The way bankers are paid has promoted a “systemic madness” across the global financial system, says Ross Buckley, professor of international finance law at the University of New South Wales.
In an article in The Australian Buckley points out that the way banks reward their staff — offering them the carrot of huge personal rewards in exchange for taking big risks — cannot be healthy. For example, it was a key reason they became so heavily embroiled in subprime-related insanity, even after it was clear to many that the credit bubble had burst.
And it does seem morally repugnant that, despite having brought some of their own institutions to the brink of bankruptcy and some economies to the brink of recession, UK-based banks, many of them investment banks in the City of London, have paid out record bonuses totalling £12.6 billion last year. It is not just the bank’s shareholders who ought to be concerned about such largesse.
The Bank of England governor Mervyn King issued a stern warning to Britain’s bankers at the end of April, suggesting that their incentive systems are intrinsically flawed as they promote reckless lending and stupid investment decisions.
Later, speaking to the Treasury select committee, Jon Moulton, founder of the private equity firm Alchemy Partners, warned that the current bonus system encourages bankers to do dangerous things. “The incentive payments do damage,” he told the committee, adding: “If you put people on 1,000 per cent bonuses they’ll do extraordinary things. No one would say things haven’t gone far too far.”
According to Robert Peston’s blog, Peston’s Picks, Hector Sants, the chief executive of the Financial Services Authority, is hoping that investors will put more pressure on bank boards to stop them from doling out absurdly inflated bonuses to so-called “Masters of the Universe” on the strength of the notional profits that they generate, rather than after years have elapsed and it is possible to gauge whether the deals made any sense.
Angela Knight, chief executive of the British Bankers’ Association, has sought to downplay such talk, arguing that the way in which banks reward their employees is a matter for their shareholders alone, implying it is of no concern for regulators such as Sants and King. She seems to think that if regulators are to become involved, the matter is best discussed in private.
She also points out that the bonus culture is a global problem, rather than being specific to the UK, and therefore wants any solution to be reached at a global, inter-governmental level. She earlier warned that banks might move jobs away from the UK if the Bank of England were to be too heavy-handed on the matter.
Buckley, however, is adamant that how bankers’ remunerate themselves is a very public matter, not least because it has such an impact on the stability of financial markets and the sustainability of the wider economic system.
Here are some excerpts from the article that Buckley had in yesterday’s The Australian:
Last month the Financial Stability Forum recommended to the G7 nations that bankers’ bonuses be tied to the quality of the financial business they generate. As you might guess, bankers hate the idea. In the words of the head of the British Bankers Association, “Remuneration is a matter for shareholders and the industry only, which is where it should stay.”
Bankers’ bonuses, which comprise the great majority of their income, are not tied to long-term performance. When profits are up, bonuses balloon. But when profits plummet, bonuses don’t.
Losses in the past financial year could hardly be worse, yet British bankers have in the past week been rewarded with record-setting bonuses of more than £12.6 billion ($26 billion).
Individual bankers simply have no incentive to be prudent and every incentive not to be. For instance, a principal driver of the sub-prime crisis was the ability of bankers to repackage loans, through securitisation, into bonds for sale to investors. The investor demand bankers were able to generate through their apparent financial alchemy meant commercial bankers kept lending, as loans would be repackaged and off their books within days or weeks of being made.
Yet banker behaviour was masking real risks that have now crystallised. The sub-prime loans were always problematic. Bankers knew this, at least at the pub on a Friday night, where they were dubbed NINJA (no income, no job, no assets) loans. That they could be repackaged, perhaps credit-enhanced, and onsold didn’t remove their fundamental flaws, it just covered them up for a while.
Bankers received higher bonuses for apparently outperforming the market, but they were not: they were simply deferring risks. However, while bankers’ bonuses depend on profits made in the present year, that is all they need to do.
The existing pay system also promotes herd behaviour. Because banker performance is measured relative to their peers, the banker who exits a rising market before the top is reached will appear to have had a very bad year, even though the following year may vindicate the decision.
Existing practices reward bankers who follow the herd. This is systemic madness, as herding increases volatility.
For all these reasons, the Financial Stability Forum has called on the industry to “align compensation models with long-term, firm-wide profitability”.
The forum didn’t prejudge how that might be achieved. The simple method would be for banks to award only a minority of each bonus at year-end and hold the balance in escrow for five years.
If losses emerge in that period, the bonuses would then be reduced accordingly. This would tie banker remuneration to the genuine quality of the business they generate, and make for a far more stable financial system.
The British Bankers Association is wrong. How bankers are paid is not a matter only for shareholders and the industry. It is rightly a matter for regulation, because it affects everyone who borrows money, all across the world. Our political leaders need to understand this.
This blog post was published on 27 May 2008