Bankers bonuses explained?

Bankers are just bonus-snaffling Marxists
Why did financiers think they could get away with rewarding themselves so lavishly? The answer lies in Tito’s Yugoslavia

Anatole Kaletsky

Times 14 January 2010

Stephen Hester, Sir Fred Goodwin’s successor as chief executive of the now-nationalised Royal Bank of Scotland, sheepishly admitted this week that even his mother and father saw his £10 million bonus package as too high. But, in less widely reported testimony to the Treasury Select Committee he made a remark that pointed to savings thousands of times larger than his bonus.

The business of RBS, he said, was now recovering so quickly that the Government would be able to reprivatise it (presumably at a large profit for the Treasury) several years ahead of schedule and the bank would make no recourse at all to the controversial government guarantees, whose potential cost to taxpayers was estimated by many experts at £200 billion or higher just six months ago.

With banks all over the world now apparently making money even faster than they were losing it last year, is it possible that bankers such as Mr Hester are, after all, financial geniuses whose talents fully justify their multimillion-pound rewards? Instinctively we all realise, like Mr Hester’s Mum and Dad, that the answer is no, but pinning down the exact reasons why bankers’ bonuses are economically unjustified is surprisingly hard. Last year’s explanation that bankers make their fortunes at the expense of taxpayers no longer seems so convincing now that the public guarantees have mostly been repaid with interest and it looks like governments all over the world will make a modest profit on their financial interventions.

Another tempting explanation is that banks overcharge consumers because they enjoy monopolies, but this is hard to sustain after a decade in which banks offered mortgages below the Bank of England’s base rate. And numerous studies by anti-trust authorities show that competition in most banking markets was actually pretty intense, at least until the crisis of 2007-09.

In the hundreds of articles and lectures about the banking crisis from academics, politicians and regulators, a plausible analysis of why bankers are overpaid has never emerged. Yet understanding this issue is critical in designing sensible policies, not only on the pay and bonus controversies, but with regard to the stability of the financial system as a whole. So here goes my attempt.

Banks are different from other businesses in two crucial respects. The products banks sell are impossible to value accurately because they relate to unpredictable future events, most obviously whether borrowers will repay their debts. This also applies to several other businesses, most obviously insurance, but banks have another unique characteristic. A bank’s survival depends entirely on the confidence of its depositors, who can withdraw their money at any time — and if confidence in one major bank collapses, a chain reaction of financial failures can easily follow, with catastrophic results for the whole economy.

These unusual features of banks imply a series of controversial conclusions. The first is that all banks are potentially too important to fail. Even if bank failures may be acceptable in normal conditions, there will be times, perhaps only once every generation, when governments simply cannot allow any bank to fail.

The idea that the regulatory problems exposed by last year’s crisis could be solved simply by breaking up banks into smaller or simpler institutions so as to overcome the “too big to fail” syndrome is a delusion. The collapse of a bank such as Lehman, with no consumer deposits, might have done no great harm had it happened a few years earlier. But against the background of a broader financial crisis, Lehman’s failure was catastrophic and imposed costs on society hundreds of times greater than the modest (or zero) cost of providing temporary government guarantees.

Once it is accepted that all banks, regardless of size, can sometimes be too important to fail, a second conclusion follows: the taxpayer is a silent partner in every banking business, whether it is openly nationalised, such as RBS, or purely private, such as Goldman Sachs or HSBC. And that, in turn, means that taxpayer interests must be explicitly represented in the business decisions of the banks, alongside the interests of the private shareholders. But how is this to be achieved?

One approach is to give taxpayers a permanent share of all bank revenues, either through special taxes or by forcing banks to keep a substantial portion of their deposits in zero-interest government bonds. Another is to ensure that banks must be managed so as to minimise the risk of the implicit taxpayer guarantees ever being called.

This is where we come back to bankers’ bonuses. The surest way of protecting the interests of taxpayers as silent shareholders in the banks is to ensure that these companies make very big profits and then to force banks to retain these profits as a cushion against future losses. The objective of bank profitability has now been spectacularly achieved by government monetary policies, rather than the financial genius of talented bankers. The next question is how banks’ boards of directors can be made to keep profits within the business instead of paying them out as excessive salaries and bonuses.

To do this, governments must recognise that their interests, as silent partners, are aligned with bank shareholders and at odds with the interests of bank employees. In a bank, as in any private business, income has to be shared between shareholders and employees. The peculiarity of banking is that boards of directors, instead of protecting shareholders’ interests, have maximised employees’ earnings. Banks have been run as old-fashioned professional partnerships or workers’ co-operatives, in which the interests of the workers come first and outside providers of capital are treated as an afterthought.

Those readers old enough may recall a fad among economists in the 1960s to extol the virtues of Yugoslav workers’ co-operatives, which supposedly combined the virtues of free enterprise and social justice towards workers. This is what most banks have become. The problem with the co-operatives became apparent only after the break-up of Yugoslavia. Managers paid out all the revenues as wages and allowed their capital to disappear. Workers’ co-operatives, by their nature, tend to decapitalise and plunder the businesses they control.

The 1980s and 1990s brought the victory of capital over labour almost everywhere. Finance was the one ironic exception. In finance, the workers triumphed over the owners of capital. Governments, as silent shareholders in every banking business, must now overcome the City and Wall Street, the last bastions of Marxist workers’ control.