For a lot of dollars more

Bonus culture is entrenched in the City but it carries huge risks, writes Richard Halstead

In Liar's Poker, Michael Lewis's seminal work on Wall Street greed in the 1980s and his part in it, he recalls a strange feeling that washed over him on the way to his first day at work. "I didn't really imagine I was going to work, more as if I were going to collect lottery winnings."

Salomon Brothers, where Lewis worked in the 1980s, had traders who would just as happily bet thousands of dollars of their own money against each other as they would risk millions of dollars of the firm's capital in the financial markets. They were earning enough: the mortgage bond department alone - 25 traders - made profits of $300m in one particularly good year, and top executives pocketed bonuses of between $2m and $5m. In one celebrated incident, Salomon chairman John Gutfreund challenged a trader, John Meriwether, to one hand of the card game liar's poker for "1 million dollars, and no tears".

Ten years, a stock market crash and a recession later, the financial landscape may have changed, but the high-rolling bonus structure is essentially the same. Star performers and valuable executives regularly command seven- figure remuneration packages. Recent examples are legion, but try these for size: Connie Voldstad, a London-based markets executive at Merrill Lynch, reportedly got a pounds 3m bonus for last year; the senior London partner of Goldman Sachs got around pounds 2m; and the recently famous fund manager Nicola Horlick is pursuing legal action to recover her 1996 bonus, estimated to exceed pounds 1m.

Beneath these headline-grabbers lies another stratum of bonus-getters: the traders, salesmen and researchers whose bonuses are a (relatively) modest upper six figures. These are the ones who make the City of London function by buying and selling financial instruments (some of which they may have even created themselves) and hoping that at the end of the day their trading account (and therefore their company) will be in healthy profit to guarantee them a particularly fat bonus cheque. The bonus money, one trader says, doesn't really matter in itself, but "it's a way of keeping score. Your number has to be bigger than that of the guy sitting next to you."

The theory behind such telephone number bonuses is simple. They encourage the trader to work harder, execute profitable trades and search for new angles and innovations. They are there for the same reason that profit- related bonuses make up a greater or lesser part of pay packets for a large segment of the British workforce - to encourage productivity.

Nor are bonuses within the Square Mile anything new. They were a feature in the compensation packages of brokers and traders working for the old stockbroking partnerships, long before Big Bang in 1986. Back then, partnership remuneration worked much like that at an accountancy practice or firm of solicitors; a small salary, topped up with partnership income based largely on seniority and drawn directly from the profits the firm made in the year. The flipside of this arrangement was that the partners would have to cough up their own money to bail the firm out if it made a loss.

Since Big Bang, most of these broking partnerships have been absorbed by the high-street clearing banks or by international investment houses. No big player in the City apart from Goldman Sachs has a partnership structure - all the traders, salesmen, researchers and even senior executives are employees, answerable ultimately to the shareholders of the bank or institution. They still get their bonuses, of course, but they no longer have to fork out their own cash when the company has a bad year. The worst thing that can happen to them is that they lose their jobs.

Herein lies the problem. In an article published in the Financial Stability Review, the house organ of the Bank of England, Daniel Davies, a financial strategist at the Bank, pointed out that divorcing the risk from the reward element in the bonus equation - traders can bet the farm even though it is not theirs any more - puts the institution itself at risk. "They may share profits from favourable trading outcomes, but it is difficult or impossible to make them compensate their employer for losses," Mr Davies writes. "Dismissal is the worst sanction an employer can inflict."

The article goes on to assess the effects of the City bonus culture, pointing out that traders may take large or unnecessary risks with the firm's capital in the hope of generating larger bonus payments. Checks and balances, such as the introduction of trading limits and deferred bonuses, are cited as ways of mitigating the risky behaviour of traders. The author also warns that "all or nothing" bonus structures - if traders miss annual profit targets, they would get no bonus at all - encourage unnecessary risks.

Reading between the lines, the Bank of England is going about as far as its mandate allows in recommending that City institutions review their reward policies. Foremost in the Bank's mind is the possibility of another Barings (caused in part by Nick Leeson's desire for a big bonus) or even a disaster on a smaller scale like last week's revelation of NatWest's pounds 50m trading loss.

