Hugo Radice: One year on, have the bankers started to repay the massive debt they owe us?

IT is now a year since the Government was forced to launch a second emergency package to rescue the banking system, including a substantial increase in the state's shareholding in Royal Bank of Scotland and Lloyds-HBOS. At that time, the downturn in economic activity and employment was accelerating, not only in the UK but around the world, and similar bank rescues were taking place in many countries.

Since then, economic activity has stabilised globally, and even the UK, which has lagged behind, is likely to record modest growth in the last quarter of 2009.

Banking around the world has broadly recovered too, and as the annual reporting season approaches, the focus of attention is on the large bonuses that the banks are expected to hand out. The Treasury Select Committee has once again been interrogating the bank bosses, while in Washington the Financial Crisis Enquiry Commission, which was appointed by Congress, has begun its work amid great fanfare.

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Not surprisingly, many people feel the resumption of bonus payments is outrageous, when the banks should be giving priority to restoring the availability of credit (especially to businesses) and to repaying the public funds that we, the taxpayers, have provided through our eventual responsibility for Government debt.

Many businesses and households are still struggling to keep their heads above water, and since the banks have only survived because of public largesse, surely now it is payback time?

The banks' main argument is that the employees who will receive the bonuses have earned them by working hard at their job, which is to make money for their employers. Performance targets are established in their employment contracts, and if they exceed those targets they are contractually entitled to certain rewards. The banks point out that the profits earned, net of salaries and bonuses, are helping to rebuild the banks' capacity to lend, and to pay back public money. They also argue that if bonuses are cut, they will lose their best staff.

So is there any truth in these claims? We must first of all understand the reasons for the recovery in banks' profitability. As last month's Bank of England financial stability report reveals, the main source of rising profits has not been from lending, but from their investment banking activities – underwriting the issuance of securities, and trading on behalf of investors in securities, commodities and currencies – and it is employees in these areas that will get the bonuses.

But greater activity in these areas has been largely the result of ideal market conditions. First, the demise of so many major banks, some like Lehman Brothers through bankruptcy, and others like HBOS by takeover, has greatly reduced competition in investment banking markets, leaving easier business conditions for those that survived.

Secondly, there has been rapid growth in the issuing of corporate bonds: big firms have turned to such long-term funding to replace bank loans, while investors such as pension funds see bonds as safer than the glitzy financial products that the banks were peddling before the crisis. Thirdly, not only have the banks been supported by Government directly, but the financial markets have been underpinned more widely by the Bank of England's programme of quantitative easing. In any case, the banks not only need to restore lending and repay public funds, they also need to rebuild their reserves of capital and reduce their reliance on borrowing.

While they have been quite successful in raising capital through share issues – again, not exactly difficult given the stock market recovery – there is still a long way to go. And buried in the detail of the Financial Stability Report is a telling sentence: "If discretionary distributions (that is, bonuses and dividends] had been 20 per cent lower per year between 2000 and 2008, banks would have generated around 75bn of additional capital – more than was provided by the public sector during the crisis". So the profits funding the bonuses have been too easily earned, and should instead go towards rebuilding the banks' capital reserves.

As for the argument that the bankers will leave London for more lucrative pastures – as argued by Mayor Boris Johnson among others in relation to the 50 per cent special levy on bonuses announced by the Chancellor – this is belied by the recent marked recovery in the luxury end of the London housing market, and the beginnings of a recovery in the commercial property market in the City.

But the furore over bonuses must not divert us from other banking issues. President Obama has proposed to Congress a special levy on banks designed to return $90bn to the US government over 10 years, leading UK Treasury minister Lord Myners to state yesterday that a similar measure should be considered here too.

However, important though it is to claw back public money after the crisis, in the longer run governments and central banks need to take measures to ensure that potential future crises are averted.

On this issue, a wide range of possible measures are under active discussion by central banks around the world through the Basel Committee on Banking Stability.

Three reforms are especially important.

First, routine "utility banking" activities must be protected from the risks associated with investment banking: if there is no return to a strict separation of the two, then the capital that a bank is required to hold by regulators must be related to the balance of its activities.

Second, new entry should be encouraged in all banking markets to reduce the scope for excessive monopoly profits.

And third, given the deep interconnections between national banking systems, there needs to be strict uniformity in regulation across the globe, including zero tolerance towards tax havens.

Hugo Radice is a senior research fellow at the University of Leeds