The government's approach to banker bonuses is flawed

Government subsidies, if they are to be effective, need to be targeted. In the case of the banks, taxpayer funds that were intended to rebuild the banking system’s capital base, to enable them to lend more and to absorb future lending losses, are instead simply being paid out in bonuses.


Caught up in the blame game of trying to shift responsibility for the banking crisis, government ministers are returning to their old tricks. Today’s generation of politicians seem to think that taxation is the answer to all our woes. Many of those who pass our tax laws have never worked in the private sector – let alone run a private business – and are oblivious to the economic damage that high taxes can inflict upon industry. Since income taxes were first introduced by William Pitt the Younger in 1798 as an easy means of funding government expenditure, successive British governments have become accustomed to responding to new problems simply by introducing new taxes. Westminster’s answer to global warming? Green taxes. A bloated, inefficient public sector? Yet more taxes. Excessive banker bonuses? Excessive banker taxes.

Whilst governments are right to attempt to contain excessive banker remuneration – especially when it is directly or indirectly funded by the public purse – higher tax rates rarely achieve their intended purpose. Rather, they tend to have a negative connotation. They discourage enterprise and investment. They encourage a highly mobile industry to relocate overseas. All these things work ultimately to reduce the overall level of tax revenues flowing into the Treasury’s coffers.

Instead of playing a tune that appeases voters, politicians are more likely to achieve lasting results if they start talking the language of business. If the banking industry expects taxpayers to be their insurer of the last resort, then the government should extract a premium for that service. That insurance premium should be sufficiently large on a collective basis to cover the cost of the last bail out as well as paying for the next one.

Banks should be left free to decide whether or not they need these government-backed insurance contracts. But those banks that choose not to insure their balance sheets would naturally be deemed high risk by the markets – by shareholders, creditors, customers – and by regulators. They would see borrowing costs rise relative to their peers. Bank shareholders and bond holders would all be put on notice that, in the event that their bank runs into capital or liquidity problems that warrant government intervention, their investments might be wiped out. Under these circumstances, the likelihood is that all bank executives would see the commercial imperative of insuring their operations against default.

As is normal practice in the insurance industry, the government – as sole insurer – would perform a rolling risk assessment of the industry, segmenting the banking industry into high risk, medium risk and low risk players, each carrying an appropriate premium. Some parts of the banking system may carry such high risks as to be uninsurable. If so, those parts of a bank would have to be segregated and would be ineligible for taxpayer funding. Indeed, as a country, we may well be better off if the riskiest parts of the banking sector left the country. They would then become a problem for another set of taxpayers.

The insurance premium would naturally reduce the pot available for bonuses. Unlike taxation, an insurance scheme provides a strong market-based rationale for capping bonuses. To tackle the bonus culture, further measures are required. We need to return to the basic principles of any good employee incentive scheme. Bonuses should be tied to the performance of the individual and the company. If the company performs disastrously, employees must share the pain. Banking profits should be calculated on a more prudent basis, with greater general provisions for future losses, so as to smoothen profits out over time – after all, many banking executives announced record profits in 2006, only to hit their shareholders with record losses a couple of years later. Bonuses should only be paid out of profits, not losses. Short term bonuses should be replaced with long term bonuses. Tie an employee’s bonus to his pension scheme and I guarantee you he will think twice about taking big bets.

If such rules were made clear now, bank executives would be forced to put their house in order, to manage costs better, rather than casually assuming that they will be bailed out with impunity. Investors would have greater clarity over which banks would be saved and which would be allowed to fail. Aggrieved shareholders or bond holders would have no case for claiming compensation.

Some argue that the Basel III rules already provide an implicit form of insurance against bank failure. The Basel III Committee in Switzerland agreed last year to raise the minimum core Tier 1 capital ratio from 2% to 7% by 2019. The problem with the Basel III rules is that they are essentially internal controls which can be easily manipulated to give regulators the perception that they are being followed. Whilst Basel III provides banks with an internal buffer against future losses, it would help to have an external buffer before the tax payer is called upon to rescue the sector.

