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Masters no more?

Thu, 13th Jan 2011

It’s hard to know which is more unappealing: ministers ineffectually begging bankers to show ‘sensitivity’ in this year’s bonus round, or the bankers themselves, who like the aristocrats of the Ancien Régime show absolutely no sign of altering their behaviour one jot until they are forced to do so.

Now, I have no problem with workers being handsomely rewarded for corporate success. The conventional view that financial capital is the scarcest and most important corporate resource, and that financial investors are the only stakeholders that matter, is ideologically-inspired nonsense. It’s human capital and the accumulated know-how embodied in products and processes that are today’s source of competitive advantage, not raw financial clout. In this perspective, Nicholas Sarkozy’s rule of thumb that in a solidly profitable company, returns should go equally to employees, shareholders and future investment (due taxes having been paid, of course) sounds about right.

So what’s the issue with bankers? Actually there are two. The first, much neglected, is internal fairness, which appears to be much better correlated with firm performance than individual rewards. Income inequality within firms, just as in society as a whole, undermines solidarity and engagement; any effect of increased competition is nullified by decreased cooperation. As the past 30 years conclusively prove, trickle-down economics is a myth.

On the other hand, bonus systems such as John Lewis’s, that reward everyone after the event and equally (in proportion), have the opposite effect. By recognising the reality that corporate success (or failure) is a collective effort, not the work of one or two stars, they foster commitment and cooperation. Individual bonuses, especially large ones, have the perverse effect of making people think about the money, not the job. The best reward system, by contrast, is fair and generous enough that no one has to think about it at all, freeing people to concentrate on the object of the exercise, ie doing a good job.

The second issue is even more basic. Lesson 1 in Economics 101 is that in a competitive economy very high profits can’t exist for long, because they will attract new entrants to the industry who will compete the excess profits away. As the sainted Adam Smith put it: ‘On the contrary, it [the rate of profit] is naturally low in rich and high in poor countries; and it is always highest in the countries which are going fastest to ruin.’

The obvious inference is the right one. Banking is not efficient, in economic terms. In fact it is profoundly inefficient. To put it more colourfully, as Tony Hilton did in the Evening Standard, the City of London and Wall Street are the biggest market failures of all time. There is no incentive to keep costs down (Merrill Lynch’s John Thain reportedly spent $1.2 million on office decorations and paid his driver $230,000 a year) – and perversely, more onerous regulation just protects the current oligopoly (and its profits) by making it harder for upstarts to break in and shake things up. Meanwhile, the size of the rewards on offer for just one large deal means that individuals are no longer subject to the reputational discipline of the past. When deal participants need never work again, the old City boast that ‘my word is my bond’ becomes irrelevant.

The situation is made still worse by the ‘too big to fail’ syndrome. As Justin Fox pointed out in a perceptive HBR blog  recently, the increasing returns to work in finance were for a long time justified as rewards for creating alpha. In light of the global financial crisis, that claim provokes hollow laughter. Instead, writes Fox, ‘it seems more likely that the combination of massive risk-taking in the financial sector and government backstops and bailouts when those bets go bad has created a situation where financial sector pay is kept artificially high’.

How high? About 40 per cent, according to academic work quoted by Fox that compares financial-sector pay packets with those of other professions where people had similar skills. Note that that's for the financial sector as a whole; in the more rarefied reaches of Wall Street and the City those percentages would be astronomically higher. Hardly surprising, then, if you can hear ‘a giant sucking sound’ (Fox’s term) as these purlieus ‘hoover up the smart and self-interested’ – among whom figure plenty of out-of-office politicians, whose presence among the snouts in the trough perhaps helps explain the strange reluctance to enact reforms that would reduce finance's unhealthy dominance, cut bonuses down to size and respond to voters' concern all at the same time.

In one sense, the bankers’ heel-digging is logical. In their eyes they really are Masters of the Universe, so why wouldn’t they expect to be paid as such? To the rest of us, they look more like the callow Sorcerer’s Apprentice, whose pretensions to power far outstripped his ability to use it, resulting eventually in a bail-out  by his master. To prevent the servant getting ideas above his station again, the banks have to be broken up, with no connections allowed between narrow utility banks, protected and guaranteed, and their casino offspring. The investment banks, too, as a useful article (you may need a subscription) by Seth Mallaby in the Financial Times points out, are riven with conflict and should ideally also be split up.

Crucially, making them small enough to fail would remove the implicit incentive for overexuberant risk-taking. Together with a Tobin tax on transactions and a requirement to subject financial innovations to pharma-style safety testing, these measures would drastically reduce the subsidised profitability of the financial sector and slash the size of the bonus pot available. Yes, short-term tax receipts would suffer; but that loss would be vastly outweighed by the benefits of a better-balanced economy, greatly reduced systemic risk and an end to that horrible sucking sound.





 


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