I have yet to see a sensible mechanism put forward for how to reward bankers in the current environment. I don't mean a proposal for how large the bonuses should be, rather a structure which achieves some degree of insulation from moral hazard.
Most commentary I come across is
populist diatribe claiming the sector is grossly overpaid, and with public funds too, so requiring that bankers are paid next to nothing. "They wouldn't even be there if we hadn't bailed them out" is a fashionable argument. Newsflash: That is not a solution, it is a quest for retribution against a single cog in a system which all stakeholders (employees, boards, shareholders, regulators, central bankers, tax collecting politicians etc) blithely allowed to develop over the last two decades
Let me assure you that average earnings at investment banks (and the capital markets operations of commercial banks) are going to remain high enough to keep you frustrated in perpetuity if you are presently at all angry about the issue. If you think otherwise, be prepared for eye bulging rage come the January round of announcements. I encourage you to let it go or find employment within the sector.......
With that caveat in mind, here's an attempt at a sensible remuneration system for a suitably chastened sector. (It's a version of a clawback system without many of the negative implications if you want to move on to the next item in your day).
As long as I can remember the total remuneration pool has been around 40-50% of top line firm revenues - let us call this the Compensation Fraction. The figure is a delicate balancing act between shareholders, management, employees and capital regulations and it should be left that way.
These revenues can be broadly summarised as the aggregate of (i)
service revenues: items that you and I would obviously recognise as revenue such as sales commissions, fees for banking services like M & A or underwriting, asset management revenues and the like and (ii)
proprietary earnings: return on capital deployed in the form of net interest margin and the change in the mark to market of proprietary positions over the course of the year. Readers will no doubt be sufficiently familiar with discussions of level 1, 2 and 3 assets to know that it is the latter of these which is most subject to debate (or abuse/manipulation if that's your perspective on it). By way of example, I identify 31% of
Goldman Sachs' recent 3Q earnings as service revenues: $10,922m out of $35,558m. Goldman itself has identified its Compensation Fraction as 47% of those same revenues.
These sources of revenue can readily be measured separately but they cannot easily be delineated politically. The oft-cited example is that of the ability of an M & A banker to close a takeover and invoice a fee being conditional on the provision of debt finance to the acquiror, requiring a proprietary credit position on the trading books (at least for a period of time). Internal arguments between Sales and Trading about ownership of relationships, revenues and the bonus pool have raged since time immemorial; this won't change, but it is irrelevant to an outsider - what is needed is a system which protects against negative externalities, not one which mollifies infighting.
Where the regulator should step in is to define how these very different revenue sources can be dispensed to employees once they have been determined and the Compensation Fraction agreed upon between the board, management and shareholders. I propose the following:
The Compensation Fraction of service revenues can be paid in cash (to whomever the bank sees fit, not necessarily those who purportedly earned the commissions - remember, regulators, politicians and central bankers don't care about the infighting).
The Compensation Fraction of proprietary earnings should be remitted to an Employee Bonus Trust ("EBT"), which subscribes for annual series of preferred equity in the firm issued at par. This preferred equity is redeemable in, say, 10 years, and pays a meaningful fixed dividend in any future year where a sensible profitability test is met by the bank. For the purposes of dividends and redemptions, the EBT acts as a pass through trust. Shares in the EBT ("EBT Shares") are distributed to whichever employees the bank sees fit each year, and they become transferrable on a 20% per annum vesting schedule in a similar fashion to many equity award schemes in use at present. Once transferrable, the EBT Shares are tradeable freely on the open market.
Where proprietary earnings in future years are negative, no dividends would be paid on extant EBT owned preference shares and no proprietary revenues are disbursed to the EBT for that year - in fact the Compensation Fraction of the negative proprietary earnings is clawed back from the aggregate extant pool of preference shares (spread across all previous series).
Pretty simple really. This achieves a number of goals (do you see how I like roman numeral lists?):
(i) For those firms where proprietary trading makes up a small or zero fraction of profitability, employees can be rewarded in cash as the firm presents little systemic risk. Boutiqes will be able to attract smooth talking banker talent who don't drain capital into supersenior air pockets.
(ii) Firms highly dependent on proprietary trading remain incentivised to take risk through the cycle - a significant negative year will hurt the EBT but the impact on the firm's capital position will be ameliorated by the preference share clawback. Commission earners in firms such as these know their fate is tied to those of the traders - sorry, but you chose to work in a bank which is in reality a hedge fund (but see (iii) below).
(iii) Any star prop trader or M&A rainmaker, in a bad year elsewhere for the firm's proprietary business, can still be compensated as the firm sees fit from either pool. Again, regulators shouldn't care about absolute sizes of individual payments and how they are comprised.
(iv) If, in a poor year for proprietary revenues, management sought to make the Compensation Fraction much lower than 40% to minimise the clawback hit to the EBT, this would apply to both the service revenues and the proprietary earnings. For example, if revenues were net zero arising from $2bn of service revenues and a $2bn hit on the prop books, a Compensation Fraction would still be declared to allow some cash bonuses to be paid, but an equal amount of clawback would then be required from the EBT.
v) Employees are free to dispose of their EBT stock on vesting. Nevertheless, the price at which they are able to cash out will depend on the market's perception of the value of these EBT Shares - they are freely tradeable and to the outside world the EBT is a pseudo closed end fund investng in fairly risky preference shares. Would a market develop in these EBT Shares? Of course. There is a price for everything. Should the employee not like that price and choose to retain his EBT Shares they will be redeemed on a rolling program as and when the pref shares are redeemed. Provided the firm remains solvent, retaining EBT Shares presents greater certainty of cashflow for the employee.
(vi) Requiring the EBT to invest in redeemable preference shares rather than ordinary equity allows the terms of the pref shares to be tailored to allow clawback. Opponents might argue that ordinary equity provides better incentive alignment but a fixed upside (dividends) and unlimited downside is exactly the sort of deferred incentive a bank's most volatile businesses need to be encouraged not to engage in unwarranted gambling.
(vii) The longer maturity of the preference shares solves issues associated with temporary mismarking of level 3 asset pools. The market price of the EBT shares will move to account for this perceived risk (I accept that there is the potential for some information asymmetry issues in the short term, but the signalling disclosures of knowledgeable insiders disposing of EBT equity should partially offset this), and 10 years is usually a long enough time for true value to emerge.
(viii) It does away with inappropriate employee option schemes. Leave that to silicon valley & venture capitalists. Bankers don't really want options, and regulators don't want bankers to have to deal with the moral hazard implications of bankers with a pile of options
So there you go. There are no doubt some problems with this proposal that I have not considered - it is a first cut - and I'd like to hear about them in the comments or elsewhere. A proposal such as this might reshape the industry somewhat - polarising it into either investment banking boutiques or hedge fund trading outfits. I think this is no bad thing. In fact, the sooner the better so that we get to a point where we can easily disentangle a third entity: the riskless narrow or utility bank contemplated by variants of a Glass Steagal for the 21st century which
I advocated some time ago, but I will leave a discussion of what that bank should look like for another day.