Tag Archives: ethics

John Kay on Bankers’ High Salaries.

John Kay, economist and chair of the Government review of equity markets and long term decision making [PDF; and it’s long!], was speaking to the Edinburgh University Business School, ostensibly on “Why are financial services so profitable?”, but essentially discussing remuneration in financial services. (This may because the answer to the original topic is a quick “they’re not!” – profits from the boom years were wiped out in the crash of 2007 and the ongoing global financial crisis: the profits were illusory).

Remuneration is of course a hot topic. The EU is developing proposals to cap bonuses; bankers’ salaries and bonuses regularly feature in the news.

The standard economic model of wages is that workers receive the same as their marginal unit productivity (I think!). The article in Wikipedia explains it better than I could… A big problem with this model is that it is very hard for organisations to know what the marginal productivity actually is. In large corporations through to the smallest business employing people, whilst the theory might say this is how wages are calculated, my guess is that actually no one knows. What is the marginal productivity of a waiter, a bar tender, a bank teller – or the CEO of a major company?

Kay discussed three different economic theories to explain real remuneration patterns and income distribution, each of which comes from different economic and political assumptions.

The first is that what may be perceived as excessive wages reflect political power and rent seeking. Economic rent the amount paid for a resource in excess of the amount to get that resource into productivity. In the example Kay used, the amount that Wayne Rooney is paid by Manchester United is probably far more than the minimum that Wooney would need to be paid to get him to play football: the difference is because ManU have to pay this excess to stop him moving to another club, who might pay more: in an open market, those other clubs bid up the price. (Kay may have been a little premature on this specific point, though the principal stands…)

The economic power in this case is with Rooney; similarly, successful bankers can threaten to move to another employer – or even another country. They could work anywhere – they have highly transferable skills – and their employers might worry that if they don’t pay their high salaries, they would lose access to the bankers’ skills. (I am not so sure that this threat is a problem now that much of their success has been proved to be illusory.)

The second model Kay covered is what he called “the estate agent problem”. The economics of estate agency is, according to Kay, curious: the rate of fees is generally static, with competition not acting to drive down prices. Estate agents generally charge the roughly the same fees as their competitors. This is because users want to pay for the best service; no one want to pay for an ok, but cheap, estate agent (let alone a bad but dirt cheap agent!), since the benefit accruing from paying a bit more for an excellent agent would far outweigh the cost.

Banks therefore pay for the quality they perceive they receive. They don’t want to pay for a mediocre performance when they believe they can pay a bit more and get excellent performance. Similarly, no board of directors is going to hire a CEO or MD they believe to be average: they will all want the best, and their recruitment firms will help – and bid up the price. But it is doubtful how much difference CEOs can actually make. Luck has an awful lot to do with their success or failure, as do the people they hire.

(Recruitment agencies and remuneration consultants have a lot to answer for, too. All firms want to be seen to be good payers – management roles, at least: job ads often describe roles – firms – as “top quartile pay”; I don’t think I have ever seen a role described as “bottom quartile pay”, though of course 25% of jobs, and firms, must be! Remuneration consultancies produce regular reports showing the market rate for specific jobs, which firms expect to have to pay to get the people they want – and the market rate inflates each year as firms adjust their rates to stay with the market.)

The third issue Kay identified is that of “bezzle“, a word coined by J. K. Galbraith to describe the undetected amount of corporate fraud. Before the fraud is discovered, the victims believe themselves better off than they are. Prior to the global financial crisis, we all thought we were better off than we actually were, because of those non-existent banking profits. As someone said (attributed to Nassim Nicholas Taleb), “we borrowed from the future, and now the future wants it back!”

Until a fraud is discovered, we are all better off! (Kay has writen about the global financial crisis in terms of the bezzle.)

The asymmetric information between financial institutions and their customers – that is, just about everyone – and between fraudsters (call them bankers, fund managers… people who are claiming their bonus for no special performance) and institutions are able to make excess profits. Until of course they get found out. Clearly, even though they have been found out, a great many still think they are worth it.

There was a discussion about how better to align reward and performance – locked-in long term share options, maybe – and perhaps a more apposite debate on the kind of people we want running our companies. This last is important. The traders who do the jobs in banks may do so precisely because they are attracted to the high risk, high return environment. Whilst we might benefit from people with less risky approaches, they are unlikely to be attracted to those jobs. Similarly, the CEOs we appoint might actually be wrong for the job – but less aggressive, flamboyant people aren’t going to apply. And what board would appoint a wall-flower against an alpha male bull? Maybe we get the management we deserve.

I’m not sure if any of this really explains extravagant remuneration and the bonus culture that has been laid bare by the crisis. Maybe it is simply greed, and people gaming the system: trying to get as much as they can.

Playing the Markets: the BBC tackles business issues in radio drama

In the last few weeks, I have listened to three plays the BBC has broadcast about business and economics. (They may have broadcast more which I didn’t hear!) The first was the Great Hargeisa Goat Bubble by Julian Gough. Then, yesterday and today were two plays about the collapse of Enron, Power Play 1 and Power Play 2 – Wilful Blindness, both by Margaret Heffernan.

The Great Hargeisa Goat Bubble, which you can read as a short story on Gough’s website, is a parable of markets – in this case, goats in (you guessed it) Hargeisa – the evolution of derivatives and a bubble, leading to a crash. It was told in a surreal fashion, was simultaneous humorous and educational – a pretty successful combination. It is rare that economics makes one laugh.

