Hugo Dixon

There was a whiff of the lynch mob in the UK last week. Stephen Hester, the current Royal Bank of Scotland boss, was bludgeoned by politicians and the media into foregoing his bonus even though he was brought in to clean up the largely state-owned bank. Two days later his predecessor, Fred Goodwin, was stripped of his knighthood. While Goodwin bore much of the responsibility for RBS’s near-bankruptcy, removing his title flouted normal procedures. Not only is such a dressing down traditionally reserved for criminals; the prime minister, David Cameron, prejudged the verdict of the committee which reviewed the knighthood. The week was capped off by the leader of the opposition, Ed Miliband, calling for a tax on bankers’ bonuses.

While the UK is currently the epicentre of the backlash against financiers, the phenomenon is widespread across the Western world. Francois Hollande, who is likely to be France’s next president, has said that his main adversary isn’t Nicolas Sarkozy but a faceless, nameless, opponent – the world of finance. And across the Atlantic, the only serious setback in Mitt Romney’s presidential campaign so far came when he revealed that in 2010 he had paid only 13.9 percent tax on his $21.7 million of income, most of which came from his time as a private equity baron.

There is certainly something ugly about the way politicians – who themselves bear some responsibility for the economic mess – have turned bankers into a scapegoats. But the public isn’t in the mood to show sympathy to bankers these days. The issue is not so much the amounts they are paid. In the same week that the banker backlash was gathering force in the UK, Facebook announced its initial public offering. Nobody batted an eyelid at the prospect of Mark Zuckerberg, the founder, being worth over $20 billion. The difference is that people think Zuckerberg deserves his billions but the bankers don’t deserve their millions.

The belief that bankers’ compensation is unfair operates at several levels. At its most basic there is the argument that, since bankers were the ones who got the world into its current mess, they shouldn’t still be coining it. This is simplistic. The mistakes made by banks were only one factor that fuelled the crisis – and many individual bankers were innocent of the mistakes.

There is, though, a more sophisticated critique: that the whole system has been rigged in financiers’ favour, allowing them to earn more than they merit. Few people complain when entrepreneurs make millions. They are seen to have come up with brilliant ideas, taken big risks or worked extremely hard. That’s how capitalism is supposed to work. But bankers have benefited from one-way bets that make a mockery of capitalism.

The system has been skewed in bankers’ favour in two main ways. First, individual traders were paid on short-term performance. That encouraged them to spin the roulette wheel. If their bets paid off, they did well; if not, their employers picked up the tab. Second, banks in general were highly leveraged. This magnified earnings and bonus pools during the good times; but when the crisis hit, many banks were bailed out.

Over the past four years, regulators have been trying to remove these one-way bets. Much has changed in the way individual bankers are paid. A bigger slice of their bonuses is paid in equity which they cannot sell for several years, tying compensation to institutions’ long-term performance. In some cases, bonuses can be clawed back. What’s more, banks have been required to cut their leverage. This, combined with the dire economic environment, has reduced earnings and so squeezed bonus pools.

But compensation hasn’t come down as rapidly as it should have. Just look at bonuses in the City of London as measured by the Centre for Economics and Business Research. These actually rose slightly in 2007/2008 to 11.6 billion pounds after the first shocks of the crisis. Although they fell to 5.3 billion pounds after Lehman Brothers went bust, they rose again the following year to 7.3 billion pounds as the benefits of the bailout started kicking in.

For the year just ended, City bonuses are forecast to be 4.2 billion pounds. Even so, compensation is still too high. One way of seeing this is to compare how well bankers do to how well their own shareholders fare. Last year, for example, Goldman Sachs cut its pay 21 percent. But earnings applicable to shareholders tumbled 67 percent and the bank’s return on equity was a measly 3.7 percent.

The public’s concern, however, should be for taxpayers rather than shareholders. Although steps have been taken to make the system safer, the changes are far from complete. Banks are being given several years to build up fatter capital buffers so that they are better able to withstand losses. Plans to enable regulators to pack banks off to the knackers’ yard rather than bail them out when they get into trouble are still on the drawing board. Meanwhile, the industry enjoys special treatment. Just think about the 500 billion euros that the European Central Bank lent to the industry in December at a measly interest rate of 1 percent. Entrepreneurs would die to be able to borrow money at such a rate.

The sad fact is that most banks are still too big to fail. Until that changes, the system will remain rigged in bankers’ favour – and they will be vulnerable to the kind of lynching suffered by Hester and Goodwin last week.

The opinions expressed are his own.

The UK’s self-immolation beggars belief. The government’s clumsy attempt to extract concessions from euro zone countries in their time of need has set off a chain reaction which could undermine Britain’s interests and even drive it out of the European Union.

It’s not clear what David Cameron thought he was doing at the European summit in the early hours of Dec. 9 when he demanded vetoes on financial regulation in the EU. Was the prime minister asking for something he knew was unacceptable so that he could return to Britain and parade as a hero in front of the euroskeptics in his Conservative Party? Or did he just vastly overestimate his negotiating position, thinking that the euro zone countries were so desperate to save their single currency that he could bounce them into accepting the British demands by presenting them with a take-it-or-leave-it offer in the middle of the night? If it was the former, Cameron was cynically putting his personal interests above those of the nation; if the latter, he was just extraordinarily inept.

