Thursday, 17 September 2009

When Does A Bonus Drive The Right Behaviour?

The front page of the FT yesterday had an article which said that en masse 30 people from Societe Generale's Hedge Fund activities in France resigned and formed their own Hedge Fund.

The whole saga was triggered, allegedly, by the French President's stated desire to curb the bonus culture in financial institutions specifically by limiting the percentage of profits earned which can be set aside for bonuses. Defenders of current and future bonuses in the City, like Barbara Knight of the British Banker's Association (BBA), would argue this would be a growing trend if bonuses are curbed meaning that extraordinary 'talent' would migrate to other places or set up their own businesses in order to maintain their earnings.

I am not sure how much bonus was in question about these 30 individuals at Soc Gen but I think it is safe to assume that it is more money in a single year than most of us would earn in a lifetime. That sort of frames the context here. We are talking incredible amounts of money. This is only a snapshot of an industry that rewards a comparitively small number of their workers with more wealth each year than the average weekly lottery pay out in the UK. It would be easy to trivialise the work that they do - I would venture to say that their jobs are hard, require incredible levels of dedication, aggression, some skill (come on, give them some credit) and specialist knowledge and I am sure also that the work is highly pressurised. We have all seen the films and TV programs about these types of job, the peer pressure is immense, the relentess pursuit of profits is huge and the potential rewards are fabulous leading to a lifestyle few of us can comprehend.

Perhaps if we knew the kind of pressure these people worked under and the level of specialist 'skills' required to do their job, we would have some sympathy with the 'Soc Gen 30' who seem to be martyrs for the cause of freedom of the right to earn in the world of finance. Is their loss to Soc Gen going to change the balance too for the French institution? Will it affect France as an economy? These are important questions as we deal with the concept of bonus and its culture in order to understand how we deal with the issue in future.

We need also to ask ourselves, if the incredible bonuses which have been earnt, say, in the last 12 years had not been available, would the financial world have been any different than it is today? Would the Credit Crunch and the fallout which we have suffered ever have existed if such levels of bonuses be available?

It's an important and fundamental question on a very complex topic.

Many entrepreneurs' memoirs say their commercial acumen was evident at very early ages. People like Richard Branson started making money when he was a schoolboy. He is today the epitome of the successful man in Britain, perhaps only dwarfed by the bizarre pedestal on which Lord Sugar is placed as some kind of Enterprise Tsar who openly ridiculed his own Viglen products with Ratner-style comments and whose business practices have their own war stories, some of which I can attest to. Clearly, success is only measured by the money made in that context as surely Sir Philip Green could not have been knighted for paying himself, via his non-domiciled wife, a single one-off dividend of £1bn in a year when his company earned less than a fraction of that amount in profit. In fact, it is not only the fact that people are revered if they have a great deal of money, we do not care how they made their billions to be idolised by would-be entrepreneurs. Perhaps this is human nature.

There is also in innate desire within such people to keep earning more and more fabulous amounts of wealth even though they have more money already than they could ever spend in their lifetime. What makes Warren Buffett get up each day or Bill Gates? What makes Philip Green want to buy another company? It would be like me winning the lottery then going to the bank to raise a loan and then spending the loan on buying more tickets. Some of us know when to quit when we are ahead, the knack for these people is to keep on going and making much more. We all want a steady rise in our eranings but this is at a much higher level.

You do not have to look far to understand that bonuses are woven deep into our society. Hardly a job in Britain, particularly in the private sector, does not have an element of the total compensation available marked as 'bonus or commission' - the part of the annual remuneration which is termed 'at risk'. You can also look at the public sector and see a great deal of evidence of the same culture at work - only today there is an article about head teachers being paid sizeable bonuses and even 'golden handshakes' for starting jobs in a very similar vain, although the figures involved are orders of magnitude less, as the world of finance. In the world of teaching, there are zero profits to be made as in the same way as in the world of finance but there are Government targets to be hit and that's where bonuses were and are still designed to attain.

