Bank Trader Bonuses – should they be paid if the bank makes a loss?

Bank Trader Bonuses – should they be paid if the bank makes a loss?

I have been cornered at a number of dinner parties and other discussions in recent years to be grilled on the controversial and sometimes hostile subject about whether or not the traders, and indeed deal originators, within investment banks should be paid substantial bonuses if the bank itself makes a loss. Having signed-off on such bonuses in the past I know what it feels like when you see the size of the number, sometimes staggeringly large, staring at you on the page, (but then most would gulp at our daily turnover of around US$ 3 billion) so I have tried to rationalise the argument ‘for’ or ‘against’.

In the early days of such traders, (latter part of the 1970’s and first half of the 1980’s), it was commonplace that the bank provided the desk, the capital, the prestige name of the bank, and the support operations. Traders were only paid a nominal salary to live on but would be entitled to a flat-rate bonus calculated at up to 10% of the net profits they generated for the bank. These traders were never considered part of the ‘family’ within the bank, and were remote to the culture of the bank. They were commonly referred to as ‘intrapreneurs’. This was a reasonable strategy for the bank in that they did not have the exposure of substantial salaries to people who might not perform, and the modest salary incentivised the trader to make profits. Many types of companies today adopt this attitude, and it is certainly a better business model than the soccer players I refer to below.

A significantly exaggerated example of this, and well recorded in books such as ‘Liars Poker’ by Michael Lewis, was the trading environment of the then Solomon Brothers investment house which was a ruthless production line of traders who performed to required levels of profit, or were discarded and replaced at will.

An analogy could be a comparison with soccer players who have a limited period of productivity (typically 5 – 10 years) who are paid substantial remuneration whilst valuable, but are readily discarded once their star no longer shines. Headhunters in banking play the role of the soccer player’s personal manager in both initiating transfer of traders between banks, and negotiating any settlement required to be paid to the former bank to overcome notice periods, garden leave, poaching costs, etc. Traders do not have a career as such, they have a window of opportunity to make large amounts of money before they burn out, and their general philosophy revolves around this short-term opportunism.

To add to this unitary approach it should also be stressed that there are a number of separate product areas within an investment bank, and they have separate profit centres which become the accumulated profit or loss of the bank. In general there is no interlinking of these profit centres within the bank, nor interdependency on performance. Therefore I suggest that a trader who performs well is entitled to their bonus, irrespective of its size, as it only reflects the quality of the person as a realised income contributor. I must emphasise that the profit against which the bonus is calculated should be fully realised without any future exposure. Accrued profits, e.g. on transactions that still have future potential exposure, is a contentious subject, and needs to be agreed on a transaction-by-transaction basis. If a trader makes losses not only do they not receive a bonus, but usually they lose their trading seat – and possibly their future as a trader.

At a simple level would you expect a car salesperson to forego the commissions due on their sales if the car manufacturer makes a loss? Scale this up to a salesperson who sells a $40 million commercial airliner on which I am led to understand they can earn a commission up to 7% of sales value. And both of these sales people will probably have a far longer career than a trader.

At the end of the day the primary difference between other corporates and investment banks is the scale of the commissions/bonuses. To put this into context an investment bank can easily turnover as much in a few days as a major corporate turns over in a year.

Please note that this blog relates to business income generators, not the fat-cats who sit at the top and mostly still receive bonuses when the bank makes a loss – this is a completely different story.


Investment Banks – do the media yet understand them?

Investment Banks – do the media yet understand them?

I read a somewhat cynical comment in the FT on 15th July that I cannot get out of my mind. It related to an Analysis article about Goldman Sachs and boldly states ‘they’re [Goldman Sachs] playing by the rules but they are very good at navigating as close to the regulatory wind as possible’. What do the journalists expect them to do?

Investment bankers have taken some serious knocks over the past few years. I am not saying that some of them did not deserve the widespread denunciation of their activities, but the media (reporters, journalists, their so-called experts, etc.) understood so little about investment banks that they delivered a grave injustice to all other investment bankers, by generally creating a feeding frenzy amongst the public, and a convenient escape route for politicians who had much to do with the economic demise of the UK economy. Can anyone remember a Labour government since WWII that did not leave us economically paralysed, and even in the hands of the IMF? I have been a banker long enough to remember serious bailouts of Governments – even when the general public had little or no knowledge of the economic dangers. And let’s not forget the then economic woes of the Eurozone struggling with the outcomes of political over economic sensibilities in an altruistic attempt to create a federal Europe.

