Thursday, February 12, 2009

The Problem With Bank Bonuses

I have a certain reluctance to agree with the editorials of the Daily Express and Daily Mail. But, I feel that in this case, the public disgust at bonuses for bankers is justified.

The first problem with the culture of bank bonuses is that they have encouraged high risk activity.
  • If banks make spectacular profits, bankers will gain from juicy bonuses.
  • However, if banks make losses, bankers don't have to pay a forfeit, or even lose previous bonuses.
  • Therefore it becomes a one way bet to take risky options that may lead to a big payoff. If you are lucky and your risky approach pays off then you are entitled to high bonuses. If the risky option loses out, you don't personally have to pay. Therefore, there is every incentive to take risky options to maximise the chance of high payouts even at the expense of increasing the bank to risk. And this is exactly what happened.
It is this corporate culture that was behind the aggressive lending of Northern Rock and aggressive expansion policies of RBS and Barclays.

At the very least bonuses should be paid after good performance in the medium term. I have no objection to paying bonuses for good performance. The problem is banks defined good performance as producing spectacular short term gains. The bonuses should have been paid to those who didn't take unnecessary risk and get involved in buying collateralised debt.

By their own reckless action, the banks have created tremendous problems for the economy and the tax payer. The fact is that without the taxpayer, the banks would be facing collapse. Since, the taxpayer has bailed out the banks, it is right the taxpayer the government dictates bonus pay policy, at least in the short term.

The other problem is that banks have a long history of encouraging reckless behaviour amongst traders. It was the prospect of high bonuses that encouraged Nick Leeson to break Barings bank. It is not as if this is the first time banks have been on the verge of collapse.

Interestingly, Nobel Prize winning economist Joseph Stiglitz has suggested just let the banks collapse and then take over them. There would be no bonuses then. - Let banks fail - J.Stiglitz

1 comment:

James said...

[Sorry for asking this here, but the "ask a question" link wasn't working for me.]

I've been wondering whether or not the Bank of England's independence might be causing them to spread 'bad news' which, prior to independency, would have been spun positively by the government. If this were the case, I'd be interested in analysing the effect of this on the current economic situation.

For example, Mervyn King has stated that the economy faces its deepest recession since the post-war years of 1945 and 1946, and its worst peace time decline since 1931. (http://www.telegraph.co.uk/finance/financetopics/financialcrisis/4596137/Mervyn-King-Economic-slump-is-worse-since-the-war.html)

Prior to the BoE's 1997 independence, would this information have been presented in an equally pessimistic way, or, in the interests of political self-preservation, would it be spun to be less pessimistic?

I'd suggest that an independent central bank's statements could have a very significant effect on public opinion - it is essentially the official source, and perhaps more believable than any newspaper, for example. If the BoE has been more pessimistic than before, I would assert that having an independent central bank could have hastened the onset of recession and caused an exaggerated fall in consumer spending, investment, etc.

Additional: If I am not mistaken the last UK recession started in 1990, before BoE independence. Would I be right in thinking that this is the first time we've been through a major slowdown with an independent central bank? Or do we have any past cases to look at?

Thanks
- James