BREXIT – 120 days on

univestBREXIT – 120 days on

It has been some 120 days post-Brexit, so where do we find ourselves when measured against the doom and gloom of the Remain campaign. We have a new PM, Teresa May who appears clear on what Brexit means, discovery that global organisations such as the IMF knowingly misled the British people, even the principal architect of the Eurozone claiming that it is now a ‘House of Cards’, and churlish self-interests trying to scupper Brexit with no regard for the democracy that they claim to cherish.

It is really sad for me to see that, amongst a significant number of people spanning all classes, there are elements of the British character that do no justice to our heritage of the UK great explorers and inventors that shaped this World of ours. I watched in disdain the current and excellent TV costume drama ‘Victoria’ recounting the trials and tribulations of Queen Victoria who reigned during the Industrial Revolution as scaremongers, vested interests, self-righteous, and ‘not-invented-here’ jealousy tried to stop the introduction of the steam locomotive. Thankfully, Prince Albert saved the day. Even today I hear eco-warriors stating that the Industrial Revolution was the beginning of the end of mankind, but where would these people, or even the World be without trains. India thrives on the railways, whereas Brazil, without much needed rail infrastructure, has serious transport and thus economic problems – look at the speed of rail infrastructure development in China.

Then I am reminded of the Neville Chamberlain pacifist era before the second world war when Winston Churchill, with his worldly experience, could see the ambitions of Hitler but, in spite of his fine rhetoric, could not persuade enough people that we needed to prepare ourselves for the inevitable. Indeed, according to Boris Johnson in his captivating book ‘The Churchill Factor: How One Man Made History’, had the war been delayed by some two weeks Churchill would already have been hounded out of office!

We are told that we must learn from the past, but do we? During the referendum debate we had the David Cameron, George Osborne and Nick Clegg elite, all from privileged schooling, all career politicians with ideologies not supported by any worldly experience, and easily persuaded by more scurrilous and self-serving influences, preaching doom and gloom if we did not stay part of the EU project. They rallied any vested interest they could find including the IMF, the OECD, and President Obama – an embarrassing chapter for all of them. But history will not record any of them as good, let alone great politicians. David Cameron was clear in his Bloomberg address that if the UK did not get significant Treaty changes for the UK then he would vote out, yet like Chamberlain he returned from Berlin with a worthless piece of paper. He will be remembered as someone who readily changed his mind on substantial matters – not good leadership. But he has realised the errors of his ways and will fade quietly away. Osborne still finds occasion to try to placate his ego, and Clegg is now trying to rally support for a blatant counter-offensive to Brexit on the basis that people do not know what Brexit means. Let me assure him that the core ‘middle-England blue-blooded Brits’ that always save the day in times of need know precisely what it means – a clean exit from the EU in all respects, returning to a Sovereign State, just like most other countries in the World. As has been shown since Brexit, the UK is a major player in this World, and when we sneeze the World coughs. The EU needs the UK far more than the UK needs the EU.

So what has happened since Brexit. I would suggest that the most significant outcome is the clear demonstration of how the elite politics of today is so out of touch with reality, as is being played out in the USA today. What did go on behind closed doors that caused Cameron to accept that the UK should be sacrificed for ‘the greater good of Europe’? How many more times does the UK have to make significant sacrifices for Europe before Europe (mainly Germany) learns from it?

Let me take some words from a Telegraph article summarising a post-Brexit report from the IMF’s Independent Evaluation Office (IEO). This report goes above the head of the managing director, Christine Lagarde. It answers solely to the board of executive directors, and those from Asia and Latin America are clearly incensed at the way EU insiders used the Fund to rescue their own rich currency union and banking system. It states:

‘The International Monetary Fund’s top staff misled their own board, made a series of calamitous misjudgments in Greece, became euphoric cheerleaders for the euro project, ignored warning signs of impending crisis, and collectively failed to grasp an elemental concept of currency theory.

This is the lacerating verdict of the IMF’s top watchdog on the Fund’s tangled political role in the eurozone debt crisis, the most damaging episode in the history of the Bretton Woods institutions.

It describes a “culture of complacency”, prone to “superficial and mechanistic” analysis, and traces a shocking break-down in the governance of the IMF, leaving it unclear who is ultimately in charge of this extremely powerful organisation.’

