Tuesday, May 6, 2008

It was the bonuses that did it.

Last week, we had the unsavoury sight of John Prescott blaming the banks for the housing bubble. "The banks distorted the market," he moaned; "We gave them stability - the very thing that they had been asking for for decades. The instability [we have now] came from the market itself."

Prescott's denunciation followed Mervyn King's attack on the banks. He blamed the "bonus culture" as a key factor behind the current financial instability.

It is hard to listen to these jokers wimpering on about the banks and the bubble. Both men held key positions of power through those miserable years of double digit housing inflation. Prescott was housing minister, while King still runs the shop at the Bank of England.

Their self-serving blame-shifting leads to an obvious question; what were they doing when the banks were spinning out of control. Unfortunately, we know the answer to that question. It is a two word answer that starts with the letter F and ends with the letter L.

There is, however, a slightly trickier question. To what extent are Prescott and King correct when they blame the banks? Did bank bonuses build the bubble?

It is hard to admit it, but Prescott and King might have a point. Bonuses have become an increasingly important component in financial sector remuneration.

For example, consider pay in the financial sector. The ONS provide data on average earnings, including bonuses for individuals working in financial services. The series looks rather odd:

Every year, average earnings in the financial sector spike during the winter. Furthermore, those spikes appear to be getting larger with every passing year. Those spikes are, of course, bonuses.

The average earnings data has another, less obvious feature. The bonuses are now so large relative to regular earnings, that one could easily think that on average financial sector salaries minus bonuses haven't actually increased that much. Earnings during the non-bonus months look rather flat.

However, the following chart will put you straight on that point.

First, an explanation; the chart above compares the highest and lowest monthly earnings in 1999-2000 and 2007-8. Back in 1999, September was lowest month for financial sector earnings. To make everything comparable we set earnings in September 1999 to 100. The highest earning month that year was March 2000, when salaries were 23 percent higher compared to September (123 compared to 100).

Turning now to 2007-8; the lowest earning month was again September. However, earnings in September 2007 was 67 percent higher than the same period back in 1999. The highest paying month was February, when salaries were 180 percent higher than September 1999.

These charts point to a couple of interesting trends. First, earnings in the financial sector, regardless of bonuses have increased very fast, and much faster than the rest of the economy. Second, the relative importance of bonuses in terms of total remuneration has also increased dramatically.

Since bonuses are invariably linked to some kind of output measure, it isn't hard to see how banks start to churn out the products. If an increasingly large part of your salary is linked to the number of mortgages you originate, wouldn't you try to sell as many as possible? So, Mervyn King is on to something when he points to bonuses as one of the factors behind the bubble.

Ironically, bonuses worked against the interests of banks. The increasing trend towards higher performance related pay distorted incentives within banks. Rather than looking at risk factors, loan officers looked at their bonuses, and extended credit to some desperate home buyers who had an unhealthy propensity to lie on their mortgage applications and default when their financial circumstances deteriorated.

The banks wanted growth, they set up their internal incentive mechanisms to reward growth, and that is what they got. They downgraded the importance of risk and they got lax risk management. It all goes to prove that age old maxim, what you pay for is what you get.


  1. Another brilliant post. Thanks.

  2. I agree with the condemnation of Prescott - but I'm inclined to think King's intentions were somewhat more honourable. King was not free to set policy - only to implement it. He spoke out on numerous occasions warning about the dangers of debt - and remember his comments going back to 2003 - at least.

    Maybe Mervyn made mistakes, but his conduct has been exemplary when compared to either Bush or Brown's treasury. The two players I think you should look at instead are:

    John Tiner - Ex CEO of the FSA - jumped ship just before Northern Rock; left to work for Morning Star Asset Management (who he dealt with in relation to the Split-Cap fraud of 2004.) He previously worked for Arthur Anderson - and left just before the Enron debacle caused it to implode.

    (Sir) John Gieve - Deputy Governor for Financial Stability and FSA member. Left running the home office after various scandals - including a £3m cash discrepancy resulting in a £946m adjustment to the accounts. John Gieve sits on both the MPC and has a senior role at the FSA.

  3. EEEak - typo hell! (Did I really write that gibberish!

    For "Bush or Brown" substitute "Blair or Brown" (How Freudian!)

  4. asteve,

    typos - so easy to make, so hard to erase.

    What is the story re: John Gieve?


  5. I can put up with my typos - until they utterly change the meaning of what I meant. Spell check just makes things worse... ;-)

    The story on John Gieve:


    I was also entirely unimpressed with him at the Treasury Select Committee after Northern Rock. He came across to me as someone who was criminally negligent. That was just my first impression, mind.

  6. Alice,

    Another good post. I hope you don't go on to join the "all City workers are evil" bandwagon that is gathering steam.

    There's a very clear class structure in the City. There's the biggest proportion, who are the clerks, administrators and so on who probably outearn their non-City equivalents but who get precious little bonus. They are the first to lose out in the periodic financial shake down

    Then there's the professional middle class of auditors, actuaries, accountants, legal etc. They again outearn their peers (I'd guess by an extra 20% basic) and also in good years get something between 10 and 100% of salary as bonus. Well (and likely over-)paid, but with genuine skills and hardly extravagent. Relative to their skills and working hours they are underpaid compared to their less talented public sector equivalents.

