It is reported by the BBC that the UK government is considering restricting banks’ ability to pay bonuses to employees who take “reckless” risks.  This assumes that:

1. Banks would otherwise want their employees to take reckless risks.
2. There are good ways to determine ex-ante which risks are reckless.

Ignoring the first point, I have severe doubts about the ability of banks or regulators to adequately provide for the second point. Assuming there is some uncertainty in the markets, there will be times when it is impossible to determine whether a trader is earning outsized profits in the short term because he is taking on positions with significant tail risk or because he holds some advantage in strategy over his rivals. Moreover, we would expect that traders who find, through accident or device, a way of earning money through risk that is unrecognized by others will give the appearance of being good at their jobs and will multiply in number and in the size of the positions they are allowed to take.

According to Lord Myners the proposed policy would mean that:

“…contracts which guarantee bonuses for several years are no longer acceptable and, if those contracts are written, they will be voided under law.”

This is a curious policy from an economist’s perspective, as a “guaranteed bonus” is not really a bonus at all, but part of a base salary. The proposed regulation could be easily circumvented by banks simply relabelling them as such.

Cross posted at Wiley Economics Focus.