The Financial Times has published an Op-Ed piece I penned on bonuses in the banking industry. Enjoy!
A bank employee recently asked me: “As a trader, my bonus is derived directly from my profit and loss, which is accrued over the quarter and kept in a separate account. It does not go into the firm’s bottom line and then back out to me. Also, like most traders, I accrue 2% of my gains in a loss provision account in case I have a major write-down in the year. My bonus is 10% of my profit for the year. If I make $50m for the year my bonus is $5m. What does my bonus have to do with the mortgage-backed securities [MBS] trader who is sitting on losses? Did I or did I not show a profit of $40m to the firm’s bottom line?”
Main Street is absolutely flabbergasted that bankers do not understand the core issues of this bonus question. Allow me to clearly outline the problem and propose a solution. Assuming this trader works for a prominent US bank that received a bailout, he is not entitled to a $5m bonus if he made $50m for the year. Why not? Because he generated that 10% return from taxpayer capital, not firm capital. For example, Goldman Sachs would have had the drawdown from purgatory had it not been rescued from a $30bn credit default swap deal with AIG.
Let’s assume AIG would have negotiated a 40% payout to Goldman Sachs, which is realistic given that litigation with an insolvent company that had many more contingent and direct claims would probably have resulted in a lower net receipt to Goldman. This alone would have resulted in a hole of about $7.8bn for the bank.
Taxpayer assistance
Combined with the Troubled Asset Relief
Program, Federal Deposit Insurance Corporation bond guarantees,
Public-Private Investment Programme for legacy assets and other alphabet
programmes, not to mention hundreds of billions of dollars in MBS
purchases that have put an artificial bid under toxic assets that abound
on big bank balance sheets, it is clear to see that banks were
undercapitalised and benefited greatly from taxpayer assistance. Without
that assistance, the trader would not have had $50m to trade and may
not have had an employer at all.
It really is that simple and there is no need to debate
whether he deserves 10%. The real issue is 10% of what? He is relying on
a 10% bookmakers’ fee for betting with taxpayer contingent capital –
not pure bank capital, and that is where the great misunderstanding
lies. Even if one could justify getting paid from taxpayer capital in
lieu of firm capital, the taxpayer capital should (as a product of
prudent business practice) have been pegged to an appropriate ‘cost’,
whose hurdle rate the trader would need to overcome. In other words,
management should say: “This $50m costs us 14% in coupons on
government-owned preference shares, thus you will not have positive
return on investment until you break that 14% mark.” If the trader
failed to breach the 14% hurdle rate, he would not have received a bonus
at all.
Simplifying
risk and return
Now,
I am sure many are quipping: “Well, how is a bank supposed to
incentivise a trader if a negative return does not fund a bonus?” But
think about it for just a moment, and you will see the implications. If
the risk-adjusted cost of capital causes a business to become
unprofitable – either for the employee or the firm – then neither the
employee nor the firm should be in that particular line of business. The
plan is ingenious in its simplicity and creates a self-regulating
mechanism that prevents risks from being decoupled from rewards. This
also applies to exotic derivatives transactions where in-built leverage
allows for little or no upfront capital. You reserve properly for risks
(counterparty, credit and market) and charge the cost of capital on the
reserves.
This plan
works for bankers too. Mergers and acquisition bankers use minimal firm
capital, thus have relatively minimal economic hurdles to overcome.
Hence, the banker would likely get a higher payout than the trader
because he risked less capital, but he would still have to be paid via
staggered or cliff vesting (depending on the nature of the deal) with
restricted stock. In this scenario, bankers would not put together deals
in a fashion that runs counter to the interests of the firm’s
stakeholders (at least not on purpose or through wilful negligence). Now
bankers and traders become true economic partners in the firm, sharing
both the reward and the risk of doing the deal – just like in the real
world.
Reggie Middleton is an independent investor and
financial analyst with experience ranging from insurance-linked
securities structuring to real estate investment. See boombustblog.com
Tags: Banking, Investment Banks, Risk Management, Strategy
NICE! absolutely GREAT to see you getting more exposure!