Sargon Nissan is a researcher in nef‘s Access to Finance team.
Listening to the debate on bankers’ bonuses over the past week is enough to make anybody seasick. It veers terrifyingly from righteous vengeance to doom-laden warnings. The Chancellor says he “won’t be held to ransom” by the RBS directors. Then we hear that taxing wealth-creators is bad and counter-productive.
Rather than being dogmatically for or against bonuses, we should take a step back and ask: what is the point of a bonus?
Bonuses are incentives. And we know that incentives are powerful and do work. So while there is a question about size – City bonuses are obscenely large and out of all step with pay in the much vaunted “real world” – the most overlooked question seems to be: are we using bonuses to incentivise the right kinds of actions and behaviours in the City?
Put like that, it is obvious that there are fundamental flaws with the City bonus systems. The current bonus system in the financial sector encourages the behaviour that wrecked our economy. My own experiences as an investment banker echo the observation by Lord Turner and now many others: much of it is indeed socially useless. It also has the potential, as we’ve seen, to bring the economy to its knees. It is dangerous and useless primarily because the opaque bonus system breeds short-termism and speculation. It pushes bank staff into overstretching their institutions’ capacity to bear risk. My experience is that even if traders want to invest long-term, they find they can’t because they are not paid to. When I traded shares for an investment bank, the managers’ patience for losing money was counted in days, not weeks or months.
A recent Harvard Law School study documents how executives from America’s two biggest failed banks were rewarded hugely for their efforts in the years leading up to the crisis. We now know that they were being paid so handsomely to bankrupt their own institutions and threaten the world economy.
I have just taken part in a Royal Society of Arts debate about whether the bonus system could possibly exist in an effective finance sector. The City insiders who defended the system inadvertently revealed the two reasons why this debate continues going in circles. First, they over-estimate the contribution of the sector’s high-paid. Second, they believe, wrongly, that bonuses reward good performance.
Even the Bischoff Report, commissioned by the government, makes this same mistake. It assumes that because the financial sector is vital that the bonuses must be vital and, crucially, that there is nothing wrong with the way bonuses are structured.
In reality, the sector’s contribution to the economy is not dependent on the bonuses likely to suffer from a windfall tax. Most bonuses that non-bankers receive (including doctors, teachers and many other private sector employees) are no more than a portion of overall annual pay.
A windfall tax will send a strong signal that bonuses have gotten too big. But a windfall tax is not enough. Incentives, rules and regulation are not encouraging the behaviour our businesses and economy need. They have encouraged the banks to become casinos and their staff to bet the house and our economy.
For banks, just as for bankers, it isn’t that incentives are the problem. Bad incentives are the problem.
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14 December, 2009 at 11:14 am
Matt Chocqueel-Mangan
Hi Sargon. Good point Sargon. I think your colleague David Boyle got it right in his article on 3rd December (http://bit.ly/6bEbdy) – the debate should be over profits, not bonuses, and how they are allowed to be big enough to pay the inflated bonuses in the first place. Not only could RBS profits start repaying the taxpayer in the shorter term, the profit levels demonstrate the monopolistic nature of the industry – something we are paying for. This is something that will continue to be tolerated as long as policy makers fall for the ‘the financial sector is vital’ argument which you rightly mention.
14 December, 2009 at 9:09 pm
Tony Bonsignore
Good blog Sargon, and I agree with you entirely. One point you haven’t touched on though are the fund managers, who egg the banks and other finance companies on into taking short term risk and so produce short term dividends and share price appreciation. These managers – who dominate the stock market and effectively own the banks – are also paid in big annual bonuses which in turn encourages them to deal in stocks on a short term horizon, as they are typically paid on an end-year peer-comparison or benchmark basis. They have little or no interest in holding the banks to account for long term risk management, as they properly should as their owners, because of the way they are paid. Plus the preponderance of peer performance and benchmark encourages a herd mentality.
It’s a pity the shortcomings of highly paid institutional fund managers aren’t coming under the microscope a little more – it’s our money they are losing after all! Pension funds have taken a hammering in recent years, and we need to ask why.
15 December, 2009 at 10:19 am
Mark P
An interesting article. But for a layperson reading about this, I’m left almost as ignorant as when I read it, about the nature of these people’s jobs and why they are paid such huge amounts. I’m left wondering: What do bankers do and what value do they give to society? Who pays their high bonuses and where does that money come from? How does ‘value’ accrue in the stock exchange? If someone in the market loses money, does that mean someone else gains? Should we worry if one banker is more successful than another? Is there a limit to the amount of money in the system, if not, then what adds value to the market?
I’d be worried that the wealthiest people/companies employ the best bankers, meaning that the flow of ‘profit’ within the market (the gravy train) is constantly being siphoned in a direction it doesn’t need to go? I mean, the benefit of being even wealthier at some point outdoes the harm done to the people on the end of that wealth redistribution, no? I mean, those who are very poor cannot maximize their talents to the benefit of society. Therefore, surely a flow of capital to the poor solves two problems in one go – activating human capital and reducing the indirect costs of poverty? Doesn’t the whole principle of banking go against this basic principle? I understand that we need large capital funds to fund capital programs and new start ups, but at what point do we say that the redistribution of wealth starts to become damaging? And where do the bankers fit into this picture?
15 January, 2010 at 5:37 pm
Le Chialeux De Salon » Blog Archive » 42 : Dette publique, Parler français, Gros bonus et Un bon commentaire
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