Cameron did little to win allies for his position, not even circulating his list of proposals in advance of the summit, according to Reuters. Even worse, he put Britain in the position of seemingly being prepared to blow up the single currency if he didn’t get his way. In fact, Cameron didn’t have the power to stop the 17 euro zone countries from agreeing to sign a new treaty committing themselves to fiscal discipline. They just sidestepped the existing EU treaty. What’s more, they got all nine of the other countries which are part of the EU but not the single currency to sign up too. So all Cameron achieved in the middle of the night was to irritate Britain’s partners massively and isolate the UK 26-1.

Where does London go from here? One approach would be for Cameron to carry out his next threat: to try to stop the euro zone countries from using the European Commission and the European Court of Justice to police their fiscal discipline on the grounds that these institutions belong to all 27 countries. It’s not clear whether this is a legally winnable position, but pushing it would certainly make Britain look petty and further antagonize other European countries.

Meanwhile, members of Cameron’s euroskeptic wing will find it hard to hide their desire to see the single currency wrecked — something that could further madden those whose livelihood depend on it.

Unnecessary battle

None of this was remotely necessary. The euro zone countries weren’t trying to impose fiscal discipline on Britain, only on themselves. In fact they weren’t trying to impose anything on the UK. True, France has often seemed like it wanted to undermine the City of London’s position as a financial center. But until now, it has had zero success because the UK has always managed to assemble enough allies to support its position. In future, though, that can no longer be guaranteed. France’s President Nicolas Sarkozy may find he has allies if he wants to push through regulations that disadvantage what he calls his “British friends.” The risk of an inner club acting as a caucus and imposing its wishes on the UK has increased significantly.

The danger extends beyond financial services. Britain has been the main campaigner for free markets within the EU in recent decades. Although it hasn’t achieved everything it wanted, there have been notable successes such as creation of the so-called single market. Germany which, in some ways, is closer to Britain than France in its economic thinking supported these initiatives. But Angela Merkel isn’t going to be so keen to do the UK favors after Cameron snubbed her. The same goes for Italy, whose new prime minister Mario Monti, was a natural ally for liberalization given his passionate advocacy of the single market.

The British PM, meanwhile, has been reduced to the pathetic position of saying that the Netherlands, a fine but rather small country, will protect its interests in the single market. But even the Dutch finance minister has said: “The situation for the UK is very serious…..If you don’t have a seat at the table, you don’t participate.”

The biggest worry is that a vicious cycle develops — in which the euro zone squeezes the UK off the top table because of its lack of cooperation, London behaves increasingly like a spoiled brat because it is frustrated by its lack of influence, and this further antagonizes the big continental powers. Life could ultimately become so uncomfortable that Britain leaves the EU.  It would then lose the automatic right of access to the world’s largest  market. Although the rest of Europe might still let British business and finance operate on its side of the English Channel, it would largely dictate the rules of engagement.

Such an outcome would be disastrous for the City, British industry and UK foreign policy. Why would the United States, China, the Middle East and India want to deal with London if it had no friends in Europe? It would also be harder to persuade foreign business to locate in the UK if it had only second-class access to the single market.

Not all lost

But it’s not too late to retrieve the situation. The business and financial community can and should put pressure on government to find some face-saving position that allows Britain to move on in harmony with the rest of Europe. Something along the following lines might work: the UK would reverse its opposition to the existing EU mechanisms being used to enforce fiscal discipline on the euro countries while also saying how much it wanted to support them in their time of need; the other countries would then say how what they were doing would in no way undermine the single market while also asserting that they had no intention of imposing any new taxes on the UK, including the so-called Tobin tax on financial transactions, unless London wanted them. The euro zone wouldn’t actually be giving anything away as the UK already has a veto on new taxes. But such a declaration would sound good.

Getting to such a position wouldn’t be easy given that Cameron would have to eat his words and France would have to be persuaded to let Britain back into the fold. But Sarkozy may no longer be France’s president in five months; and the UK government may not be totally impervious to argument.

One pressure point are the Liberal Democrats, the minority partners in the coalition. They think of themselves as pro-Europeans and are aghast at Britain’s far from splendid isolation. Their leader, Nick Clegg, who is also the deputy prime minister, foolishly backed Cameron’s negotiating strategy without thinking through how it was likely to play out. He has now performed a U-turn, saying he is “bitterly disappointed” at the outcome. That, of course, is not the same as leaving the coalition. The LibDems will be reluctant to go down that route because they are scared of being slaughtered if there is a new election. But the chances of a collapse of the government have definitely risen.

Another pressure point, paradoxically, may be Boris Johnson, the euroskeptic Mayor of London. Cameron may well have hardened his line on Europe because he didn’t want to be outflanked by Johnson, a hugely popular figure in the Conservative Party. But the summit’s outcome isn’t in the interest of the City and therefore isn’t in the interest of London. If bankers can bring this point home to Johnson, who is an old friend of mine and whom I informally advise from time to time, he may soften his line — allowing Cameron to take a more accommodating position too.

Salvaging the situation will be tricky. But Britain doesn’t have an interest in being at loggerheads with the rest of Europe or vice versa — especially when the region’s worst financial crisis in a lifetime is still raging.

PHOTO: Britain’s Prime Minister David Cameron (C) looks at Germany’s Chancellor Angela Merkel (L) at a European Union summit in Brussels December 9, 2011.  REUTERS/Yves Herman