Also in this issue: read Michael Prest's companion essay "What is a banker worth?"
Bonus bashing is good politics. Is it also good economics? The argument against limiting bonuses was crisply put by John Thain, until recently head of Merrill Lynch. Thain defended his decision to authorise bonuses of almost $4bn despite his company having lost nearly eight times that amount with an appeal to a free market axiom. "If you don't pay your best people," said Thain, "you will destroy your franchise." Put another way: if banks cannot retain and motivate talented staff, how can they keep capital flowing efficiently around the economy?
Whatever the moral shortcomings of Thain's argument there are holes in his logic that any reformer should consider.First, the incentive function of large bonuses is to be doubted, at least at the margin. Barclays chairman Marcus Agius said in Davos that too many bankers are used to receiving incentives "for basically turning up." He is correct. Second, attempts to reform financial pay have not so far challenged the principle that financial services are based on highly mobile human capital and that the rewards to that capital have to be exceptional.
Even the Obama administration's apparently draconian pay cap on directors of companies taking government funds applies only to cash awards. The prospect of private equity-like returns to executives paid primarily in stock and prepared to remain in post for the medium term may return to haunt the administration. Banking stocks are at historic lows but assuming that the world economy does not slide into permanent depression, share prices may triple over the next three years—roughly the lock-in period in the US plan.
This would hardly constitute a lack of incentive to perform well. What it would do is to bind executives' self-interest more tightly to that of shareholders—including governments offering lifelines to beleaguered banks. This principle is not foolproof: Dick Fuld, the head of Lehman Brothers, owned huge amounts of Lehman stock. But if it is to be applied at all the principle of alignment of interests should stretch beyond the boardroom to the trading floors where many of the most disastrous investment decisions of the past few years were actually taken.
In a typical profitable year, an investment bank will pay out roughly half its net revenues in staff costs. Fixed salaries usually account for only about one fifth of this amount, with the remainder made up of bonuses. The more senior and successful an investment banker becomes, the greater a percentage of his or her total earnings will be paid in bonuses.
A junior analyst, not long out of university, might until recently have had a base salary of £40,000 and earned the same again in bonus. At the other end of the scale, a managing director with a decade or more of experience earning a basic salary of £125,000 might have been paid a bonus worth five, ten or 15 times that amount—there was no formal upper limit.
Compensation was at least theoretically linked to performance, with priority being given to individual performance, taking into account team performance and finally, the profitability of the bank overall. It was this high profitability—unlikely to be repeated in the coming years—that really drove high bonuses.
The percentage of bonuses paid in stock varied according to seniority but never formed a majority of most bankers' earnings. An analyst might have received his or her bonus in cash. The managing director was likely to have received stock equivalent to the value of one-third his or her bonus. Stock would become available for sale in tranches typically spread over three or four years. As "rational actors," most bankers preferred cash today to the uncertain value of stock tomorrow, particularly since outstanding stock was typically forfeit should the banker leave.
The predominance of cash in bonuses is now widely seen to have contributed to inappropriate risk-taking. The underlying problem is this: investment bankers and traders of many kinds are encouraged to think of themselves as entrepreneurs, but they are not paid like entrepreneurs. In the majority of cases, business builders in the real economy achieve wealth only through the creation of long-term enterprise value, realised through eventual market floatation or a trade sale. In investment banking, wealth has been available up-front, with limited thought to the medium-term sustainability of earnings, and with shareholding in the broader company almost an unintended consequence of high compensation.
Attempts at reform, with and without government pressure, are underway. UBS, the Swiss bank, is delaying bonus payments until it is clear that they have been earned from the profitability of the business. Deutsche Bank, Morgan Stanley and others have introduced a rule whereby employees who act against the interests of the company would forfeit some or all deferred compensation. Such a measure would address some perverse incentives that have contributed to the crisis.
This combination of much lower profits, stock-based bonuses and loss of income for inappropriate behaviour will change the picture. That may not satisfy demands for strict limits to bankers' pay. But it does offer the prospect of a more sensible alignment of genuine risk with genuine reward without undermining the banks' ability to attract top talent.