The IEO Report states that since 2011 some 80% of all IMF lending was secretly used to support the Euro – not within the mandate of the IMF, and why Asia and Latin America are so incensed. Add to this the recent publication by Prof Otmar Issing, the first chief economist of the ECB and principal architect of the Euro, in which he states that the rules laid down for the Euro have been so debased by politicians that the currency, and thus the Eurozone, is but a ‘House of Cards’ waiting to collapse. Thus the desperate need to keep the fastest growing economy in the Western World, the UK, inside the EU, not least because of the unique capital raising power of the City of London – thus the lies to the British public by both the IMF and the OECD during the referendum campaign.

By far the biggest everyday loss to the EU is the City of London. With the City inside the EU it could claim to be the most significant financial power on the international stage. Without it the Eurozone does not even have the capacity to clear its own currency. The EU desperately needs the capital raising powers of the City. All of this posturing regarding passporting can be put into perspective by ING announcing last week that it is moving some 40 of its prominent traders from two locations within the EU to London. The worst case scenario is we will return to the days before passporting whereby, under the rules that international banks can only engage in business in countries in which they have a physical presence, banks will re-establish little more than a rep office through which transactions will be directed to London. As for moving banking to Frankfurt and/or Paris it should be noted that during my more than 35 years in the City this has been muted on a number of occasions. Paris is a non-starter for a number of technical reasons, and Frankfurt for even more including that no self-respecting high flier banker would consider living there.

As for corporate business I think that the recent announcement by Apple, the largest company in the World, that it is moving and consolidation its European headquarters in London, with all of the tax implications included, states the blindingly obvious – London is the gateway to Europe.

In a recent French Presidential Campaign speech by Nicolas Sarkozy he clearly stated that his first day in office (if elected) would be spent in Berlin (note: not Brussels) putting a new EU Treaty together that would address the concerns of the UK to encourage them to stay within the EU. He knows that there will be revolution in France if the farmers got even a whisper that tariff barriers were to be imposed on the UK.

In Germany we also have elections on the horizon. I am certain that the elite of Germany will resign themselves to the inevitable Brexit and thus quietly encourage election results that will ensure that no harm comes to the valuable existing trading relations with the UK.

The principle voices of Angela Merkel in Brussels, Donald Tusk, Martin Schulz, and Jean-Claude Junker, are synonymous with the problems faced by the EU. On the one hand they are stating that the EU will survive Brexit. On the other that are issuing instructions to member states to clamp down on rising nationalism.

The good news is that GBP has depreciated from its over-valued level by some 17% causing the UK Stock Market to regain some of its lost value over recent years, and provide the stimulus for the return for a much increased manufacturing base – jobs, prosperity, less dependency on imports. It should be remembered that Germany pushed through the Eurozone project to devalue the over-inflated Deutshemark by some 30% – great for Germany, but a disaster for most other members.

This devaluation will mean price increases to the UK consumer of imported goods and thus stimulate much needed, but controlled inflation reducing the need for QE and restoring interest rates to more normal economic levels. Some of this increase could be artificial as EU Governments put pressure on their major suppliers to increase prices to the UK as per the much publicised Unilever to Tesco increases which resulted in an embarrassing climb-down by Unilever. The real price increases will put upward pressure on wage demands – good for the workers who generate the wealth but contained to 2% pa or less wage growth over recent years, but not so good for fat executives who have enriched themselves with wage growth of around 10% pa during the same period. Also we can be competitive manufacturers and return to the days of ‘Buy British’. We can even return to eating our own delicious apples, currently outlawed by the EU to force import from the likes of France. The UK Government could easily buffer the increased price of fuel and energy (increases not EU related) by reducing, or indeed eliminating all of the absurd anti-competitive eco taxes on UK energy prices.

Trading with the World, including Europe will certainly not get worse, but is likely to improve. The intransigence of the EU Commission regarding trade with the EU is legion – ask the Americans. Our global relationships will prosper far more after the dust of Brexit has settled.

