The Heart of Banker's Bonuses (Part 2a)

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.

In Part 1 we showed commercial reasons for bonuses in banks. In Part 2, we saw that there are even cases for bonuses in loss-making businesses. While Part 3 will deal with the size and distribution of surpluses, I was at a meeting earlier this week with a group of policy makers, advisors and bank executives to discuss the EU and UK banking code on bonuses and their treatment.

The abridged version is that banks would establish which staff are to be subject to a code of practice. The UK has chosen to define code staff as those whose activities potentially have a material impact on the risk profile of the firm. This is a far broader definition than in other countries.

For code staff, salaries should be set at a level that staff accept the possibility of no bonus at all. At least 40% of the bonus must be deferred over a period of at least 3 years. Where the bonus is £500,000 or higher at least 60% of the amount must be deferred. 50% of the bonus must be in shares or share-like instruments. Firms should be able to reduce deferred bonuses prior to vesting in the event of poor performance. Of the bonus immediately available, only 50% is available in cash. The balance is in shares or share-like instruments. While the staff member would own them they would not be available for sale for 6 to 12 months. This link provides good working examples of the mechanism at different bonus levels.

More to the point is that in the meeting a gentleman asked, "What problem are we trying to solve? Will this achieve the objectives?" Strangely, there was a rather embarrassed silence. He went on, "Will these measures change the behaviour that led to the crisis?" Most people thought not. Perversely, there is even a chance that with comfortable normal salaries, staff could more safely "bet the bank" as they have less personal risk. A counter argument is that as the deferred bonuses build-up they will become more risk averse to protect the built-up bonuses. But only time will tell.

Interestingly the tax status of these bonuses has yet to be worked out. At one extreme, the taxes are levied only when the bonuses 'vest': after the 3 year period. Using the £1,000,000 bonus from our example, the tax in year 1 would be £200,000 with the balance of next £300,000 after three years. Compare this to a normal tax take of £500,000 in year 1. I'm surprised the tax authorities haven't campaigned harder against this scheme.

At the other extreme, the full tax is payable: a person earning the bonus would have to pay in all £500,000 immediately. But they only received cash of £200,000! Then if there is claw-back because of bad performance do the tax authorities give a them a tax refund? Tax is an issue that needs quicker resolution.

More to the point of this debate was our gentleman's last question, "Speaking as a Barclays shareholder, how is that total remuneration at Barclays is up 20%, while dividends are 5.5p compared with 34p in 2007?"

Reviewing the size and distribution of surplus is the task of Part 3.

The Heart of Banker's Bonuses (Part 2)

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.

In Part 1, we established that viewing banks as businesses easily explained the reasons for bank's staff to call for a share of the surplus profits. The claim is most strident where the surplus can be claimed because of staff members' special skills and knowledge.

How do we resolve the paradox of bonuses being demanded and payed where there are losses?

Originally the argument in favour of bonuses pools for staff was applied to the whole firm. If the firm does well the staff who helped it do well should share in some of the rewards. But recently we have seen large bonuses in the presence of large losses. Three possibilities exists: self interest - staff members are calling for bonuses for their contribution irrespective of how the firm has done: tactical - bonuses need to be paid to keep staff from leaving and going to profitable businesses or to attract revenue generating staff into the business; and market driven - bonuses are actually an expected part of package.

Market driven arguments are most often used to justify paying bonuses in government, utility, NGO and other not-for -profit settings. Staff argue that their skills are transferable and they could easily work in those firms who do pay bonuses.

Tactical arguments - that bonuses are needed to attract and retain staff - abound in times like these. They justify signing-on bonuses. They justify bonuses for turn-around executives who are successful in making smaller losses than their predecessors. They are used to keep "mobile" profit contributors in their loss making companies. These are future focussed and should have clear targets and claw-backs. Without a return to profits, paying bonuses in these situations is not sustainable.

Self-interested arguments are ok when there is overall profitability in the business with only a few loss making units: "I made a profit", proponents argue, "I can only control my area. I can't control other parts of the business." But they are weak in the face of losses across a whole business. "If it wasn't for my efforts the losses would have been greater." True. But without the whole business their part of the business would disappear as well. When self-interested arguments are confronted with reality, they usually become tactical arguments.

There is an old adage that you get what you reward. Bonuses need to be carefully structured to ensure that they don't have perverse side-effects. Rewarding sales growth, for example, will get more sales - not necessarily profitable sales. The mortgage origination industry was awash with these rewards in the period leading up to the crisis.

In Part 1 we saw that staff can make a legitimate claim on all or a part of the surplus after shareholders have received a reward commensurate with the riskiness of the business. In part 2, we saw that there are cases for bonuses in loss-making businesses.

Part 3, reviews the claims of others to all or part of the surplus. It reviews the question of fairness in the size and distribution of the surplus.

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.......