Is Darling right to target bankers’ bonuses?

In his pre-Budget report today, Alistair Darling announced proposals to double tax bankers’ bonuses – a 50% super tax paid by banks on any bonuses paid to employees over £25,000 on top of the normal income tax payable by bankers on their bonuses for the year to 31 December 2009. Is he right to levy a punitive tax on bankers’ bonuses in this way? And, even if this is a one-off levy, what message does it send to the outside world about the UK’s readiness to portray itself as a global financial centre?

Bankers’ bonuses
The British Bankers’ Association has taken a tough line against the government’s willingness to bash bankers for electoral gain. They argue that if you pay peanuts, you get monkeys, so big bonuses are justified in order to attract and retain the talent we need to bring our banks back to profitability.

Yet bonus systems for banks seem to work in a different way than for the rest of us. Bonuses are meant to reward good performance. Most bonus systems require two conditions before a large payout is made to an individual. The first is that the individual’s performance must exceed expectations and the second is that the company’s profits justify a payment.

Many would argue that neither condition has been met in the case of many bankers: for example, some of the executives in line for large payouts were the same ones that were in charge at the height of the banking crisis last year; moreover, if the ‘bonus period’ were measured over the last two years, rather than the generally accepted bonus period of one year, many banks that claim to be profitable in 2009 would in fact be reporting record losses over the last two years.

Profit manipulation by banks is a real risk for shareholders of banks. After all, many bank executives told their shareholders that they had made record profits in 2005 and 2006, only to hit them with some of the biggest losses (and bankruptcies) in corporate history just a year or two later in 2008. The problem with banking is that it you never know how much profit you’ve made each year. It’s always a guess. And that’s because banks are different to any other industry.

If you read Ford’s accounts, things are pretty simple. They bought this much steel, this much plastic, put it together with a bit of electronics and wheeled out this many cars. Make a few adjustments and hey presto, this is your profit – or loss in their case. The key thing is, in the majority of industries, most of that profit is actually generated by selling your product and banking the cash. Profits will, of course, be manipulated by accounting provisions and be affected by year end stock levels. But the maximum stock a car company, say, might hold could be a month’s worth of cars, maybe two months.

At a bank the maximum stock – by way of loans – could be ten, perhaps twenty years. But whilst banking profits can only be realised in the long term, bonuses are paid out in the short term. If things turn sour from one year to the next and you’ve paid out too much in bonuses – tough shit.

Banks calculate a big element of their profits not by what they’ve sold, but by pricing what they haven’t sold. In the jargon, it’s called mark to market. These profits are sent up or down at the click of a computer mouse. They’re not based on real sales – like they are at Ford, or Apple or McDonalds. They’re based on guessing the value of their assets. The higher the valuation of those assets, the higher the bonus pool for the banks’ key executives.

If you think it’s easy to mark to market, have a word with Ben Bernanke. The Fed Chairman said on Tuesday 17 November 2009, “It’s inherently extraordinarily difficult to know whether an asset price is in line with its fundamental value.” If the world’s most powerful central banker finds it difficult to value banking assets – which directly impact bank profits – why would you trust a bank’s employees (whose bonuses depend on the outcome) to do it?

Some would say that if you live by the sword die, you should die by the sword. The sword of bankers is capitalism. The first rule of capitalism is that you should protect capital; yet all banks failed to do that. The second rule of capitalism is that it is survival of the fittest; yet bankers expect taxpayers to bail them out when they lead their businesses to the brink of bankruptcy. The third rule of capitalism is that the providers of capital should reap the biggest rewards. Yet the biggest provider of capital to UK banks over the last year has been the UK government – on behalf of the UK taxpayer. We have provided direct capital injections into banks like RBS and HBOS and indirect support to banks like HSBC and Barclays, who would have lower profits had taxpayer’s money not come to their assistance. Yet, as the largest provider of capital, the UK government seems to have little control over how that capital is allocated. No doubt that is partly because the capital was handed over to the banks at a time of crisis, when the Treasury was more concerned about averting financial meltdown than negotiating a good deal for the taxpayer. Yet now, after averting the banks from bankruptcy, the banks seem to be in a state of ‘employee capture’. Employees are grabbing capital provided by their shareholders to enrich themselves rather than using it for the intended purpose – to recapitalise the banks. The profits generated from the owners of capital are not going back to them, but being diverted to labour. That’s not supposed to be how capitalism works.

And that’s because capitalism in the banking sector has been distorted by moral hazard - the concept that bankers will continue to take excessive risks with other people's money as long as they know that the government will be there to bail them out.

The concept of moral hazard is against the instinct of all free market economists. In capitalism, if you take big risks and fail, you go bankrupt. That’s the end of it. In the banking sector however, several banks took large risks, secure in the knowledge that – because they were too big to fail – we would never let them go bankrupt. In September 2008, the former US Treasury Secretary Hank Paulson called Lehman Brothers’ bluff on this and let them go under, but he got heavily criticised for it afterwards, with some commentators blaming him for the subsequent carnage in the wider economy as banks refused to lend to each other. Since then the global banking sector has received support from taxpayers amounting to 5% of global output, according to The Economist. Banking profitability is directly linked to the taxpayer support they received. And the rewards for that capital support, in a capitalist society, should go to the providers of capital – us – yet governments appear to be unable to stop those rewards from falling into the wrong hands.

Even George Soros, the legendary hedge fund manager, told the Financial Times a few weeks ago, that “Those earnings [referring to bankers’ bonuses] are not the achievement of risk-takers. These are gifts, hidden gifts, from the government.”

The UK as a global financial centre
Whilst the question foremost in the minds of UK taxpayers is why their money is being used to pay bankers’ bonuses when it should be used to rebuild the capital base of our banking system, the bigger question is this. What do we want the UK banking industry to look like in five years’ time? And how do we shape regulatory policy to achieve that vision?

Today financial service revenues account for around 10% of UK output. By global standards that is relatively high. Proponents of a large financial services sector argue that the UK should protect its overgrown banking sector and continue to focus on what it does best. Opponents argue that the costs of insuring our banking sector are simply too high and the industry itself is not paying a high enough premium to taxpayers for the insurance that taxpayers provide. There is nothing wrong with having an oversized banking sector, provided we understand what that means – it means we, as taxpayers, are taking on more risk.

What this banking crisis has illustrated beyond any doubt is that risks taken by the UK’s investment bankers are synonymous with risks taken by the UK taxpayer, because when things go sour, it is the taxpayer that picks up the bill. In extreme cases, the bill racked up by a poorly regulated banking sector can bankrupt an entire nation, as was the case in Iceland. Other countries are showing signs of heading that way too. A couple of weeks ago, the government of Dubai indicated that it would not honour the debt commitments of companies it wholly owns. Greece has this week seen its sovereign debt downgraded to BBB+. The UK itself has received several warnings from rating agency analysts that its sovereign debt may be downgraded if adequate plans to reduce public borrowing are not forthcoming by the time of the election to be held by June 2010 at the latest.

The bigger the UK investment banking sector, the bigger the risks to the UK taxpayer, because the game of investment banking is a game of risk taking. And it is not bankers that take the ultimate risk, it is the country. So, as custodian of UK plc on behalf of us taxpayers, it is the UK government, as chief risk taker, that needs to decide whether it is in the UK’s national interest to have such a large financial services sector.

And if the government concludes that the risk levels are too high, given the size of the UK economy as a whole, it has a duty to manage that risk by downsizing the UK banking sector.