Bank bonuses: no rhyme, reason or justification

How many words have been written on the subject of bankers’ remuneration in recent years? And how many have been illuminating? Virtually none.

But I would chose two contributions that anyone who wants to understand the issue ought to read.

The first is an article that appeared in the Financial Times in December 2009  by Martin Taylor, a former chief executive of Barclays and now a member of the Government’s Independent Commission on Banking.

It’s worth quoting at some length:

“High remuneration, not just individually, but in total, was paid out between 2004 and 2007. Observers of financial services saw unbelievable prosperity and apparently immense value added. Yet two years later the whole industry was bankrupt. A simple reason underlies this: any industry that pays out in cash colossal accounting profits that are largely imaginary will go bust quickly. Not only has the industry…been spending money that is no longer there, it has been giving away money that it only imagined it had in the first place. Worse, it seems to want to do it all again. What were the sources of this imaginary wealth? First, spreads on credit that took no account of default probabilities (bankers have been doing this for centuries, but not on this scale). Second, unrealised mark-to-market profits on the trading book, especially in illiquid instruments. Third, profits conjured up by taking the net present value of streams of income stretching into the future, on derivative issuance for example. In the last two of these the bank was not receiving any income, merely ‘booking revenues’. How could they pay this non-existent wealth out in cash to their employees? Because they had no measure of cash flow to tell them they were idiots, and because everyone else was doing it. Paying out 50 per cent of revenues to staff had become the rule, even when the ‘revenues’ did not actually consist of money.”

The second contribution is a July 2009 report by the New York Attorney General, Andrew Cuomo, who analysed in detail the manner in which Wall Street banks paid bonuses to their staff over a number of years.

Here is his conclusion:

“There is no clear rhyme or reason to the way banks compensate and reward their employees. In many ways, the past three years have provided a virtual laboratory in which to test the hypothesis that compensation in the financial industry was performance-based. But even a cursory examination of the data suggests that in these challenging economic times, compensation for bank employees has become unmoored from the banks’ performance. Thus when the banks did well, their employees were paid well. When the banks did poorly, their employees were paid well. And when the banks did very poorly, they were bailed out by taxpayers and their employees were still paid well. Bonuses and overall compensation did not vary significantly as profits diminished.”

Consider the implications of those two conclusions. Banks are paying out vast remuneration to staff based on profits that are yet to be realised and could easily prove to be illusory. And even when banks are driven to the brink of bankruptcy by poor risk management and bad investment, their employees still receive vast bonuses. This is a manifestly broken system.

Cuomo’s analysis is powerful because it shows just how steady the compensation of US investment bankers remained as a percentage of revenues through the boom and the bust (ranging between 20-60 per cent), yet how it ballooned as a percentage of reported profits in the crash.

For instance in 2007 Goldman Sachs paid out 44 per cent of its revenues in compensation, representing 174 per cent of its profits. Yet in 2008 Goldman paid out 49 per cent of its revenues in compensation, representing 470 per cent of profits. (p17)

In 2007 Morgan Stanley paid out 60 per cent of its revenues in compensation, representing 147 per cent of profits. Yet in 2008 the bank paid out 50 per cent of revenues, representing an astonishing 721 per cent of profits. (p19)

As Cuomo argues, Wall Street bankers get their huge bonuses regardless of how the bank performs. The argument that bankers’ pay rewards performance is manifestly nonsense.

That’s Wall Street of course. But I’ve done some research that suggests exactly the same rewards for failure take place in the investment arms of British universal banks.

banks

A brief  note on the table above. Barclays and Lloyds  do not break down the costs of their investment banking divisions in their annual reports, so the figures above for “pay” at those two banks include all operating expenses. But a cross analysis of other banks which do break down costs show that staff pay in investment banking sectors makes up the bulk (typically around 60%) of operating expenses in any case.

What the above data shows is that the pay of investment bankers remained remarkably steady, despite the wildly fluctuating performances of the underlying bank or division.

Investment bankers at RBS received £2.7bn in pay in the same year (2008) as its global banking and markets division registered an £11bn loss. Employees at Lloyds’ wholesale division received £4.2bn in pay in 2009, despite lumbering the bank with a £4.7bn loss. Profits at Barclays Capital fell 43 per cent from £2.3bn in 2007 to £1.3bn in 2008, but pay for staff fell only 7.5 per cent from £4bn to £3.7bn.

Just as Cuomo found in Wall Street, there is no rhyme or reason to the lavish remuneration enjoyed by traders and investment bankers at Britain’s four mega-banks.

The managers of our four large banks argue that they exist in an ultra-competitive environment. They claim that if they are prevented paying huge bonuses,  star performers will desert them. But this data does not suggest a competitive employment market, but rather a bankers’ racket, run at the expense of shareholders, customers and taxpayers.

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