30 SECOND GUIDE: Bonus targets

By THIS IS MONEY
Updated: 05:06 EST, 7 December 2011

The Daily Mail City team explains the methodology used to calculate the bonuses of investment bankers

For who?

Investment bankers, who are under the spotlight as politicians and investors urge restraint on bonuses. Windfalls are set to fall this year, but only because investment banking revenues have been meagre. The more relevant element of the discussion is the methodology used to calculate them.

City bonuses: The Daily Mail City team explains the methodology used to calculate the bonuses of investment bankers

So?

Bank of England policymaker Andy Haldane has some pretty strong views on this. He wants banks to discard ‘return on equity’ as a measure for determining bonuses. Instead, says Haldane, they should focus instead on ‘return on assets’.

Come again?

The problem with the ‘return on equity’ is it rewards the bonus recipient for making his employer profits that may have risks associated with them that are yet to be recognised. As Haldane puts it, ‘instead of adjusting for risk, ROE is flattered by it’. That means short-term achievements are rewarded at the expense of long-term stability.

Got an analogy?

Take a mortgage. If the value of your home rises from £100,000 to £110,000, the return on assets is £10,000, or 10 per cent. If you bought the house with a £10,000 deposit and £90,000 of debt, the return on your £10,000 of debt-backed equity is 100 per cent.

Of course, if you can’t pay back the debt, it’s you who takes the hit. If you’re a bank, the taxpayer picks up the tab.