All film directors leave footage on the cutting room floor. The same is true for authors. A very early proposal for my book “Why Aren’t They Shouting?” contained a chapter on bonuses that never made it to the final version although various sections were rescued and thus ended up making their way into the finished product. But I thought it would be nice to post the original chapter since the subject of bonuses is always current. It’s a long read, but I hope you enjoy it.

Banker! Pay Thyself!

My colleague had just come back on the Eurostar from a recruitment visit to his old business school in Paris. It was 2010 and I was full of sympathy as I could well imagine the disdain that students felt towards him as a representative of our discredited industry. I shouldn’t have worried. “We were mobbed”, he told me, wryly. “All this stuff in the press about ‘obscene bonuses’ had them queuing up. I think they’re all curious to find out just how obscene these bonuses really are; are we talking topless girls on page three of the Sun or something solidly X-rated?”

Ah, bonuses. There is strong strand of public opinion that contends that there is a simple answer to the question of why banks fail; they fail because of bonuses. Very little about banking generates quite so much resentment and anger and it is easy to see why given some of the sums paid and the terribly harmful knock-on effects of banking failure. But is the link as simple as it seems?

First, though, I want to clear up a misconception. It is a common theme that ‘bankers pay themselves huge bonuses’. But bankers don’t pay themselves. Had I been asked to do so, during my time in the industry, the first such invitation would have led to an abrupt end to my career as I walked out of the office to the pub with a cheque for a billion (unjustified) quid in my jacket pocket.

Instead, the employees of any bank bargain about their pay with the senior management of the bank (the Board, which represents the shareholders) just like employees of any capitalistic firm involved in any other business anywhere in the world. To conflate the Boards of banks (which represent Capital) and the workers in banks (who do not) by labelling them all ‘bankers’ is a fundamental error. Nobody ever talks about ‘steelworkers paying themselves’ simply because the Board members of a steel company are, in a technical sense, ‘steel workers’. It clearly sounds wrong, and it is just as wrong for bankers. Naturally, as happens in any industry, banking Boards can, and do, drive a hard bargain if they think it is in the shareholders’ interests and they can get away with it. If you doubt this, here is an excerpt from a recent campaign document from ‘The Committee for Better Banks’ – an umbrella organisation of unions representing finance workers in the US – a campaign which is seeking better pay and conditions for their members: “average bank worker wages are so low that almost one third of bank tellers in America receive some sort of public assistance. Over a third of tellers are living at or below poverty level”. Clearly, they are not paying themselves.

But at first sight banking Boards appear to be a softer touch in the case of investment bankers. By way of illustration: the average compensation of securities employees in New York in 2012 was $360,000, over five times the average in the rest of the private sector. Of this, around 60% was fixed salary and 40% was bonus. The reason that investment banks pay in this peculiar way dates from their pre-history as partnerships – a greater proportion of variable pay gave the partners more flexibility to keep staff in a poor year for the business. The system has survived the transition to shareholder ownership and spread to non-investment-bank people (especially in so-called ‘universal banks’ where retail, commercial and investment banking sit side-by-side).   Pay also takes a very large proportion of firms’ profits. For example, in 2013, the investment bank Goldman Sachs made revenues of $34 billion on expenses of $22 billion of which approximately $13.5 billion was staff compensation for its 33,000 staff (an average of $410,000 per person). The totals and averages hide a heavy skew whereby a relatively small number of individuals take a large proportion of the pot. This is not simply a peculiarity of investment banking Boards. In a universal bank, investment bankers and retail bankers can be paid very differently even though they share exactly the same Board and shareholders.

The level of pay for investment bankers is commonly, and pejoratively, put down simply to their ‘greed’. If you feel that way, I won’t try to change your mind with the usual rather weak arguments that ‘bankers work hard’ (so do nurses) or ‘they pay a lot of tax’ (they do, but simply as a consequence of high pay). In truth, some (not all, or indeed, most) bankers get paid a lot because they have the bargaining power to demand a large slice of profits from the providers of capital, who, in time-honoured fashion, would prefer to keep the money themselves.. I am not going to try to defend bankers but I would point out that workers’ desire to use their bargaining power (singly or in combination within unions) in order to earn more money for themselves is pretty common, if not universal. Common too is the desire to have a lot of money, whether for security or for status. Every year about 70% of the public regularly take part in lotteries in those countries in which they are held. Given that ticket sales rise as prizes increase in size (because of rollovers and the like) it would seem fair to assume that the public’s understandable, even laudable, objective is to gain the chance to win millions of dollars. But the ethical arguments about high pay, taxation on high pay and all the usual associated topics, although assuredly crucial in a wider sense, are off the point of this chapter. The critical issue that I want to explore is whether the way incentives are designed encourages the conditions for banking crises and failure.