But senior City figures believe the problems caused by the bonus culture run much deeper. It is not just the risk presented by the trader going for his or her bonus, they say, it is the spiralling wage bills caused by the existence of bonuses themselves, and their distorting effects on the labour market.

Ironically, some of this is caused by the more modern and supposedly "safer" methods of structuring bonus packages. These days a large element of bonus is deferred, in part to ensure that a trader's books add up correctly, but mostly to serve as "golden handcuffs" to keep an employee loyal. If a rival firm wants to hire someone who has not yet been paid the deferred element, it will have to match it (at which point it becomes a "golden hello"). The result for any firm recruiting aggressively, or just doing more than the average hiring and firing, is that the wage bill starts to spiral.

"It is very easy in the City to create an environment where any problem is solved by throwing money at it," says Peter Christie, head of banking practice at Towers Perrin, a human resources and pay consultancy. "They see a gap in their expertise and say: 'Let's hire Joe Bloggs and pay whatever it takes.' It can create a very mercenary environment, and can really heat up the labour market."

Mr Christie adds that labour market distortions would only increase if bank employees were to get financial punishments for poor performance, as well as bonuses for good performance. "Anyone with any talent or sense would migrate to the firms which would guarantee bonuses."

The distortions in the labour market caused by large up-front bonus demands and forced deferred bonus "buyouts" have taken a particularly heavy toll on Deutsche Morgan Grenfell and BZW. Deutsche set the ball rolling about 18 months ago by poaching entire teams and paying large initial "sign- on" fees to new staff. More recently, BZW has paid heavily for the management upheavals following the appointments of Bill Harrison as chief executive and Bob Diamond as head of its markets division. Since their appointment the firm has seen a large number of arrivals and departures, most of which required either big sign-on fees or even larger redundancy packages. Last month Barclays Bank chief executive Martin Taylor admitted that BZW's staff costs had risen by pounds 120m in 1996, including pounds 45m on "upgrading" - hiring and firing. One estimate puts the number of arrivals and departures at the firm in the last six months of 1996 at 300 people.

The headline cost of such high-priced labour might be frightening, looking more like a Premier League football team's wage structure than that of a service company. But here's the clincher: does it actually make people better bankers? Not according to one former member of the bonus culture. "One day my boss said to me: 'Go on, guess how much I've asked for you to be paid as a bonus this year?' Then he told me - $200,000. It was like winning the lottery. I sat there stunned. Then I thought: I have enough money to pay my children's school fees. Why am I doing this? Do I really want to think about bond yields for the rest of my life?"

The banker, who preferred not to be named, is now a happy (and still rich) community activist. He still argues that bonuses do not necessarily breed motivated people, particularly among the boffin element that has been recruited to City dealing rooms to deal with the higher mathematics of derivatives. "There are plenty of people desperate to get out, only to get dragged in by the bonus culture." But he remains an active investor, and worries about the effect of huge bonuses on banks' profitability. "In my opinion, the shareholders of a bank are just being done. Every time someone gets hired or fired, they lose out. I would not be terribly impressed if I were one of those shareholders."

The million-pound trader

Every City institution has its own method of rewarding staff. The table below takes a hypothetical example of a trader at a large, multinational bank. The package would involve a small base salary, usually less than 20 per cent of total income. On top of that a trader would expect to receive the largest single element of his or her bonus from the profits on his or her trading account. There would also be a team bonus based on the performance of the desk, or possibly of the whole division, within a particular market. A third bonus element designed to keep traders loyal to the firm would be deferred, usually shares paid into an escrow account that traders can access in one or two years' time, as long as they stay with the company. Finally, the trader's boss would be authorised to top the bonus payment up if the trader had done particularly prudent trades, or was important enough to merit more reward than his or her peers.

Base salary pounds 120,000

Trading profit bonus pounds 400,000

Team/division bonus pounds 140,000

Deferred loyalty

bonus pounds 300,000

Manager's discretionary

bonus pounds 100,000

Total pounds 1,060,000