Sunday, October 19, 2008


Politically, one of the single biggest issues arising from the financial crisis is capping investment bankers' bonuses and CEO-pay on the grounds that the bonus culture is said to have led to irresponsibile risk-taking. It is proving not at all an easy or simple matter to resolve, notwithstanding that it is a vital condition that politicians and taxpayers demand be attached to bailouts, to TARP and SARP. Bonus culture has been declared dead several times in recent weeks. At the UK Labour Party conference on 22 September, Alistair Darling, The Chancellor (Finance Minister), promised a crackdown on City bonuses, tougher financial regulation and the early publication of banking legislation, telling the Labour conference: “The financial system will never be the same again.” Less than a month later, yesterday the newspapers were aghast with shock that massive bonus payments are going ahead anyway. The survival of bonuses appears to be more than just a matter of irresponsible greed. The Chairman of the UK Regulator, FSA, said today that it is outside the FSA's mandate to curb bonuses, that is matter only for progressive taxation. The FSA can insist that banks must only ensure that they comply with capital adequacy ratios first before making payouts. Why are multi-million bonuses so vital to banking? To understand the answer further it may help to consider vitalism*, a centuries old doctrine (like soul-force). This posits that the functions of a living organism are due to the processes of life not being explained by the laws of physics and chemistry alone, but somehow self-determining. Some form of Vitalism may explain the $70bn Wall Street pay, mostly bonuses that will be paid and that has inexplicably survived this year’s performance disasters (front page The Guardian 18 Oct). In the City of London the sum is $28bn (front page The Independent 18 Oct). When Morgan Stanley fell to under $11bn equity value, it could have been purchased on behalf of all employees by the firm’s wage & bonus pot. There was $6bn bonus & wages pot, mostly bonuses, at Lehmans when it went bust. Government ministers, legislators and new media have all called the “end of the bonus culture”. “end of the era of irresponsibility”, and “no more rewards for failure!” Regulators like the FSA said at first they would write new rules for capping bonuses as a risk mitigation measure, bonus culture having been blamed for much of the crisis. The result of this is more in line with polite guidance and a reiteration of broad principles. Within days this was followed by a warning that principles-based regulation is over and rules will be strictly prescribed and fully enforced. Question marks were also raised over whether to wipe the regulation slate clean and start again, thereby placing the future of Basel II in doubt (more on this next essay). But Basel II is law and no-one can show that it is to blame when it was only half-way to being fully implemented by banks? One additional idea is a new set of rules about bonuses (maybe as part of Operational Risk)? Now, days later, we learn that ending the bonus culture hard because it is competitively necessary; any centre that curtails bonuses may lose out to other financial centres?
Shareholder action (such as at UBS and similar elsewhere) has in recent years challenged the bonus pay models. Banks defended their bonus algorithms by saying performance should be measured absolutely (competitively) and relative to peer groups, with a modest % related to share price performance i.e. shareholder value is only part of a bigger picture? This means less that bonuses would fall as performance falls (year on year) and more that bonuses correlate to net performance above the average performance of peers, and, say half, be measured over a few years. Much of the bonus pay is therefore related to performance over several years as well as to whether the stock fell more or less than some other, or all other, bank stocks? Performance is not to be measured absolutely but relatively, subject to what is competitively necessary to keep the rainmakers based on what other firms are willing to pay. This then make bonuses a market rate, not a fundamental value calculation. In any case are there are other maybe more compelling reasons for the sub-prime crisis? Legislators, shareholders and the general public are asking why this is? Why there is such life in the bonus culture that bankers will be paid the same this year as last year and were paid last year the same as the year before? Up until a few years back, if banks’ profit and share price performances were down so too were the bonus payouts. Senator Barbara Boxer of California kindly emailed me last night to say that Congressional Democrats who opposed TARP did so to stop it subsidizing CEO pay on top of stunned outrage at being asked to sign a blank cheque (check) after the Administration had been telling them “the fundamentals of our economy were strong just two weeks before”. She says, “They had failed to use the powers Congress gave them to stop bad mortgages. Where was the oversight in their proposal? Where was taxpayer equity? Where was the control over CEO pay?” The legislators put these questions into the negotiations with Hank Paulson. “The answer back from Mr. Paulson on a phone call with dozens of Senators was: No restrictions on this bailout.” It should be no great surprise therefore that Congress caused a week’s delay and got its political conditions attached to TARP. Since then TARP has been on a back-burner and may have died now that over a third of the money has been taken to buy preference shares instead of buying toxic assets directly. As I wrote at the time (in various earlier essays) no banks are going to suicide themselves by applying to TARP if it means they advertise that they are so desperate they would sacrifice bonuses (and thereby still risk credit rating downgrades) just to save the bank in this way; any other way is better. One obvious reason for this is that if bonuses are curtailed in banks, bankers will leave to join fund managers and hedge funds or leave the country for wherever they are better rewarded. Some answers to the question of vitalism in bonus culture is that many bonuses became non-discretionary contracts (salary plus minimum bonus). Bonuses were also backing up from previous years and are particular to each line of business and subsidiaries with only some of the pot subject to the performance of the group’s stock. Large Banking groups in this regard are like franchises and partnerships. But, shareholders don’t see it that way. In a world of high leverage shareholders interests get shunned, no less than they’ve been shunned in government bail-out packages. Anyway maybe shareholders, some of them, should be penalized for lending, renting and pledging (as collateral) banks’ shares to short-sellers (prime brokers, hedge funds etc.) Nevertheless, it appears a fair question; should bonus funds have been raided to top up banks’ capital reserves? Instead, they were been treated contractually with the same inviolate sanctity that applies with the force of law to corporate pension funds (to many, if not to all of them?). Truth is that many banks found themselves this fall as having potential net liabilities far in excess of equity and other capital reserves. If there was vitalism in the bonus pool, there seemed absolutely none in interbank liquidity and suddenly very little in mortgage assets or most big banks’ share values. In the teeth of such disaster that last thing a bank can afford, which is a professional service, is a bunch of de-motivated people handling its finances and maybe losing clients and engaging in loss-making or illegal deals. It is an immense Operational Risk to disincentivise employees. In the trading rooms of big banks a single dealer has the same economics about him or her as an average main street branch. When you have senior managers with personal sign-off over $100s of millions, or even $billions, you do not tell them they’re only going to get paid the equivalent of what they see as one day’s win or lose!
Ironically, the more banks talked the talk of shareholder value the more they walked the walk of star-player bonus culture. It would not be wrong to equate this change with the wider zeitgeist of similar and even more extreme financial culture change in Hollywood, Sport, Television and media generally. Old-fashioned ethics and moral values went when most of the generation in its 50s were forced into early retirement in the ‘90s leaving the way open for a dramatic change in culture across several major industries. Bank customers were the first to notice the technocratic changes, the automation of risk. Only rich customers and big ticket deals got the personal manager-level treatment. From the bank’s point of view bonuses topped up the wage bill until the total was half or more of net revenues. Shareholders were increasingly concerned, but this concern may have translated into banks taking even bigger risks to continue generating double digit revenue growth to keep the shareholders happy and not press harder and successfully to change the bonus regime. It was not for nothing that banks paid 40% of all share dividends when they were only 20% of stock markets' value. Shareholders needed to recognise the risks implicit in that margin when banks were growing their share of GDP at twice the rate of all other sectors. When Nomura bought bankrupt Lehmans London, pay and bonuses they promised to keep 2,500 staff was $400,000 on average per person! Unlike Lehmans New York (bought by Barclays) there was no pay and bonus pool left behind since $4 billions had been transferred to NYC hours before the firm went into chapter 11. I struggle to believe either that all those people are so vital and impossible to replace or that without them the business would become so hard to financially account for and manage? Maybe the truth is that, despite the amount of computerization and front, middle and back office accounting systems, and risk accounting of relationship banking, the true infrastructure of an investment bank is far more its people than its systems or its brand?
Melvyn Bragg (BBC radio) tells me in an email that vitalistic ideas from Aristotle to DNA have all that time been a tough call to refute. There are no books written about vitalism, only about bits of it, e.g. 18th century schools at Paris and Montpellier, but not about the whole thing. To track vitalism through the centuries is nowadays regarded as old-fashioned. Who among the regulators is going track it through modern banks' bonus cultures? Vitalism, like bonuses and commission fees, is now outside of time, rather like stem cell research, it can’t be discussed without bringing in religious ideology and politics (for which read trust in markets and ratings agency ethics). It is noteworthy that while retail bankers who have had to resign or been sacked have sometimes walked without getting a severance pot of gold, investment bankers tend to insist on severance pay!

