What is the role of a bonus?
A friend of mine describes his (modest) bonus as "a pat on the back at the end of a good year". A commentator on Radio 4 at the weekend described a bonus as "something rare that should reward exceptional performance" (sorry, no link - you'll have to trust me). These both rely on us interpreting the word bonus as a benevolent gift. I intend to persuade you that a bonus is nothing of the sort.
The purpose of a bonus is simple: to align the incentives of the workforce with those of the shareholders. This is important because of the presence of agency costs - where people act in their own interests rather than in the interests of the organisation that employs them. At the low levels this leads to minor problems such as process blockages and lazy workers. At the highest level this leads to potentially disastrous decisions (a good example being Hester's predecessor Fred Goodwin's purchase of ABN Amro which appeared to be more a case of empire building than a sound economic decision).
So how do we deal with this problem? How about by paying people only when they act in the interests of the shareholders? Just like salespeople take commission when they sell, so executives should get higher pay when they add value. Stephen Hester receives much of his remuneration package in the form of shares in trust or share options, both of which pay out more when the share price remains high.
Why should executives get such big bonuses?
To eliminate all agency costs it would sensible for all employees' pay to be contingent on the performance of the company. However you would struggle to attract staff if you were to implement this strategy. I wouldn't accept such a wildly fluctuating income. On top of this it may not even solve the agency cost problem for most members of staff since at the low levels you have essentially no impact on the performance of the entire company. However as you go through the management levels you see people whose influence becomes greater and greater, and you see people whose remuneration would be better linked to company performance.
The people at the top should have proportionally more of their pay in the form of bonuses than those at the bottom. Since you would also expect the salaries to be higher at this level you see highly variable salaries. Stephen Hester's £1.2m basic pay makes up a small part of his total remuneration package. In theory his total pay is unlimited since there is no limit on the share price.
Note also that this payment is contractual. Hester will get a bonus each year, it is only its amount that changes.
Yes, but why do executives get paid so much?
This is harder to answer, and I would refer you back to the old rule of supply and demand. It is easy for us to criticise the decisions of those at the very top, but do we really believe we could do a better job? And do we ever expect to be given the chance? Wayne Rooney gets paid so much because his employers require such a high level of ability that they cannot obtain what they need for less. If they didn't pay enough I'm sure he could find another team who would without even moving house. Why do we think this should not be the case for senior bankers, where even greater sums of money are involved?
I don't think Hester should have forfeited his bonus. He's been made a scapegoat for the failures of an industry he wasn't even working in at the time.
But on top of that I don't think it was the fault of the bonus system either. Bonuses have been portrayed as a reward for failure. I would say removing bonuses risks rewarding failure even more.