To answer this, it is worth looking at the way the annual bonus process works in a bank. During the course of the year the Board of the bank will have been putting money aside (‘accruing’) in order to pay for bonuses. The amount they set aside is largely determined by how much money the bank is making each quarter but the proportion that is put aside also depends on how much other, rival, banks are accruing. There is a complex process of signalling going on because the amounts are disclosed to shareholders and thus, importantly, to the bank’s employees. (Citibank is putting big sums aside and your bank isn’t? Maybe it’s time to take that call from the headhunter who has been bugging you!) It’s at the end of the year that the real fun begins. Managers of businesses lobby their bosses for a slice of the bank’s accrued pool to be used to pay the people in their area; they try to get as much money as possible. In doing this, their overriding concern is to try to retain their best staff. Why is this?

Skills in investment banking are specialised and top performers have usually honed these skills over years. They will probably be a member of a team that relies on them. If they leave to join a rival bank (or fund) the disruption can be immense; they will take their knowledge, expertise and client relationships with them. Also, someone else will now need to do the work. As a manager what should you do? Promote from within? By definition a less experienced person does the role. Hire from outside? You will need to pay up and there is a long delay as you interview candidates, decide on one of them to hire and then wait for your choice’s ‘gardening leave’ to end (typically, three months). And even then, you can’t really tell until the new person has joined whether they’ll perform as well as the leaver did or fit in to the team – it’s a big risk. Every manager I know has had at least one shocker. Consider ‘Michael’ (name changed to protect the guilty) whom I hired in a hurry to fill a gap. He looked great on paper and was convincing, enthusiastic and likeable at interview. Sadly, when background checks were completed after his appointment, his CV turned out to be pretty much 100% fictional. When asked to explain the inconsistencies between his CV and the somewhat less impressive facts we had gleaned from objective reality, his – admittedly accurate – response was, ‘Well, I lied’. Goodbye Michael.

So as you can see, managers have every incentive to try to get ‘their’ people paid by lobbying hard. Staff retention is crucial for a business to make money, which, in turn, means that the business’s manager himself gets well paid. It is a little-remarked-upon truth, but the role of a manager who is not a Board member is as much that of a union leader trying to get the best deal for his ‘members’ as it is a caretaker of the shareholders’ interests. Two things help you as a manager in arguing for money: first, if your business is making money or, better yet, making more money year-on-year, the Board will, quite rationally, direct bonus dollars at the business in order to keep it stable. Second, it helps if plenty of your staff have been lured away during the year to other firms; this obviously proves they were underpaid. (Or possibly it just proves that they hated working for you, although nobody goes in hard with that alternative hypothesis). Given the importance of getting the bonus allocation right and the gigantic sums involved – in total, worldwide, each year, tens of billions of dollars – hoards of consultants vie to provide managers and Boards with detailed, but anonymised, information about pay across the industry to help both sides argue their case. Headhunters – think football agents but with more impressive degree certificates and nicer suits – are always on hand all year round to point out ‘pricing discrepancies’ to employees (i.e. “you can get more money at J.P.Morgan”) and to get a cut of their pay if and when they jump ship. All in all, the market for staff is cutthroat, global and, to an extent, efficient.

Once the bank’s pool is carved up and pieces are handed to individual business managers, the process continues at finer and finer levels of detail (maybe a chunk of the FX pool is handed to the manager of the FX spot business, for example) until the point comes where the decision of what to pay particular people is reached. Now, as a manager, you could just use your entire pot on one chap and give nothing to the others; alternatively you could divide the pot equally between everyone. But, for obvious reasons, these extreme poles are most likely going to lose you some staff. The trick is to distribute the money in such a way as to hit the exact amount of pay for every team member that will ‘clear’ (bankerspeak for ‘satisfy them and stop them looking elsewhere’) and thus to maximise the chances that the staff – at least the ones you need to keep – will stay.

Every manager has a different way of achieving this difficult balancing act. My own was to corral every senior member of staff of my business in one room for a couple of days (usually just before Christmas, which always added to the fun) to argue and debate all the various sums for every one of the dozens, or latterly hundreds, of employees worldwide who were more junior than them. The idea was to apply the ancient principle of the ‘wisdom of crowds’ and get the most balanced and fair assessment of each person. But regardless of method, two vital questions dominate: first, how good is this person at his job; in particular, how much money has this person made and can he make in the future (which is a good guide to how much other banks or funds would be willing to pay him). And second, how disruptive would his departure be? The second question is usually tied up with the person’s seniority – a graduate fresh out of college is not a big loss; a fifteen-year veteran would be. The mathematical analysis I did each year on the way ‘my’ people had been paid always bore this out. The only two consistently statistically significant factors affecting pay were the employee’s performance ranking and their seniority as measured by corporate title. Indeed, this – probably unsurprising – statement is backed by academic research on pay.

So here we see the obvious connection between payment (bonus) and risk taking. ‘Performance’ is – to a large extent – measured by how much money is being made. Making money often requires the bank to be put at risk. ‘Performance’ is rewarded with pay and pay can only be positive. Therefore, the argument goes, bank employees are motivated to take as much risk as possible because, as the trite cliché has it, they are participating in a game of ‘heads I win, tails you lose’ whereby the personal downside of risk is limited (they can be fired, but that’s it) while the upside is limitless. The colloquial name for this is the ‘Trader’s Option’ because the payout imitates that of a call option where a fixed and limited premium buys a theoretically infinite gain if things go well. The reality of bank employee behaviour, however, is more complex.

