Now that all of the great and the good have weighed in on bankers’ bonuses, perhaps it is time for someone to take up the cudgels on the other side of the battle. Before doing that though, I have to clarify a few things from my past articles to brush aside any charges of inconsistency:
1. In one article, I defended the right of banks to pay bonuses for the right people who could navigate them out of a mess.
2. In another article a few months later, I wrote about the source of profits at banks, alluding to the egregious (albeit clueless) subsidies provided to the sector by governments.
3. Later articles have been fairly caustic about illusory sources of bonuses that are being taxed by governments around the world.
In March last year, I wrote:
Contrary to what is being proposed by the US and other G7 [Group of Seven] administrations, the way out of the financial logjam is to provide incentives for the private sector to get its act together rather than cause more confusion by retrospective and counter-contractual moves designed to placate popular anger. Governments don’t have any experts to deal with this problem, and it is time they acknowledged that little fact.
The article concluded:
Snap. There ends the dream. Instead of the above, what we have is ham-handed meddling in the private sector, barrels of pork being unrolled onto the unsuspecting public, significant future tax increases in store across G7, wholesale currency devaluations around the world … ( See Bonus-free knuckleheads, Asia Times Online, March 21, 2009.)
Then last July I wrote:
To read the financial media after Goldman Sachs announced its results for the second quarter felt rather like reading about the chap who turned up wearing his birthday suit to a funeral. America was in mourning for its lost economy, bust through the shenanigans of the Fed and millions of greedy, vacuous Americans and yet, here was a firm – a bunch of financial men for goodness sake – who dared, nay even boasted about their ability to make money. Surely, fumed the great unwashed, such a travesty cannot be allowed to happen in the Land of the Obama-magic?
The article continues:
When the US Fed and Treasury rolled out blank checks galore to the rescue of banks, along with the governments of the UK and the rest of Europe, they embarked on a series of moves that guaranteed the persistence of moral hazard for another two generations. Bankers, as I wrote about in the article “The New Brahmins”, had become the most protected species on the planet. Fear about failing banks had led governments into a series of protective steps that were bound to be capitalized on by at least one bunch of intelligent people if not the next. (See The new Brahmins, Asia Times Online, March 29, 2008, and Goldman’s Atlas shrug, Asia Times Online, July 22, 2009.)
In the event, Goldman Sachs fully tapped the government-guaranteed funding market and issued for itself a lot of cheap long-term financing; that was in turn ploughed back into the purchase of deeply distressed securities, many of which were trading below their statistically implied probability of defaults and asset recoveries. The end result was electric – a massive rally in the prices of such securities, which acted as a growth driver pushing its fixed income up more than three times since this time last year.
So what exactly is my key issue with the current kerfuffle on bankers’ bonuses? To arrive at that point, perhaps it would be appropriate to start at the source of bankers’ bonuses, namely their “extra” profits.
To be clear, banks pay their employees a lot of money, with the primary objective of not losing any. That, however, is a glib way of highlighting the fundamental percept of banking, namely the sheer danger of losing everything one lends. Typically, banks do not pay bonuses to people who “only” do their jobs, that is make loans and fill out paperwork.
A brief recap of what banking is about: borrow money from a bunch of average people and then lend to another bunch of people at a higher rate. As long as you make more on the difference (“spread”) than the cost of your people and premises, you make a profit. Add a bunch of complexities such as required capital (because the authorities would like to make sure you set aside enough money in case some of the money lent doesn’t come back), securities (same as lending except you can sell or buy freely) and derivatives (seriously, not worth discussing here).
When considered in this harsh light of reality, it is a wonder that banks pay well, and more so even pay bonuses. The reason for that is relative to the “spread”, people usually do not renege on their loans, so the cost of defaults is actually rather low. Even so, basic banking, that is to say lending, isn’t remunerated quite as well as you’d think from reading the papers. Instead, the areas within banks that elicit the highest bonuses are the following:
a. Traditional investment banking, which is a business involving the vetting and introduction of pools of capital to specific opportunities. This area includes subjects such as initial public offerings (IPOs), fixed-income syndication (selling new bonds to investors), and the most controversial of all, namely mergers and acquisitions (M&A), where prices for transactions can be set and details such as documentation finalized.
b. Proprietary trading, which involves banks using their temporary pools of capital (renting the balance sheet) to generate extra profits. Think of it like this: banks have a whole lot of loans, on which money could be lost at any time; however, until such losses occur, the capital of the bank is idle. If it can be used to take other risks – such as securities trading – then shareholders could generate more profits than would be otherwise possible from pure spreads.
c. Transformational banking, which is the art of taking banking assets like loans and transforming them into securities. This involves standardization of the underlying assets, documentation that supports the cash flow rights of the new buyers (transferring from the original bankers) and getting the rating agencies that provide opinions on the sustainability of cash flows in the structure.
The question is – why these three? The first area is simple – traditional investment banking has a very high ratio of failure; for example, only one in 10 M&A deals actually succeed in going through for a bank; the ratio is improved for a larger bank (mainly because there are two sides to any M&A) but it’s not a whole lot higher. Deals generate valuable fee income that depends not so much on the bank’s balance sheet (or lending prowess) but on the bankers’ skill in understanding the complexities of any deal and making sure that the chances of success involving multiple investors and clients can be maximized. In this business, banks need bankers more than the other way around; hence the talent that can credibly do transactions without the franchise command a very high premium, that is, a percentage of profits made on all the transactions.
The second and third areas occupy a more controversial space – while easy to understand, the basic premise is flawed for banks because capital dependence is much higher, particularly in the capital-constrained world that followed the financial crisis in 2007. It is also the area where the activities of governments had the most direct impact on the ability of banks to actually generate profits.
Think of an alternate world where governments had not bailed out the banks. Instead of having governments as their sponsors, banks would have had to scratch around for capital to pay for their loan and other losses. To do this, their ability to trade proprietary capital would have been miniscule, while their ability to transform assets would also have been too risky.
In effect, the profits of all banks from proprietary trading last year were derived from government largesse. If we lived in a world where governments actually understood economics, they would have figured that the true benefits of their implicit guarantees were substantial enough for banks to require significant payments in the form of “insurance”, ie the upfront payment for future protection. If banks had been forced to pay this insurance, there would have been no money left to gamble on proprietary trading or securitization.
Then again, look at the deal that the US and European governments struck with their banks. While the US government did force any bank receiving state money to grant it warrants, there wasn’t any clause to prevent them from returning the money too quickly or at too low a price. Clearly, they had neglected to pay the Category A bankers, ie investment bankers, to properly work for them in structuring these transactions, and that is why recipients of bailouts quickly wriggled out of the government clutches without so much as a “Thank You”.
As always, things are worse in Europe, where governments have failed even to force banks to issue new capital, let alone provide them with controlling interests or supervisory functions. The net result has been to allow banks with very low capital ratios (even negative ones) to still claim extraordinary profits and the rewards that go with them for bankers.
Those of a more poetic mind would see bank bonuses as representing greed, gluttony and perhaps lust; but in so doing, they ignore the very factors that allowed the banks to make such profits – such as the sloth of central bankers, pride of governments in their financial systems and despair at losing their economic might; not to mention the envy of the hoi polloi and alleged wrath of employees who aren’t paid their just remuneration.
When and if the drama from bankers’ bonuses ends, it will be because people realize the true culprits in all this are governments and not the bankers.