I am a sales animal at heart and a portion of my attainable earnings each year has been driven by attaining targets - in some cases it has doubled my annual salary. From the web 1.0 era I also had stock options which came to nothing but at one stage I could have speculated about possibly paying off my mortgage if not more if things had gone right. However, in all situations, if I did not reach minimum target levels or if the business collectively suffered then my bonus/commissions and stock options were completely at risk, if worth anything at all. In many schemes it was normal to have 'clawback' mechanisms that adjusted automatically my bonuses over a year-to-date performance so if one good month triggered a bonanza and then there was poor performance, over time I earned only the average amount. Such schemes are commonplace and can be very complicated, often have large caveats to reward specific behaviour and not unwanted ones and even be taken away at the discretion of the company for whatever reason they dreamt up. Some schemes in the IT business could see SAP or other big ticket software salespeople earn over £250,000 a year in total remuneration while in general people could have anywhere from 20 to 60% of their overall package geared on achieving certain targets. I am not talking about anything unusual which has not gone on in my business for a long while.

This is generally acknowledged to be a successful system - you pay for achieving but you don't pay for not achieving - some companies do get this wrong but that is in the minority. Also, in general, it has promoted the generation of profits based on product or service sales which have added value to the customers who bought them - and this is critical in our analysis. In the public sector, when profits are not at stake, then other performance measurements and targets are in place. Some of these are just silly as they are often handed out for no more than someone doing what is on their job description and that can lead to people believing that bonuses are some sort of guaranteed element of their earnings which in turn can lead to big issues when a recession arrives.

But the general principle is the same - in Britain today, bonus culture goes far, wide and deep in both the private and public sector.

So why are we so inflamed by the bonuses in the financial world? The Soc Gen 30 would argue that they are high performers in their field, they might argue that they have generated €billions in profits for their company, they might argue that they are the 'best in class' people in their field, they might even argue that they did not cause the credit crunch and associated losses and indeed, during that time, they continued to generate profits possibly. I am sure that this will be the basis of argument for the majority of traders in the financial world - it was someone else who lost the money or management's fault for not covering the risk. And we are talking $billions and billions of profit. In fact, the amount of money allocated to bonus pools is actually a small fraction of the kind of money these financial companies have earned - let us not forget that they have also distributed a great deal of wealth to their shareholders while handsomely rewarding other sorts of investors like bondholders. The base argument here is that such incredible profits cannot be generated without the vast bonuses available to be earned down at the traders' end and the management above. One does not go without the other. Before we argue otherwiese, you have to agree with the basic principle as it pervades in all business and even the public sector as I have argued above.

Bonus drives profit - that's the credo.

Well it is not always true. In the case of the financial world we have learned that it is not true. And let us be clear here - the incredible amounts of profits earned in the last 10 years by banks have all been written off with few exceptions. Most financial companies in the main stream of commerce have had to write off all, if not more, of the profits they have made over a period of around 10 years. If companies have not already done so, i.e. those who have not made such huge losses, then they probably will at some point in the future. The reality is that the financial system has regularly given back the proceeds of periods of huge growth as huge losses, and some more learned than me would argue that the only stable underlying profit banks make are from general lending, mortgages and insurance products. Almost all profits associated with investment banking or hedge funds are regularly wiped out.

But in those periods of huge profits, a comparitively small number of people make massive bonuses. It could be argued that our financial system today, our prosperity as a world even, cannot be as we observe it today without the world of finance driving such massive profit cycles to end in bust. In the last 10 to 15 years since deregulation of the financial system we have experienced an unprecedented period of 'sustained growth'. We have found, to our cost, this has been a false boom. Yet in that period, bank executives and traders have earned more in bonuses than they ever have. And as the trades got riskier, they earned more.

