Memo to banks – it’s not all about the money

August 7, 2009

peter-dixon- Peter Dixon is a guest columnist, the views expressed are his own. He is global financial economist at Commerzbank -

In the course of this week, we have received a mixed bag of first half results from all the big UK banks. On balance, earnings were slightly ahead of expectations, even for those banks which still registered big losses.

The broad conclusion which we can draw is that retail operations have endured a tough six months, thanks to rising default rates and higher loss provisions, but those banks with significant trading operations have been able to offset these problems due to a major improvement in global market conditions. Moreover, the results have reawakened public interest in the bonus culture and have raised many questions about where we go from  here.

The question of bonuses has become highly emotive in recent months. The standard argument used by opponents is that it is immoral for banks which have been propped up by public money to reward those who gamble in the casino of international finance – particularly since it is precisely such behaviour which brought the banks to their knees in the first place. Banks counter this criticism by arguing that good fee earners generate huge income for their company and should be rewarded commensurately.

But even if we accept this view, there is an issue of how big a share of earnings should be paid to the fee earner. The compensation model used in the finance sector today is based upon that of the old partnership system, when individuals’ wealth was at stake and they were paid for taking genuine risks. Most fee earners today are taking risks with shareholders money. From an economic perspective, shareholders should receive the bulk of the revenue in the form of dividends whilst bankers compensation should be treated as little other than a brokerage fee (unsurprisingly, that is not a popular view on the trading floor).

Whilst the structure of banking sector compensation is a major talking point, it pales into insignificance against the question of how UK banks will pay back the money pumped in by the government. Unfortunately, those banks which have accepted public funds are those which are primarily focused on the domestic market, and which are in no position to generate big profits from their trading operations. Following the principle that there is nothing to be gained by throwing good money after bad, this suggests that banks will be circumspect in their lending activities for the foreseeable future – precisely not what the government desires. Moreover, profitability will be restored more quickly if banks maintain high interest rate margins, which is another activity not in the best economic interests of the public.

Clearly, the restoration of banking profitability will be a long haul. But what is an appropriate rate of return for banks? After all, a bank is merely an intermediary which brings together those with excess savings with those who wish to borrow. In theory, a bank should not be more profitable than the activities which it is financing, since otherwise there is no incentive to engage in enterprise, and we should instead invest in banks. Of course, this is a logical inconsistency for if there were no lending activities taking place, banks would not be able to generate profit.

But the point is made that on economic grounds, there ought to be a natural limit to bank profitability and there are a few economic reasons for paying bankers massive bonuses. A reduction in banking sector rewards ought to allow more talent to flow into other sectors engaged in more socially useful activities, thus generating higher social welfare. Contrary to what many people believe about economics, sometimes it really isn’t all about money.

Comments

“Most fee earners today are taking risks with shareholders money.” – That is the root of the problem.
Any small business owner can go to the wall, while a large ‘important’ bank can go to the government and the management ‘gurus’ running the show still get the golden handshake.
The only reason this continues is that the public are duped by, or very much in fear of, the financial system.
Without sounding alarmist (or popularist), only when the people (of all classes and risk-takers) opt out of the financial system will the financial system opt out of its current malaise.

 
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