It was good to see Mervyn King launching an attack on the City bonus culture this week. The Governor of the Bank of England has come under ferocious attack from bankers during this crisis. At lunch the other day, the chairman of one of the biggest banks in the City banged his fist on the table and ranted that he thought King’s behaviour had been “disgusting, disgusting”.
King’s crime is not doing more to bail the banks out of this hole of their own making. Meanwhile, the bankers themselves have been given an astonishingly free ride by much of the media. So it must have felt good for King to turn the tables and put the spotlight back where it belongs.
King was, of course, right on the money. The City’s skewed incentive structures are at the heart of this financial crisis. The worst are the notorious two-and-twenty fee structures enjoyed by hedge funds and private equity firms. These firms typically charge a 2% management fee plus a 20% performance fee on any profits. The problem with this structure is that it is asymmetrical: it gives the fund manager a huge share in any success, but no share in the losses when things go wrong. That can act as a powerful incentive for fund managers to pile on risky bets.
But there are plenty of other bad incentive structures right through the financial system. The embrace by many traditional lending banks of the new “originate and distribute” model of banking – where loans were packaged up and sold on, rather than held on the bank’s balance sheet – lies behind many of the problems today. The new model incentivised bankers to focus on volume of loans rather than the quality, since they would not be left with the credit risk. And the rating agencies on which the buyers relied for credit analysis were paid by the selling banks, which meant they were not truly independent.
Meanwhile, throughout the City and Wall Street, traders and bankers were rewarded according to the profits made each year by their own desk or department, often regardless of the performance of the rest of the bank. That was what led to the banks paying out obscene bonuses earlier this year, even as they were reporting losses. Too often, this bonus culture based on profits extended right to the top, which encouraged reckless risk-taking even when it might prove damaging to shareholders.
It is axiomatic in business that you get what you pay for. Human beings respond to incentives. This is not just true of the City – you see it throughout industry too. Companies that incentivise bosses to deliver sales growth get sales growth – even if that growth isn’t very profitable. Companies that target earnings growth get earnings growth, even if it comes at the expense of investment.
The best system is one that encourages long-term worker share ownership. It is no coincidence that two of the banks that have come out of the credit crunch best – Goldman Sachs and Lehman Brothers – have very high levels of employee share ownership. The household goods company Reckitt Benckiser goes one better and forces its top managers to buy large stakes in the company with their own money as a condition of employment. The results were evident this week when the shares rose 7% on the back of a sparkling performance.
But reforming the City’s incentive structures won’t be easy. Mervyn King may have identified the problem, but it is not up to him how banks pay their staff. Nor is it clear that he would do any better job than the market. There is a strong case for regulators looking at incentive structures when assessing a bank’s risk profile, but it will be hard to establish hard and fast rules. Any reform is a matter for shareholders. King’s best hope is that they have been so badly stung they insist on change. But imposing new remuneration structures is extraordinarily tricky – and persuading executives to accept them even trickier. Somehow I don’t see it happening.
A good bubble?
At a dinner the other evening, the mood among the corporate bigwigs and City hotshots ranged from gloom to despair. Nobody thought the UK economy had a prayer this year or next – and when a Treasury mandarin tried to defend the government’s 1.6% growth forecast for this year, on the grounds that there was more to the UK than the City, he was drowned out by protests. The general view was that the bubble had been a terrible mistake for which we must all now pay a big price.
But I wonder if we will look back on it that way. Bubbles are always painful when they burst since they represent a misallocation of capital, much of which has to be written off. But rarely is all that capital completely wasted. Past bubbles have bought us canals, railways, consumer electronics and the internet.
For many in Britain, the latest bubble’s achievements may look dubious, consisting primarily of shopping centres and tens of thousands of flats. But as one guest pointed out, it also bought two billion people out of poverty. That may be causing the world some adjustment problems – but these are good problems to have.
Simon Nixon is executive editor of Breakingviews.com