months?

As a matter of fact, Mr. Darling may have opened up an interesting way forward. The levy runs out on 5 April 2010. I believe that he should now start to prepare a replacement.

Flying in the face of City opinion, I believe the levy should be renewed for the 2010-2011 tax year subject to one major change. It should be applied only to 'bad' bonus schemes. A "bad" bonus scheme would be one that encouraged reckless behaviour. There were plenty of examples of these before the crash. A bad bonus scheme might also be one that had a guaranteed element, for if a payment is guaranteed, it cannot act as an incentive. There are still lots of these around.

Another example of a bad scheme would be one that rewarded executives for fortunate market movements that no single individual can bring about. Good bonus schemes would reward only genuine "value added". And they would be paid only after a sufficient period had elapsed to establish that what seemed like a good deal when it was made had proved worthwhile in the fullness of time.

I advocate this approach because it would serve to clean up the London market by driving out badly constructed bonus arrangements. It would make the City even more professional. And, crowning glory, moral outrage would have brought about an improvement in City practices.

a.whittamsmith@independent.co.uk