Is this the end for the £1m City bonus?

Towards the end of each year work at investment banks almost grinds to a halt. This is partly due to the reduced deal flow but also because bankers spend much of their time politicking and positioning themselves to get the biggest bonus possible.

During the boom years banks have faced the constant problem of rewarding the best-performing people without prompting others to walk out and join a rival, but those days are largely over.

There is a bigger cloud of doubt hanging over City bonuses than at any time in the past. Bankers face questions about whether they will receive a payout at all for this year while the authorities are increasingly blaming pay structures at financial companies for encouraging reckless behaviour that caused the credit crunch.

With the Government desperate to avoid blame for the financial crisis and to be seen to act, there is a new resolve to rein in incentives that allow bankers to get rich before the true results of their trading and deal making are known.

The Government is looking to the Financial Services Authority to do the work rather than planning legislation. The FSA's new chairman, Lord Turner, weighed in on Sunday before even taking up his post yesterday. "There are some very important issues to be questioned about the time periods over which bonuses are paid out [and] the information on which they are measured," he said. "These are legitimate issues for regulators to be quizzing banks about."

A managing director in an investment bank's corporate finance department might typically be on £150,000 a year as a basic salary but make £1m or many more millions when the bonus is taken into account. The most high-profile disclosed bonus in the City is that of Bob Diamond, the president and investment banking chief at Barclays. Mr Diamond earned a mere £250,000 in salary last year but was paid a £6.5m cash bonus, with share options taking his total remuneration to £18.5m.

The FSA has warned before that it would take a look at pay structures when assessing the risks being taken by financial institutions. But the watchdog now has a specific project in train and is working with its international counterparts to co-ordinate action. Actions the regulator could take include requiring banks with racier bonus plans to hold more capital against losses.

Shaun Springer, the chief executive of Napier Scott, a City recruiter, said: "It is unquestionably the most uncertain year we have ever had in terms of expectations except for the certainty that bonuses will be down on the previous year and could be down by 50-60 per cent. For many, the bonus will be employment in January."

The Centre for Economic and Business Research (CEBR) has forecast that City-type bonuses will fall to £5bn this year from £8.5bn in 2007, but it is now revising its predictions for a far bigger fall as the financial crisis deepens. That spells bad news for the UK's finances, which could have received about £3bn from last year's bonus pool. City bonuses have been a source of controversy for years for aggravating economic inequality but governments have generally left financial firms to their own devices because of the revenues they bring.

Now the financial world faces the argument that its reward structure has caused reckless risk-taking, plunging economies into recession and requiring bail-outs by taxpayers. The US government has been forced to announce an extraordinary $700bn fund to take on banks' toxic assets.

Ben Read, a senior economist at CEBR, says that despite the Government's rhetoric it will have to tread carefully. "Financial services have been one of the key drivers of the economy during New Labour's term in office," he says. "Anything that reduces the competitiveness of the City as a place to work compared with other potentially large financial centres in the Far East or wherever, you could see a large shift away from the City of London."

Solutions put forward include paying a greater proportion of bonuses in company shares over a longer period of time. But about 30 per cent of Lehman Brothers' stock was held by its employees and this did not stop the bank taking risks that led to its bankruptcy.

Peter Hahn, a fellow at City University's Cass Business School, says change is needed but that big bonuses will remain part of City life because people make big investments to get top jobs – often spending £100,000 on an MBA – and sacrifice their personal lives for their careers.

"We shouldn't focus on how much; what we need to focus on is what we pay people for. Incentives should be aligned with goals but nobody was asking what the goals were. It was a huge failure in regulation. Critics of increased oversight of pay say regulators cannot police what individual banks pay their traders. But Mr Hahn, a former senior Citigroup banker, says if watchdogs insist that the pay of chief executives and other top managers is aligned to risk then change will permeate down through the company.

"At the operating level the management of a business needs to determine how it pays people. The pay of the very top people needs to be part of the regulatory package," he says.

But others doubt that the City will ever change and believe the markets and their highly paid financial brains will ultimately stay ahead of governments and regulators.

A senior City recruiter. who declined to be named. said: "I think it is one of those things that is discussed and as soon as the market picks up people will forget about it."

Yes... Says Vince Cable

There is a corrosive effect on society in general if people are paid enormous sums for activities that are destabilising. In the financial structure there is now quite a lot of serious research that shows that the bonus structure for transactions completed destabilises financial institutions by encouraging them to take bigger risks than they should and it has the effect of weakening the financial services sector. It should be possible to insist that bonus payments are paid in non-redeemable stock rather than cash bonuses so people can only collect them in five years. That would act as something of a dampener. I'm not an anti-capitalist. If people like Bill Gates make themselves enormously rich through entrepreneurial activity then you can't quarrel but if people are making large sums of money through financial churning that is destabilising. It [fundamental change] will happen this time because the mood has changed in the US. When the American taxpayer is being asked to cough up hundreds of billions of dollars there will be people in Congress and the administration who are going to say stop this.

Vince Cable is treasury spokesman for the Liberal Democrats

No... Says Patrick Minford

It is not feasible. It is nonsense. The bonus structure is there because of the extreme insecurity. In the City you can lose your job and you might not work again for a very long time. What happens is people open their mouths but perhaps they don't think very carefully, especially politicians. What has it got to do with them? There is already substantial regulation under Basel 2. It is unfortunate that the banks evaded it. The difficulty is that incentive structures are very widespread throughout the whole of the industry. It is not clear whether a chief executive takes more risks because of how they are rewarded. I think the FSA can take risk into account but I don't think there is necessarily a correlation between bonuses and risk-taking behaviour. Companies could be asked to define performance in a better way that is more long term but it is pretty hard to write these things into an FSA directive. It is one of these things that blows up but perhaps people will go cool on when they think about it. People are always fulminating about these contracts but it is not clear what the alternative is.

Patrick Minford is professor of applied economics, Cardiff Business School