Why are we so worried about bonuses?

I got caught up in a debate about pay and remuneration in finance this week.

This is because Stephen Hester at RBS had his package hiked to £9.6 million if he delivers all of his targets – of which the main target appears to be achieving a 70 pence share price as that will make UK plc a profit of about £8 billion – whilst Citibank and others are increasing basic remuneration and lowering bonuses to keep staff.

Now I find it interesting that folks believe pay caps, bonus cuts and other changes – such as shareholders setting executive packages – is a viable, appropriate or good thing to do.

You see there are several issues here.

First, it is not the amount of pay we give to our leaders in financial services, or any other industry, it is the measures by which we reward them.

What you measure is what you get, as they say. And what you measure and reward first, is what you get first. And what you measure first and reward the most, is what you get delivered.

This is why financial services failed – because we measured and rewarded short-term profit without balance of the long-term risks being taken to get that profit.

It is equally why we will continue to get this wrong.

For example, many of us lament the fact that quarterly results and shareholder returns drives inappropriate management behaviours, and yet that is exactly how we are incentivising and focusing Mr. Hester at RBS.

This creates the issue where management almost soley focus upon delivering short-term results, with no thought for the long-term.

The idea of growing new business arenas, entering new markets, spending more on R&D, developing intellectual capital and so on and so forth, goes by the by … or bye-bye to be honest.

Who wants to invest in the future when your only measure is the next quarter’s profit and the share price?

Second, if bankers can earn double in the bank next door, why are they gonna stay in this crummy place? We all talk about the fact that bankers can’t find homes in other banks as they’re all failing right now, but that’s not true. Just look at what happened to UBS last week:

June 25 (Bloomberg) -- UBS AG sued Jefferies Group Inc., saying a “massive, premeditated raid” cost the Swiss bank at least 36 health-care investment bankers including unit chief Benjamin Lorello.

The departures, from June 17 to 21, amount to the “nearly complete lift-out” of the UBS health-care division, which ranked among the top three in the world and had $1 billion in revenue since 2005, UBS said in a June 22 petition in New York Supreme Court. UBS won a temporary court order this week barring Jefferies from recruiting employees from the group who have not already agreed to join.

Or the activities of firms such as Barclays Capital:

BarCap, which bought the Wall Street operations of the collapsed investment bank Lehman last year, is hiring in Europe and the Middle East. In the past six months it has picked up 460 people and plans to lure another 300 before the year is out. Last week it snapped up three highly regarded banks analysts from Citigroup, the biggest financial firm in the world until the credit crunch struck and left it needing to be bailed out by the US authorities. BarCap also plucked leading bankers Matthew Ponsonby from Citigroup and Mark Warham from Morgan Stanley last week to the new positions of co-head of mergers and acquisitions.

It’s a dog-eat-dog world, and if you can’t cut it then get out.

Third, the markets set their own value, just as other markets such as football do. It’s all based upon individual talent, and you have to pay to get the best talent. We didn’t hear anyone whining about Ronaldo’s £80 million move to Real Madrid or his £200,000 a week demands.

Because we can see he is worth it.

On a football field, the guy who scores the most goals deserves the highest wage. And so isn’t it true in the financial world that the guys who create the most value deserve the highest incentives and bonuses?

Finally, a healthy bank is one that is crushing unhealthy banks, as proven above. Therefore, healthy banks are only created by having healthy income from healthy investment managers who run healthy portfolios.

It’s this last point which went wrong, and it relates back to where I started.

What you measure is what you get, and what you measure and reward the most is what you get first.

Stephen Hester is being measured and rewarded on share price, and so that’s where he’ll focus. But then I immediately said that a pure share price focus is not good as it creates short-termism, and so I could challenge whether this is the right package for him.

Equally, if your investment teams can be lifted and dropped into another firm as a complete team, then you have to work out who you want to keep and why.

If UBS wanted to keep the healthcare team, then they should have recognised that:

(a) they were a healthy team, 
(b) they were being measured and rewarded based upon value creation and risk avoidance, and 
(c) they would have been rewarded based upon value creation and risk avoidance better than any package held out to them by Jefferies Group or anyone else.

And there’s the rub really.

To have a strong banking system, there has to be accountability and a tie between risk and reward.

Seems obvious now.

This means that the best banks will relate risk in the long-term to the rewards they provide in the short-term; and they will also build-in clawback terms to any bonuses paid such that if those bonuses blow-up as high profile risk and losses in the future, they get the cash back.

Meantime, the whingers who don’t like the City having big bonus bankers back in town are just jealous … I suggest they go and find a talent themselves that can pay somewhere else.

Ever tried kicking a football?

More on the arguments for and against bonuses:

City watchdog (FSA) pays £20m in bonuses (Guardian)
Tough targets set for Hester’s package (Financial Times)
Citigroup revamps pay structure (Financial Times)

Bankers deserve their bonuses (The Finanser)
Bankers deserve bonuses? You're an idiot! (The Finanser)