The Heart of Bankers' Bonuses (Part 1)

Arguing about how unfair bankers' bonuses are is a futile exercise. More to the point is to ask about banking profits and who shares in them.

Banks are no different from other businesses. Capital is provided by shareholders who expect a return. The capital is bulked-up through borrowing and then the total is invested in income generating projects. The technical term for this process is leverage.

In a conventional business, the borrowing is from banks. In a bank borrowing from other banks is known as wholesale funding. But banks also borrow from the general public. We understand this as saving or depositing.

In a conventional business, the income generating projects are usually in the form of equipment, materials, goods, advertising and other easily recognized business expenses. The aim of the business is to more than cover these expenses and pay part of the surplus to shareholders in dividends and to retain the balance of the surplus to expand the business. The same is true for banks except that the majority of the funds raised are lent to the public - other people and businesses - or other banks in exchange for interest payments. We understand this as lending.

Staff are paid a market related salary to carry out profitably the various activities of the business. By doing so they ensure the growth and well-being of the business. The issue of bonuses is related to the division of the profits or surplus.

Stern Stewart developed an approach called economic vale added (EVA) which took the view that shareholders were at the minimum entitled to a risk adjusted share of the surplus. The balance, managers and staff argue, is because of their special skills and efforts. Without them the surplus would not exist. And so all or part belonged to the them because of their special skills and efforts. The EVA system and its derivatives is now common practice in most Western-oriented businesses. Including the banks.

There has to be a surplus beyond the basic shareholder return for this to work. Two questions spring to mind. How is it possible to have a claim to bonuses in loss-making businesses? Are the shareholders getting the correct return for their capital?

Part 2 will deal with the answers.......