Bankers' bonuses: two solutions

What issue has such purchase on the public imagination that it - at least in the UK - just keeps coming back, again and again, as people's top concern about the financial crisis and the recession?

Of course, it's the bonuses paid to bank employees.

The psychology of this conversation is revealing. Nobody really notices if RBS makes £6 billion in profits. But when one RBS employee gets a $10 million bonus - that's about 1/1000th of the amount - suddenly it's a big deal. We can relate much better to (relatively) small numbers with people attached to them than we do to huge figures.

Clearly the government has a political problem: it doesn't want to be seen to be allowing high bonuses to be paid when the public has paid for the banks to be rescued.

But it also has a commercial problem: the rescue is a sunk cost, and the bonuses are part of the bank's strategy to incentivise future behaviour. If RBS doesn't pay any bonuses, perhaps their top people will leave and the value of the public's 84% stake in RBS will be diminished. And if (say) Barclays doesn't pay bonuses, perhaps their people will leave, damaging the government's future tax revenues from Barclays' profits and their executives' pay.

But why is it that the market outcome is to pay such high bonuses? Surely finance is a competitive marketplace and some of these high returns should be competed away?

Unfortunately not. The fact is that there are two constraints on supply in finance, both of which push up prices and pay. The first is that there are not really that many financial institutions, and in each individual marketplace there tend to be only two or three dominant ones because of powerful network effects. This is not enough to create real price competition, so investment banks' profits can be very high even in a recession.

The second constraint is on staff. Entry into the financial sector is closely guarded, as are the knowledge and contacts of those already working there. A fall in demand and thus in revenues (such as last year's) is greeted with layoffs in preference to pay cuts, keeping supply tight.

So banks have high profits because there are few of them; and employees get to capture a lot of these profits in bonuses because there are few of them too.

The clear solution to these problems, then, is to increase supply. In a working market, the shareholders of the banks would be insisting on this themselves. No private company wants to have its costs pushed up by a labour shortage. But the finance sector, more than most industries, is controlled by those who work in it. The executives of the banks themselves hold much of the equity in most investment banks - and the outside shareholders are mainly other financial institutions, whose employees' interests in restricting supply are just the same as those of the banks.

Through its control of RBS, the government - as a shareholder - can set out to change this. It should recruit thousands of new people - there are plenty out there - and create a competitive labour market for skilled finance professionals. In the medium term, this would enable RBS shareholders to capture a much higher share of profits relative to those going to highly-paid traders, boosting the value of the government's shares.

In the long term, it would encourage a more competitive market among banks themselves, reducing their profits and increasing the surplus available to the rest of the economy.

That still leaves the short term. Here is the second solution, which deals with that.

Two major sources of RBS's profits this year are: the combination of cheap money from central banks, and tight credit conditions enabling the bank to charge high interest on loans; and its underwriting and dealing commissions on huge issuance of government debt.

Both of these are essentially a subsidy from the public sector. It would be economically legitimate for RBS to pay a proper price for these public services - whether through a high rate of tax on profits, or a specific levy. This could equally be considered as a price on the externality that banks impose on the public through their implicit government guarantees. The Treasury will not want to hurt RBS's capital position, so it could exempt, or reduce tax on, the portion of profits which are set aside as permanent capital not for the immediate benefit of shareholders (or employees).

By reducing the retained profits available to the banking sector, this action would reduce the available pool of money for bonuses in a way that fairly reflects the costs that the banking sector has imposed on the rest of us.

Would it affect employees' beliefs about the future in such a way as to cause a bunch of people to leave the company? That's not clear, but it should at least be made clear that these taxes or levies are a temporary measure to recapitalise and restore stability to the sector to provide the basis for future growth. Once the market is competitive enough, there will be no need to continue this scheme anyway.

In short: competition, and pricing of externalities, will restore balance to the banking sector and let it play its proper social role at a reasonable cost. Nothing too controversial about that, as any economist would agree.

Update: A commenter on Robert Peston's blog points out a typical job posting for one of the mid-to-high end investment banking positions. I thought the following "requirement" was very revealing:
You must be extremely professional and polished in person and be able to gain the commitment and trust of your existing client relationships who will want to work with you again if you were to move to a new opportunity. Individuals who apply must be well connected and have very good money generating contacts.
Difficult-to-replicate skills and knowledge? Mm-hmm.

Update 2: Chris Dillow proposes an alternative approach: instead of rewarding bankers when they do well, kill them when they do badly. Feel free to form your own opinions on that.


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