There is nothing more deceptive than an obvious fact.

What behaviour would we expect of risk takers if they exploited the Trader’s Option in a coldly rational manner? I suggest that they would constantly lobby for their pay to be linked exclusively to objective results in a formulaic way (so-called, ‘eat what you kill’) and they would take as much risk as they could get away with within risk limits that they would tirelessly try to increase. I have occasionally encountered people who have done this, but they have been extremely rare.

One was a man called Brendan (not his real name). Brendan was, and no doubt still is, a very charming, confident and clever chap. He traded natural gas for Deutsche Bank in the US – a blisteringly volatile, difficult and demanding market about which he was an expert. I encountered him when I was appointed to be his boss because of an internal re-organisation. He had been having a good year up until then because a big bet on higher natural gas prices had paid off for him in February. Two things struck me about him when I met him: his constant focus on pay and, in particular, what percentage of his revenues would accrue to him personally; and his total self-confidence and belief in his views on the market. This self-belief got him into trouble a few weeks later in December when his theory that gas prices would decline (a perfectly well thought out and rational idea, to be fair, but expressed in very large size) was confounded by a freak storm hitting the Eastern Seaboard of the US which set gas prices rocketing as New York shivered. The loss that resulted was – for the department at the time – a body blow measured in tens of millions of dollars. Shortly afterwards, Brendan and Deutsche Bank parted company in circumstances that could be described as both physically and metaphorically ‘frosty’. Having left and having received no bonus, Brendan launched a court case against Deutsche that he eventually lost.

After Deutsche, Brendan went to a hedge fund where, once again, he took massive risk on natural gas. In 2005, around the time that hurricane Katrina hit New Orleans and disrupted gas supplies, he made an astonishing one billion dollars for the fund. When this news became public, my reputation as a manager of traders suffered a sharp downtick within Deutsche; I was subtly made to feel a little like the guy who turned down the Beatles – this despite my continuing belief that a trader so nakedly wedded to using the Trader’s Option was a Bad Thing for the bank. In 2006, Brendan gambled massively again, but this time he lost. A series of stupefyingly large bets on gas went wrong and, sadly for Brendan and, more pertinently, the fund’s investors, his employer was bankrupted to the tune of $6.5 billion. At the time, it was the biggest single trading loss in history. My reputation rallied a touch.

But for every Brendan there have been a hundred bankers in my experience whose motivations have been more nuanced. Take ‘Daniel’ (name changed to avoid embarrassing him) who was hired as a proprietary trader in late 2006. His job was to take risk and to try to make money on the bank’s behalf. During the first half of 2007, he was doing well in a steady and disciplined way. The chaos caused by the start of the Crisis wiped out his gains and caused sufficient losses to make it extremely unlikely he would be paid a bonus for the year. A rational response of someone whose motivations were purely monetary might well have been to give up for the year or to find another job. Instead, he worked carefully for long hours and made back most of the loss but, as expected, he made insufficient money to break into profit, and bonus, by the end of the year.   Why had he done so? What was the point? “Because I am a trader and that’s my job” was his response when I asked him. But this somewhat terse answer was, I firmly believe, the mask for a number of mingled motivations all of which were benign. First, I am sure that he felt a strong sense of professional pride – a desire to do a good job. He had lost but he felt a need to prove (to himself as much as others) that he had the skill to come back from the loss. Second, a feeling of duty towards the people who had hired him (I was one of them) and to his colleagues with whom he was friendly. In short, he didn’t want to let them down, Third, and possibly more self-servingly, a desire to show his bosses that he could be trusted to do the right thing and thus to prolong his career. It worked; he is still with the bank, is well respected and is in a senior position.

It is vital to understand that the people who work in banks are not just personal-wealth-maximising automata. They are human. They operate in a social setting both inside and outside their place of employment. Although the Trader’s Option strategy looks fine in theory, in practice most people do not use it because the personal ‘psychic’ costs if it goes wrong are too high. Bankers do not like losing money – it wounds their egos as well as their pocketbook. Like most people in most jobs, bankers like to think they are doing their job well purely as a matter of self-image. It’s nice to feel competent. And just like other people, they particularly do not like being fired. Even the most hardened professional has friends, possibly a partner and children, and probably a proud mother to whom they will need to explain themselves. Here’s what Brendan had to say about his exit from Deutsche, “It was one of the low points in my life…I was humiliated, it was embarrassing”. Losing your job is a crushing psychological blow (not for nothing is it considered one of the most stressful of life events along with divorce and bereavement). Put another way, “What is at stake for the bank is money. What is at stake for the trader is also reputation and other psychological outcomes, which may have greater pull than mere avarice”.

