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.

Denial - A Powerful Beast

I don't know how many times I have blogged on the subject of denial but it seems the theme just won't go away.

I have argued it can be a powerful mechanism used by successful business people to block out the negative issues and to focus on the positives which often is a trait of highly successful individuals. It is also, at the other extreme, the powerful force that allows psyochopaths to marginalise their crimes and live a normal life. It is the force that allows those who commit adultery under the noses of their spouses to act as if nothing is happening and even to turn the situation around and make out they are the victim not the cheated-on spouse. It is the power force that allows dictators like Col Gadaffi to welcome home convicted bombers as if they are national heroes while denying a shred of remorse for the victims of the crime. It is that powerful.

So here is a classic example of denial. In the wake of the credit crunch, the Government has urged banks to lend a great deal more to small businesses. There have been various intiatives to facilitate this, not least vast amounts of cheap loan support, Quantitative Easing (QE), underwriting of Toxic Debt, the Enterprise Loan Guarantee Scheme (ELG) and much more. Banks, meanwhile have consistently missed their lending targets, even those who are actually partially or mostly owned by us, the taxpayer. In fact, in the last quarter banks actually took back more than they lent out from businesses to the tune of over £4.5bn.

In the face of such actions, the banks claim that they are fearful of more bad debts, which may be natural. But when the ELG Scheme offers up to 75% of a loan to be guaranteed by the Government, why is so little credit being offered to small businesses?

In a classic case of denial (on many counts), Barbara Knight of the British Bankers' Association (BBA), which is a name to be played with if ever there was one, asserts with a straight face that 'demand for credit has dropped off'. It makes you wonder which planet she arrived from. She further supports the lack of regulation on bank compensation - in all aspects from salaries to guarantees, to golden hanshakes, to wholesale headhunting and extravagent bonuses linked to whatever they wish - for fear that the City will become uncompetitive and we will see top talent drain away to other centres with a more liberal view on earnings of such creatures.

This is denial at its worst or best, depending on which way you look at it. From a taxpayers point of view, the fact we have shelled out around £1.3trillion in capital, loans, guarantees and whatnot seems to have gone unnoticed. Further, our incredibly generous sums of money at rock bottom prices that we have lent to banks seems to be remaining in their strongholds when the precise purpose of our lavish philanthropy was to stimulate the economy by having all that glittering dosh used as credit to mainly small businesses.

Instead, we have banks who are not just holding onto our cheap cash but they are actually taking back more money from business - even consumers actually repaid some of the vast £1.5 trillion of collective debt for the first time since records began. In reality, banks have acted in exactly the opposite way we asked them to (and note I say asked them as there were no strings attached to the money we gave them, even for those banks we have a stake in - forward planning is not a strength of this Government, especially in a crisis).

Further, the banks have waved two fingers at us all and used most of the cash we gave them to actually invest more in the markets that failed us so badly last time around. And the bonus schemes are being tinkered with, the salaries are rising, the land-grab for 'talent' is occurring right in front of our faces at a pace that would make Usain Bolt cry.

In less than two weeks time we will have the anniversary of the fateful crash of Lehman Bros - which I read recently is what tipped us all into recession. Denial is a powerful beast because this did not trigger the recession just as sub-prime did not trigger the credit crunch - these were inevitable consequences of a fundamentally flawed financial system and they were merely manifestations of the underlying issues that everyone was systematically ignoring or denying.

Even intelligent economists as well as ministers were deluding themselves, and us, that we had never been better off and propects were at their best. The fuse was already burning, sub prime and Lehmans were merely the first of the firecracker-style explosions. They were not triggers in my analogies, they were the crisis exploding in our faces. The credit crunch was the next part of the explosion. Recession, in my mind, was going to happen anyway - it had to as the economies of the US and Britain were built on mortgage equity releases more than actual household incomes. For the first time in history, it was the perfect financial storm brewing and it was all there for everyone to see.

People like Barbara Knight, to my mind, are very dangerous. In her world, and those of the people she represents, it is perfectly acceptable to have a financial crash instigated by her members which helps drive unemployment toward 3m and to exacerbate the problem by not doing the core operation of any banking system which is lending to help stop it. In her world, it is far better to deny that her members had anything to do with it, make sure they are better looked after than before and deny that anyone is asking for credit.

In this case, along with the regulators and many of her members, many of whom advise our Government on a startegy that is patently failing, Barbara Knight needs to be replaced by people who have a sense of reality. The problems in our finacial system will not be recognised, let alone rectified, if people like Knight stay in her job. I am sure she is a very nice lady but in the grim reality of civvy street where the world looks very different, she would have lost her job for dramatic failure not as a consequence of dwindling profits - the same for the regulators and most of those whizz kid traders.

Many have written that there now exists two worlds - the real world in which we all actually live and try and survive in and that seen by a thin minority of financial people who are incredibly wealthy and believe that they are owed their extravagant living because of the essential work they do for the economy. They failed spectacularly - you cannot put it in any other terms as the scale of failure was so high that rich countries may be borrowing up to and beyond their GDP in order to pay for it in the near future, some countries went to the brink of bankruptcy. It means that all those profits that these people thought they were making were in fact made up - all of them and more were lost because they were never real.

All links to the fundamentals were lost and they violated the basic principles of a calculator let alone a financial system - the profits were only in their minds. Out there, in the real world, anyone with a modicum of intelligence could see that it was fundamentally and catastrophically flawed.

And now the remedy is failing by the actions of the same people who brought us down. We gave them more money than they lost and they cannot do the simple things we ask of them to help rescue the economy because they are too busy feathering their own nests again and justifying why the pursuit of incredibly high risk investments to produce imaginary profits to fuel their incredible bonuses is in fact the right thing to do for the good of us all - because if we didn't have such heroes, such Masters of the Univere (as Vince Cable calls them), we would be a sorry lot.

Well hello! The coffee's on and is smelling strongly, Ms. Knight. Some of the best talent in Britain, a whole generation of youth is languishing on the dole queue and we gave you every penny which saved your sorry skins. Now it's time to get a dose of reality - the world is very different to the one you see. The problem is, only when the Government drives those investment banker advisers out of their ears, stops pandering to the whims of incredibly wealthy people and stops appointing failed businessmen to key positons in the Lords and influential bodies, will we see some change.

But denial is a very powerful beast.