    Then there's the front office and senior management. They take the huge bonuses (but only some of them in any given year) and mess up the system for everyone else. They also have the least identifiable skills, above blagging and hubris.

    Right now anyone outside the City is likely to want to murder all of them, irrespective of who is worthy.


  7. Nick,

    All valid points. In an earlier version of the post, I actually said something about lower paid finance sector workers. You had made a similar point in an earlier comment. In the end, I left it out, just to maintain the flow (a poor reason, I know).

    I was also careful not to criticize people directly (apart from that old fool Prescott). The problem is definitely distorted incentives, which tends to amplify risk taking.


  8. After reading this piece, I want to get a job in a bank.

  9. These frakking investment bankers have driven up the price of 2-bed flats in Notting Hill from £300k in 1999 to £1.5 million in 2005. Kill em all.

  10. Alice- excellent post... just like all the others you've written

    I love your spikey earnings chart.

    Nobody loves Prezz or the bankers, but asteve is quite right - Tiner is the one nobody has fingered yet (pedant point- he's gone to New Star Asset Management).

    As for Gieve, he was a toatl disaster at the Home Office, and he's repeated the performance at the Bank. It's shocking he was ever given the gig (see several BOM posts, eg http://burningourmoney.blogspot.com/2007/09/amateur-delivers-northern-wreck.html and http://burningourmoney.blogspot.com/2006/04/cult-of-amateur.html )

    Keep up the outstanding work

  11. Yep Alice, I wasn't accusing you of getting a torch and a pitchfork and leading the mod to the City. As you mentioned, your post was pretty considered and tempered given the audacity of the people involved.

    I too think Mervyn King is the closest a central banker will ever get to being an honest man. But, and its a big but, he's still in charged of destroying the currency and helping out bankers.


  12. Thanks Mr Tyler... You are absolutely right. "New Star Asset Management" - Morning was a figment of my imagination.

    Can you comment about the extent to which NSAM was involved in the Split-Cap debacle that Tiner settled?

  13. you've got lots of fans...

  14. Banks make money by chasing maximal profit. They then offer large rewards to the staff who deliver the most profit in a given year. I don't make a tenth what a senior front office banker does in a good year, but I don't waste my time on envy. They get paid a lot because when they do well, they make a lot of money for their employers. When they lose money, they get fired.

    The question is, is it the banks own fault that for years maximal profit was to be found making ever larger loans to the consumer housing sector?

    I don't think so. The reason this was a profitable thing to do was because the government gave the Bank of England and inflation target coupled with an ever-changing method of calculating inflation that understated many living costs, and totally ignored the obvious asset bubble in housing. Mervyn King's a public servant following his remit. As far as I can tell he did his best to avoid bailing out banks with our public money for quite some time. I think he's pretty blameless here.

    Prescott and Brown thought this bubble (or 'boom' as it was called then) was a wonderful thing when it was working in their favour. Brown ignored the ever deepening indebtedness of the british public for a decade, whilst simultaneously increasing their tax burden and juggling public debt off the balance sheet. He could have instructed the BoE to use a measure of inflation like RPI, or give them the remit to keep a watch on asset bubbles. He didn't, because he knew (at least at the back of his mind) that the only apparent growth in the UK economy was coming from an asset bubble which was fooling the populace into sinking deeper into debt as they consumed illusiory debt-based wealth.

    It's Brown's fault.

  15. Only the poorer, defaulting mortgage holders wil suffer. They lose their homes. Bankers get a bonus. What rhymes with banker?

  16. Switching to the SVR will hurt many many hundreds of thousands of first time buyers that purchased during the last few years.

  17. Bonuses are at the heart of this crisis. Too much reward leading to too much risk taking.

  18. I'm still surprised that so many intelligent people think that we could avoid asset bubbles if only professional investors were paid less.

    They didn't get paid so much to cause a credit crunch. Central banks under political direction created the conditions for a series of asset bubbles, and the bankers were simply attempting to maximise profits in the conditions the state had created.

  19. Spot on, Powerman.

    Politicians don't change and the herd is as easy to direct as ever. Government created this problem and now they want to look like they are fixing it. It's easy to blame the City because they are such a low proportion of the nation's voters and there's been a long-standing public perception that working in the City is a highly paid holiday.

    There's also the politics of envy. Easy to blame everything on "the banks" or "the traders". Again, it deflects attention from the government who created the mess, and the greedy homedebtors who wanted in on the bubble.


  20. Finnish ObserverMay 12, 2008 at 12:36 PM

    You are right on target here. The very same problem has surfaced in other countries as well and anyone with an IQ of over 90 could have predicted that people optimize their personal income foremost. If their "performance" is measured yearly, then they don't care much about what happens after five years or so. Consider ARM's for example - almost any customer would show up as "profit" for the first two-years and after handsome bonus the manager could have easily switched to another bank leaving wreckage behind.

    I don't quite understand how politicians and businessmen can get away with all this bullshit, but I hope this whole stupid bonus-orgy is coming to an end now. And I do hope that people will force politicians to accept responsibility of their actions and decisions. As they have no sense of dignity, it has to be forced.