And even if you cling to the idea that risk-taking bankers are, in aggregate, purely trying to maximise their wealth, it is still possible to see why they would not take excessive risk. Remember that, as well as ‘performance’, ‘seniority’ is a big driver of pay. It is difficult to gain seniority if you are being fired regularly for swinging the bat and missing every couple of years. A chunk of time at one bank is a prerequisite for career advancement as you build up a track record that makes more senior staff trust you. There is therefore a trade off between maximising pay in one year and maximising it over a career; the latter breeds a more cautious approach. A very interesting academic study compared traders’ attitudes to risk to that of other professions and found that: “Overall, traders are more risk averse than other groups. In particular they are noticeably less inclined to take social or career risks” (my emphasis). This is not an isolated finding. A huge study on the pay and incentives of senior finance executives carried out by the accountancy firm PWC in 2012 found that, “…contrary to popular perception, executives working in the financial sector were slightly more risk-averse than the general population”. The inbuilt caution of traders probably explains the admittedly anecdotal observation that, in my experience, risk limits are only intermittently maxed out in a bank – something you would expect to happen all the time if the bulk of risk takers used the Trader’s Option.

Regardless of all this, the idea that bonus incentives were responsible for the excessive risk and bubbles that formed in 1997-8 and 2007-8 is pervasive. But I believe that there are further inconvenient facts and arguments to take into account that throw more doubt on strength of the linkage. One obvious problem with the idea that high bonuses, in themselves, are the root of all banking crises is this: why should the motivating factor of pay necessarily result in bad risk? No-one cares at bonus time what view you had on the market to make your money. There is just as much incentive to be short an overpriced market (that is, betting it will go lower) as to be long (that is, rooting for it to go higher). My ex-colleague Greg, for example, made $1.5 billion profit for Deutsche Bank from shorting $5 billion of sub-prime in 2007, a profit that he claimed, “is more money on a single position than any other trade had ever made for Deutsche Bank in its history”. For this he was paid $47 million. Greg was known as the Cassandra of sub-prime, but that’s not a strictly accurate comparison. Although Cassandra was proved right about her most important prophecy (Trojan Horse), no one believed her. But plenty of people in hedge funds believed Greg, followed his example and made a fortune as a result; they were all paid spectacularly for bucking convention.

My own experience shorting Russian debt and Russian roubles in 1998 was similar in flavour, if not, I am sad to say, in magnitude. Optimistic conventional wisdom was widespread: “Russia will pull through”; “The IMF would not let a nuclear-armed power go under”; “No country would default on its domestic debt”. But history shows that the optimists were proved wrong and the pessimists were proved right. My own reason for pessimism was simple: a young Russian colleague of mine called Alex told me one sweltering day in July 1998 that his parents were so concerned about Russia’s finances that they had taken all their money out of their bank account and converted the roubles to dollar bills which they were hiding in their house. In a sudden flash of insight I imagined this repeated a few million times across the country and grew scared. My motivations for then shorting Russia were various: in part I felt a duty to protect my bank, and my colleagues, many of whom were friends, from losses (“Because I am a trader and that’s my job”); in part I had a strong desire to have a winning trade to prove to myself, and to my colleagues, that I was a talented trader; but naturally a large part of my thinking was that by shorting Russia I’d make a lot of money and be well paid for doing so. I was in no way unique: every other trader looking at the Russian market or the Asian market or the sub-prime market would have had similar motivations. The critical question to ask about incentives is therefore not the size of them (which is the same for both bad and good risk), but what it is about them that could result in a market getting out of balance to the extent that the banking system could be damaged.

They say the secret of good comedy is timing. It’s also the secret to shorting a carry trade. Go too late and you’ve missed the chance. Go too early and you’ll bleed to death. Take Russia: given that the country defaulted in August, in a way it was a good thing that Alex’s mum and dad indirectly provided me with my epiphany in July rather than any earlier. Rouble yields (interest rates) reached triple digits that summer, which meant that every $1 million equivalent of short position I wanted to put on the books cost at least $20,000 per week to fund. A substantial position of $100 million would have cost $2 million each week. I put on a really big position, but holding it for more than a month would have been a huge problem as losses mounted. The people who shorted sub-prime had a similar problem. They were paying an insurance premium for an accident that was waiting, and waiting, and waiting to happen. Greg’s short (which at the time, was smaller than $5 billion) cost him $20 million in 2006 and, having grown, presumably cost much more in 2007.

A trader called Howie Hubler at Morgan Stanley was paying $200 million a year to short $2 billion of BBB (i.e. pretty risky) tranches of sub-prime CDOs via CDS trades. Bearish hedge funds had similar costs. The problem with accumulating losses each week, or month, or even each year, is sticking with the trade as the market confounds your pessimism. My colleague Greg needed to convince his bosses – right up to the head of the investment bank, who was somewhat sceptical about his view – to let him keep the position. Happily for him, for them, and for Deutsche Bank’s shareholders, he did a good job and they listened. Howie Hubler did something different; he decided to hedge his bets. Instead of reducing his short on the BBB tranches he decided to go long AAA as well. The idea was that the insurance premium he would collect from the CDS on the AAA tranches would offset the cost of the short. He planned to get the best of both worlds: the bet against the risky BBB stuff would pay off in the event of a downturn (a win for Howie) but the bets on the ‘riskless’ AAA would not (ditto). The problem was that the AAA (being, nominally, less risky) paid a fraction of the premium per unit notional that he was paying on the BBB. So to even out the premiums he just bought multiples more of the AAA – $16 billion all told. Of course, when the crash came, every tranche blew up – BBB and AAA alike – and the unfortunate Mr Hubler promptly lost Morgan Stanley $9 billion, thereby proving that a short on a carry trade can be a tricky thing to manage.

