How to Restore Stability to the Banking Industry

How to Restore Stability to the Battered Banking Industry Now that both Gordon Brown and Alastair Darling have thrilled their left-wing colleagues by promising ‘to do something about excessive City bonuses’, they will now be expected to come up with actual measures to match the rhetoric. They won’t find this easy, not least because the whole subject is more complicated than it appears.

The stereotypical image is of the City trader, surrounded by screens, three telephones stuck in each ear. He furiously hurls other people’s money at obscure and incomprehensible financial instruments, safe in the knowledge that if he gets it right his bonus will be more than most people make in a life-time. If he gets it wrong, his worst fate will be a search for another job.

That is the image. It is unattractive. The man in the street cannot see that the activities of such traders are doing him any good at all. He has a deep and entirely reasonable conviction that the payment of huge rewards for what is essentially speculation is simply wrong. But is the matter so straightforward?

Let us set aside envy here and ask ourselves two questions. Why are large bonuses for City folk wrong? And by ‘doing something about them’, what do we hope to achieve?

Where’s all the money coming from?

The answer to the first question really depends upon the source of the profits from which these bonuses are paid, and whether they do the rest of us any real damage. My first job was with a firm of stockbrokers. It was a partnership that made its money from the commission charged on deals that it transacted for its clients on the stock market.

The partners did well out of it, especially in a good year, but it was hard to see that they were doing any harm to anyone. Of course, in those days there were fixed rates of dealing commission that from today’s standpoint look extremely generous and the stock exchange was a closed shop. None of these advantages pertain today, but my point is that clients dealt in the stock exchange because they chose to. They knew the terms of business and were prepared to pay the price.

The same is true today. Stockbrokers still make good money in the right market environment, but they operate in a competitive market, and their customers are free to move elsewhere. The same observation could equally be applied to other highly remunerated City professions. Some of the highest paid people in the City are the lawyers, while mergers and acquisitions specialists are also paid generously for their advice. I often hear businessmen and women complain of the size of their fees, and yet they make little effort to shop around or negotiate. In other words they pay the fees that fill the enormous bonus pools of their own free will – so who can complain about that?

If you don’t like hedge fund fees… don’t give them your cash

The same can be said for vilified hedge fund managers, who take some of the very highest bonuses of all. How? Because they typically charge a 2% annual fee for fund management but also take 20% of any gains on the fund above a threshold of perhaps 10%. So if they manage a £1bn fund and make 30% in a year they get a management fee of £20m plus an extra £40m share of the profit. This is an absurd reward for simply managing a portfolio, especially as if the fund loses 30% the following year the fund manager is not expected to pay anything back.

But however unpalatable this might be to you and I, and however much hedge fund managers may profit from short-selling (which is a separate issue), the fact is that the contract between the investor and hedge fund manager is freely entered into. If the investors are dumb enough to agree to it, then to my mind they are the ones that deserve the criticism.

There are two fundamental reasons why City firms can make a lot of money. The first is that vast sums of money pass through City hands each day and they only need to slice off a fraction each time and the total soon mounts up. The second reason is that City firms have little requirement for capital investment beyond an office and some IT. So, as with football for example, there is little to stop the money that is earned finding its way into the pockets of the directors and staff. So unless the City comes over all humble and voluntarily pays itself less, I doubt whether Brown and Darling can make much difference to the bonuses cropped from most City activities.

Here’s where the government should get involved: Make banks be banks

There is, though, one area of legitimate public concern and this involves the trading activities of the commercial banks. If a hedge fund manager, or a corporate finance advisor or (chance would be a fine thing!) a legal firm loses money, that is a matter for them and their customers but it need not concern the rest of us. But if a bank loses money then it does concern the rest of us. This is partly because they might be gambling with our money, but mainly because the whole inverted pyramid of lending upon which economic activity relies is supported by a small base of assets. If bankers erode their asset base then they have to cut back their lending. That has a domino effect on other banks and on the wider economy, as we have seen.

So while there are many areas of financial life where one would very much wish to see customers driving a much harder bargain on fees – and one suspects that they do not do so because one overpaid person is not inclined to criticize another – the area of commercial banking is one that may need government intervention.

This could be achieved by insisting that a bank should be a bank and not a trading house. It should be allowed to take deposits and make loans to borrowers. It should be permitted to arrange foreign exchange transactions and trade finance on behalf of its customers. But it should not be allowed to trade assets. It should not be allowed to sell off its loans to another party – which is a type of trading. It should not be allowed to speculate in any way with its own capital. It should have relationships with its depositors and with its borrowers and with no-one else. Its principal role should be to safeguard the interests of depositors.

That calls for the sort of conservative approach to lending that now seems so old-fashioned. Licenses should only be given on condition that banks stick to these basic functions. That would mean saying good-bye to those red-necked bank traders with their huge bonuses and their unrivalled ability to lose huge amounts of our money, and it should restore some stability to the battered banking industry. Anybody still in pursuit of obscene remuneration would have to find a different type of City job – or learn to play football.

That’s all from me today. Next time, I’ll be back on the small cap trail…

Tom Bulford
for The Penny Sleuth

P.P.S. If you want to follow the insights of a small company investor, and uncover the hidden gems of the stock market, find out more about The Penny Sleuth by clicking here.

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