In fact, they are still doing so and more aggressively as now they have the safety net that if they do make huge mistakes that incur amazing losses there is an unlimited fund available to pay for their mistakes - they have the freedom to trade as hard as they like, risk more and get paid more without fear of losing. It's like playing the casino with fake money.

And these people are already fabulously wealthy. Many earn each year in bonuses the equivalent of an individual like me winning a single lottery jackpot which is a once in a life time experience and has a chance of one in 14 million of occurring. For these people, playing the lottery is a mug's game, they have a far more secure way of winning. It's called using other people's money and the financial system.

While I would expect, quite habitually, that if I did not acheive my goals that I would not get paid a bonus or, as in the case right now, I would not get paid at all, these people have no such level of accountability. The financial system has just been bailed out to the tune of $15trillion globally and the measure of accountability has been almsot zero with the odd exception and in reality the actual collapse, far from wiping out the stupid banks that caused, it has actually primed them again to believe they can make money out of the losses they incurred.

Think about that last statement as this is the essence of the argument. By wiping the slate clean for all these people and allowing them to keep their methods of working, they will make $billions on the fact that they made the losses. Lehman Bros derivative positions worth just fractions of of their original values are now potential gold mines in the eyes of financial people. Toxic debt will be worth billions in speculation that there are plenty of potential good bits in there. Bankers already speculated before the fall of the system that repackaged Government debt would be worth trillions.

Why? Because we underwrite the whole thing and these people simply do not get it. You cannot make money out of nothing - someone, somewhere pays for it. You can buy a derivative from Lehmans for 20 cents in the dollar without someone someone else paying for that loss. When Barclays bought the assets of Lehmans for less than $2bn, it has been now alleged that the structure of the deal allowed them to make $8bn immediately. We can sit here in awe that such daring and brilliance can occur or we can stand up and call a halt to this fantastic game that is being played with our money.

The point about bonuses is that it drives behaviour. In the public sector it makes people do only the the things that hit targets - if it is reducing waiting times in Accident & Emergency at hospitals then people will be registered minutes after they arrive and then wait hours to be seen by a medical person because the statistic records that they are not really waiting at all. If the target is 20 operations per day and ingrowing toenails operations take 30 minutes but heart surgery takes 5 hours, then only ingrowing toenails get done by surgeons skilled to save lives not nails.

You get what you pay for - you reap what you sew. You gear people to take incredibly high risks without fear of accountability or losing their bonuses by selling products of no real value then they will take ever more riskier options and they will dream up ever more creative ideas to create bonuses knowing full well that such profits that are earned have to be given back at some time as they are literally conjured out of nothing.

There is a price to pay. As numb taxpayers we can watch in awe as £1.5 trillion is added to the National Debt of which by 2014 the interest alone will be £60bn which is equivalent to the entire annual education budget. Do we scrap education or raise tax to cover it? You guessed it - and the whizz kids in the City will employ clever accountants so that neither the companies who incurred the debt or the traders who engineered it pay anything like their fair share of that £60bn.

It is that perverse. We sit here glibbly reading about the whole situation and we think that because we think we understand bonuses that the financial system should have them, it is just a matter of how much they are. But we don't get it as we are the only schmucks who pay for them - they are not, over the long term, paid back for the sustained losses made; these bonuses are paid for by the taxpayer to cover the losses that are really being made.

But banning or curtailing bonuses is not the answer as the Soc Gen 30 have shown. They simply will up sticks and go elsewhere. The economy does not lose out, France does not lose as they simply do the same eleswhere - maybe Soc Gen loses for a while. The point is that until we change the system at the fundamental level to properly define what these people can trade, then will we start to get to pay them for doing things which really help our economy rather than just helping themselves.

The time has passed when we could do this and so the new course has been set. The financial world is at the trough making vast profits out of the losses they made and maybe we can curb the bonuses but we cannot stop the damage they are causing.

It's like building your house with bricks of poor stone, it does not matter how much you pay for them, your house will fall over sooner or later.

Bonuses are not the problem. It's the industry that is the problem.

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