Being long a carry trade, on the other hand, is a doddle. Every day that doesn’t bring disaster instead brings a fat coupon. And every year that doesn’t bring disaster brings a bonus. It’s on this point that I believe critics of bonuses are on the strongest ground. If the period needed to pop a bubble and unwind a carry trade is greater than the period of the bonus cycle then risk decisions can be made, and rewarded, before the consequences are felt. For Asia and Russia in 1990s, the carry trade lasted around three or four years. Sub-prime was approximately the same (2003-2007). But bonus cycles have always been annual. So here we see a mechanism that could explain the part played by bonuses in the formation of bubbles.

However, there are evidential problems with this view of causation. A big one is that there doesn’t appear to be a very strong relationship between the way firms paid their employees (we’ll return to CEOs and Board members in a bit) and the degree to which they came unstuck in the crises in 1997-98 and 2007-8. Let’s focus on the latter. One of the most famous casualties of the Crisis was Lehman Brothers; pay at Lehman was nothing short of extravagant. In 2007, the average employee – Lehman had close to 29,000 of them – was paid $330,000. But pay for the highest-ranking employees was staggering. Documents made public as part of the Lehman Brothers bankruptcy show that the top fifty employees were paid a total of around $700 million that year. The highest earner, one Robert Millard, was paid $51.3 million – more than the CEO Dick Fuld – for running Lehman’s ‘Global Trading Strategies Group’, a proprietary trading team. Ten months after payday the bank was toast – a fact that seems to lend credence to the ‘bonus culture leads to disaster’ argument.

But not so fast! In September 2007 the British mortgage bank Northern Rock was damaged so badly that it needed to be nationalised by the British government. The causes of its downfall were practically identical to those of Lehman Brothers. Both had bad mortgage risk on the books, both were very highly leveraged and both were funded with short-term money that suddenly dried up. In contrast to Lehman however, pay at Northern Rock was extremely modest. In 2006, Northern Rock’s 6,000 employees were paid £162mm in total, an average of £27,000 per person. This was only a few thousand pounds above the average wage in the UK for all workers. At the exchange rate at the time, £27,000 was equal to approximately $50,000 – less than a sixth of the pay of the average Lehmanite. As to bonuses, Northern Rock had a Share Option Scheme that accounted for only a tiny fraction of total compensation to employees (a total of £1.4mm granted in 2006) and a Share Scheme limited to £3,000 per person. The highest paid person at Northern Rock was its CEO Adam Applegarth who earned £1.3 million ($2.4 million) that year: half in salary, half in bonus. This is a large sum to be sure, but not even in the same postcode as Wall Street higher-ups or even other UK-based CEOs.

In fact, if you look at the list of failures and survivors in the Great Financial Crisis, it is difficult to discern a clear pattern with respect to pay. Merrill Lynch was a big payer in its investment bank and would have collapsed but for its rescue-purchase by Bank of America. In contrast, J.P.Morgan was a big payer in its investment bank and was healthy enough to be tapped up by the US authorities to be the backstop buyer of both Bear Stearns and Washington Mutual when they failed. British bank HSBC paid people well in its investment bank and survived the crisis more or less unscathed. British bank HBOS, on the other hand, whose history “provides a manual of bad banking”, was a larger scale version of Northern Rock and failed despite its modest wage bill. To conclude: if you constructed a classic management consultant’s two-by-two matrix showing ‘paid-like-normal-folk’ vs. ‘paid-like-rock-stars’ on one axis and ‘took-stupid-risk-to-the-point-of-extinction’ vs. ‘sort-of-did-alright’ on the other, you could populate each one of the resulting four boxes with a number of examples from the Crisis. Correlation? Pretty much zero.

Another complication in the picture is that of ‘bonus deferral’ – a wrinkle that means it isn’t wholly correct to say that employees who lost money for their banks walked away with no loss. Let me explain how this works. In the early years of my career, bonuses were paid entirely in cash – usually by bank transfer one day late in December. Towards the mid-90s, more senior (i.e. higher-paid) staff increasingly received a proportion of their variable pay in the form of stock. Typically this stock award was deferred for some time (a common scheme was to give you a third each year for three years as long as you remained employed by the bank; the three years is known as the ‘vesting period’). At Bankers Trust the stated aim of paying in stock was ‘to align employees with the shareholders’ – we’d all feel their joy and we’d suffer their pain, that sort of caper – although at the time even the most credulous among us thought that this was total balls. To us, the bank’s motivation looked less noble. Paying in equity meant paying less in cash. What’s more it meant that if another firm wanted to nab an employee, it would need to replace the – as yet unpaid and so soon to be lost – chunk of equity. In effect it was like the bank was imposing a transfer fee; for properly senior people it could grow to be a very large number indeed after a few years.

