How bankers’ bonuses are contributing to the new credit crunch

Investors do not trust a banking sector grown drunk on bonuses - one of the reasons why we are facing a new credit crunch, writes Cormac Hollingsworth.

 

Last week saw a co-ordinated intervention by the world’s major central banks to lend to commercial banks globally. 

We are back in a new “credit crunch” according to Bank of England Governor Mervyn King. We warned in October this was coming our way: the ability of banks to lend is related to their ability to borrow, and already in September banks were struggling.

Banking is global, and the UK is suffering from the poor capitalization of European banks – that is, once you take into account everything European banks owe to others, they do not have enough capital to cover potential losses.

The eurozone governments did not restructure their banks as we did in 2008, by putting £50bn into Lloyds, RBS and HBOS, firing the management of RBS, and forcing Barclays to raise equity.

They gambled that the UK and US had done enough, and they did not need to do likewise – even though the IMF estimated in 2010 that the Eurozone needed to put in $380 billion into their banks versus zero for the UK.  

They gambled and lost. And it’s the bad apples of Eurozone banks that have spoilt the market for everyone.  However, this isn’t the whole story. 

In the twelve months before the October 2008 crash, there were many private investors, such as pension funds and insurance companies, who were happy to put new equity into banks so that they could cover their losses and continue to make new loans – in effect, a private recapitalisation.

In 2008 shareholders were prepared to give the management of banks a second chance. Between the stabilisation of the money markets – the place where banks lend to and borrow from one another – in 2010 and those markets freezing in August 2011, there’s also been plenty of time. 

So why weren’t there similar private recapitalisations in the first half of 2011? The answer is that private shareholders are not prepared to give the current bankers another chance. And a lot of that is down to bankers’ pay.

By January 2011 the Financial Times was reporting (£):

The world’s largest investment banks are setting aside a bigger slice of their revenues to pay staff, in spite of lower profits and the ongoing backlash against bankers’ bonuses.

In 2010 new hires in investment banks were promising a whopping 8.5% of the bonus pool on average according to the survey of the bankers’ lobby firm, the Institute of International Finance (IIF). That was higher than both the highest year for bonuses of 7.1% in 2007, and way above the year previously, the worst year for bonuses, 2009, a proportion of 5.5% of the bonus pool.

It is very difficult to measure what guaranteed bonuses have been promised to existing employees, particularly they are now banned by the Basel-based Financial Stability Board (FSB). However, this IIF survey is indicative of the direction of pay across the industry.

So in February this year, while Bob Diamond was telling the Treasury select committee that “the time for banker remorse was over”, shareholders were concluding something different. The lesson investors learnt since the public bailouts in 2008 was that behavior in banking wasn’t going to change. The banks were going to continue to divert much of their revenues towards bonuses  

At a visceral level, investors concluded that much of the new capital went straight to bankers’ bonuses. This has made them unwilling to provide new capital.

As the FT’s Lex Column said (£) at the end of October, “London banker bonus: beware investors”:

Bankers need to moderate their expectations [on bonuses]. If profits fall, so must pay… Reform in a global sector is hard to achieve. But there is a force to be reckoned with: under-remunerated investors, who provide the bankers’ capital, can always sell their shares. So bankers should beware the years to come.”

By October this warning was too late, bank shareholders had started to sell their bank shares in droves and as a result, bank share prices have halved during the past three months. RBS share prices spent a week below 20p last week. 

This is an important level, the last time they were below 20p was the week of they hit their low in January 2009. Indeed, according to RBS CEO Stephen Hester, bank shares are now viewed as a “dumb investment”.

An argument between City shareholders and City bankers about who gets a dividend versus who gets a bonus is not normally an area for public concern, except when it is in banking. It runs through the lack of capital to the lack of confidence in the wholesale money markets where banks need to borrow. 

And now, because nothing has been done over the last two months despite share price levels not seen since Jan 2009, it’s about to be felt across the economy.

There are many causes of this coming crisis: the unwillingness of eurozone governments to force their banks to recapitalize; the zero growth for the past year has reduced UK company credit-worthiness; the government has failed to raise requirements for bank capital ratios to be high enough.

But these all could have had a private sector solution over the past 18 months.  That they didn’t is because of the unchanged behavior of the banks.

When Stephen Hester appeared before the Treasury select committee a fortnight ago, he said “cutting banker pay would not increase lending” to the economy. He’s wrong, because banker’s pay is at the core of this renewed banking crisis.

See also:

Coalition fails “moment of truth” on bankers’ bonusesWill Straw, February 9th 2011

Countering the myths that bankers will leave if bonuses are reducedDuncan Exley, February 9th 2011

Top Lib Dem: Bankers’ bonuses are “moment of truth for coalition”Will Straw, January 10th 2011

Johnson: Clegg’s talk on bankers’ bonuses all “hot air”Chris Tarquini, December 17th 2010

Labour MEPs win vote on capping bankers’ bonusesWill Straw, June 23rd 2010

20 Responses to “How bankers’ bonuses are contributing to the new credit crunch”

  1. Anonymous

    1. Biggest impact is people not paying their debts. That comes off capital.

    The ability to loan depends on the level of gearing the bank is running at. Around 8-10 times capital.

    So for every defaulter, that 10 loans that can’t be made.

    2. Next is that ratio. Decrease it, and unless there is a new source of capital, the ability to loan goes down. So if its reduced from 10 to 8, its a big reduction. If the bank has 9 loans out there, it needs to force one person to repay, and can’t make any loans unless it forces another to repay, or raises capital.

    3. The government is taxing capital. That means it is actively preventing banks from lending. However, it needs the the cash to pay its debts.

    4. Mervyn King. The man who can’t control inflation and has written more apology notes than I’ve had hot dinners, has also just insisted banks stock pile lots of cash.

    Then we come to people like you. You’re acting just like the BNP and their little racists ways.

    The BNP will say blacks commit lots of crimes so all blacks are criminals.

    You’re doing exactly the same.

    Some banks were criminally reckless, so all banks are criminally reckless. Same argument.

    Keep pushing that and the banks will get the message. You don’t want them. They will bugger off as a result.

    Likewise for bonuses.

    If someone makes 20 million for their bank, why shouldn’t they get a cut? They have worked hard for it.

    However, its just your way of thinking. You want the money, but you won’t put the work in. Tax is a good example. 50% of the reward for none of the risk, none of the work. Not fair, but fairness has never been a strong point with Labour. It’s all about getting other people’s money and leaving them in debt.

  2. Will Hensher

    http://t.co/6LM4qQI0 If only shareholders did behave like this. But they don't.

  3. Joseph Burnett

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  4. Samantha Johnston

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  5. Justin B

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  6. Martin Johnston

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  8. Pucci D

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  10. A.N.Other Twit

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  11. RecessionInfo 4 All

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  12. Kelly

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  13. bankingfodder

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  14. Cormac Hollingsworth

    Persistent global banking liquidity problems? yesterday on @leftfootfwd: How bankers’ bonuses are contributing http://t.co/b6tAJh3n

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  18. Miles Albrecht

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