Bankers' Bonuses - A Fairer Solution

The media, both conventional and newer social media, is full of hysteria about bankers’ bonuses right now, but nobody seems to be suggesting solutions beyond either the status quo or stop them completely; neither offers a satisfactory solution.  For me, the only solution for the future is to look to the past and who this problem was addressed successfully for many generations.

Until the deregulation of the 1980s, there was clear demarcation between commercial banking, i.e. deposit taking and using those funds to make loans to individuals and businesses, and investment banking, i.e. the issuing and trading of securities and associated advisory activities, at least as far as the major Anglo-Saxon economies (Continental Europe had followed a different path, but one with less active securities markets.)  Those involved in investment banking (the US variant) or merchant banking (the UK variant that added trade finance but removed securities market trading from the business mix) were traditionally organised as partnerships, (just as other professions such as lawyers and accountants) and even when they converted to limited liability companies, they retained the basic partnership concepts: those who ran the business, owned the business and they shared both the profits and the risks.

The last 30 years have seen a dramatic change to this model; the people actively engaged in the business generally have little ownership of the business, share significantly in the upside but run little risk beyond that of losing a job.  The capital is now largely provided by large financial conglomerates, often with commercial banking at their heart, with management who have little understanding of the investment banking business.  The financial crisis of 2008 added a very dangerous new development; for the first time investment banks found themselves beneficiaries of tax-payer funded bail-outs.

The Vickers Report in the UK has recommended the ring-fencing of UK commercial banking from investment banking and international operations, and this has been generally accepted by George Osborne.  My suggestion is to take this one stage further, and to an element return investment banking to a partnership type structure, albeit one that accepts the reality of larger capital basis than was feasible in the days of partnerships.

The “classic” financial model for investment banks was for revenues to be split three ways: staff, capital and other costs, but it only makes sense if the staff that earn the large elements of the revenue also participate in any downsides.  My model, which is based on the British legal system and the assumption that the investment bank is part of a larger financial conglomerate, is as follows:

• The investment banking activities are transferred into a limited liability partnership (“LLP”) where the existing owner (the financial conglomerate) is one member and the senior staff (the definition of which could relate to seniority and/or pay, but with the caveat that nobody could earn over £100,000 per annum unless they were a member of the LLP) at the investment bank are the other members.  
• The voting rights of the LLP would be 50% to the financial conglomerate and 50% to the working members (split on internally agreed percentages).
• The non-member staff would be paid salaries as normal, deducted, along with the costs of running the business before any profits were made.
• The financial conglomerate would receive the first “slice” of the profits, receiving an agreed percentage of the capital it contributes, say 5% over the Bank of England Base Rate, (5.5% at current levels).
• The remaining profits would then be split on the same proportions as voting rights, but with 50% of all profits being reinvested as member equity in order to grow the business.
• If the business made a loss, this would be reflected in no remuneration for the working members and a reduction in the value of their equity stakes in the business.

Using this model, the investment bankers would be encouraged to act as entrepreneurial business people, rather than short term traders.  In good years they would see their remuneration rise and their equity stake increase in value, with the opposite in bad years.  At the same time, the parent financial conglomerate would be insulated from the activities of the investment bank, making it much easier to separate in the case of a catastrophe, and provide a barrier to the issues of “moral hazard” that became prevalent at the time of the 2008 crash.  This model would truly reward success and punish failure.

Nick