*Note: An Italian Dr. Ure experimented with resuscitating the hanged murderer Clydesdale in 1803 using electric shocks to try a prove this was the vital spark of life, and inspired Mary Shelley's Frankenstein (1818) in which the revived monster has a fine intelect but is soulless. Hollywood’s 20th century versions didn’t even allow the monster intelligence except of the most brutish kind. Today, is this not unlike the public’s idea of investment banking and its bonus culture. They do not want this revived. But neither is it yet dead.Where vitalism explicitly invokes a vital principle, that element is often referred to as the "vital spark," "energy" or "√©lan vital," which some equate with the "soul." I’m reminded here of a recent visit to Holy Loch in the Firth of Clyde and seeing where the puffer boat Vital Spark is now moored from the popular Para Handy films of 1959-60, written by Neil Munro (d.1930) who also wrote the history of the first two centuries of the Royal Bank of Scotland whose history as an independent bank now appears to be ending in calumny. Holy Loch is also where the most important US nuclear deterrent, the North Atlantic Polaris and Trident fleet was based for 30 years during the Cold War, which with the British Polaris fleet next door had enough power to blow up half the world. The sub-prime crisis is said to be capable of blowing up half of the world’s capitalism. Analysis of what went wrong is as complicated for political-economy as Vitalism’s long history in medical philosophy: most traditional healing practices posited that disease is the result of some imbalance in the vital energies that distinguish organic from inorganic matter, or flows from stocks and income from assets. In the Western tradition founded by Hippocrates, vital forces were associated with the four temperaments and humours; Eastern traditions posited similar forces such as qi and prana.

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