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Towards a no bonus culture

RP’s Diary

This morning the FT reported that some of Wall Street’s top executives, including the heads of JP Morgan and Citigroup, Jamie Dimon and Vikram Pandit, were given double-digit annual pay rises averaging almost 12%, despite widespread falls in profits and share prices.

The news confirms claims that banks are finding ways round the clamp down on bonuses. It also shows the Dimons and Pandits of this world continue to take home pay packages that do not reflect the underlying performance of their firms. Shares in the two banks traded at roughly $40 this time last year. Today they are valued at $35 and $26 respectively.

Bank bonuses were considered taboo after the financial crisis when many senior executives walked away from their failed banks with very rewarding pay packages and cosy pensions, often at the expense of taxpayers. Yet there remain concerns that bank pay is too closely linked to the short-term performance of a firm.

Regulators have been pushing for new rules that limit upfront payment in a bid encourage executives to take a long-term view. A recent EU law requires companies to defer 40 to 60 per cent of bonuses for three years or longer. There are also discussions about implementing a cap on bonuses that would maximise the variable payout at 100 per cent of a fixed salary.

The tougher regulations have prompted many banks to increase fixed salaries, defer large parts of bonuses and subject them to clawbacks in the case of future losses.

However, some experts have expressed doubts over whether placing restrictions on bonuses will reduce risky behaviour and short-term profiteering.

A study co-authored by Ian Tonks, a professor at the University of Bath, investigates whether bank executives had been incentivised to take undue risks as a result of performance-related pay.

He finds that contrary to expectations, pay was not highly sensitive to the short-term performance of banks and in general was actually quite low relative to other sectors. In other words, bank executives were paid irrespective of their performance.

The wickedness of bonuses

Three flaws in the bonus culture make it poisonous for banks and society. First, it is impossible to tie pay to performance. Second, one person’s achievements result from using the credit of the bank – its name and reputation; this credit has been built up by the low-risk, conservative judgments made by generations of bankers. Thirdly, bonuses make it possible – indeed, they make it irresistible – for one generation of bankers, even one top man, to harvest all the gains built up by the patient labour of previous generations. The result is always to destroy the credit of the bank, and thus its ability to perform any useful social role.

There is another way

The Handelsbanken experience provides an alternative approach. In 1993, Sweden’s government agreed to bailout the country’s failed banks after years of imprudent regulation and loose credit sparked a property boom and bust leaving the country in ruins. Out of the state’s 114 banks, Handelsbanken was the only one that did not need a blanket guarantee for deposits and creditors.

In his book, A Blueprint for Better Banking, Niels Kroner explains how the bank’s prudent governance practices and decentralised organisational structure – with underwriting and credit default risk managed at branch level – helped the bank weather successive crises. To this day, this relatively unknown bank is one of the 25 largest in Europe with an estimated market capitalisation of €9 billion.

What distinguishes Handelsbanken from most of its competitors is that it has no bonus programme or sales targets for senior management and staff members. “The payment of bonuses and the whole bonus culture carries the risk of creating the wrong incentives,” says Colum O’Driscoll, a bank manager at Handelsbanken.

A no-bonus culture, like the one adopted by Handelsbanken, should be the new standard for banking. The payment of bonuses has no place in high street commercial banking. But if bonuses are to be offer at investment banks, they must be tied to the long-term profitability of a firm, rather than handed out on a silver platter. One way to achieve this would be to state that banks paying staff bonuses would not be eligible for public support in an emergency.