But, in this way, for all our cynicism, senior people gradually did become very exposed to the health of the firm. As a colleague of mine once put it, “Deutsche Bank pays me and will pay me in the future; it holds my pension; its name is all over my CV; and to top it off I’m long a ton of stock in deferrals. The only way I could get any longer of Deutsche Bank is if they kidnapped one of my kids each time we have a down quarter”. He was exaggerating – no bank has ever kidnapped children – but the point stands. What is peculiar about the Crisis is that the very banks that did worst, deferred the most. As a United Nations report from 2012 states: “Bear Stearns and Lehman were known for having compensation structures with high levels of deferrals and a full 5-year vesting period rather than the 2-3 years that many Wall Street firms used…close to a third of the stock of Bear Stearns was owned by the employees at the time it sank”. The culture of these two firms exaggerated the impact because it was considered disloyal to sell your stock once it had vested. As a result, “…executives who headed Bear Stearns and Lehman lost close to $1 billion each”. I don’t imagine them walking away whistling nonchalantly.

To sum up: although it just seems like common sense to say that large rewards must be the driver of bad risks in banks, and despite the fact that there is a mechanism by which this could happen (the timing mismatch between bubble formation and compensation cycles), the picture in practice is cloudier. Bankers are risk averse; they hate getting fired; they are compensated just as well for making money by shorting bubbles as the opposite; they are exposed to losses like the shareholders are, at least to some extent; and, crucially, they still screw up even when they aren’t being paid remotely extravagantly (e.g. Northern Rock). What else could be going on?

Welcome to the machine

All the time Greg was shorting sub-prime CDOs, the complex mechanism of people, products and deals that he referred to as the market’s “CDO machine” was still humming. When asked by the US Senate’s Subcommittee on Investigations why that was so, “he pointed to investment banking fees, prestige, and pressure to preserve the CDO jobs involved”. Prestige! Unless you have worked in an investment bank it might be difficult to comprehend the intense pressure bankers face to do deals. At its best, there is a good business sense behind the pressure because doing deals brings in revenue, market share and league table rankings which are a very successful form of advertising. Clients prefer to use banks that are popular with other clients; it’s a bit like preferring to go into a crowded restaurant rather than one that sits empty and forlorn.

But at its worst, the need to ‘win’ becomes an end in itself. In the world of Mergers and Acquisitions, they call this ‘deal fever’ – a headlong rush to do a deal even when doubts start to emerge. I have on occasion in my career aborted deals that I considered to be overly risky late in the day, and the stress and ill feeling it causes are immense. Trust me, it is not a quick route to popularity. Any risks in a deal are always a matter of opinion. You can never be certain that a deal is really too risky, and besides, if the deal does go wrong it will go wrong in the future. In contrast, the happy customer, the congratulatory emails, the celebratory dinner – in short, the glory – will happen right now. If you stand in the way of a deal you risk being dubbed with that most scathing of investment banking insults: “Business Prevention Officer”. Actually – and this may surprise you – few people in banks like to rock the boat. The desire to please others is strong and it is easy to be optimistic when the prospect of failure is distant. The psychological study of finance folk that I quoted earlier says it best, “Careers in the finance profession have profiles that attract people who are disinclined to stand out from the crowd or to take chances”. Deals get waved through as a result. Once the mighty CDO machine started to grind, the personally risky thing to do, the thing that would have made someone ‘stand out from the crowd’, would have been to stop the machine, not keep it running; by and large, at most banks, no-one did. As Charles Prince, the (then shortly-to-be-ex) CEO of Citibank, said in an interview in July 2007, “As long as the music is still playing, you’ve got to get up and dance”.

The really scary thing, though, isn’t that traders sneakily piled on sub-prime risk knowing it could kill their banks, all the while grabbing their bonuses each year and cackling maniacally when it all came to an end. The scary thing is that they didn’t think they were taking much risk at all. The Swiss bank UBS lost over $40 billion from sub-prime; this prompted its regulators (the Swiss Federal Banking Commission or SFBC) to launch an investigation. The following, profoundly depressing, quotes are from the report that they wrote. “UBS was not aware of the extent and the nature of its risk exposure…until the beginning of August 2007” (my emphasis). “Management…remained convinced that its business strategy carried relatively low risks”. And, as if to comfort themselves, “The same errors were made by virtually all the other market players”. We shall look at the reasons that UBS (along with many others) ‘was not aware’ of risk that caused it to lose $40 billion in the chapters that follow this one. For now, let’s stick to bonuses. On that subject the report was clear, “[There was no] evidence that managers…purposefully damaged the bank, or consciously incurred incalculable risks for the sole purpose of obtaining a higher bonus”. Regardless of this, the fact remains that the bank, as well as many of its rivals, was damaged badly by its CDO machine; this machine was operating in full sight of the bank’s most senior people. This suggests one further question about bonuses we need to address. The ultimate control of any bank, its strategy and its risks, is in the hands of its Board and CEO. Did the incentives that they faced as a group (as opposed to those facing banks’ employees, which we have been looking at) contribute to failure?