The issues we face today are the posturing, petulance, grandstanding, etc by both a dying EU and those die-hard remainers in the UK who have jettisoned democracy in favour of their own self-interests. This causes turbulence in the markets, no doubt exacerbated by the more influential remainers. The professional financial markets love such turbulence as they use it to generate good profits. The losers are the general public in whose lives the media relish creating uncertainty, and which impacts their cost of living resulting in understandable protest. How many media outlets have directly associated recent fuel price increases with Brexit? Oil prices are recovering from two years of global turmoil, and should settle around US$60 per barrel. The UK has a much needed currency devaluation regardless of Brexit. De facto prices will increase from their extraordinary lows over recent months regardless of Brexit. I can remember when oil prices were US$16 per barrel, and more recently US$120 per barrel – but neither to do with the EU or Brexit.

Brexit has not yielded doom and gloom, not even a technical recession. The UK is now projected as the fastest growing Western economy. Just as with the resistance to the steam locomotive in Victorian times it is time to ignore the doomsayers and grasp the opportunities that now present themselves so that, as with the proliferation of railways, the UK will again rise be a major and great player in this World in its own name.

 

Investment Banking – The Way Forward

univestInvestment Banking – The Way Forward

Having previously looked at the history of investment banking, and where they are today, what is needed in the future to ensure the credibility of these important banks.

Even today, post the 2007/08 meltdown, we find the mavericks still essentially in control of many of the investment banks, epitomised by the most recent scandal in the UK whereby corporate bankers, probably from an orchestrated script that even they did not understand, were encouraged to sell complex SWAP instruments to small corporates with devastating effect. Bonuses taken, but leaving the banks to face humiliating fines and further damage to reputation.

If it is accepted that we have defined a major, if not predominant, flaw in investment banking culture then what practices could be instituted to change this culture to a more acceptable form of banking without losing the creative skills for formulation of new and applicable products, and the liquidity environment to make such products attractive to the widest range of investors.

The Role of Regulators

The typical cry from outraged politicians across the world (who for all intent know little or nothing about these markets) is for more regulation. This is nonsense as no amount of regulation will impact a short-term culture environment where traders will take whatever risks they need to make their bonus as they will be long gone to their retreat in Barbados before the devastating  (both reputation and financial) impact of their actions are felt by the banks. The only changes to regulation that will extract any effect would be the prosecution of reckless traders who profit from the damage they do albeit I see a legal minefield differentiating between rogue trader, and irresponsible trading with plausible deniable consent of management. The legal maxim actus non facit reum, nisi mens sit rea comes to mind. Furthermore the UK Financial Services Act would need to be amended to bring habeas corpus into effect for individual prosecution so that banks could limit their legal liability to the trader and thus impose some responsibility discipline into their actions without removal of the rights of the individual in Common Law. The Serious Fraud Office, who would have to seriously increase their skills, would need to be the prosecutor for UK based traders. Importantly any such change of this type of prosecution needs parity in each of the major financial centres to have any real deterrent value. Rendition of individuals to the USA when London is the heart of the financial World is not a reasonable solution.

Furthermore my experience of regulators is that they have little or no knowledge of the complexities of securities products, or the markets. Forensics and post-mortem after the event is a far cry from being able to evaluate the impact of new financing structures, e.g. super-senior debt, and realise the impact of such artificial concepts on the market, and thus prevent its introduction. It is also worthy of note that the independent rating agencies and monoline insurers also need to take responsibility for what they are prepared to acknowledge as worthy credit, and in the case of monoline insurers, their capacity to manage major defaults.

Regulators such as the FCA in London do not have remuneration structures at a level to attract the people skilled in such instruments. Why regulators appoint youngsters when there is a vast body of 50+ knowledge and invaluable experience who may desire a more relaxing environment than the daily frenzy within the banking environment to see out their days. It was the smart youngsters who were encouraged by the mavericks to engage in casino transactions, without knowledge of impact, thus bringing the system to its knees. If regulators are to regulate the markets against transaction types that will create havoc then they need a ‘poacher turned gamekeeper’ approach to recruitment – and reward these people properly. If this credibility existed within regulators then every new instrument proposed by investment banks should be approved for full or specific limited usage. Likewise, as a general rule, unregulated OTC markets should be seriously curtailed, if not banned, or fully regulated. Leaving a door even slightly ajar invites clever investment bankers to find a way through it.

