A river runs through it

A river of money that is. Writing in the FT, Raghuram Rajan comments on recent bonus decisions:

Banks have recently been acknowledging enormous losses, yet those losses are barely reflected in employee compensation. For example, Morgan Stanley announced a $9.4bn charge-off in the fourth quarter and at the same time increased its bonus pool by 18 per cent. The justification was that many employees had a banner year and their compensation should not be held hostage to mistakes that were made in the subprime market.

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Even so, most readers would suspect something is not right here.

FT alphaville provides further background:

Banks structured bonuses to include a greater proportion of restricted stock, which is released over several years. And they set explicit targets for compensation costs as a proportion of revenues, typically around 50 per cent.

The pitch to investors was simple: we may give our staff half of everything they bring in, but this will rise and fall in line with the state of the business.

This formula worked well in boom years, but is beginning to creak. Of the Wall Street banks that have released fourth-quarter earnings so far, the two most affected by the subprime meltdown reported sharp increases in their compensation ratios. In 2007, Morgan Stanley’s wage and bonuses bill rose 18 per cent, to $16.6bn.

This in a year when the bank’s revenues fell 6 per cent, it wrote off $9.4bn in subprime losses, and was forced to raise $5bn from China Investment Corporation. At Bear Stearns, the bonus pot shrank by a fifth, but revenues fell more than a third.

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There is a certain logic to this largesse. The subprime losses are generally the work of a small number of people working in the fixed income division. Meanwhile, other parts of the business have enjoyed record years. It may be in the bank’s interests to pay to keep its best people, even if there’s not much left for shareholders.

This argument fails to acknowledge the fact that all employees benefited when the fixed income operations were raking in the profits during the credit boom, and should probably share in the losses. It also highlights a fundamental flaw in the bonus culture: that costs and benefits associated with risk-taking are not equally shared.

Here's the problem. Suppose after costs you split the pile 50/50 between shareholders and staff. Staff expect 50% of what they make. But there is no such thing as a negative bonus, and all attempts at delaying compensation or holding money back for later have proved profoundly demotivating and ineffective. So while most people are making money, paying 50% of the upside to staff is fine. But if one group loses, oh say $10B and everyone else makes money, you have a real problem, and one that slashing bonuses for the head of the business does not solve. In reality there is no collective responsibility in most investment banks and little sense of working for shareholders. Bankers are more like piece workers than traditional employees - but your average piece worker can't endanger his employer's capital base. The only solution to this issue will be if shareholders demand it and if the industry collectively changes: if anyone breaks ranks to gain competitive advantage, reform will fail. And we know how good investment banks are at cooperation...