Bank bonus season again

January 12, 2011

–Laurence Copeland is a professor of finance at Cardiff University Business School . The opinions expressed are his own–

Bank bonuses are in the news again, and once more we see the spectacle of the Prime Minister indirectly pleading with the bankers not to be too greedy. Note the contradiction in the government’s position: even though we own two of the largest and most culpable banks, we dare not impose explicit limits on their pay lest they decamp to places where the political climate is more hospitable and the regulators more tolerant. But although enforced limits are out of the question, it’s quite OK to pressure them by every other means  – which, of course, raises the question: why should bankers be more willing to stay in Britain when their pay packet is limited by “voluntary” restraint rather than government intervention?

Of course, as I have argued here before, the likelihood of them moving any substantial part of their business overseas is grossly exaggerated and in any case is a far less worrying prospect than is often suggested. We should not be intimidated by dark hints about investment banking operations moving lock, stock and barrel to Frankfurt, Paris, Singapore or Shanghai. First, the world’s major investment banks typically employ hundreds, sometimes thousands of people in every major financial centre, so at worst we are talking about a marginal reallocation of staff from London towards the other four or five cities which are serious competitors. Is that such an awful prospect?

Recall that no less a figure than Adair Turner called for a reduction in Britain’s financial sector, on the grounds that it is far too large relative to our economy. Moreover, every time you hear mention of the contribution of investment banks to the UK economy – the taxes they pay and the number of people they employ – bear in mind that in the last two years they have cost us far, far more than they will ever provide in tax revenue, and that will still be true even if we are able to avoid another systemic banking crisis for the rest of the century.

Some readers may think I am exaggerating – far from it. There have been many estimates of the cost of bailing out the banks, most of which only include the more-or-less direct costs of recapitalising them, buying up their toxic assets, providing open-ended guarantees, and so on. But there are other costs which, though indirect, are no less real.

I was reminded of one major cost the other day, while checking my credit card statements. Consider the following facts: if I were tempted to borrow on my credit card this month, I would be charged interest of 23% on purchases or 28% on cash, compared to only 20% or 22% in mid-2006. Yet back then, before the crisis, the banks themselves had to pay around 4.5% to borrow in the money markets, whereas today they can raise funds for 0.5% or even less. In other words, banks have been allowed to exploit their monopoly power – greatly increased after the crisis mergers – to push their gross margins up by about 7 percentage points to what must be all-time record levels, simply so as to allow them to rebuild their reserves. By my back-of-the-envelope calculations, the cost to credit card borrowers of this dispensation must be something approaching £5bn per year.

Then bear in mind that credit cards are simply one form of unsecured lending, which is in any case dwarfed in volume by mortgages, where admittedly margins probably have not increased quite as dramatically. Nonetheless, in total the cost to the consumers and businesses (especially small firms) of refinancing the banks must be running at a level of £50-100bn per year, simply in additional interest cost alone – all of this on top of the billions (or trillions) officially acknowledged.

I expect, if you asked bankers to justify the increase in borrowing costs, they would fall back on the excuse that the risk of lending to consumers and small businesses is higher in the post-crisis world, and this needs to be reflected in interest rates. But in reality, the rise in bad debts has so far been moderate – certainly far less than is warranted by the increase in interest rates -  leaving the banks with a multi-billion surplus available to cream off in bonuses.

Incidentally, this enormous margin between borrowing and lending rates explains the turnaround in bank profitability on which the bank bosses are basing their claims to massive bonuses. In reality, of course, they have been operating in an environment so favourable that it would have taken very special expertise to lose money from the business of lending.

Ultimately, we taxpayers have put bank chiefs in charge of a money machine and then allowed them to reward themselves with bonuses taken directly out of the funds we have provided to save them from bankruptcy.

If you are wondering whether it is worth spending so much money to keep our inflated banking sector at the standard to which it has become accustomed, rather than allow it to drift away from London, ask yourself the following question: do you think the Irish regret not having been more generous in past years, so as to attract more banks to Dublin and have a larger financial sector? What about the Icelanders?

The answer is self-evident. The only basis on which it makes sense to wish to attract financial institutions is one which strictly limits taxpayers’ future liabilities, and that is impossible unless the banks are broken up into units which are of manageable size and which engage either in bread-and-butter banking or in investment banking – but never in both. Banks which are Too Big To Fail cannot be properly regulated – they can always call the regulator’s bluff, which is what they have implicitly or explicitly done on a number of occasions during the crisis in the UK and U.S. Moreover, their managements seem to be immune from the pressures of corporate governance – judging by the PM’s pleas, it seems that even an 80% shareholder is unable to control them directly.

So why not cut them down to size, as the Governor of the Bank of England has advocated? This proposal sends shivers down the spine of bank managements, mainly because the size of their organisations is used to justify their superstar pay levels (which, to be fair, is the criterion used in the non-bank corporate sector too).

All the proposals to increase bank capital ratios in one form or another are simply a waste of time as long as they continue to loom over our economy like jerry-built skyscrapers in an earthquake zone.

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