Leading article: The issue of bankers' pay cannot be ignored

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Such are the miseries galloping through western economies at the moment that talk of regulatory reform of the global financial sector inevitably sounds like stable doors slamming. And it is true that no reform our political leaders push through now can change where we are. The credit crunch cannot be reversed.

But, unless one subscribes to the idea that the present crisis is the end of capitalism, there is still merit in having a public discussion about how we can avoid ending up in quite such a deep hole again in the years to come. Memories in financial markets are notoriously short. It makes sense to implement reform now, before the next boom causes all the valuable lessons of the present bust to be forgotten.

So it was encouraging to hear Henry Paulson, the US Treasury Secretary, call during a visit in London this week for improvements to the regulatory system of financial institutions. The former head of Goldman Sachs wants better advance warnings of trouble and new powers for the authorities to extract information from large banks about the risks they are running.

All this is certainly necessary, and not just in America, but here in Britain too. The US Federal Reserve's orchestrated rescue of Bear Stearns and our own Treasury's nationalisation of Northern Rock have given the lie to the idea that we can afford to leave the financial sector to its own devices. The consequences of allowing either of these two institutions to go under would have been truly horrendous for our economies. They were too big to fail. The state had to step in.

Furthermore, the actions of the Federal Reserve and the Bank of England to swap government bonds for the mortgage-backed securities that the banks can no longer sell amounts to a public bail out for the financial sector of unprecedented proportions. The price of such support must be greater scrutiny of their affairs and more powers for the regulators to curtail irresponsible lending. In a free economy, governments cannot eliminate boom and bust cycles, but they can certainly do more to stop destabilising bubbles inflating in the first place.

The problem is that Mr Paulson does not go far enough. One of the driving factors behind the excesses of the boom was the flawed remuneration arrangements of high-rolling bank employees. Bonus packages were tailored to the amount of debt they sold, not the soundness of the underlying loans. Bank managements, whose own pay was also linked to the volume of business transacted rather than its quality, turned a blind eye. Risk assessment across the entire sector became hopelessly compromised.

Now the bubble has burst. The banks, nursing huge write-offs, have stopped lending. And we are all paying the price. At the very time our economies are slowing down, the banks are starving them of cash. As for the bankers responsible for the toxic loans, it is true that many of them have lost their jobs, but they still have their fortunes made at the height of the boom. What is this if not a form of "moral hazard"?

Asked in an interview yesterday on whether the US has any plans to impose controls on bank remuneration policies, Mr Paulson was unenthusiastic. While admitting that "no one wants to see high compensation for failure", he said: "I believe in market discipline. I think we are going to see markets react". The implication here is that bank shareholders, who have lost money, will take this action to modify the incentives system of their own accord. This seems rather optimistic, to put it mildly.

Governments are right to grapple with the regulation agenda. But, as sensitive and complex a challenge as it will doubtless be, they also need to turn their attention to the regulation of remuneration in the world of finance.

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