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Hand back your bonus Sir Fred and see if the City boys follow

Business Comment: By Ian Fraser

HAS Sir Fred Goodwin got anything to learn from Willie Walsh? On May 16, Walsh, the Irish-born BA boss refused to accept his bonus of some £550,000 because he wanted to take personal responsibility for the Heathrow Terminal Five fiasco, when tens of thousands of bags went missing and hundreds of flights from the showcase terminal were cancelled. Given the egg on BA's face, Walsh felt it would be "inappropriate" to accept a bonus that would have nearly doubled his £700,000 salary.

His decision may have had more to do with PR than with genuine contrition. However, there are probably some lessons for the beleaguered RBS boss. In February Sir Fred Goodwin was offered and accepted a £2.86 million bonus based on the strength of his performance last year. This took his total pay for the year to more than £4m. With the benefit of hindsight, Goodwin should almost certainly have turned down his co-directors' largesse.

After all, 2007 was a year in which Sir Fred had arguably presided over the destruction of about £20-£30 billion of shareholder value through what now looks like poor decision-making. First came his decision to plough ahead with the takeover of ABN Amro in the face of financial headwinds. Second, the Edinburgh-based bank, and particularly its bonus-fuelled employees at RBS Greenwich in the US, was badly caught out when the sub-prime dance stopped last summer.

Admittedly, at the time Goodwin's bonus was officially awarded, to coincide with RBS annual results for the year to December 2007 in February, the seriousness and the repercussions had yet to become fully apparent. One wonders, however, how those at the top of RBS could have been so blissfully unaware of the deep doo-doo they were in. At results time in February, RBS's bullish demeanour cheered investors. The impression was given that RBS was much less exposed to the sub-prime crisis than many had feared. Not surprisingly, the shares rose 7% to 500p that morning.

Now that the true extent of RBS's exposure has necessitated emergency surgery to strengthen its balance sheet, shares are languishing at 236p, their lowest for eight years. In part, this is because they have been weighed down by the imminence of the world's largest ever rights issue, for which applications must be received by Friday. But all this does make one wonder whether Sir Fred should have accepted his bonus.

Following the investor disquiet over HSBC's £120m jackpot for directors, which surfaced at its AGM on Friday, and the recent figures showing City institutions have already paid out £13.2bn in bonuses for 2007, it is time to take a closer look at the City's bonus culture.

The emerging consensus among professors of finance and regulators around is that it skews bank decision-making and was one of the key drivers of the current sub-prime-related crisis. Clearly, the short-term financial gains that investment bankers and their disciples in the financial markets believed they could make by investing, or dealing, in what was later revealed to be dross, had a major effect on bank behaviour. Driven by the potential rewards, many bankers lost their ability to recognise risk.

Some must have convinced themselves that sub-prime-related securities, whose value was linked to the propensity of sub-prime borrowers in the US to repay their mortgages, genuinely deserved to be AAA-rated, meaning as risk-free as sovereign debt. Others probably didn't even bother to think about it. The more cynical jokingly referred to the new-found instruments as Ninja ("no income, job or assets") loans on retiring to their Wall Street and City wine bars after a hard day shovelling billions of dollars worth of the stuff and infecting the global financial system in the process.

I know Goodwin likes to gain first-mover advantage. He now has a wonderful opportunity to break with the herd. It is hardly going to cure the problem overnight, but were he to hand back his bonus, it could neutralise the negativity coming RBS's way. It might even persuade some of those Greenwich boys to hand back theirs too.

In a recent article, Ross Buckley, a professor of international finance at the University of New South Wales, argues that the banks' approach to remuneration gives individual bankers "no incentive to be prudent and every incentive not to be". He summarises how bank remuneration policies can distort economies by explaining how securitisation make banks lend to people they would not otherwise lend to. Buckley says this is because in about 2000, the bankers discovered they could repackage their dodgy loans, give them a bit of a respray through securitisation, and then convert them into bonds that investors were persuaded to think of as virtually without risk.

The demand that the bankers were able to drum up for these instruments through their "financial alchemy" persuaded most of the world's commercial banks, including the likes of Northern Rock, that they could keep on lending willy-nilly, as the loans they provided would be repackaged and off their books within days or weeks.

"Yet," Buckley adds, "this was masking real risks that have now crystallised. Bankers received higher bonuses for apparently outperforming the market, but they were not: they were simply deferring risks."

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