The temptation – which many commentators have succumbed to – is just to say, ‘yes’, since banking CEOs were, and are, paid a lot of money, and banks failed. ‘Cum hoc, ergo propter hoc’ as we Latin scholars say. “If we really want to stop Wall Street from creating another bubble…we need to change the way bankers are paid”, opined Paul Krugman representatively on this subject in The New York Times in 2009. But, because CEO and Board level pay is disclosed to shareholders and thus readily available publicly, several statistical studies have been performed to test the theory of the linkage between CEO pay and failure, rather than merely guessing that it is true. One, from the Journal of Financial Economics in 2011, which looked in detail at CEO pay at 95 banks, concluded, “Based on our evidence, lack of alignment of bank CEO incentives with shareholder interests cannot be blamed for the credit crisis…” That is, CEOs didn’t enrich themselves at the shareholders’ expense. Another one from 2011, carried out by researchers from the Universities of Reading and of Bath in the UK, looked at incentives across various industries and was entitled, ‘Did bankers’ bonuses cause the crisis?’ Short answer: no, not really – “there is no evidence to support the argument that inappropriate incentive structures led banking executives to take excessive risks for short-term profits”.

It wasn’t all good news for bankers, however. Professor Tonks (one of the research team), talking about the results at the time, said, “I should emphasise that we are not trying to defend bankers’ pay; our argument is simply that any poor decisions made by bankers that led to the financial crisis were not made because of their incentive payment structures”. In other words, they screwed up royally – but it was for love, not money. These conclusions do not surprise me in any way. I have met a number of CEOs of banks and they have all been charming, intelligent, well dressed and articulate. They have also all had (how shall I put this?) the towering self-confidence of heavyweight boxers, which I suppose is why they got to sit in the big glass office in the first place. In my opinion, there is virtually no amount of money that they, or their peers, would have accepted to undergo the humiliation of being in charge of a failing bank, especially since they had all no doubt already been made wealthy by their ascent to the top. The very same calculus of ‘psychic cost’ outweighing financial gain that I mentioned applying to the humble trader applies in greatly magnified form for people whose successes and failures are played out on such a public stage.

Putting out the fire (with gasoline).

None of this has stopped politicians and regulators weighing in with new proposals on compensation. In a way, you can see their point – it all looks so obvious and, besides, no politician has ever faced an angry mob shrieking: “What do we want?”, “More cash for bankers!”, “When do we want it?”, “Deferred for three to five years to align incentives!”  However, if the goal is to prevent bank failure (rather than simply be seen to be ‘doing something’ popular), then the problem is that most of the changes probably won’t help much, or could conceivably make matters worse. One example: there is pressure on banks to defer ever-bigger chunks of (especially senior) bankers’ pay for even longer – up to ten years. However, that could have unintended consequences. One strong finding of the PWC survey of financial workers’ attitudes to pay is that, “executives apply discount rates to deferred payments that are massively in excess of economic discount rates”. That is, the more you delay payment the less people will think they are getting paid (since they discount at around 30% per year – way over and above the time value of money). The natural tendency will be for employees to bargain for higher nominal payments to make up. Besides, as we have seen, significant deferrals in the past didn’t help.

The same could be said of the related idea of ‘malus’ or ‘clawback’, whereby deferred bonus payments can be cancelled if losses occur as a result of trades that were done in the past. First off, this will no doubt compound the discounting effect we just discussed. Second, although it would give pause to the rare cynical trader (he of the ‘maniacal laughter’) who deliberately takes bad risk, it might not stop the over-optimistic chap who genuinely does not believe he is putting the bank in peril. Also, although it would appeal to most people’s idea of natural justice to see bankers who cause a blow up being stripped of their wealth, the amount that the relatively small numbers of people responsible for losses in 2008 would have been able to disgorge would not have made a dent in the damage the banks suffered. In other words, it will make everyone else feel good but it will do very little to make the consequences of failure less painful for the rest of society. It’s a little reminiscent of the French court’s decision in the case of the rogue trader Jerome Kerviel who lost his employer Société Générale $6.7 billion in 2008 – he was jailed for five years and ordered to pay back the money he lost. This decision is one of impeccable logic and justice but, regarding the fine, I do question its practicality.

Happy to say, these measures will probably merely be useless; the worst piece of legislation is the EU’s newly mandated cap on bonuses which could actually be harmful. The legislation prevents banks paying an employee a bonus greater than his salary, although, with the agreement of the shareholders, the ratio can be extended to two-to-one. It applies to EU-domiciled banks’ employees globally and to the employees of foreign banks (American, say) based anywhere in the EU. Aside for the obvious problem that it doesn’t apply consistently across the globe (prompting strangulated, and largely gleefully ignored, cries from bankers that it could lead to an exodus of talent from the EU) it will alter incentives in a way that is perverse.

