Why RBS and other banks pay big bonuses

RBS yesterday reported that 323 of its staff are to share a bonus pot of £375 million which in another universe would be enough to employ 12,500 teachers at £30k each.  And yet it turns out that this is just the tip of the iceberg.  According to the BBC this is just the figure for its “code” staff as defined by the FSA – that is those executives who are perceived to do things that have a bearing on the risk the bank takes, but excluding other staff such as traders who earned even more than this.

There is obviously something very wrong here and the public is predictably outraged but powerless.  The banks will claim that they have no choice if they are to remain competitive and the politicians will make ritual comments deploring greed, but actually do nothing, not even where the state has the majority shareholding.

Yet, why banks pay these obscene sums is a question I have yet to see the mainstream press even ask, let alone answer.  In fact, the only place I have found a coherent account of this by a banking insider is in Yves Smith’s “Econned: How unenlightened self-interest undermined democracy and corrupted democracy“.   She also writes the excellent (and deeply liberal) naked capitalism blog – see links.

So, with apologies if I’ve got anything materially wrong, here is what I understand from her work plus bits and pieces from other sources.

The big investment banks are financial services conglomerates bringing together under one corporate roof many very different businesses.  Many of these businesses operate in markets that are not very liquid (which means that margins tend to be high) and/or which are very complex (also meaning that margins tend to be high).   The newer, the more complex and the harder-to-understand  a bank’s products the better the chance it has to make exceptional profits by, not to put it too finely, exploiting its better knowledge and market power to fool and gouge its customers.  Simple and transparent are NOT virtues in the world of investment banking.

Naturally, sailing close to the wind like this soon brings traders up against the limits of law or regulation.  But not usually for long; laws and regulations can often be circumvented by a subtle change of wording; for example Credit Default Swops are a form of insurance but, by calling them “swops” they evade regulations that would apply to insurance (obviously this needs a supine regulator as well so wording changes per se are only part of the story).  If clever rewording doesn’t work, there is still the option of “regulatory arbitrage”.   If a particular scheme is illegal in, say, London then the business can be done in the name of a subsidiary in Dublin or the Caymans or some other jurisdiction that specialises in facilitating dodgy dealing (as does the City in some instances).   All it requires is an “innovative” approach that finds ways round difficulties.

That is why banks place great emphasis on “innovation” and often stress how important, fundamental even, it is to their business.  But this sort of innovation is socially toxic, an evil twin of innovation in more life-enhancing fields.  No less an authority than Paul Volcker, a former chairman of the Federal Reserve has opined that the peak of useful innovation in banking was the invention of the ATM and that, “he has yet to see any evidence that financial market innovations have provided any benefit to the economy.

When huge short-term profits are the reward for evading regulation, then the inevitable outcome is a race to the bottom as banks strive to outdo each other, leaving no stone unturned in the search for short-run profit, no matter how risky or destructive their activities are in the medium to long run.  The justification is always “efficiency” which, in finance, means higher profit (or putatively for bank customers, lower costs).   But “efficiency” is always a trade-off with “stability” in a complex system.  The profits may indeed be lower for a time – until the whole systems blows up.  Funnily enough this trade-off is never pointed out – but then stability doesn’t pay bonuses.

Another feature of investment banking is that profit opportunities are typically fleeting, depending on an ever-changing transaction flow so, to be competitive, a firm must delegate a great deal of authority to relatively junior traders and analysts who have world-scale experience in a niche business that may directly employ only a few dozen people worldwide yet which can be obscenely profitable if they get it right.  Given that some of these niche businesses have big returns to scale (roughly, that the biggest player makes the most money by a country mile), all this makes the perfect recipe for high pay and bonuses.  That is, at root, why the banks are so insistent that they MUST pay whopping sums and why, even in state-owned banks, the politicians back off when this is explained to them.

These traders and analysts report to managers who may have little or no direct experience of that niche and whose motivations are deeply conflicted by sharing in the bonuses – a principle that applies all the way up the line to the board.   Hence, the FSA is utterley deluded if it thinks that traders’ activities have no bearing on the risks the bank takes or that they can be reliably controlled by their managers per the BBC item referenced above.  Traders specialise in evading and bending rules.  Have they never heard of Nick Leeson or the many other “rogue” traders who lost their employers millions, even billions?

In short, this is a business model built around creating then exploiting market imperfections.   Whereas a regular and socially useful business makes money by serving the needs of its customers, banking has an inbuilt tendency to go beyond this and make even more money by ripping off its customers.  When it does this it becomes a zero sum game, redistributing wealth rather than creating it; knowing that if the house of cards collapses the miscreants will be long gone with their bonuses.

As Akerlof and Romer put it (quoted in “Econned”),

“… an economic underground can come to life if firms have an incentive to go broke for profit at society’s expense (to loot) instead of to go for broke (to gamble on success).  Bankruptcy for profit will occur if poor accounting, lax regulation, or low penalties for abuse give owners an incentive to pay themselves more than their firms are worth and then default on their debt obligations.  Bankruptcy for profit occurs most commonly when a government guarantees a firm’s debt obligations …

“Because net worth is typically a small fraction of total assets for the insured institutions [i.e. they have big assets, but equally big debts]…   bankruptcy for profit can easily become a more attractive strategy for the owners than maximising the true economic value.  If so, the normal economics of maximising economic value is replaced by the topsy-turvy economics of maximising extractable value which tend to drive the firm’s economic net worth deeply negative.” [i.e. leaving a big bill for the taxpayer to pick up] [Emphasis added]

In other words, bank profits are not the result of a healthy economy as they would have us believe.  Rather banking has become an extractive industry hoovering up wealth from the real economy for private gain and its huge profits are symptoms of a sick economy that is succeeding only at the wrong things.

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