Bank bonuses again rile politicians

Business theorist Frederick Winslow Taylor believed that performance related pay was the way to encourage production and efficiency. Investment Banks have been paying bonuses on Wall Street and the Wharf for decades.

Investment Banks are split into various departments: back, middle and front office. Bonuses are distributed amongst the entire company’s employees - back office accounting, legal and technology, along with the Risk, Product Control, the middle office coders, and the front office business teams, research, trading and sales are all given a generous bonus each year. The people closest to the money are given the most generous bonus.

I once overheard a young lady saying if she got the same bonus the following year she would be able to retire in the Hamptons. The following March, the lady of Hampton wishes, was made redundant along with 40% of the sales force. Bankers are paid huge wads of cash because they live on risk, and turnover can be high for many roles that generate this cash. If we are going to bash bankers, we need to know who we are bashing and how to bash them!

Is an analyst programmer in the back office a banker? I would argue not but maybe he should be aware of what the work he is doing is contributing to. Most desks at investment banks these days are process desk, rarely is there proprietary trading occurring (where people invest their own money for the sake of making money), especially after the Dodd-Frank act tries to deal with this. It is far from brain surgery, rocket science or any other intellectually challenging profession. The commissions charged would drop if more could offer the same services. Some hedge fund managers charge 10% of any return for the money you invest with them. Yet according to numerous academic articles and heuristic arguments they cannot beat the market.

According to CAPM, a theory invented in 1961 by academics and an old equation, a stock will generate returns above the market index in accordance with its risk. Desks will use this equation to help product control understand their risk that needs to be clearly explained to investors in financial statements.

If we assume that government bonds are risk free, a silly idea if you are European right now, this would mean that a stock will return more than a bond over a year in accordance with the company’s risk. But most investors know this well, or do they? Studies have analysed fund managers returns along with their risk and the evidence points to your average rich investor being better off if they just invest in the FTSE 100 or leaving their money in a high street account. So apart from charity events and tips to waitresses do Fund Managers generate any value at all?

If this was common knowledge that many more hedge funds would go out of business more quickly, not many in London would have survived the credit crunch. The government is in a position of needing to persuade the public that what they are doing is the best way to handle the bonus issue so that other corporations and individuals don’t feel that they are being unfairly treated. But why not change the system and reward genuine innovation and make the rewards more longer term? Quick solutions don’t exist.

If an analyst creates a new financial product reward him; if a Managing Director cuts costs whilst producing the same value reward him; but don’t hand out bonuses to people because they generate above average returns for one year.

This encourages risk taking and an environment of cash grabbing. If employees were concentrating on their jobs and the process of generating value instead of the end of year bonus there would be less risk, happier employees and a less emotive public gang of banker bashers. At the same time, the corporate world and the public should realise that they will be unfairly treated by bankers until they understand what the banks actually do.