Banks' Earnings and Big Bonuses

The issue of bank bonuses is complicated and emotive. Set out below are my thoughts on a simple yet different approach.

The UK needs a healthy banking system in which bankers are appropriately incentivized and rewarded.

However, banks have a public role. The degree to which and the terms on which they provide finance has a direct influence on the health of UK businesses, our economy, and people's well-being.

Finance is the life blood of businesses. SMEs predominantly rely on capital from their owners and bank borrowings. Larger companies rely mainly on shareholders' funds, bank lending and finance from the capital markets. It is the ability for large UK companies to source keenly priced finance from the capital markets that gives them the wherewithal to operate on the world stage.

Generally speaking, retail banking operations provide the much needed debt facilities to individuals, and SMEs. And the investment banks provide large companies with access to cost efficient capital markets.

Both retail and investment banks are needed and they have a significant role to play in underpinning the economic recovery and the well-being of the UK economy. Both types of banks need to prosper, lend, provide capital to large and small businesses and should be able to reward their staff appropriately.

However, it should be remembered that banks borrow cheap money from the Bank of England and benefit from an implicit Government guarantee (being too big to fail). So where banks derive significant profits by exploiting the needs of borrowers by lending at disproportionately high rates of interest or where big profits come from risky and speculative activities then these activities are counterproductive.

Lest we lose sight of the overall picture, UK financial services, according to research undertaken by PwC, contributed £61.4bn to the Treasury's coffers in the financial year 2008 / 09, (just over 12% of all Government taxes) and of this it is estimated that £26.4bn was employment taxes. The City is not just made up of bankers. There are other high earners who rely on a prosperous banking community.

So how might the bonus conundrum be resolved without driving business offshore?

Working on the KIS, keep it simple, principle I have two proposals:

1. Excessive risk taking was at the heart of the banking crash. Higher risk for many years meant higher rewards and big bonuses. Then when the big risks went sour the problems started.

Proposal #1: Losses (including apportioned overheads) incurred on significant speculative activities would cease to be tax deductible.
This would encourage bank bosses to focus on downside risks and their risk appetite.
=> Significant speculative activities would need to be defined, but could include: the use of uncovered derivatives; short selling; lending with an excessively high loan to value ratio or a very low debt service cover ratio; and might include investing in high risk securitized products. However, market making activities should be excluded.

2. Big bonuses and risky activities went hand in hand. For many years a bank's access to cheap money enabled those whose gambles paid off to make fortunes. Banks are in a privileged position.

Proposal #2: For those companies which borrow directly from the Bank of England, the Companies Act should be amended. A second tier of dividend cover rules, should be introduced, whereby the big bonuses paid to their employees are classified as "personal dividends". A big bonus could be greater than say £20,000.

As with shareholders' dividends, these "personal dividends" could only be paid out of retained / distributable earnings and would relate to:

a. The bank as a whole and the subsidiary in which the bonus receiving employee worked.
=> (To keep a level playing field - for overseas banks operating in the UK, it would be the UK subsidiary that would fall under these rules).
=> and be for a specified period (say a 5 year rolling period)

b. The cover figure by which "personal dividends" would need to be covered by retained earnings would be set down by the financial regulator.
So, if one or more banks are seen to be acting in an anti-competitive manner, (e.g. overcharging their clients), or in a high risk manner then the authorities could have the power to revise the "personal dividend" cover ratio upwards for offenders.

c. "Personal dividends" just like shareholders' dividends would be paid out of the bank's after tax profits, but would come with a 0% tax credit. Yes, there would be National Insurance benefits for those receiving the bonus, but this would be more than offset by these big bonuses being a dividend and therefore not being tax deductible for the bank.

d. For six figure bonuses a percentage could be required to be taken in new shares of the bank. How long these shares would have to be kept would be determined by the bank's directors but this would require shareholder approval.

e. Transparency: Bonuses that are, say, greater than £20,000 would be disclosed and, like shareholders' dividends and directors' pay, they would be subject to shareholder approval.
=> Shareholders would be able to take a view on whether the balance between shareholders' dividends and "personal dividends" was appropriate.

f. To counter balance the ability of bankers to pay big bonuses out of illusory profits, there could be clawback provisions. "Personal dividends" could be subject to a full or partial clawback if the bank (or the subsidiary) breaches the "personal dividend" cover ratio within a specified number of years.

What might an appropriate minimum "personal dividend" cover ratio be? The figure relates to the bank's retained earnings and it broadly represents how much would be ploughed back into the business and how much would be paid out to those who make the profits. A "personal dividend" cover ratio of between 3 and 7 would lead to a bonus pool of between 14.3% and 33.3% of the money available for reinvesting in the bank.

Unlike a Tobin tax which does not address the underlying problems, the above suggestions would provide a framework whereby UK based bankers could be rewarded at a level appropriate to their success. Big bonuses could and would still be paid, but they would be with the support of the shareholders. And in setting the overall sum available for bonuses the financial authorities no doubt would be mindful of the benefits that a prosperous banking sector gives to the British economy.



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