Bankers’ bonuses and unlimited liability

On the 29th of February, Conservative MP Steve Baker tabled a 10 minute rule bill on bankers’ bonuses. In it he proposes that directors of financial institutions post personal bonds that can be called in should an institution they hold responsibility for fail. Essentially, this increases the liability of directors of financial institutions to a far greater, and personally significant, level.

This is an interesting proposal and one that is supported by a number of luminaries – the Bank of England’s financial stability guru Andy Haldane being one, and the substance of the bill has been crafted by professor Kevin Dowd and Gordon Kerr, himself a banker and founder of Cobden Partners. This is certainly timely and the whole debate about bonuses is far from being settled. But in looking for a long term solution to this question of remuneration, it is worth casting an eye to the pre Big Bang City, when soon-to-be-created investment banks were still merchant banks, jobbers and brokers. This was a time when membership of the London Stock Exchange required that member firms could either be a broker, acting as an agent between end users and the market itself for a fixed rate commission, or a jobber acting solely as a market maker and prohibited from any contact whatsoever with the end use investor. As a fresh faced junior on the floor of the Stock Exchange in 1982 – a “blue button” – I was paid a base salary of £3,500 per annum, with an indicated bonus of 65% paid at a rate of 15% each quarter with the final 20% at the year end, depending on results and personal performance. The reason for this arrangement was two-fold. Firstly, there was (and still is) a requirement that all regulated firms hold a reserve of regulatory capital that is equivalent to 90 days operating costs. Reduce your fixed costs by having a low base salary (topped up by non-guaranteed bonuses) and you reduce your regulatory capital requirement. But the second reason relates to the structure of the firms themselves. Unlike modern businesses, the pre Big Bang firms were unlimited liability partnerships. The partners of the firms wanted to mitigate their liabilities until they knew how profitable they had been at the year end and so we staffers put up with a slightly erratic method of remuneration.

But it was this element of unlimited liability that was a key to the stability of the City. Every member firm had a group of individuals running it who had a huge vested interest in the financial stability of the firm. Every partner watched his or her part of the business like a hawk and was party to every decision on expenditure and risk taking. It was an incredibly effective system. Every partner knew that if he or she messed up, it was not just their bonus or their job they were losing: they would lose their home, their son would be chucked out of their private school, their daughter would have her pony repossessed by an unsympathetic bailiff, and the Jaguar would go back to the showroom. Everything would be gone including their dignity. The fact is, there is no better way to regulate risk than have the deal maker waking up at three in the morning in a cold sweat about an ill conceived decision.

Wind forward twenty or so years and the deal maker’s downside is now no more than his or her job. If it is a terrible error they have made, at best the shareholders of the bank pick up the bill; at worse, the taxpayer.

Steve Baker’s bill seeks to move some way towards restoring this old regime. By posting a bond as part of the regulatory capital of a bank, as Steve’s bill proposes, the liability of an individual director is part guaranteed. But the director has, ultimately, unlimited liability on the debts of the firm he governs. The recovery capital – that which the director will cough up should the bond be called in – is a minute fraction of the potential liability of any of the significant institutions concerned. With balance sheets reaching a trillion pounds or more, a director’s personal wealth will never make a significant difference to losses. But committing a risk taker at an institution to effectively put up his life’s accumulated worth is a serious and effective way of ensuring that this individual thinks far more carefully when looking to speculate with someone else’s balance sheet.

However, I fear that Steve’s bill, whilst a smart way of ensuring risk is mitigated from those at the top of an institution – the directors – may not go far enough. After all, very few directors of these institutions will be aware of the day-to-day activities of any trading desk. Far more effective would be a solution whereby those heading up business divisions of regulated institutions would carry a liability restricted to just those areas under their control. Spreading the risk amongst a wider range of those on the payroll would generate more capital and so be a more realistic resource in the event of a failure. It would also be a far more effective way of ensuring a wider spread of risk takers buy into the risks associated with their activities. In return, those who are prepared to participate in the risk element of the business would be able to participate in generous bonus schemes and the moral hazard that is a significant feature of the current bonus schemes would be eliminated.

Of course, details would need to be looked at in terms of what constitutes risk business and non-risk, agency business. But what is important about Steve Baker’s bill is that it opens a new area of debate restoring the risk / reward balance in favour of the taxpayer. With a system so jammed packed with moral hazard, Steve’s thinking is a helpful contribution to a complex and important issue.