Osborne plays politics with bonus plan

October 26, 2009

The two most emotive issues in the political furore surrounding British banking are bonuses and the shortage of lending. So George Osborne must be delighted to have found a way of linking the two. However, it is far from clear that the shadow chancellor’s proposed solution — forcing banks to pay bonuses entirely in shares — would increase the supply of credit to the economy.

Osborne is attempting to capitalise on public anger about resurgent bank bonuses at a time when the UK is still mired in recession. By banning all cash bonuses, he goes further than the principles agreed by the G20 group of leading nations and — crucially — the guidelines introduced by Britain’s Financial Services Authority. This makes it hard for the government to respond. Bankers, meanwhile, can expect little public sympathy.

Yet while Osborne may have earned some political capital, his financial logic is suspect. First, the British banks fingered by Osborne — including Royal Bank of Scotland, Lloyds Banking Group and Barclays — have already agreed to pay a “significant” proportion of future bonuses in deferred stock. The remaining cash element of this year’s bonus pot is unlikely to amount to more than a few hundred million pounds per bank. Even if this additional capital was fully converted into lending, it would equate to a few billion pounds of additional credit — a tiny proportion of the 550 billion pounds that the Bank of England estimates has been borrowed by British businesses.

But there is a more fundamental objection. While it is true that British companies are repaying debt, it is far from clear that a shortage of credit is the problem. Companies may also be reluctant to borrow. Of course, loans have become more expensive, and businesses at the margin that were able to borrow a few years ago have found their access to credit constrained. However, this partly reflects the withdrawal of aggressive Irish and Icelandic banks from the UK market. Short of forcing British banks to cut their lending rates — something neither the government nor Osborne has suggested — it is hard to see how this can be resolved.

Osborne’s proposals would also create an unequal playing field, as U.S. and European investment banks operating in London would not be subject to the same restrictions.

Some may argue that opposition proposals should not be taken at face value – after all, Osborne is unlikely to become the Chancellor of the Exchequer until May next year, when the furore may have died down.

However, given his party’s lead in the opinion polls, Osborne’s words carry additional weight. As with his flawed plan for overhauling Britain’s system of financial regulation, his attack on bonuses appears more interested in scoring short-term political points than contributing to meaningful long-term reform of the financial system.

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