There is no point or value in having regulators in different major financial centres who cannot exactly agree on how investment banks and products should be regulated. I believe that the decision by the SEC unilaterally allowing the US investment banks to increase their capital gearing to 40:1 was a major contributor to the financial problems through 2007/08. Not only did this encourage casino gambling by investment banks in the USA but also provided a competitive edge to US investment banks that had to be mirrored throughout the whole investment banking community to maintain a level playing field. Securities and associated derivatives are the essence of a global capital markets and, just as with Central Banks, requires one central governing body regulating capital adequacy and risk. Regulators throughout the World have to be in harmony on the essential capital and risk management of investment banks, and the products in which they can engage. This would also prevent anticompetitive meddling such as the EU Governments attempting to impose a financial transaction levy on banks throughout Europe which would clearly be more detrimental to London than anywhere else.

It might also be worth considering nomination of major financial centres in the World where every investment bank in those centres operated under identical rule sets. Indeed this idea could be expanded to contain all investment banking activities to these major financial centres and thus all investment banking would be under the same regulatory umbrella. Much of such investment banking activities occur in the recognised major financial centres today so this would not be onerous to implement.

At the beginning of the widespread use of International securities in the 1970’s every Eurobond instrument was supported by an identifiable asset, even if just a Balance Sheet. This provided a clear understanding of the risks involved with holding the Eurobond. When more complex securities such as asset-backed securitisation came into being there was still a pool of assets that could be clearly identified. With mortgage-backed securities the asset cover was usually provided by a ‘AAA’ rated monoline insurer credit wrap (without stressing the Balance Sheet of the monoline) thus the asset was the Balance Sheet of the monoline insurer backed ultimately by the underlying property assets. Today it is very difficult with many securities products to adequately identify the underlying asset in a direct way, if indeed any such asset exists. As existing securities are partially stripped and repackaged the underlying asset becomes blurred, and there is no fundamental economic benefit that can accrue from such instruments. So is it time to retreat from synthetic casino instruments of no real economic value and thus ensure that there is a clear economic reason for the issue of any securities product, including derivatives. In recent years banks have used casino instruments such as the Snowrange issues that essentially bet on stock market activity or interest rate movements to raise cheap capital. Having studied a number of these issues I am disappointed that banks need to use such nebulous mechanisms in this way when, if structured with some thought, they can provide a needed and valuable project finance collateral instrument, especially in developing economies, and which achieves the same objective for the bank, but also provides real and identifiable economic benefit. Perhaps investment banks should use their financial skills to revert to structured project finance to win back credibility. If investors are provided with a continual flow of instruments which are no more than a casino gamble then this consumes capital that could be more usefully employed in economic growth. If regulators remove casino products from investment banking then investment bankers have to apply themselves to raising capital for economic activity. This would also force mainstream banks to use depositor funds for lending purposes rather than engaging in casino gambling.

 

The Role of Compliance

It is very rare to meet a compliance officer within an investment bank with the knowledge and expertise to be accepted as a positive contributor to the business rather than the person to be avoided as a constraint to business because of the ‘if in doubt, say no’ where doubt can be interpreted as the lack of knowledge and understanding of the business.

Compliance officers are essentially the eyes and ears of the regulators. Therefore their knowledge needs to be thorough, and their role clearly defined. In my early days at Citicorp we had compliance in the form of an internal audit team the head of which reported only to the President of the bank, and with the absolute authority, without the consent of the President, to close down any operation or entity that was considered non-compliant. Internal audit consisted of a small team of inspectors that could go to any operation anywhere in the World without notice. Within each corporate entity there would be representation proportionate to the size of the entity and who reported only to the head of internal audit. They could summon the inspectors if they felt that something was wrong, and had not been corrected to their satisfaction. Believe me that this internal audit team put more fear into every aspect of the business than any compliance team I have encountered post-big bang. Bob Diamond suggested that Barclays had some 200 compliance officers yet he was still allowed to operate as he pleased. Compliance similar to the internal audit team I experienced at Citicorp but where they are paid by the bank, but ultimately report to a senior regulator, should impose much needed discipline into investment banks, especially at a senior level. However, such compliance officers need to be well trained, and worthy of the power that they wield.

