For and Against: Bankers' bonuses
Bob Garratt is an international consultant on board evaluation and development, corporate governance and strategic thinking. He is the author of 'The Fish Rots From The Head: The Crisis in our Boardrooms - Developing the Crucial Skills of the Competent Director', a bestselling book on corporate governance.
Dr Ruth Bender
Dr Ruth Bender is reader in corporate financial strategy at Cranfield School of Management. Her main teaching areas are corporate financial strategy and corporate governance. Her research is in the practical implications of corporate governance for boards, in particular executive compensation.
The real question is: should high street banks be separated from the investment banks that have caused the Western financial debt and credit crisis? Sir John Vickers is presenting his report to the government on the future structure of UK banking. Within that, the big proposition is whether retail and investment banking should split.
I am in favour of this separation because the two kinds of bank are chalk and cheese. If you go back to the Wall Street Crash, we had the Glass-Steagall Act of 1932 in the US which deliberately made sure you had healthy retail banking centres. In the US you don't have the five major banks like there are in the UK, but hundreds of local banks that service local industry and are a healthy part of the economy.
When you try to bring the two systems together, you've taken what is a very stable system and added huge risk and instability, because investment banking is about high risk in the end. As we have seen, you can unfairly pass the risk on to the wrong people.
Retail banking is very simple: know your customers, never lend them quite as much money as they want, and then track them like hawks. If you do that, retail banking is very boring but incredibly profitable and also develops local communities. The other side of it, which used to be called 'merchant banking' but is now called 'investment banking', is very dangerous. There's only one thing you need to know there, and that is that a successful investment bank only trades on behalf of its customers and not on its own behalf.
As soon as the Big Bang happened, retail banking was seen as old-fashioned and boring. The sexy thing was investment banking. But most people still don't know how to assess risk. More importantly, they came to realise they could trade on their own behalf so it became a massive trading activity, which completely destabilised the old notion of the integrated bank.
Then there was the appearance of more and more financial products. Nobody really understood them, including their designers. They were sold on, and the system became more unstable. Why would seemingly reasonable bankers sell mortgages to people who can't afford them? Because, if you bundle them up, securitise them and sell them on to people who would take the risk, superficially it looked like a reasonable idea.
But it was complete nonsense. The credit-rating agencies totally corrupted themselves as they started selling ratings rather than standing back and being independent. So you had these bundles of corrupt products floating around and the only questions were: who was the greatest fool, and what would happen when the music stopped?
Well the music did stop in 2007 and people started asking if there was a credit crisis in what was meant to be the stable part of the system, particularly - though not exclusively - in the US.
This is why people get so angry with bankers receiving huge bonuses. The person in the street feels rightly hard done by, as the expectation was that the individual's money would be dealt with prudently, yet it was used by the banks in their own gambling. I can see why citizens would feel that bankers are rewarded for creating the problem.
I don't have an issue with bankers earning huge amounts of money, but I do have an issue with them selling products that are untested and basically corrupt - i.e., not what it said on the tin. The system exists in such a way that the bonuses exist, which is why I'm arguing that we need to split investment banking from the retail side.
The reason for the split is to safeguard the retail sector and the national economy: the normal person doing normal things such as getting mortgages and loans. The investment side is a law unto itself, which is fine - or would be fine if it took the consequences of the high risks being taken.
In the credit shortage that started in 2007, the wrong people were paying for it. We were, and we were nothing to do with it.
There is no logical reason why investment bankers should get substantial bonuses and engineers not. Then again, there is no logical reason why investment bankers should be paid more than engineers at all. Or indeed, why engineers should be paid more than, say, nurses. Nobody really knows who should get what. Back in the 13th century, philosopher St Thomas Aquinas tackled this, looking to determine the 'just price' for any piece of work. He failed, and it would be presumptuous of me to assume that I can do any better.
Nevertheless, although I can't justify it, I can explain why they are paid in this way. In every industry, pay is set according to the 'market'; the norms of our jobs in relation to our peers. Banking has developed such a market. So, the questions to ask are: Why did this happen? What would happen if we tried to change it?
The nature of investment banking means that profits are volatile, and depend very much on the activities and talents of individuals. There is considerable scope for an individual to make the bank a lot of money by performing well - or to lose it by messing up. In such circumstances, many people argue that a bonus will motivate better performance.
When times are good, investment banking is a very profitable business, so there's a big pot available for bonuses. It may be that money motivates individuals, or that may be totally fallacious. But if the money is there, the argument is that it's probably worth spreading it around generously, just in case that was what was driving the profits.
The third reason why large bonuses are available in banking relates to the nature of the business. Their stock in trade is money; they are (metaphorically) surrounded by it.
Many years ago, when I worked in a Spam factory, I was allowed to buy Spam cheaply as a 'perk' of the job. By the same token, bankers might argue that they deserve some of their product too. And working with large sums of money each day means that one becomes insensitive to small sums, which is why the bonuses are so big.
So, that is why we are where we are. Let's turn now to what might happen if we were to try to change the system. It would not be pleasant.
A few years ago I did research into executive pay, interviewing the great and the good to determine why they got paid what they did. One City CEO explained it very simply. He said that if 'they' were to halve the pay of all the CEOs in the City, then no one would bat an eyelid. But it would have to be all the CEOs. If even one individual retained his high compensation, then the others would demand parity. So, we cannot change pay for just some bankers - just in the UK, or only in certain banks - any more than we can change the traffic rules so that blue or red cars have to drive on the right.
If somehow one did persuade all bankers to do without their bonuses, it is likely that their base salaries would increase. As I said, there's no logical reason why bankers get paid the sums they do. But the fact is that they do, and they have developed lifestyles based on this. If bonuses were to disappear, it would constitute a change in terms of employment, making it likely that base pay would have to rise to compensate. And that high base pay would be required every year; even in years when they made losses. Surely in a business where profit is so volatile, it makes sense to have compensation linked to results?
Another reason for retaining the bonus is that some individuals would leave if it were removed. Not every banker is immensely talented, and not every banker could find another well-paid job. But if a sufficient amount of the good ones found employment elsewhere, that could decimate the industry. And with only 90 per cent of the banking industry left, the UK would no longer be a world leader. Which, despite what you may think, does matter. *
Do you agree?
To maintain a stable engineering sector, bankers shouldn't receive huge bonuses during a credit crisis.
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