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.....

Sunday, 20 February 2011

The Foundation of Short Selling

This is my response to George Monbiot's poorly researched and inaccurate article about Short Selling in the Guardian on 15th February 2011. It is not surprising that Monbiot evidently understands nothing about short selling as a practice, and that he doesn't even seem to have understood the documents he references in his article, since in the detailed account he gives of his life on his blog nowhere is mentioned any study of banking, finance or financial markets. None the less his ill-informed writings are enormously influential, and that is why I feel obliged to write something to set the record straight, even if my ramblings are only seen by a few people.

I'm aware that lots of people find financial terms difficult to understand, and I don't want to give anyone brainache.  So instead of talking about money and various types of financial transaction, I'm going to talk about makeup.  I sell it, you see.  I work for a company that sells makeup.

I did a naked short sale the other day.  I sold a tube of foundation cream that I didn't have in stock.  I promised my client that I would get it for her as soon as I could.  She is still waiting because my supplier had a stock out.  Embarrassing for me, frustrating for her and may lose me a client if it continues for too long.

To avoid upsetting my client, I could borrow some foundation from another consultant with the promise that I'll replace the tube as soon as my supplier sends my order. After all, one tube of foundation is just the same as another.  She could charge me a small amount for this - say 5% of the sale price - but as my commission on makeup sales is 35 % I don't mind this too much.

In order to do this, my consultant friend has to have excess stocks of foundation - more than she can sell in the next few days. We can say that whereas I am "SHORT" of foundation, she is "LONG" in foundation.  These excess stocks are sitting in her stock box not earning her any money. Lending them out is a way of generating some money from them - not as much as she would get by selling them, but definitely better than nothing.  In fact if she makes a habit of lending out her foundation stocks for a small fee, getting them back after a few days (well, identical replacements) then lending them again, she could make quite a lot of money out of not selling foundation. This is what financial LENDERS do - they lend out what we might call "financial products" to traders who need them to settle their trades, and they charge the traders for this.

Let's suppose that a few months pass.  Suppliers aren't getting any better at delivering stocks in time - in fact it's got worse because they are having big rows with their lawyers.  Clients are complaining to Head Office that they are ordering makeup that they don't get for months.  So Head Office decides to impose a rule that no consultant can sell a client makeup she physically doesn't have in stock at the time of sale.  I am shocked.  I haven't got the money to keep stocks on hand like that - heaven knows when I will sell them, after all, and I'm not allowed to charge people for their makeup until I physically deliver it.  But there is a solution - my friendly consultant who is lending her stocks out.  Suddenly all the other consultants (including me) come to her to borrow her stocks. She is on to a winner! Actually she has more people wanting to borrow her makeup than she has makeup available. Excellent! So she raises her prices and lends only to those who are willing to pay the higher price.  Guess what the consultants do? They raise their prices too....but these are prices charged directly to customers.  What do the customers do? They go to Boots instead!

Head Office realises that they are losing customers because consultants have had to put prices up to cover the cost of borrowing their makeup.  So they impose another rule.  No-one is allowed to sell a customer makeup that they don't OWN.  If they are SHORT of foundation, they simply can't trade. My friend's lending business immediately collapses.  Several consultants (probably including me) give up completely because they can't afford the up-front cost of buying all that makeup.  The rest order huge amounts of makeup from the suppliers.  Remember what I said about the suppliers having problems with delivery? Now they've got LOTS more orders to fulfil.  Hopeless. Well, they can't, of course.  The consultants wait for months for their makeup to arrive, and in the meantime they can't sell ANYTHING to customers.  Guess what the customers do? They go to Boots instead!

Financial markets work in a very similar way to my example above.  Traders need to be able to sell things they don't physically have at the time of trade because otherwise the whole system grinds to a halt.  Borrowing the things they need to settle their trades is generally a good idea, but it can have the effect of pushing up prices. 

There are of course two risks associated with selling things you don't have.  The first is that you can't actually get them at all and therefore the trade falls through.  This is known as "settlement default".  If I did this a lot, as a tied agent for an image consultancy, I would probably be sacked.  In financial markets severe fines are imposed on traders who default on settlement, and individual traders can also be sacked. 

The second risk is that in the days between doing the deal with the customer and actually delivering the product, the supplier can raise their price - or, as noted above, the lender could.  Actually they could raise their price to lots more than I have charged the customer for her makeup.  Oh heck. I could make a really serious loss.  To help me decide whether this is a risk worth taking I need to know a lot about my market - suppliers' production costs, the cost of raw materials, the price of similar makeup for example at Boots, the inflation rate in the cosmetics industry, and how bloodyminded my lender is feeling.  I therefore employ a rocket scientist to research these things and do some fiendishly difficult mathematical calculations to give me some idea of the risk I am running in selling things I am SHORT of.  These people are called analysts.  Without their work, selling SHORT is, as Monbiot says, insanely risky.  So no-one does that, actually.  Financial institutions employ lots of analysts and pay them a LOT of money.  Good analysts can earn as much as traders do.

