No Claims (to) Bonus

The debate on bonus pay has been characterised by rhetoric proposing aggressive reform, as politicians compete to provide the most draconian measures – including some that seek to retrosepectively tax banker’s incomes over the past decade.

The charge was led by Nicholas Sarkozy, who imposed tight restrictions on bonuses for those wishing to provide services to the French government. So far, only BNP Paribas and Credit Agricole have agreed. Alastair Darling delivered a speech to the Labour party conference promising to ‘end the reckless culture that puts short-term profits over long term success’. This brought a response from Angela Knight, chair of the British Bankers Association, who described bonuses as a ‘dog-whistle issue’ – politically expedient but damaging to the country’s economy.

In many ways, it is worth considering why the financial industry has such a unique pay structure, in which the significant majority of the compensation for its best comes in the form of bonuses.

The key fact about the financial services industry which enables the bonus system is that performance and profits can be attributed directly to their source: a trader’s profit and loss statement is available in the morning every day, as is a statement of a salesperson’s commission. It is this relationship and independence from the rest of the bank that means struggling banks often pay large bonuses to successful desks and individuals. Given readily available comprehensive performance metrics, it is not surprising that most compensation comes in the form of performance related bonuses rather than salary.

Alastair Darling criticised the culture of short term profits, but in financial services the short term and long term tend to go together. The valuation of an asset or derivative is based on the present value of future expected cashflows, so it is very difficult to make short term profits at the expense of long-term success. While problems do exist in valuations of assets marked to models, where models are often designed by those whose bonuses depend on the valuations, it might be more appropriate to look at reform in this specific area.

The great advantage of paying staff primarily through bonuses is that they are adjustable. Because of its dependence on the wider economy, the financial industry experiences greater cyclicality. While the economy dropped by less than 5 percent, turnover at banks fell by substantially more in 2008. In this situation, banks were able to pay smaller bonuses and save money, allowing for more agile adjustment to a downturn in the financial sector.

Talent is highly transferrable in the financial industry. When someone moves from one firm to another, there is very little lost. They take with them their ability, their knowledge and their contacts. Often, they are working at full capacity within days of joining. Because moving firms is so easy, compensation levels need to be higher to retain talented staff.

The recent controversy over bonuses has been primarily driven by three factors: it is perceived that banks are reluctant to lend, yet are paying their staff substantial bonuses; that paying bonuses to staff in firms that have received government bailouts is not in the taxpayer’s best interests and that these bonuses have not been earned.

Banks lend for profit. If they are reluctant to lend, it is because they don’t think that the loan makes economic sense – the borrower is not creditworthy. It is worth remembering that the current crisis began with banks being required to lend to ‘underprivileged borrowers’ in the US. To argue for making loans instead of ensuring you have qualified people deciding on loans could be described as reckless behaviour.

Banks pay bonuses to their staff because it makes commercial sense – it is better for the bank. As they are the same as any other banks, so it also makes commercial sense for banks bailed out by the state to pay bonuses, and taxpayers as shareholders should demand in their best interests – paying bonuses to retain talented staff. It is worth noting that many of RBS and Merrill Lynch’s best desks were hired away by other firms after they were prohibited from paying bonuses.

Finally, 2009 has been the best year on record for the leading investment banks. Several expect to report revenues for investment banking which are more than double the level of 2007. In this context, it is likely that the bonuses paid in January 2010 will be higher than every, provoking further rhetoric from governments.

Without doubt, bonuses are sometimes paid to those who have not earned them. Reform is needed in some of the practises of the financial sector, but it should always be inspired by sound economic arguments rather than political expediency.