Remember that a lack of capital and a lack of liquidity were the two primary causes of this crisis. Had banks put aside enough capital and enough cash to cover their losses, we may not be in this mess today. But banks are never likely to maintain adequate capital over the long term because their industry suffers from ‘moral hazard’ – that is, bankers know that if their own capital reserves are inadequate to absorb future losses, they can always rely on the taxpayer to bail them out. If banks are forced to pay a premium for the taxpayer guarantee their industry demands, the problem of moral hazard partly falls away. In the long run, that is the only way to prevent the banking industry from bringing us all down.

Another banking crisis looms

The public’s anger towards bankers stems from their refusal to exercise any form of humility (i.e. pay restraint) in the wake of the biggest banking rescue package in history. Politicians’ anger is based on bankers’ resistance towards the reform measures needed to avert another banking crisis.

Some economists say that the cost of this financial crisis has already exceeded 6% of world GDP – or over $3trillion. Britain has borne the brunt of this – relative to the size of its economy – because it relies so heavily on financial services. The British government's budget deficit has risen from 2.4% of GDP to 11.8% of GDP in just two years, purely as a result of the recession that followed the banking crisis. And it could all happen again. Only next time, it could bankrupt the country. That’s what makes banking reform the biggest election issue of all. It is being ignored at our peril. If banks are not reformed, we may all be the proud donors of another multi-billion bank bailout within the next parliament.

So let’s re-examine what went wrong in banking and ask how we should fix it.

What went wrong?
Before we look at the causes, it’s worth reminding ourselves what banks actually do. Banks don’t sell cars or iPods or hamburgers. Banks sell trust. You go to the bank, you hand over your money and you TRUST that they will give it back to you when you need it. And of course when an industry is based on trust – solely on trust – there is an awful lot of scope for abuse.

And over the last 10 to 20 years, bankers have blatantly abused that trust. Simply by not putting aside enough money – enough ‘capital’ – to guarantee that they could pay back the money they owed when things got tricky.

Now trust takes a long time to acquire. London became a leading banking centre because it had built up trust over the centuries. Then somewhere along the way, the honour dropped out of the banker’s dictionary. Traditional, safe banks became hijacked by pirates, by treasure hunters, by risk takers. People who rarely risked their own money, but were happy to risk yours. And to add insult to injury, they’d get you to pick up the losses whilst they kept the bulk of the profits.

How did this come about? And why did so many commentators brand this an Anglo Saxon crisis? Well, the two single biggest triggers were Anglo Saxon:

1. Big Bang, 1986, UK

2. Repeal of Glass Steagall, 1999, USA


Big bang in 1986
Big bang was the sudden deregulation of the UK’s financial markets under Margaret Thatcher. It was done to make London an attractive place for foreign banks to set up shop. And it worked. It became easier to get a banking licence and you could do more with it. Everyone, especially the American banks, came to London to do what they weren’t allowed to do by law in their own back yard: take excessive risks and invent highly complex products that no one could understand.

London became one big free-for-all and banking became ridiculously complicated overnight. No one could understand how everything fitted together any more, or how some of these fancy derivatives worked, least of all the boards of the banks that took big risks with our money.

Repeal of glass Steagall act in 1999
The Glass Steagall Act was the 1933 political response to the credit crisis that created the Great Depression in the 1930s. Its sole purpose was to prevent bankers from putting savers’ deposits into risky investments. It separated retail banking from investment banking. The risky bit of banking would stay in investment banks and the safe bit in retail banks.

There was a good reason for this split. Depositors regard banks as an institution whose core role is to safeguard their money. Attaching a casino to a bank is not the best way to safeguard depositors’ money. And that’s exactly what the Glass Steagall Act was designed to do – to prevent bankers for making bets with your money.