If prices are falling, selling SHORT can be a way of making more money.  Suppose - unlikely though it seems - that my suppliers reduce their prices in the time period between selling foundation to my client and receiving the delivery from them.  Or, suppose that the suppliers get better at delivering products on time, so fewer consultants borrow from my friend and she has to reduce her prices.  The price I have charged my client for her makeup is governed by the cost to me of obtaining it, either directly from the supplier or from my lending friend.  But my costs have gone down.  Do I tell my client? Of course not. She's agreed the price.  I'm going to make more money hurrah! 

Some financial traders deliberately choose to sell things they are SHORT of in the hope that prices will drop.  These are the people that Monbiot is complaining about. As I've already pointed out, their SHORT selling will be backed by extensive research and analysis, so the risk is a calculated one.  However, some of them have got it wrong and lost a lot of money.  Should all SHORT selling be banned because of this? Clearly not. The system would grind to a halt.  Should traders be forced always to borrow things they are SHORT of? Lenders would love that, wouldn't they - here come much higher borrowing charges hurrah!  Frankly it's the traders' risk.  If they lose their shirts I don't see why anyone should bail them out. They're gambling, after all. 

Suppose lots of consultants band together to sell lots and lots of foundation that they haven't got. Suddenly every woman in the country has ordered that foundation.  It's worthless.  It doesn't matter that they can't deliver the stuff, because the clients aren't interested any more - what woman wants to be seen to be wearing the same foundation as everyone else?  The price of the foundation drops through the floor.  This is where my analogy falls down - foundation, even cheap foundation, still has value to the person using it if it works for them, and anyway this company has other makeup lines it can sell.  It isn't going to go bust. But when this is done with currencies, which are only of value to the extent that they can purchase other products, the effect is disastrous for the economy of the country concerned.  Deliberate forcing down of prices like this by means of SHORT selling is called "market abuse", and should be outlawed by international law.  The EU, supported by the UK, is producing legislation along these lines.

As we all know, times are difficult at the moment - prices are generally rising.  But suppose that for reasons that are not entirely clear - maybe fewer women are buying the more expensive makeup products because they are totally skint - the price of the foundation starts to fall.  I know that that if I sell the foundation before I buy it in, I will pay a lower price to my supplier and still get a higher price from my customer, so I deliberately sell SHORT.  Head Office doesn't like this, because the supplier (which is them, actually) is losing money while I'm still making it, so they decide to impose a temporary ban on selling SHORT in that particular product while the price is unstable. This is what the EU wants to do with certain types of "financial product", notably sovereign debt (which is money borrowed by governments) and related products - remember I said they ARE the supplier?  I suspect this proposed ban is driven by Germany, which has already banned SHORT selling in these products and really wants the rest of the EU to fall in line, for reasons which will shortly become apparent. Other countries such as the US and Japan have also imposed temporary bans on SHORT selling in certain financial products to prevent prices dropping too much.  At present the UK doesn't think it's necessary - and there's a reason for that.

Remember that I said that when I am banned from selling makeup I haven't got, the customers go to Boots? Similarly, when a country bans SHORT selling in certain financial products, trading moves to a country where it is allowed.  Germany, Japan and the US among others have temporarily banned some SHORT selling. The UK has not. Guess where the trading is going!  Why would the UK want to close a gap that it benefits from?

Now, Monbiot is correct in saying that the reason that UK opposes the EU's ban on SHORT selling is because it is making lots of money from it.  But he is wrong to suggest that the EU wants to impose a general ban on SHORT selling.  It doesn't - it's only on certain products, mostly those where EU goverments are the suppliers.  He's wrong to suggest that the bans in US and Japan, among others, are permanent.  They aren't - they are temporary bans intended to calm the markets in a difficult financial situation by limiting the amount by which prices can fall or rise.  As soon as conditions are more favourable these bans will probably be lifted.  He's also wrong to suggest that the UK is opposed to banning any naked SHORT selling.  On the contrary, it is actively participating in preparation of EU-wide legislation to prevent the kind of SHORT selling that is intended to drive companies or countries to the wall.  And finally, he is wrong to suggest that naked SHORT selling is necessarily "insanely risky".  It isn't if it is done on the basis of proper analysis and research - and indeed, as I showed above, some "naked" SHORT selling is necessary to keep borrowing costs down.

It seems to me that Monbiot has jumped on a bandwagon that he doesn't understand. He is somehow implying that making money from certain aspects of normal financial market trading is inherently bad. No, George, it isn't. It makes huge amounts of money on which huge amounts of tax are paid (I'm not going to get into the tax avoidance question here), which goes to the government to fund spending programmes that benefit you and me.  Yes, the people who do the trading may be very rich. But they are also making lots of money for the UK economy - not just for the "super-rich".

I'm not going to comment on Monbiot's diatribe against the people he sees as the "elite" - somehow fundamentally different from you and me.  That's his opinion, and he's entitled to express it.  But I object to his partial selection and misrepresentation of facts to support his opinion. That is irresponsible journalism.

Oh, and by the way - it really is VERY good foundation cream.  I strongly recommend it.