The two pieces about Enron were very different. The first was a complex sound collage, with the narrative about a trader joining the trading desk following deregulation of the Californian energy market being played out besides excerpts from Enron’s annual reports, statements to Congressional committees and news reports. This complex structure made it quite hard to follow the issues – this may have been deliberate, since the Enron story was complex and hard to follow itself. The second had a more linear narrative, imagining a meeting between former CEO Kenneth Lay and a former Enron employee on 4 July 2005 – the day before Lay’s death, after he had been found guilty of fraud but before he had been sentenced. Neither of the plays about Enron worked well for me – the first because it seemed to elide complicated issues in a simplistic fashion, the second because it painted Lay as wilfully naïve.

Both the Enron and the goat bubble plays investigate the sometimes absurd ways in which financial markets can operate, and all three plays tackle difficult, complex subjects – the economics of markets, the creation and use of derivatives, the ability to rig markets, the importance of regulation and the ethics of business abuse. It is interesting – and commendable – that the BBC is using the medium of plays to broadcast about these topics. The breadth of Power Play 1 made it the more difficult play; in contrast, the simplicity of Power Play 2 – a three-handed, “typical” radio drama, concentrating on the ethical dimension – enabled it to explore more. But I think the Hargeisa Goat Bubble worked best – distilling a complex field with great humour and warmth.

“Wholly, exclusively and necessarily…”

I tend to shy away from overtly political topics on this blog, but the MPs’ expenses furore seems somewhat outside the normal political boundaries – even the LibDems seem to have dirty fingers – and I wanted to put in my tuppenyworth, prompted by the MP in the constituency I used to live in emailing a link to his online statement on his own actions.

What I find interesting about his statement is that – despite accruing expenses within the rules and for what appear to be wholly understandable and acceptable reasons – he is repaying half of the legal costs of acquiring his “second home” in London.

This suggests some very weak thinking: he appears instead to feel he has to be seen to be doing something. He hasn’t (and doesn’t think he has) done anything wrong. He is worried that others – his constituents (or the media?) – might think that the legal fees were high.

Many, many years ago, I was the financial controller of a small part of a larger organisation, and I had to sign off certain expenses claims. Including my boss’s. He had difficulty in distinguishing the company’s money from his own, and several times I had to tell him he couldn’t claim for particular things. It wasn’t comfortable, but it seemed pretty clear to me what were expenses incurred in the course of the business and what weren’t, and I had to say so.

Many of the MPs’ expenses reported in the Daily Telegraph are clearly not business related – almost any private business would quibble over servicing an Aga, buying cat food and a chocolate Santa, or purchasing eye-liner (and that is only up to the Es!) – unless it is agreed that it forms part of their remuneration (and at that point becomes taxable). Just like other workers, MPs expenses must be incurred “wholly, necessarily and exclusively” to do their job (the words come from the HMRC about employees, but they were just used by an MP on Radio4’s WatO). It is pretty easy for most items to work out whether these conditions are met. Usually, one can also apply a “reasonableness test” – is it reasonable for someone to charge those items as expenses. (Clue: husband watching videos – of whatever nature – no!)

Many MPs were clearly “swinging the lead” – seeing what they could get away with (horse manure, anyone?), and they should be subject to review and censure. But the sight of MPs falling over themselves to pay back what seem perfectly reasonable expenses is bizarre. And paying back half of the expenses which you clearly feel were ok (because otherwise you’d be paying back all of that money) is doubly so.

The role of ethics and morality in business

I heard James Espey give an wide-ranging and entertaining talk last week. It was unstructured and meandering, and all the better for it: Espey was riffing on the themes in business and management that interested him, and he had a lot to say. I was thinking about this today as I read in the paper about John Thain, formerly of Merrill Lynch:

…Mr Thain spent $1.2m (£865,000) to redecorate his office even as Merrill’s losses were skyrocketing… He signed off on the purchase of an $87,000 rug for his personal conference room, a 19th-century credenza costing $48,000 and a “parchment waste can” worth $1,400, among numerous luxury items. The work totalled $1.2m, including an $800,000 fee for the celebrity designer Michael Smith, who is currently redesigning the White House for the Obama family for just $100,000.


What planet does he live on? You might have thought a little restraint would have been called for with Wall Street’s greed-fuelled antics accused of having brought the world economy to its knees. Public anger over the robber barons of banking is already at fever pitch. This was not the time to be flashing your money about.

Espey is a non-exec of Whyte & Mackay, whisky distillers, A.G. Barr, makers of Scotland’s second national drink, and Fullers; he has spent most of his career in drinks’ marketing; and has recently launched the Last Drop, a rare, blended whisky. (Unfortunately, he brought samples of Irn Bru – but not the Last Drop! Still, the Irn Bru hit the mark, too!)

Espey said that he thought the recession had in part been brought about through the corruption of money – a bonus culture brought about by a moral failure that rewarded growth at any cost and saw money as an end in itself. He mourned a society where greed and the desire for possessions had pushed aside all other considerations – and he was worried that we had nothing to fill the gap once the credit tap was turned off.

It isn’t often one hears successful businessmen describing their world in such moral terms.

It was very refreshing; but I worry it is too late.

“The Corporation”

This is a post I wrote elsewhere, in June 2007. I am trying to work out whether the turmoil in the economic and financial markets over the last year make me want to revise my views…

“The Corporation” was a film which was turned into a book, by Joel Bakan; or maybe it was the other way around. A film described as “the thinking man’s Fahrenheit 9/11”. I’ve not seen the film; but I have read the book.

It describes how large companies – the multinationals, the global firms that are so economically active and powerful – are by their nature dysfunctional, set up to solely to meet the short term needs of shareholders by means fair and foul – the book focuses on the foul – and how, based on medical definitions, if they were people they would be defined as sociopathic.
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