It’s Always Bonus Time For Bankers

The Evening Standard  –  25 Feb 2011

But I don’t understand why you lot get paid a bonus every year just for doing your job. That’s what the aggressive lady sitting next to me grumbled at a stultifying dinner party. After patiently explaining that I left the City three years ago I went on to try to justify the rationale for the banks’ bonus system. I failed dismally.

The free-flowing booze resulted in a stuttering load of codswallop that made the average footballer’s post-match analysis sound like the erudite reasoning of Isaiah Berlin.

So, I will now try to explain, if not excuse, the City’s bizarre system of remuneration that is again under the spotlight after bailed-out Royal Bank of Scotland announced nearly £1 billion in bonuses yesterday and Lloyds Banking Group, reporting results today, gave departing chief executive Eric Daniels a £1.45 million bonus.

In the 1970s most investment banks and brokerage firms were partnerships. The partners not only ran the bank, they also owned it. So, if the firm had a good year they’d award each other serious payouts but if it got into financial trouble they had to reach into their own pockets. Hence, every decision these “owner managers” made was informed by the knowledge there was not only a potential reward but also a potential risk.

Then, in 1986 Margaret Thatcher instigated a series of financial reforms that became known as Big Bang, which allowed foreign banks to acquire these old-school City partnerships. Of course, many of the staff, including the newly-enriched ex-partners, stayed on and worked for their new masters.

Fortunately for today’s bankers, the concept of performance-related bonuses did not die with the end of the partnerships. Strangely, the foreign banks and new shareholders felt obliged to adopt it.

So, despite the fact that the senior employees no longer owned the firm they continued to be paid as if they still took a personal financial risk from any financial downturn when, of course, they no longer did.

This peculiar situation resulted in bankers taking most of the profits during the good times (generally 50% of revenues) and shareholders bearing most of the losses during the bad times.This ridiculously skewed employee profit share happens in no other industry (except perhaps football) and led to my ex-colleagues and I regularly concluding over a bottle or eight of Dom Perignon that “investment banking is a great business… if you’re an investment banker!”.

But why the hell do the shareholders of investment banks put up with this raw deal?

It’s partly because the shareholders were rendered complacent by the still decent returns that they secured, until recently, during the market’s 30-year bull run. It’s also because of their conviction that this is “how business has always been done” and because they have been convinced that any bank that tried to unilaterally change its bonus system would face a mass exodus of its talented staff.

Funnily enough, the bankers themselves have spent a lot of energy inventing some vaguely plausible arguments to justify the continuation of a system that keeps them in Ferraris and Rolexes.

They argue that banks have high fixed costs (City office rental, IT, etc.) yet revenues are massively unpredictable. Hence, the bonus system actually reduces risks for the banks because the firm pays for performance after it has already been delivered rather than in the hope that it will be delivered. They also argue that a bank’s assets are its people since it delivers advice and does not manufacture expensive products and hence the employees deserve the lion’s share of the revenues their vast brains “create”.

Then they bang on about the need to attract and retain the “best people” and the need to incentivise these “geniuses” (the same guys who bought you the credit crunch!).

Finally, they’ll talk about investment banks’ impressive profit-per-employee ratio though they’ll neglect to mention that this is only so high because of the lack of competition and the unofficial government insurance policy that all banks that are “too big to fail” enjoy.

So, the partnerships’ sensible profit and risk-sharing system morphed into an extraordinarily lucrative get- rich-quick scheme that encourages reckless gambling because “traders can bet the farm even though it’s not theirs any more”.

Hence, Lehman Brothers paid out $22 billion (£14 billion) to its staff in its past three years yet left its shareholders nothing. Despite the credit crunch bringing this ridiculous situation to our attention no politician has yet had the guts to force radical changes to a system that has left the world reeling.

The greatest trick the devil ever pulled was to convince the world he didn’t exist. The greatest trick bankers ever pulled was convincing their new owners not to change a system of remuneration that subsequently offered vast, risk-free payouts for bankers and financial calamity for shareholders and taxpayers.

Frankly, even the devil might have struggled with that one!