One aspect of compliance which I consider unwieldly is the amount of written documentation involved in this process, much of it in a legal jargon. Is it reasonable to expect our compliance officers to be trained lawyers, or is it more important that they understand the business, the products, and the markets? The more cumbersome the role of compliance, the less likely that it will be effective. Therefore I would suggest that the whole concept of regulation be re-visited to determine the type of regulatory structure that can be reasonably and effectively implemented.

Much of who can engage in what activities can be controlled by rule tables within competent computer systems. If new products are pre-vetted by Regulators then, again, computer systems can control what transactions are admissible, and in what size, volume, etc. This was all possible in the late 1980’s and early 1990’s with the advent of AI. Technology has moved on to a more mobile capability, but the challenges presented by allowing high value transactions to be executed using such technology do require extensive risk/reward assessment where convenience is the very last consideration. I have experienced the attempts by traders to circumvent rules built into systems. For example we had a fixed income trader who wanted to step out of their allowed range of traded instruments to engage in gilt futures. A trader authorised in this product was on leave, but somehow had allowed his login details to become known to the fixed income trader who used this information to access the gilt futures markets. Unfortunately for him the computer systems knew that the gilt trader was out of office so an alert was posted to the trading floor manager, the head of settlements, the compliance officer, and the director of operations (me). Thus this potentially very expensive transgression could be swiftly dealt with.

This level of control is relatively simple when trading is contained to a trading room but, now I understand that there are traders who can use their mobile phones to trade from anywhere, and I  am also aware of trading stations at the homes of traders. This poses enormous problems for compliance. I would propose that unless every aspect of any transaction can be properly and fully recorded, including any and all voice communication, then trading should be contained to a specific trading room. Remote trading stations pose significant risks, not least from hackers. If hackers can infiltrate the most sophisticated (and budgetless) systems in the intelligence community then this is a risk too far. Furthermore remote trading opens the door to orchestrated trading, whether market manipulation or book distortion. If one analyses this problem laterally there is no excuse for remote trading out of hours as processes to overcome the global nature of trading were introduced in the 1980’s to roll active positions to a trader in the next time zone with instructions on how to react in the event of certain market conditions. If these market conditions do not arise then the position will revert untouched to the originating trader at the opening of the next business day.

Trading practices today centre around the ‘convenience’ to the trader, and the argument won on the basis of ‘profit’. A number of very expensive and publicised trader problems have occurred as a result of such practices, and I would wager from my own experience that many more have gone unreported. It is time to change the argument to one which states that if any trading practice cannot meet robust compliance requirements then such practices should not be allowed.

A Change in Culture

Although the regulatory and compliance structures outlined above would provide a more mature and robust environment for investment banking activities, the changes required to the current risk taking attitude of traders will not occur without a radical change in the way that investment banks are managed. Soccer players are a reasonable analogy to traders because their career is short-term, as is their perspective. I think it is arguably universally accepted that Sir Alex Ferguson is the most successful and respected soccer manager in the World. We know him as a strong character who can build and mould successful soccer teams using a well-honed balance of discipline and encouragement of flair with his players. The players know that Alex is the boss, and know that his words are essentially law. He instils a belonging in his players to Manchester United Football Club, the most renowned soccer club in the World, and commands loyalty and respect from his players and supporters alike. If any player thinks themselves bigger than the club, e.g. Beckham and Ronaldo, no matter how good a player, they are sold on as they have clearly forgotten from where their fortunes derive. Players such as Scholes and Giggs have been loyal to the club for the whole of their professional football career even though they were both World-class players who would be welcome at any other soccer club in the World. Players such as Cantona, who had such a bad reputation and not wanted by any club, was given an opportunity to redeem himself by Alex, and proved to be a great and loyal asset to the club for the remainder of his playing career. In a slightly different light we see that every Formula 1 driver expresses a desire to drive for Ferrari at some point in their career regardless of how Ferrari is performing. And note that these people vocally praise the support teams that make their success possible. These are success stories in an environment of high energy, high risk, short career span people who want to belong and are prepared to openly express their commitment and loyalty. How could investment banks learn and profit from a culture change that encourages long-term loyalty in a team structure that strives for success as a collective rather than individual reward.

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. Like soccer players they have individual skills and flair which needs to be positively moulded into a successful team. Teams of like-minded people create a sense of belonging and loyalty as a natural progression of working together. 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 the 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. In our analogy to Alex Ferguson all team members know that the manager has a formidable knowledge of the game.

