Saturday, 26 February 2011

In Defence of Bank Bonuses

Well, that's an inflammatory title, isn't it? I'll probably get lots of abusive remarks, and lots of people won't even bother to read this post because of the title.  But I really feel that someone needs to set the record straight, because there is an AWFUL lot of rubbish being spouted about bankers' bonuses at the moment.

The first thing to note is that banks pay bonuses to three different groups of people.  From the headlines you would think that only senior bank executives receive bonuses. But two other groups also receive bonus payments:

- traders
- ordinary bank staff.

Let's look at the bonuses paid to these three different groups of people.

1.  Senior executives.
These are the headline-grabbing figures. Bob Diamond (CEO of Barclays) awarded bonus of about £9m. Stephen Hester (RBS) paid a bonus of £2.04m. Eric Daniels, outgoing CEO of Lloyds, received £1.45m. Doesn't it make you see red?

From the headlines you would think that these people are being paid this amount of cash, wouldn't you? Well, you would be wrong. The cash amount paid in these bonuses is tiny. The vast majority of the bonus is paid in shares in the company.  In fact new EU rules enforce payment of bank executive bonuses almost entirely in equity shares. 

The intention behind paying senior executives in equity is to tie their remuneration to the performance of the company. The company does well, their shares increase in value. The company does badly, their shares decline in value. This is called performance-related pay (I shall return to this subject later on).  The idea is that if the value of their own pay package is partially determined by the success of the company they will want to make sure that the company they lead does well.  Surely this is a good idea?  It is also the standard pay formula for senior execs of large and medium-sized corporations in all industries. Why should banks be any different?

Now, we can discuss whether or not equity incentives actually work in practice, and whether the remainder of the average pay package for senior bank executives - salary and pension contributions resembling telephone numbers - is sufficiently ginormous to eclipse the equity incentives and render performance-related pay ineffective. This is a far more sensible debate.  The Hutton Report on local authority pay has looked at pay caps and other measures to keep senior executives pay at least on the same planet as that of their staff. Obviously this report is written with the public sector in mind, but its findings are relevant here too - particularly as banking is so critical to our economy that it can almost be regarded as a public service.

To my mind, if you want to make bank execs more responsible and accountable, you might want to reduce their base pay so that the performance incentives in the bonuses can be really effective. Pay them less just for being there, and make them earn the rest of their remuneration through company success.  So let's have MORE bonus payments to senior bank executives, not less.

Oh and by the way - if anyone thinks that loss-making banks shouldn't be paying their senior executives bonuses, consider this.  Corporation tax law allows companies (including banks) that make a loss to carry that loss forward for up to five years and use it to reduce tax payments during that period. Because of this, Barclays paid almost no corporation tax on profits of £4.9bn in 2009, Lloyds is paying no corporation tax on profits of £2.2bn in 2010, and RBS won't pay any corporation tax either for a while even when it gets back into the black (it's still making losses at the moment).  However, senior executives pay tax currently at 50% on the cash portion of their bonuses and on share dividend payments. If they sell the shares they incur capital gains tax at the top rate.  So effectively loss-making banks pay more in tax if they DO pay bonuses than if they don't. We would be nuts to stop them.

2. Traders

Traders are the people who buy and sell (or lend and borrow) things financial on the world markets.  They are just what their name suggests - market traders.  These days trading is done by telephone and on computers.  But until quite recently some financial markets (LIFFE, for example) operated by "open outcry" - yelling trades across a roomful of people all doing the same thing. Just like Walford market.

Traders, therefore, are SALESMEN.  And like all salesmen, they are motivated by money.  The more they sell, the more they get. 

ALL sales forces, in all industries, are paid on results.  Typically a salesman's pay package will be made up of basic + commission on trades.  Successful salesmen are then usually also paid yearly bonuses relating to the value they have generated for the company as a whole - i.e. performance-related pay (again).  Because salesmen are motivated by money and generally have a pretty short-term view, it's not usually appropriate to pay them in company shares (although senior ones, who have management responsibilities, may be rewarded in this way).  They need cash - it's the only thing they understand.

Now, we can discuss whether traders being allowed to generate huge amounts of money from reselling derivative products to each other at ever more inflated prices is a good thing. Personally I think it's daft.  But I can't criticise them for doing it.  If they can sell something and make loadsamoney from it they will.  Controlling their activities is the responsibility of bank management and external regulators.  And the fact is that they did - and do - generate huge amounts of income for banks. They deserve to be rewarded for this just as successful salesforces in other industries are.  So there is NO justification for restricting cash bonuses to bank traders.  The EU attempted to do this and the banks - rightly in my view - refused to cooperate.

