Lesser of Two Evils

With Goldman Sachs and JP Morgan Chase registering record profits in the third quarter there are signs that these banks may have returned to ‘business as usual’ following a tumultuous two years for the financial industry. Goldman Sachs recorded profits of £1.96 billion- a fourfold increase from the same period in 2008. JP Morgan profits were even more impressive at £2.5 billion. Both banks have set aside vast sums to cover pay and bonuses this year prompting threatening government rhetoric and leaving many wondering whether banks have learnt any lessons from the financial crisis.

Large bonus payouts are vital for banks to attract and keep the best talent in the industry. However, continuing with the bonus culture may, yet again, encourage bankers to focus particularly on short term results and dabble in stranger, more complex products in order to earn more in bonuses. Without accounting for their own bank’s long term goals or the effect that these products may have on the wider economy, such banker’s could once again create a new problem similar to the sub-prime mortgage crisis. Most banks have received direct government assistance in order to expand their reserves so they can return to normal levels of lending. While the taxpayer is footing the bill and governments face huge deficits after spending huge sums on bailouts, bolstering the banks’ balance sheets should be the main priority and the billions set aside for bonuses could be saved and kept for this purpose.

Governments were quick to bail out banks in the first place because they felt that such institutions were ‘too big to fail’ – if they collapsed, the financial pain would be felt by many more innocent people and the crisis would have worsened. However there is the question about moral hazard; to what extent should the government help a bank that has behaved badly? Governments could have let struggling banks collapse, as the US government did with Lehman Brothers, thus sending a strong message to banks to act responsibly. However in this current crisis, it is clear that almost all banks have been hit hard and to prevent any further damage to the wider economy the government stepped in.

Just this week, the government announced it would pump a further £37 billion into RBS and Lloyds TSB (merged with HBOS), in which the taxpayer now has a 60 percent and 40 percent stake respectively. While these banks continue to post record losses, the amount of state aid they have received also forced the European commission to order their break up to improve competition within the banking system. This will eventually lead to a return to private ownership of these banks but it will take some time before taxpayers can recoup their money.

In exchange for their assistance, governments have looked to implement a number of reforms to the financial industry to ensure that banks cannot take on such excessive risk again. Yet despite strong rhetoric, governments remain unsure as to what extent they should limit bonuses. In the UK, the Financial Services Authority has sought to gear rewarding bonuses towards long term success. Thus bonuses will no longer be guaranteed for more than a year and, for senior employees, bonuses will be spread over three years. In the USA, there were calls for a 90 percent tax levy on bonuses after public outrage over AIG’s announcement that it would pay bonuses, just a day after receiving $170 billion in bailout funds. This law was never passed and the only action from the Obama administration was to appoint Kenneth Feinberg as “pay tsar” – able to veto bonuses or take back money on contracts made before 11 February from banks that took US taxpayer money. These measures in both countries are still too weak and loosely implemented.

The French president, Nicolas Sarkozy, has been the most vocal among western leaders over bonus reform. In a discussion with BNP Paribas and other major banks it was agreed that among the new rules, guaranteed bonuses will be limited to one year. A minimum of half these bonus payments will be deferred to a later date, and a third of the deferred portion will be paid in shares in the bank. Mr Sarkozy also advocated a mandatory cap on bonus payments but this was opposed by the British and US governments. For the UK, trying the French model is not a bad idea. It sends a strong message that the government is clamping down on the bonus culture and the risky behaviour it fuels and it will also help to appease angry taxpayers (and voters) that their money is not simply being given to the people who have created this crisis in the first place.