Asking a trading manager to operate with constraint is counterproductive as it is easier to ask forgiveness than seek permission. Equally you would not expect such a trading manager to determine credit or risk policy as this would invariably lean toward excess. The role of the trading manager is to maximise return on capital employed within pre-determined credit and risk boundaries and thus looks out into the market to seek opportunity. The trading manager, director, or whatever you wish to call him plays the role of the team captain in our soccer analogy ensuring that the play strategy is right, and that every player is contributing at peak performance.

Therefore a counterbalance is needed to ensure that rules and boundaries are independently derived, and then observed at all times in order to protect the Balance Sheet of the bank from inappropriate exposure, i.e. looking inwards. In conventional businesses such activities can be dealt with over days or even weeks, but in a trading environment with a turnover of some USD billions per day such attention can be minute by minute. Whereas a Credit Committee can provide overall guidelines on limits and exposure, the reality of the trading environment requires credit and risk limits such as new counterparties, trading in hybrid securities to fulfil a client requirement, etc. to be determined swiftly, and certainly within a trading day. Thus a combination of compliance, settlements, and funding act as the referee during the trading day (the game).

Likewise traders should not be allowed to determine their own strategies without reference and approval of a detached COO – the Alex Ferguson role. Traders who cannot properly articulate their proposed activities in a coherent manner should be refused the right of execution.

On the subject of behaviour it can readily be demonstrated why a trading director is generally not the right person to manage the discipline of traders – not least because the director of trading is one of them – they are the pack, and the trading director the pack leader. The trading director considers the loss of a good trader before the serious nature of his behaviour, and the behavioural impact on the other traders by forgiving unacceptable behaviour. I am aware of forgiveness of extremes of behaviour throughout the investment banking sector, but certainly not exclusively to it.

If we look at banks that have either failed (Barings, Lehmans), or banks that have suffered large losses under the heading of ‘rogue traders’ (SocGen, UBS), we will find a common denominator – the front-office was all powerful, and the back-office were considered irrelevant people with no voice. I know that this attitude to back-office exists in many investment banks today, yet a good operations support team is equally as valuable as the front-office in securing, realising and protecting revenues. If allowed to properly engage they provide valuable input to traders and are valuable eyes and ears of the COO who controls all of these activities. The COO provides the boundaries of the playing field, the rules of the game, and the moulding of all of the players into a team, including the Director of Trading whose natural self-preservation and ego will provide some initial hurdles. Having seen this in action turnover of staff diminished to an extraordinarily low level, and the ability to cross-cover in times of volatility was exceptional.

The Bonus Culture

How many investment banks still have the perverse attitude that traders should receive vast bonuses whilst the support function that at the very least minimises the cost to do business receive only a nominal percentage of salary. This attitude is so wrong in every respect and is an inherent facet of the corrupt culture within the investment banking sector where the top people take care of themselves, and spread a few crumbs for those that actually made their profits possible. A good support operation controls the downside risks thus more of the income is translated into profit.

Can we change the existing bonus culture in a way that it will be adopted throughout the investment banking sector, help to avoid reckless transactions, and encourage more term loyalty of investment bankers. I have listened to a number of options in this direction, especially from grandstanding politicians and media reporters. However none have grasped the nature of bonuses in the investment banking sector so their suggestions, whilst sounding good to their audience, will be rejected out of hand by the bankers.

When sales people of any product or service complete a transaction they are generally entitled to a commission within a short time frame as part of their remuneration package. This commission is their incentive to perform and is the general nature of the sales process throughout the World. Some transactions involve a term timeline to completion so commissions are scheduled according to the value received at various points along the timeline. Some sales involve a sole sale person, others require a team approach and thus a commission pool is created and the value of this pool distributed to each team member at periodic interval tied to the value received by the company. Such commissions are referred to as bonuses in the investment banks, but otherwise share all of the above characteristics of commissions. I have already discussed the origin of bonuses in a previous blog. So how can the bonus system be modified to help to properly reflect performance, as well as to encourage loyalty. It is worth noting that an investment bank can have a daily turnover equivalent to that of a major corporation over a whole year, so understanding scale is important.