3.  Bank staff

I've worked for a number of banks, mostly as an independent consultant.  But I was an employee of Midland Bank (subsequently HSBC), SBC Warburg (now UBS), and Charities Aid Foundation (CAF) - which is also a bank (not many people know that!).  I've never been a trader, and I've never been a senior executive.  But in every bank where I was an employee, I received a yearly bonus. This was my share of the profits generated by the bank, and it was related to my performance as an employee.  If I did a good job, I got more: if I was less effective I got less (and if I was dreadful I got nothing, of course...).  The yearly appraisal didn't just affect my future pay (as in pay rises and promotion), it determined my bonus amount for the CURRENT year. Staff bonuses can typically be taken as cash, shares or increased pension contributions - or given to charity - or a mixture of all of these.

The vast majority of bank staff, even in the City, are not particularly well paid, although they do get good benefits packages.  Branch-based frontline and admin staff currently earn £14-17K on average.  Credit controllers and similar junior management personnel earn £20-25K. Junior back office staff in the City earn £15-17K. Even branch managers - the traditional "bank managers" - only earn £28-50K depending on the size and location of the branch they run (figures from Hays Banking Personnel)  So the yearly bonus is a welcome addition to their pay packets.  And it means that the staff benefit directly from their company doing well.  Does anyone really have a problem with a bank cashier receiving a small amount of money (believe me, it isn't much) once a year in addition to her (most bank cashiers are women) meagre salary?

Giving staff yearly performance-related profit-share bonuses is widely recognised as good remuneration practice across all industries.  I would HATE to see banks stopped from doing this because of concerns about their profitability, tax contribution and past behaviour.

Now, we can have a discussion about whether banks should be continuing to operate in the way that generated their huge profits in recent years, given that some of their activities were so high risk that they weren't sustainable and therefore caused the current financial crisis. Some of them also were perhaps morally and even legally dodgy.  But that isn't the fault of bank staff.  Why should they lose their bonuses because people who don't work for banks want banks to pay loadsamoney to the government - which is at least partly responsible itself for the collapse of the financial system?  There is NO justification for extra tax charges to banks that result in ordinary bank staff losing bonuses and maybe even having their pay restricted.

So, to summarise - get off the banks' backs and stop moaning about bonuses. There are far more important things to worry about that.  Like bank regulation, for example - or lack of it.  Oh, wait, though - that's to do with the government, isn't it? oops.....


  1. Interesting post. Firstly, I agree with your concluding remarks. Regulation is more important, and I agree with your points on general bank staff too. I also agree that derivatives are pure nonsense, though am not convinced that there is 'no justification' for restricting their bonuses. Regardless of the moral arguments (trader X makes fortune Y for bank Z, so deserves a cut of it), surely if trader bonuses are a driver for excessively risky behaviour, the wider economic and social consequences of which are now all too apparent, then there is an obvious, and wider moral justification, for restricting them? I also disagree with your points on senior executives receiving bonuses, no matter what form they come in (a £4million equity bonus at %50 tax is still effectively a £2m cash bonus should they choose to sell). The main reason I have for this is that I can see no reason why a basic pay package (and the potential loss of it for underperformance) should not be sufficient motivation, as indeed it is expected to be for the vast majority of people in 'normal' jobs, for good performance. Moreover, the idea that senior executives form some kind of 'elite pool of talent' that will simply move elsewhere in a global market if they are not sufficiently remunerated in the manner to which they have become accustomed (a point that you don't make, but one that accompanies these debates) is completely unsubstantiated. But even if it were true, I scarcely think, on the evidence of the past few years, that the senior layer of the banking system is half as uniquely talented as they would would have us believe. I am convinced, in fact, that many, many people could do what they do, and for much less than the current cost. But this is more than a critique of the banking system, and more a point directed to the culture of senior executive nonsense that currently prevails.

  2. Many good points here, Steve - thank you. I agree that the high bonus culture did drive excessively risky behaviour by traders. However, it was a failure of management and regulation - and especially internal financial control within banks - that led to them being allowed to take these risks at all. Restricting traders' bonuses doesn't address the management failures. It's the equivalent of shooting the messenger.
    Re exec pay - yes, I agree that the "talent pool" is ridiculously restricted and even incestuous. But the Hutton report on senior local government pay made EXACTLY the same point about chief execs of local authorities. Clearly this problem isn't limited to banks. My other point was that it is normal in all industries, and increasingly in the public sector too, for senior exec pay to include a performance-related element. There may well be a case for senior execs in all industries to be simply paid for their job, as you suggest, rather than all this performance-related stuff. But there is no reason to single out bank execs in this respect.

  3. Yep. Agree with all of that - except 'maybe' the last point. When the banking industry gets it wrong, we all suffer. To that degree they have a unique position, and should be treated as such.

  4. I do think that the stranglehold that the banking industry has on the economy needs to be released. But that is a matter for government. And maybe we will end up recognising retail banking, at any rate, as the public service that it has now become - we can't do without it - and regulating it like other public services in private hands. Roll on OFFIN!

  5. Very intersting article and comments. Thanks. Paying bonuses in the form of equity can also lead to risky decisions to artificially inflate the share price. I agree with SK on bonuses. Wouldn't a flat salary place a burden on institutions to introduce the management qualities you discuss?