President Clinton repealed the Act in 1999. That allowed the investment banks to take your money and gamble it away, laying the foundations for this crash.

So within two decades you had a banking regulatory environment that was just asking for trouble on both sides of the Atlantic. In the UK, you had regulation that was so light it was virtually invisible. In the US, you had the government openly signalling to their banks that it was OK for them to use depositors money to invest in risky assets like subprime debt.

As if that weren’t enough, you also had cheap money, thanks to Alan Greenspan, the Chairman of the Federal Reserve. That meant banks could borrow money at very low interest rates. Cheap money can be a good thing if it is used to lend to solid, growing businesses to generate wealth and jobs. But when cheap money is simply used to make the bankers themselves rich, that’s what Lord Turner was referring to when he described them as socially useless. And that’s what they did. The banks used cheap money to gear up their own positions to absurd levels. For example, Lehman Brothers balance sheet, just before it went bust, had a gearing ratio of 40x. That meant that for every £1 of its own money it invested, it borrowed £39 from someone else. In the old days, that ratio was closer to one or two.

Did you spot the problem? If you did, you’ve passed the test to become CEO of an investment bank. Congratulations. We know from our own experience that too much borrowing can bring us down. Yet, the banking regulators ignored this danger. They simply left the banks to manage their own risk and to police themselves and then looked shocked when they turned the place into a City of Thieves.

Regulation
Now it’s easy to bash regulators. But it’s not so easy to be one. Banking regulation is a difficult balancing act because your number one priority is to ensure banks don’t go under. Yet banks by the nature of what they do are always technically bankrupt: to be bankrupt means you are unable to pay short term debts as they fall due.

Banks borrow short term and lend long term. At any point in time they are always technically bankrupt, because they are unable to pay all their depositors at once, because of the maturity profile of their assets. The only thing that actually stops banks from going bankrupt every day is confidence in the banking system. And the job of the regulator is to maintain confidence in the system. So the Bank of England, when it was in charge, had sensible rules that had been developed over hundreds of years to safeguard depositors’ assets – to make sure that our money was rarely put at risk:

Basic common sense rules and guidelines:

- Don’t lend over 3x borrower’s income (for housebuyers)

- Keep sufficient general reserves to allow you to cope with bad times

- Pay bonuses only out of profits not out of revenues

- Golden rule: don’t invest in anything you don’t understand

In 2007, not one of these basic common sense rules was being followed at any major bank. Why? Partly greed, partly the global nature of banking flows and partly bad regulation.

Regulators simply do not understand all the new banking products that have been emerging with alarming speed – it’s not because the products were particularly complicated or that regulators are particularly stupid – although both are undoubtedly true – it is because banking itself had become too complex for any one human brain to comprehend.

Of course, the biggest problem the regulator faces is exerting authority over the bankers themselves. Let me put it this way, how do you give orders to someone who is taking home a hundred times what you make? It kind of saps your confidence a bit, don’t you think?

Causes of the banking crisis
Today, as we exit this banking crisis, we do so knowing that another crisis is inevitable. How do we know this? Because the three main causes of this crisis have not yet been addressed.

1. Bonus culture

2. Moral Hazard

3. Conflicts of interest


Bonus culture
When I was young, looking in from the outside, the City looked like the perfect world – clever people using their brains to make lots of money. As a Cambridge undergraduate I was once seduced by this dream. But when I became an insider, I very quickly learned the truth. Investment bankers weren’t succeeding because they were smart; they were making money because they were bending the rules and fixing the match, the authorities stood on the side line and turned a blind eye as vast tax receipts rolled in. The City is not a place for the principled.

In the boom years, bankers justified record bonuses by pointing to record profits. And herein lies the problem. You see, the problem with banking is that you never know what profit you’ve actually made until years – sometimes decades – later. It’s always a guess. After all, many bank executives reported record profits to their shareholders in 2005 and 2006 only to hit them with the biggest banking losses in banking history just a year later in 2008.