Deferred bonus for completed transactions is neither popular nor equitable. The bank has the value of the transactions in its profits, and thus the bonuses should be paid. It is also counterproductive as it causes discontent, and a headhunter can readily negotiate a payment of such deferred bonus as an inducement for a good trader to move. Alternatively, for a term transaction, a bonus should not be paid until the bank has accrued real value less any required contingency for future risk until such time as the transaction completes, and is without further potential liability. This is an equitable approach regardless of sole trader or team, and the latter case will probably have the greatest impact on bonus culture.

My experience suggests that the more important issue to be addressed by investment bankers is whether or not it is more appropriate to engage in pool bonus structures to encourage team performance, and thus loyalty. I am in favour of pool systems for a number of important reasons. Firstly and foremost it does encourage team performance which significant reduces the possibility of rogue activities, and provides a natural cover for sickness and holidays. Other benefits include natural selection in that if any member of a team is not performing this becomes immediately apparent making the exit of the non-performer self-evident.

As for quantum, remember our soccer players, Formula 1 racing drivers, and their short career span. I have experienced many traders freeze or completely fold at their desks over the years. These people will never trade again, and probably not work again so I do not resent high bonus payments as it might well be their last. The only time I have exception is when these traders are so greedy that they always look for ways to trade outside of the acceptable range of activity, and will not even consider contribution to a pool for the people who support them, and without whom they would not make any bonus.

Summary

From my experience the counterbalance resource that represents our Alex Ferguson role is an executive COO with the following characteristics:

  • Highly experienced in all aspects of investment banking – but not from a deal origination background
  • Has control of all aspects of the operational business base including risk, exposure, compliance, settlements, funding, and systems including origination/execution staff discipline, but excluding business daily strategy within approved guidelines.
  • If there is an investment bank CEO then this COO should have equal status and equal responsibility to the Board. If there is a parent company then both the CEO and COO should have equal representation on this Board.
  • This COO should be the main contact of the investment bank with regulators such as the Bank of England.
  • This COO should not be obliged to accept market sensitive information without the opportunity to check such information with the source.

This resource will provide the counterbalance to the ‘Bob Diamond’s’ of this World and preserve a more stable environment without loss of business opportunity, and without loss of credibility. Under such a structure rogue traders would be confined to history as there would be no means of hiding such activity, and any activities outside of risk and credit lines (which can occur during a trading day) would be monitored in real time and corrected within that trading day.

There is no doubt that the ‘Bob Diamond’s’ of investment banking are valuable resources as deal makers but if the bank is to achieve stability and credibility such people need a tight rein to curb their natural tendencies to push the boundaries beyond reasonable limits of risk and exposure in the name of profit. However, giving such people executive power is tantamount to giving a nuclear warhead to a fanatic. The Peter Principle needs to be applied with rigour, regardless of the demands/charm for executive status ‘as a requirement to perform’. They can assume the title of ‘director’ for market purposes, but without executive portfolio.

I have no doubt that, assuming that such existing people can be persuaded back to their deal making tasks, there will be continual clashes of personality and will to regain their executive control as their deal making ego will see robust management as a constraint to profit generation. But I have already referred to the specialist management skills needed within an investment banking environment, and shareholders must support this position instead of listening to the charm of fool’s gold from reckless risks. Assuming that you can walk into a casino, put all your money on ‘00’ at the roulette table expecting to win, invariable ends in tears.

The outcry about bonus payments need to be put into perspective, albeit they need to be rationalised as previously described to encourage loyalty and fair distribution.

Robust management supported by a regulatory system which has professional competence and provides pro-active oversight with universally accepted rules of engagement throughout the World will provide the framework for investment banks to perform their specialist and fundamental role in global economic recovery, and its continued growth. This does not mean more regulation by grandstanding politicians (just look at the mess they are creating in the Eurozone debacle). It requires a unification of existing regulation, and then implementation with the required skills. Investment banking is a global business, and needs a uniform global platform of regulation.

One important lesson of the past 20 years is that the door was open to let the mavericks take control, and they were treated as gods. They have taken their rich bonuses and so can live in luxury whilst everyone else has to burden the cost and pain of their activities. Only after a major reorganisation of investment banking, essentially from within, can we revert back to the banker’s creed ‘My Word is My Bond’ with any sincerity.