Also in this issue: read Michael Prest's companion essay "What is a banker worth?"
Bonus bashing is good politics. Is it also good economics? The argument against limiting bonuses was crisply put by John Thain, until recently head of Merrill Lynch. Thain defended his decision to authorise bonuses of almost $4bn despite his company having lost nearly eight times that amount with an appeal to a free market axiom. "If you don't pay your best people," said Thain, "you will destroy your franchise." Put another way: if banks cannot retain and motivate talented staff, how can they keep capital flowing efficiently around the economy?
Whatever the moral shortcomings of Thain's argument there are holes in his logic that any reformer should consider.First, the incentive function of large bonuses is to be doubted, at least at the margin. Barclays chairman Marcus Agius said in Davos that too many bankers are used to receiving incentives "for basically turning up." He is correct. Second, attempts to reform financial pay have not so far challenged the principle that financial services are based on highly mobile human capital and that the rewards to that capital have to be exceptional.
Even the Obama administration's apparently draconian pay cap on directors of companies taking government funds applies only to cash awards. The prospect of private equity-like returns to executives paid primarily in stock and prepared to remain in post for the medium term may return to haunt the administration. Banking stocks are at historic lows but assuming that the world economy does not slide into permanent depression, share prices may triple over the next three years—roughly the lock-in period in the US plan.
This would hardly constitute a lack of incentive to perform well. What it would do is to bind executives' self-interest more tightly to that of shareholders—including governments offering lifelines to beleaguered banks. This principle is not foolproof: Dick Fuld, the head of Lehman Brothers, owned huge amounts of Lehman stock. But if it is to be applied at all the principle of alignment of interests should stretch beyond the boardroom to the trading floors where many of the most disastrous investment decisions of the past few years were actually taken.
In a typical profitable year, an investment bank will pay out roughly half its net revenues in staff costs. Fixed salaries usually account for only about one fifth of this amount, with the remainder made up of bonuses. The more senior and successful an investment banker becomes, the greater a percentage of his or her total earnings will be paid in bonuses.
A junior analyst, not long out of university, might until recently have had a base salary of £40,000 and earned the same again in bonus. At the other end of the scale, a managing director with a decade or more of experience earning a basic salary of £125,000 might have been paid a bonus worth five, ten or 15 times that amount—there was no formal upper limit.
Compensation was at least theoretically linked to performance, with priority being given to individual performance, taking into account team performance and finally, the profitability of the bank overall. It was this high profitability—unlikely to be repeated in the coming years—that really drove high bonuses.
The percentage of bonuses paid in stock varied according to seniority but never formed a majority of most bankers' earnings. An analyst might have received his or her bonus in cash. The managing director was likely to have received stock equivalent to the value of one-third his or her bonus. Stock would become available for sale in tranches typically spread over three or four years. As "rational actors," most bankers preferred cash today to the uncertain value of stock tomorrow, particularly since outstanding stock was typically forfeit should the banker leave.
The predominance of cash in bonuses is now widely seen to have contributed to inappropriate risk-taking. The underlying problem is this: investment bankers and traders of many kinds are encouraged to think of themselves as entrepreneurs, but they are not paid like entrepreneurs. In the majority of cases, business builders in the real economy achieve wealth only through the creation of long-term enterprise value, realised through eventual market floatation or a trade sale. In investment banking, wealth has been available up-front, with limited thought to the medium-term sustainability of earnings, and with shareholding in the broader company almost an unintended consequence of high compensation.
Attempts at reform, with and without government pressure, are underway. UBS, the Swiss bank, is delaying bonus payments until it is clear that they have been earned from the profitability of the business. Deutsche Bank, Morgan Stanley and others have introduced a rule whereby employees who act against the interests of the company would forfeit some or all deferred compensation. Such a measure would address some perverse incentives that have contributed to the crisis.
This combination of much lower profits, stock-based bonuses and loss of income for inappropriate behaviour will change the picture. That may not satisfy demands for strict limits to bankers' pay. But it does offer the prospect of a more sensible alignment of genuine risk with genuine reward without undermining the banks' ability to attract top talent.
Also in this issue: read Michael Prest's companion essay "What is a banker worth?"
