Paul Collier: Gamblers who must be punished

There's a way to avoid excess risk-taking by bankers - make it a crime

This column is about bonuses in the financial sector. Please do not read it if you suffer from high blood pressure. As the season of goodwill app-roaches, the news that the investment banks will be paying out $30bn in bonuses should gladden the heart. So why do I feel like Scrooge? Put crudely, it is because it has dawned on me where all the enormous earnings in the financial sector are coming from. Despite wanting to think of myself as generous, I baulk at being that generous: they are coming from people like me, and yes, I am sorry to say, like you.

To earn your share of $30bn in bonuses you have to be smart. Here, let me be generous: smarter than I am. Indeed, many Oxford economics students have headed into the financial sector and I must have been pretty stupid to hang around teaching them. But being smart is not the same as being productive. Yes, in one sense these people have earned their money: their time at work has generated enormous profits for their companies. But what was the basis for those profits?

It is not just the investment banks. The financial sector has been enormously profitable: in the US in recent years it has accounted for around a third of all corporate profits. Despite the meltdown of the sector it continues to be enormously profitable: in the second quarter of 2009 its share was 29 per cent. One recent source of profit has been that the banks can now virtually borrow for free. Don't take it from me, take it from Christian Noyer, governor of the French central bank: "It is clear to everyone that recent profits in the financial sector are, for the most part, a result of public policies implemented to combat the crisis." Please try not to be upset by that.

What you should be upset about is the other source of profit. Mr Rajaratnam of Galleon Holdings should give you a clue. His alleged insider trading may have overstepped the law, which I doubt is the case with those bonuses: remember, these people are very smart. But their return on all that smartness is primarily the result of the enormous rents on superior short-term information in the selection of financial assets. Although capturing those rents is privately profitable, it is socially useless. Quite obviously, the financial sector has not added a third of all corporate value to the real economy: even at their best, financial services merely facilitate real activity. The rents are transfers from the poor suckers who sell assets a little too cheaply, and buy assets that are a little overvalued.

Those poor suckers are me and you, via our pension funds. Your pension is managed by people who are paid far more than you are. You pay them a lot precisely because the returns on superior information in investment management are so high. But you do not pay enough to match the fancy bonuses. Those bonuses are earned by outsmarting our managers and so depressing the returns on our pensions.

Bankers now complain that restrictions on their bonus payments will weaken incentives. You may feel that they are ill-advised to voice these arguments given public sentiment and the proximity of lampposts, but to be fair to them they do cite academic research as evidence.

A new study by the National Bureau of Economic Research finds that bankers lost their own money as well as that of other people. If bankers lost their own money, so the argument goes, bonus incentives to take big risks cannot have been the problem. While I realise that modern economic analysis has much to answer for, it does come up with a convincing response to this sort of argument.

The killer effect of bonuses has probably not been on the marginal behaviour of managers, but on the selection of the people who become managers. Primarily, the problem is not that bonuses tempt managers to do with other people's money what they would not be prepared to do with their own. Rather, it is that the bonus culture attracts risk-lovers into management instead of the prudent.

Before the financial crash, the gamblers suspected that if collectively they got into trouble their firms would be bailed out by the Government. The key change since the financial crisis is that suspicion has been replaced by certainty. To date there has been little to counter the heightened danger that they will gleefully repeat the trick of privatising the upside risks while socialising the downside.

Tighter regulation has foundered on a lack of international coordination: each government wants to offer the most tolerant environment; splitting the banks up, as advocated by Governor Mervyn King, has foundered on the opposition of Prime Minister Prudence. Instead, with its trademark blend of hype and confusion the Government has announced a one-off tax on bonus pools. Most banks have decided to leave bonuses intact and pay it from profits, so the tax will fall on shareholders. As a result of the bailout, the largest bank shareholder is the Government. Yes, this is a reverse "stealth tax", more visible than real.

Let me try to break the deadlock. There is a simple way of avoiding excess risk-taking by the managers of our financial institutions. It is to make it a crime. The problem with criminal prosecutions against financial crime has been the legal hurdle of proof: a key American prosecution of hedge fund managers recently failed on this count. The solution comes from how we handle unlawful killing: we have two different crimes.

Murder requires proof of intention, but manslaughter merely requires the prosecution to demonstrate recklessness: that a normally cautious person would not have behaved in the same way. We already have the equivalent financial crime to murder, but we need the crime of bankslaughter. One neat thing about criminalising recklessness, in contrast to fiddling with bonuses, is that if a reckless management decision eventually blows up the long reach of the law can pursue the person who took that decision.

The reason why this is important is not the delightful frisson of vengeance at the spectacle of some elderly gent being dragged off the golf course. It is that had a crime for reckless management of a financial institution been on the books, Northern Rock and RBS would not have blown up.

Reckless management of the Treasury would, of course, be exempted.

Paul Collier is professor of economics at Oxford University