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The role of stratospheric banking bonuses in encouraging the culture of greed and excessive short-term risk-taking by bankers has now been fairly widely publicised in the context of the financial meltdown of 2008. Is this the full story, however? Should bonuses be reduced, controlled, set differently, or abolished altogether?

Conflicting interests: The biggest problem that massive remuneration packages cause is the misalignment between the interests of bank executives, who want to maximise their year-end cash reward by any means open to them, and the companies’ shareholders, who are interested in long-term growth and stability of their investments. There is thus a different appetite for risk between these groups: bankers are risk-takers as incentivised by their pay structure; shareholders are much more risk-averse.

Banks’ top management will say all the right things about the duty they have to responsibly manage their shareholders’ investments. The truth remains, that if one’s banking bonus is many times the basic salary, in the heat of daily deal-making and profit-chasing it seems all too easy to forget this duty to the ultimate investor. It seems that presently, there is no 100% effective mechanism ensuring bankers are fulfilling their responsibilities to look after this money.

Ultimately, if a banker messes up and loses their firm a lot of money, they tend to be able to find another job elsewhere. And they might not feel strong pangs of conscience – as the money they gambled never felt like it was their own, duty to the shareholder forgotten, and their own assets retained. However if shares become worthless, shareholders feel the pain immediately as it was their own money.

Fancy words: Whilst banks’ management will all say (in AGMs, on their mission statements, in the press, etc) that they aim to maximise shareholder value, effectively they often allow more junior staff to do this with risky strategies that take a short term view despite being long term in their execution. This can backfire like it did with sub-prime mortgage investments in America: bankers who packaged these very dubious loans and sold them on as over-rated investment bundles only wanted to earn a bigger bonus in that particular year.  

Internal compliance and risk control departments – here to give comfort to senior management that all is well – cannot have kept tabs on such activities effectively, otherwise banks would not have gotten into trouble.

Thus we have a lack of accountability of the real deal-makers, plus a disconnect between senior management’s eloquent words of responsibility to shareholders and the reality. The few high-profile court cases where senior people were brought in before legislative bodies to answer for the negligent financial misdeeds of their firms are presently the exception, not the norm. And the real deal-makers are never being brought in to answer.

Banking bonuses in recent years: Let’s look at some recent numbers.

UK: In 2006, 4000 people earned more than £1m each in bonuses in the City of London.

In 2007, with the global credit crunch already in full swing, City million-pound bonuses seem to have been given to over 4200 people. In total, the City paid out about £14 billion in bonuses for 2007 to 1 million City employees – an increase of 30% on 2006 (2006 bonuses: $10.9bn. Source – Office for National Statistics (ONS) ).

Overall, bonus payments in the UK financial sector have more than trebled since 2003, when about £5bn was paid out (Source: ONS).

US: Wall Street bonuses were approximately $24 billion in New York City for 2006. In 2007, despite the credit crunch, mounting billion-dollar losses and write-downs on Wall Street, bonuses were $38 billion.

So, we can see that bonuses have been on the rise up until 2008, the year when the proverbial really hit the fan. Bankers have been heard justifying the increase in 2007 bonuses citing large profits of early 2007, before the credit crunch really hit. Yet again, it just shows bankers taking a short-term view of their activities.

Are bonuses to blame for the current crisis?  To some extent, yes, although there is a danger of over-focussing on bonuses themselves as THE only culprit.

We have seen how the promise of bonuses can encourage short term irresponsible risk-taking. But some trading strategies can yield large profits in a short space of time and not destabilise the bank.

What is really missing is the ability of management to assess the riskiness of activities of its deal-makers, and adjust their bonuses accordingly – not just look at the bottom line profit number earned in the current year.

For instance, if the effect of banker’s transaction can be felt over several years, rewards for its success should be deferred and spread over a number of years years and not paid immediately. So if a deal goes sour in the longer run, the individual will not get rewarded for it at all.

To encourage longer-term view of banking, more bonuses should be paid in shares or options rather than cash. Such share or option schemes can be sellable only several years down the line, encouraging the individual to stay with the firm, work hard and wait for their incentive schemes to come into force.

And I think that there needs to be more accountability by more layers of bankers – not just top CEOs and an odd rogue trader. Regulations should be watertight so that irresponsible behaviour is easier to spot and stop, and if need be taken to court.

Will bonuses be reduced? In the short term, definitely. 2008 bonuses are expected to fall 60% in the City.

However big bonuses are probably here to stay to some extent. This is partially because bankers make big investments to get top jobs (an MBA can set you back £100,000) – and give up their personal lives for their careers.

But crucially, I feel that the external regulators and internal risk controllers must step up their game and play a strong role in defining the guidelines and recommendations on how banking rewards should be set. The objective is to incentivise responsible risk-taking behaviour that takes a long term view.

If this line is taken and successfully implemented, then surely rewarding some exceptionally hard working bankers will not be such a big deal – as long as we know they are taking good care of our finances?

Then I would suggest the answer becomes – bonuses should to some extent be controlled through following new regulatory guidelines and should be set using different methods and types of incentive, but not abolished or reduced on a whim.  

… but the culprit goes unpunished today: What hurts most is that even as the global credit crunch is unravelling this year, bankers who caused it and earned their massive bonuses in recent years are currently in the Bahamas sunning themselves not knowing how to best spend their money.

Apparently there is a real shortage of luxury accomodation in exotic tropical destinations.

And that really shows that we are letting the real culprits get away with it today.

 

Copyright 2008 by CuriouslyInspired

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It’s pretty scary out there in the world of finance right now. Apocalyptic predictions of further meltdowns are rife and, to be honest, even if we ignore the scariest over-the-top forecasts we know that we are in for a tough ride.

I was getting carried away 2 weeks ago commenting on the events in the banking world as they were unfolding, but taking several days off temporarily cured me of this obsessive watching and recording of the crisis. I might come back to that in due course, but meantime I wanted to refocus instead on my own perspective of events, which really is the purpose of this blog – in this case to talk about bad staff management techniques I have seen in the banking industry.

I spent 10 years working in banking in various support roles, most recently in project management and IT. It was great around 2000 – money was abundant and life was fairly easy. Maybe not 9 to 5, but looking back it feels like we got paid quite well for doing an average job and not straining ourselves beyond sensible limits. To be honest there seemed to be a fair number of people around who were getting away with not doing anything much and still got paid. What we did was a skilled job, of course, requiring knowledge of finance, accountancy, or IT, and there was of course a degree of stress attached to delivering things correctly and on time, but generally it was a time of plenty – of money, bonuses, opportunity, and jobs all easy to come by. But then it got a great deal harder. Read the rest of this entry »

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