    As far as reducing banking stranglehold on economy: wouldn't a return to seperate retail and investment banks go a long way to achieving that?

  6. Thanks Joseph. This is exactly the kind of debate I wanted to initiate.
    I included a link to the Hutton Report because it spends considerable time discussing the relationship between pay related to the JOB ITSELF and pay related to PERFORMANCE IN THE JOB. It concludes that senior salaries should contain an element of both. I think that this is a useful model for bank senior execs remuneration as well. My concern is that very large basic pay packages render the performance element irrelevant. The bankers who presided over the collapse of HBOS and RBS among others had salaries so large as to eclipse the performance related element almost completely - in effect a flat salary. Very evidently this failed to prevent them making a complete hash of their management responsibilities. I am suggesting massively cutting their base pay so that the performance element is more significant, which might give them more incentive to do their jobs a bit better. I do agree though that this could lead to risky decisions to inflate the share price.

    The jury is out, currently, on separate retail and investment banks. I am personally not convinced that separate legal institutions are necessary, but there should be "chinese walls" to director level preventing cross-subsidy from retail to investment and vice versa. Hedge transactions and market trades on behalf of high net worth individuals should be done at arms-length - back to back transactions. This would be good practice now anyway. There should also be completely separate regulation of retail (clearing) banking and investment banking - two separate independent bodies are required. The FSA and BoE are utterly inadequate to this task.

    As always, we keep pointing the finger at the offending banks, without seeing the joint culpability of government in their offences.

  7. I need to do some homework on Hutton.

    As for government guilt, yes the government should carry a large share of the blame. New Labour turned its back on regulation and backed the City to generate the growth to fund its more progressive social reforms. Obviously that plan backfired.

    Is the City so good for us? It seems to me that the destabilising effects of the City outweigh many of the benefits. The high returns suck talent and investment from other areas of the country and sectors of the economy. Our investment record in manufacturing is dreadful and gets worse with each recession and the IFS are warning that we are losing market share despite the low £. Giving the financial sector even more power!

    Professor Richard Layard at LSE has done some interesting work on the economics of happiness (we should be a bit poorer but a lot happier)and the OECD are now promoting the benefits of more equal distribution of wealth. Even Cameron dismissed the 'trickle down effect' when he was in opposition. Let the bankers who don't want to stay chase higher salaries in other countries. There is a brief discussion in this post:

  8. I'm not entirely convinced that the salesman analogy is necessarily the correct one.

    For starters, in a company of any real size, ordinarily a salesman is not responsible for the quality of the product that they are selling, which is handled elsewhere and rewarded appropriately. They will be given a product and will be rewarded based on how effectively they sell it - failure results in either low margins, or unsold stock.

    Traders on the other hand are responsible for buying and selling magic widgets whose value at any point in time is often speculative. Assuming (in the most simple form) that their transactions come in pairs (buy/sell or short-sell/buy), part-way through any pair of transactions there's a risk of loss of capital investment. That's a level of end-to-end responsibility that doesn't exist in a normal salesman's role, so it doesn't naturally follow that the same rules ought to apply.

    Paying commission on profits generated by gambling with capital is an inherently flawed mechanism, because it's uneven. The tax example (offsetting last year's loss against this year's profit) works here - over the course of a decade, a company will have paid the appropriate amount of tax on their aggregate profit, even if the tax paid in any individual year doesn't look right. Say I employ two traders, on 1% commission - one makes £1,000 and one loses £1,000. My aggregate profit position is break-even, but I'm paying out £10 bonus to the good trader, and effectively capping the bonus for the bad trader at a bottom level of £0.

    Without an effective concept of clawback (which we both know wouldn't work because traders are motivated by short term remuneration), the commission model fails to factor in the risk element of the role, and isn't fit for purpose.

  9. Yes, that's a fair point. Position trading does require end-to-end risk management whereas Walford market generally doesn't, and of course the potential losses are far greater as well. However, the MINDSET of bank traders is definitely Walford market - and therein lies the problem.

    I've worked with traders. Some care about the risks they are running, but a lot don't care about their risks if the potential loss will be incurred by a different desk. They need to carry risks PERSONALLY in order for them to be remotely interested.

    Personally I think most traders would be fine with clawback of cash bonuses - it's language they understand: if they make loadsamoney, they buy a Porsche, but if they lose loadsamoney the Porsche has to go. I don't have a problem with clawback of cash bonuses to traders, and the threat of this might force them to take more notice of the risks they are running. Interestingly among the EU new rules on bank bonuses is provision for regulators to claw back bonuses where losses occur after payment.

  10. Many Very good points : Risk Capital / Buy & hold / Invest-not-save . But Financial & Corporate Market Activity - focused on value creation & boosting RoE based on S-T indicators will shrink And it should do so, as we become increasingly active investors/ participants in Productive Society that adds- not just strips - value. We must also ensure OUR agents (Pension Funds, Boards, Elected representatives) focus, not on unsustainable & costly to Society RoE but on Sustainable Risk-Adjusted Return on Capital.