It was the bonuses that did it.

Last week, we had the unsavoury sight of John Prescott blaming the banks for the housing bubble. "The banks distorted the market," he moaned; "We gave them stability - the very thing that they had been asking for for decades. The instability [we have now] came from the market itself."

Prescott's denunciation followed Mervyn King's attack on the banks. He blamed the "bonus culture" as a key factor behind the current financial instability.

It is hard to listen to these jokers wimpering on about the banks and the bubble. Both men held key positions of power through those miserable years of double digit housing inflation. Prescott was housing minister, while King still runs the shop at the Bank of England.

Their self-serving blame-shifting leads to an obvious question; what were they doing when the banks were spinning out of control. Unfortunately, we know the answer to that question. It is a two word answer that starts with the letter F and ends with the letter L.

There is, however, a slightly trickier question. To what extent are Prescott and King correct when they blame the banks? Did bank bonuses build the bubble?

It is hard to admit it, but Prescott and King might have a point. Bonuses have become an increasingly important component in financial sector remuneration.

For example, consider pay in the financial sector. The ONS provide data on average earnings, including bonuses for individuals working in financial services. The series looks rather odd:

Every year, average earnings in the financial sector spike during the winter. Furthermore, those spikes appear to be getting larger with every passing year. Those spikes are, of course, bonuses.

The average earnings data has another, less obvious feature. The bonuses are now so large relative to regular earnings, that one could easily think that on average financial sector salaries minus bonuses haven't actually increased that much. Earnings during the non-bonus months look rather flat.

However, the following chart will put you straight on that point.


First, an explanation; the chart above compares the highest and lowest monthly earnings in 1999-2000 and 2007-8. Back in 1999, September was lowest month for financial sector earnings. To make everything comparable we set earnings in September 1999 to 100. The highest earning month that year was March 2000, when salaries were 23 percent higher compared to September (123 compared to 100).

Turning now to 2007-8; the lowest earning month was again September. However, earnings in September 2007 was 67 percent higher than the same period back in 1999. The highest paying month was February, when salaries were 180 percent higher than September 1999.

These charts point to a couple of interesting trends. First, earnings in the financial sector, regardless of bonuses have increased very fast, and much faster than the rest of the economy. Second, the relative importance of bonuses in terms of total remuneration has also increased dramatically.

Since bonuses are invariably linked to some kind of output measure, it isn't hard to see how banks start to churn out the products. If an increasingly large part of your salary is linked to the number of mortgages you originate, wouldn't you try to sell as many as possible? So, Mervyn King is on to something when he points to bonuses as one of the factors behind the bubble.

Ironically, bonuses worked against the interests of banks. The increasing trend towards higher performance related pay distorted incentives within banks. Rather than looking at risk factors, loan officers looked at their bonuses, and extended credit to some desperate home buyers who had an unhealthy propensity to lie on their mortgage applications and default when their financial circumstances deteriorated.

The banks wanted growth, they set up their internal incentive mechanisms to reward growth, and that is what they got. They downgraded the importance of risk and they got lax risk management. It all goes to prove that age old maxim, what you pay for is what you get.