If nothing else changes, bankers will bargain to be paid the same total compensation as if the rule was not in place – capping bonuses will not do anything to stop that. What will happen (and as I write, is already happening) is that salaries will rise across the board to allow banks to pay people and be in compliance with the rules. Why should this be a problem? Andrew Bailey of the Bank of England’s Prudential Regulatory Authority put it like this when he addressed the UK’s Treasury Select Committee in 2014 in the run up to the EU vote on the measures: “I do detect a pressure to increase fixed remuneration at the expense of variable bonus. It raises two concerns; firstly, it risks reducing the ability of banks to cut remuneration and therefore build capital and secondly, it risks creating the wrong incentives.” Worried about bank employees being immune to the downside of taking risk? Just make sure more of their pay is fixed – that’ll sort it.

Overall though, the truly worrying thing about the focus on compensation is that it is a distraction. There is only so much regulatory effort that can be expended on curing the weaknesses in the financial system and time is of the essence. Every ounce of effort spent on bringing in rules on compensation – which wasn’t the cause of the Crisis – takes away effort from addressing the real issues.



  • “If you doubt this, here is an excerpt…” [Footnote] From report by Committee for Better Banks published online by Union Solidarity International, February 14th
  • “By way of illustration: the average compensation…” Data from press release, Office of the New York State Comptroller, March 12th
  • “For example, in 2013…” Data from Goldman Sachs Annual Report 2013.
  • “Every year about 70%…” 70% figure taken from quote from spokesman for Camelot (runner of UK lottery) reported in article, “National Lottery is ‘tax on poor’” from Daily Telegraph, July 27th US figures from “Gambling on the lottery: socio-demographic correlates across the lifespan”. Barnes, Welte, Tidwell and Hoffmann, Journal of Gambling Studies, December 2011.
  • “Indeed, this – probably unsurprising – statement…” An interesting discussion of the ‘Superstar’ effect is included in “Bankers’ pay and extreme wage inequality in the UK”, Bell and Van Reenen, Centre for Economic Performance, London School of Economics, April 2010.
  • “One was a man named Brendan…” “Hedge Hogs”, Dreyfuss, Random House, July 2013.
  • “Here’s what Brendan had to say…” Ibid, chapter 2.
  • “Put another way, “What is at stake…”” Quote from chapter 5, “Traders”, O-Creevy, Nicholson, Soane and Willman, Oxford University Press, 2005
  • “A very interesting academic study…” Ibid, chapter 6.
  • “A huge study on the pay and incentives…” From “Pay: what motivates financial services executives”, study by PWC, August 2012, published online in
  • “My ex-colleague Greg…” Section VI (B-3), “Wall Street and the Financial Crisis”. Permanent Subcommittee on Investigations, United States Senate, April 2011.
  • “For this he was paid $47 million…” Epilogue, “The Big Short”, Lewis, Allen Lane / Penguin, 2010.
  • “But plenty of people in hedge funds…” Chapter 5, ibid.
  • “Greg’s short…” Chapter 9, ibid.
  • “One of the most famous casualties…” Lehman Brothers Holdings Annual Report 2007.
  • “Documents made public…” From “Lehman Bros. elite stood to get $700 million”, Hamilton, Tangel and Pfeifer, Los Angeles Times, April 27th
  • “In September 2007 the British mortgage bank…” “Why Northern Rock was doomed to fail”, Day, Daily Telegraph, September 16th
  • “In 2006, Northern Rock’s 6,000 employees…” Northern Rock Annual Report, 2006.
  • “In fact, if you look at the list…” See for example Table 1 in “Pay, Politics and the Financial Crisis”, Murphy, University of Southern California, Marshall School of Business, February 16th
  • “British bank HBOS…” From “’An accident waiting to happen’: The failure of HBOS”, Parliamentary Commission on Banking Standards, April 2013, published online at uk
  • “As a United Nations report from 2012 states…” “Financial sector compensation and excess risk-taking”, Sharma, United Nations DESA working paper no. 115, April 2012.
  • “All the time Greg was shorting…” Section VI (B-4), “Wall Street and the Financial Crisis”. Permanent Subcommittee on Investigations, United States Senate, April 2011.
  • “The psychological study of finance folk…” Chapter 6, “Traders”, O-Creevy, Nicholson, Soane and Willman, Oxford University Press, 2005
  • “As Charles Prince said…” From “Citigroup chief stays bullish on buy-outs”, Nakamoto, Wighton, Financial Times, July 9th
  • “The Swiss bank UBS…” From “Subprime Crisis: SFBC investigation into the Causes of the Write-downs of UBS AG”, SFBC, September 30th
  • “If we really want to stop Wall Street…” “Reform or Bust”, Krugman, The New York Times, September 20th
  • “One, from the Journal of Financial Economics…” “Bank CEO incentives and the credit crisis”, Fahlenbrach and Stultz, Journal of Financial Economics, 2011.
  • “Another one, from 2011…” “Executive Pay and Performance: Did Bankers’ Bonuses Cause the Crisis?” Gregg, Jewell and Tonks, International Review of Finance, 2011.
  • “Professor Tonks…” “Bankers’ Bonuses ‘Not to Blame’ for Financial Crisis – New Research”, University of Reading Press Release, December 21st
  • “One strong finding of the PWC…” From “Pay: what motivates financial services executives”, study by PWC, August 2012, published online in
  • “Andrew Bailey of the Bank of England…” “PRA warns EU bonus cap will create riskier banks”, article published online in