One glowing example of this lack of understanding of investment banks was the reporting by Robert Peston during 2007/08, and whom we labelled ‘the Pest’ or with his partner-in-crime, Vince Cable MP, the ‘Ministry of Mis-information’. There is a saying in the English language about someone with a little knowledge, and Peston was certainly going to use his little knowledge to make his name no matter how incompetent the reporting. Indeed it became apparent after a while that the banks had found a way to feed him with what they wanted him to report, even if yet again the information was not credible – he would not know, and thus challenge his reporting credibility amongst those who do understand. The damage caused throughout the population by such uninformed reporting, both socially and economically, must be colossal. Knowing exactly what had happened within the investment banks, I found his reporting frustratingly depressing.

So what are investment banks and why do we need them? During the mid-1980’s they evolved out of the former Merchant Banks which provided the liquidity for global trade, and structured debt solutions for major projects throughout the world. However, capital movement around the world was somewhat limited thus frustrating economic growth through lack of available capital. Deregulation of the capital markets of the world in the mid-1980’s enabled rich sources of new capital, but it required very special and creative structured finance skills to satisfy the investment terms of these new investors with the financing needs of projects. For example we saw the global expansion of international securities, the design of structured securities products aimed at providing finance more aligned with the specific needs of a project, and the attraction of major global institutions and private investors to purchase such securities thus providing liquidity to the system that banks alone could not provide. It was instilled into me in those early days that our role was to match financing need with capital availability providing the expertise to both optimally structure the risk in the funding requirement, and to demonstrate our integrity to investors that would lead to the trust to provide the funding. Investment banks do not lend money (their income essentially comes from origination fees and trading profits), but they make it possible for investors to provide capital to funding requirements, (thus the Capital Markets) and facilitate the liquidity of capital investment to optimise the flows of investment capital.

Managing any self-respecting professional investment banker, whether deal origination/execution, support operations, or systems is a very special skill. These are not conventional people. They live on the edge of the box or totally outside of the box, and not willing to comply with boring rules of convention. This is the essential characteristic of their ability to be creative and productive in such an energetic environment where things happen in the moment with no dwell time to consider. They must have confidence and conviction supported with knowledge. If they have been through higher education, and succumbed to conventional wisdom during the process, they are unlikely to survive no matter how bright they are. The management of such people needs to provide a suitable working environment which contains the necessary constraints regarding risk and excess without trying to apply any conventional management techniques that will stifle performance. Like soccer players they are contained within the boundaries of the playing pitch, where they are encouraged to combine their individual talents to win the game within the constraints of the rules of the game.

For some years this new market worked very well especially in the arena of infrastructure and global business development which was a necessary part of global economic development. New products emerged such as asset-backed securitisation making it possible to provide ever increasing funds to satisfy mortgage demand, credit card finance, lease finance, etc. However, just as the Manhattan Project produced a new science of nuclear fission which could significantly benefit the world in the development of electronics, energy production, medical treatments, etc., in the wrong hands such innovation would have devastating results. If we can accept that history has many examples of great inventiveness being used with moral integrity to the greater good of many, and by the few intent only upon greed, avarice and power, then we can draw upon these flaws in human nature to describe the culture that emerged within investment banks over some 15 years.

For investment bankers pushing the boundaries is a way of life, to find ever more innovative ways to ensure the maximum availability of capital to service the ever growing capital demands of the world. Indeed Goldman Sachs is the most aggressive of the major investment banks, and their creativity is legend. Thus you could conclude that the missing ingredient was moral integrity. But where were the financial regulators in the early 1990’s when the few were screaming into the abyss that control of risk was being sacrificed in the name of profit – and the stakeholders in the banks poured praise onto the generators of these great profits. I find it somewhat disingenuous that financial regulators, who should have been proactive in maintaining moral integrity throughout those 15 years or so, are now reaping the rewards of large fines from the banks whilst normal households are struggling to make ends meet, partly as a result of their failure. And thus my concern at the comment in the FT.

Last year I was asked by a group of senior bankers and economists to produce a report describing the evolution of the problems within the investment banks, and suggestions of how their credibility (moral integrity) can be restored as there is no doubt that they are fundamental to maintaining global capital liquidity. Whereas this report was distributed around major banks it was considered too long for publishing. If there is enough interest in knowing what really happened then I will find a way to make it available electronically. As this is likely to cost me money there may be a nominal charge which I guess will be processed by the likes of PayPal (who will also charge me). However, the feedback from the intended audience, and a business school who studied a copy, suggest that this paper is required reading for those interested about the failure of investment banks from the inside.