Banks are not like any other company. 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 adjustments 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 twenty years. But whilst a bank’s profitability can only be certain 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 can manipulate profits like my baby daughter can manipulate her daddy. 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. By the time we figure out what the real value of a bank’s assets are – the bonuses have already bolted out the door. And all your left holding in your hand is the same stuff that I’ve got every morning right after my daughter’s nappy change. And it stinks.

The banking industry’s line on bonuses is, of course, predictable: Talent has to be rewarded. Risk takers have to be rewarded. Recent bonuses have been close to all time highs, yet what risk have bankers taken when their businesses have been underwritten by taxpayers? George Soros, the legendary investor, summed this up in an interview he gave the FT recently, “Those earnings [referring to bankers’ bonuses] are not the achievement of risk-takers. These are gifts, hidden gifts, from the government.”

As I said earlier, banks sell trust. When you’re in the trust business, you have to act honourably. And honour simply doesn't sit comfortably with bonuses. Greed and honour just don’t go together. They’re like chalk and cheese.

So to those people who say that we need to reward talent with multi-million dollar bonuses, I say you’re hiring exactly the wrong kind of talent. Honour doesn't come with such a heavy price tag.

Moral hazard
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 two years 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 capital 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 its own 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’. Bank employees are grabbing capital provided by their shareholders to enrich themselves rather than using it to recapitalise their banks. 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 they were too big to fail.

Now I’m not going to argue why we need to save big banks – that’s obvious – the economy would collapse if the banking system collapsed. What I want to focus on is why have banks taken on such big risks. And that leads me to the conflicts of interest that continue to plague the banking sector.

Conflicts of interest
Now there are many types of conflicts of interest within a large investment bank. My book, City of Thieves, for example, covers one type of conflict – the conflicts an analyst faces every day. He’s under pressure to change a rating because somebody somewhere in the bank stands to make a lot of money by manipulating stock ratings. That type of conflict is well documented. It was headline news in 2002, when Eliot Spitzer, the New York Attorney General humiliated the top 10 US investment banks by pointing out that analysts like Merrill Lynch’s Henry Blodget were telling clients to buy internet stocks whilst internally saying they were crap.

Spitzer fined the banks $1.4bn for allowing these conflicts to go unchecked. A year later he was very publicly discredited when he found himself embroiled in a prostitution racket. Since then very few regulators have had the guts to take on the banks with quite the same vigour and success as Spitzer. So the banks just returned to business as usual. Back to precisely the same bad old tricks, for which they had been fined $1.4bn back in 2003 by Wall Street’s highest ranking law enforcement officer.

As a result of the conflicts exposed by Spitzer, pension funds and other big investors still – to this day – do not trust the stock research flowing out from the big banks. There’s always an angle, always a hidden agenda behind it. An analyst at a big bank is supposed to provide independent analysis. But he has a lot of big hitters to please back at head office – the commercial lending guys, the M&A guys, the equity capital markets team, the derivatives team and the fixed income guys. And it shows in the research.

Going one step higher than conflicts faced by stock analysts, the mother of all conflicts of interest is how banks handle your money. Remember, bank’s sell trust. You give them you’re money and trust you can get it back any time. You might even pay them a fee to hold it. You expect them to take care of it, to put it in safe investments. But of course safe investments don’t generate big returns. Risky investments generate big returns... sometimes.

So the biggest conflict of all in a bank is that bankers are tempted to put money – your money – that should be destined for safe investments into risky investments, without telling you about it. It’s a major conflict because it goes to the very heart of what banks are – custodians of our money.

Conclusion
As a society, our livelihoods and even our happiness are to a large extent determined by the morals and values that we are taught to hold dear. They are ingrained in us from an early age and they form the fibre of our being. We never really think about them until they are undermined.

So if any of you out there want to find your dream job working for a big investment bank, then remember what’s important. Banking is about honour. My generation forgot that. Make sure you don’t.