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OPINION

Bonusphobia part 4: the worrying consequences of the bonus myth

Bonusphobia part 4: the worrying consequences of the bonus myth
October 2, 2014
Bonusphobia part 4: the worrying consequences of the bonus myth

This sounds so sensible that you might wonder why the UK has taken seven years to get around to requiring a substantial part of high bonuses to be paid in shares and the shares tied up for 10 years. This will increase accountability, particularly because the shares can be forfeited if problems emerge years after the award. This applies to banks but there's no reason why it can't apply to other sectors as well.

Contrary to common belief, though, many senior bank executives were already hanging onto their shares voluntarily. Sir Fred was a significant RBS shareholder in his own right, so much so that when the price collapsed, estimates are that he lost more than £5m. Andy Hornby, at HBOS, was later to claim that he too had lost more in HBOS shares than he'd been paid as CEO through his salary.

Which is odd, isn't it? Both stood to lose far more than they'd have gained in bonuses if the risks they took had paid off so, if money talks, you'd expect their shares to have moderated their actions. Ah, you might think, greed must be the explanation. But the alternative is much more likely: both thought they were doing the right thing. They simply underestimated the risks and were undone by events beyond their control.

So anyone who says that limiting bankers' bonuses will 'put an end to the culture of excessive bonuses, which encouraged risk-taking for short-term gains' is on shaky ground. And yet that's exactly what Jose Manuel Barroso, the European Commission president, said when he proposed that within the EU, bankers' annual bonuses should be no more than their annual salary (or, with shareholder approval, twice the salary).

Of course, if he's right, then limiting bonuses is logical. There's no doubt that there was a culture of high bonuses, but only in some parts of investment banking and more in the US than Europe. There's also no doubt that some (not all) banks took on excessive risks. It's also true that some gains were short term and that some individuals gained personally. But these are mere correlations. Until there's proof that significantly less risk would have been taken had bonuses been lower, the proposal will be based on a hunch.

Even the idea that bonuses have to be a multiple of salary is suspect. Unless employers act in concert, they'll lose key people with specialist skills if their total pay (salary and bonuses) doesn't come near to what others pay. Hold down total pay too much and the internationally mobile go abroad. Hold down bonuses, and salaries are pushed up.

The whole point of bonuses is their flexibility: unlike salaries, they can go down in bad times. So what is being proposed is a moral hazard. A regime of higher salaries and lower bonuses subsidises lower performing employees because they get more in salary than they would have done before. It also forces a poorly performing bank to pay out more in pay at the very time it can afford it least. These extra potential costs are risks; they make banks more cautious. This leads to less credit in the system, constrained lending and so less economic growth.

Some banks have responded by introducing new discretionary allowances and share awards to try and keep some flexibility. 'Well, they're not bonuses, tied to performance, are they?' they argue. 'And they're not salaries, either, so that's alright then.' The EU is threatening new guidelines.

The UK government is challenging the EU proposals, which will hit British banks harder than the rest. They question what benefits the proposals will bring, especially considering that the British banks that collapsed were not in general paying high bonuses. Bank executives already complain of the blizzard of bureaucracy foisted on them by increased regulation and say that managers have become risk averse. Managers would rather lose new business than risk later criticism.

There's no global agreement on bank bonuses. The Dodd-Frank Act in the US did propose that excessive executive compensation should be subject to regulatory oversight, but it's not been adopted. Perversely, considering that the first phase of the banking crisis was largely due to the actions of US banks and lax US regulation, New York has now overtaken London as the largest global financial centre. New business is also heading for Asia, where global financial businesses are employing more people.

Like it or not, interfering with pay, along with clumsy regulation, saps not just banks and their shareholders. Bonusphobia also hits the economies in which they operate. And that means all of us.

RBS and the price of bonusphobia

After Sir Fred Goodwin left RBS (to become just plain Fred) together with a number of senior managers, Stephen Hester was roped in as the new CEO. He described his challenge as defusing a time bomb. As chalices go, the poison in this one was truly brimming over.

His salary was £1.1m amidst a media storm about a 'golden hello' of share awards worth £15m. But these had strings attached: Hester would only get £15m if the RBS share price went up so much that UK taxpayers made a profit of £8bn on their £45bn bail-out. This could, of course, happen simply because stock markets surged, so there was a second performance condition, requiring RBS to outperform its competitors. Mr Hester had nothing to do with the banking crisis and yet his pay was still heavily criticised at the time. But scaled down, it doesn't seem such a bad deal: he'd have got about £2 for every £1,000 he and his team made for taxpayers.

Hester set out to use the investment bank to trade RBS out of trouble. But then politicians stepped in. They confused acceptable investment banking with casino banking, lumping the two together as if there's no difference between them and assuming, for good measure, that bonuses were at the root of the problem.

Time and again, every time RBS set bonuses, it was criticised for paying too much. When NatWest had system failures, Mr Hester himself, under pressure, sacrificed his own bonus. The idea that bonuses allocate resources more efficiently than paying higher salaries was trumped by the mistaken assumption that bonuses should only be for exceptional performance.

Under political pressure, RBS was blocked from paying competitive bonuses and people began to leave. Mr Hester was forced into running down the investment bank, much to the secret delight of RBS's competitors.The smaller scale meant higher proportional costs and a reduced range of products. This put off large corporate clients because RBS was no longer offering a full spectrum of international services.

In June 2013, Mr Hester was sacked, not for doing a bad job (by common consent, he'd actually done rather a good one) but for political reasons. His successors continue with the process of turning RBS into an incredibly shrinking bank. The prospect of taxpayers ever recovering the cost of the bail-out is receding.

The question then is this: how much better off would RBS shareholders and the country have been had RBS been left alone to sort itself out? The target of an £8bn profit was always ambitious, but it's fair to say that RBS could have competed better if it had not been constantly hounded on pay.

Fleecing the banks

Standard Chartered Asia CEO Jaspal Bindra recently spoke for many when he said that "banks have been asked to play the role of policing anti-money laundering...[but when] we have a lapse we don't get treated like a policeman, we are treated like a criminal..." Fearing reprisals, his London bosses were quick to disassociate themselves from his views.

He was referring to a fine of $340m imposed on Standard Chartered not for money laundering but because there was a glitch in the new software system rushed in to check that none was going on. This followed HSBC's 2012 fine of $1.9bn again not for money laundering but because they hadn't followed paperwork rules closely enough to prove they hadn't been. BNP Paribas was recently fined $8.9bn for not complying with US foreign policy. Neither the EU nor the UN has sanctions against Cuba or Sudan, but the US does and the bank was fined for making US dollar transactions with them. This fine was so large that the French claimed it would damage their economy. From these and other European banks, the US has extracted over $15bn since 2007.

These are massive fines for relatively minor offences and appear to be in revenge for the banking crisis. The irony is that the two British banks steered clear of the toxic derivatives that caused it.

There appears to be no check on the US regulators and Department of Justice. Whatever they fine US banks is a domestic matter - and they've raised over $100bn that way. But some foreign banks have been fined for events beyond US borders only because the US dollar is the global reserve currency; foreign banks can't avoid using it. The UK can't do much about this alone and the EU is being called upon to use its political muscle to challenge the US about what many consider to be an abuse of power.

Standard Chartered still suffered reprisals. It now has to ask permission before opening dollar accounts for new clients at its New York branch, is restricted on US dollar business with certain Hong Kong business clients, and has to monitor some clients in the United Arab Republic more closely. True, it could have been worse, but even so, no other country has interfered like this in business beyond its borders.