Tag Archives: finance

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.

Trying to Understand the Financial Crisis…

Some time back, someone shared a new acronym with me: GFC. For those, like me, not in the know, this is apparently the hip shorthand for the global financial crisis – the economic mire that engulfs us all. It has been going on, more or less, for five years now, with every indication that it will get worse. It is its evolution from a banking crisis to a sovereign debt crisis – at least within the Eurozone – that gives me my optimistic outlook. I’ve been trying to write this post for ages, but every time I do, the story gets bigger and and seem to be constantly changing. It still is.

I have written this in an attempt to understand how we got here. I must stress that, whilst I have taken a couple of classes in economics, I am not an economist. I am sure I am missing large chunks, and I look forward to being corrected by people who have a greater understanding of these matters than I have.
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BarCampBank: Reinventing Finance?

Ten years ago or so, I did a university course on finance and banking; as a final flourish to my presentation, I held up my mobile phone and predicted that in the future we’d be using our phones as electronic wallets. The other day, Barclay’s launched a smart phone app that can be used to transfer money from one person’s account to another. It has taken a decade, but that future seems to be moving closer…

A couple of weeks ago, I went to BarCampBank London (#5, I think), which was full of such talk: how could banks and banking be re-engineered? What is the future of banking? Most of all, what IS a bank?

That question was debated a lot – I think it cropped up in every session – and there wasn’t really a satisfactory answer. Maybe a bank is simply an organisation with a banking licence – or one that the banking regulators deem to be worthy of regulation. (It sounds like the regulators are somewhat more active now than they were six or seven years ago…)

An unconference – albeit one that had a bit more structure than most I have attended – BarCampBank had multiple sessions running concurrently. Some concentrated on technical issues; I attended those that dealt with behavioural and human side of the industry.

The first session I attended was provocatively titled “Is Banking A Human Right?” Whilst possibly quickly consigned to the category of “QTWTAIN”, the discussion was engaging, focussing on customers and their needs rather than the institutions that serve them. “Banking” provides access to many more services than just banking: the unbanked of the world can suffer injustice that those more privileged – that’ll be me – find it hard to conceive. (There are between 600,000 and 1.2 million households without access to the banking system in the UK alone [pdf] figures for 2009.)

The basic bank account promoted by the last Labour government in the UK has done little to plug the gap. (The government likes people to use bank accounts because it may help reduce fraud.) In India, the inability of people to identify themselves has denied them access to banking – one of the drivers for the Indian ID scheme. (An anathema to many BarCampers who can be fierce privacy advocates…)

The next session had a similarly provocative title, “Do social media change anything or everything in finance?” – this time answered with a resounding YES. And, erm, NO.

Banking is clearly social – we use banks to make payments to each other, in all sorts of combinations. (I would maintain that actually any business is social, but that is a different post…) Social networks can be thriving economies – Second Life apparently has a huge economy mediated by “Linden dollars”; eBay a larger one using real dollars exchanged by PayPal; and Facebook credits are the social network’s currency. Dutch law recognises virtual assets within World of Warcraft as real as far as property rights are concerned.

But do social media change anything or are they just a new channel or platform for existing services or organisations providing them? The ease with which some people who have grown up with the service place their trust in Facebook – probably greater than their trust is stolid institutions like banks which they have just seen come crashing to the ground – suggest there might be an opening. But why would Facebook – or Twitter, or Google, or … – want to become a bank? Maybe to use a multi-billion dollar cash pile, though a similar argument was used in the 1990s to predict that Microsoft might become the first virtual bank, which it failed to do. (Observers still discuss the possibility.) Regulators may well determine this – Microsoft had enough problems with regulators without involving more of them, and Google and Facebook look like they may be facing similar regulatory issues in the future.

The need to transfer money cheaply around the world – meeting the needs of the increasing, and increasingly connected, diaspora – may be one driver: a social media bank that could build on existing trust and reputation relationships to leverage scale might succeed.

Similarly, banks are becoming more aware of online trust and reputation. MovenBank is specifically using applicants’ social graph as one of their criteria in lending decisions. Existing online services such as Zopa (who I believe were represented at BarCampBank), Kiva, PayPal and Wonga perform near-banking functions, and some at least have a social aspect to them. Crowd-sourcing and crowd-funding platforms like Kickstarter and Indiegogo (which were also covered by sessions I didn’t attend – next time, I must remember to take my clone…) could morph into banks.

The session “How Could the Finance Sector Work Differently?” was perhaps the least satisfactory – if only because we were instructed to think positively! Bankers of course come in many different types; those manning the local branches of retail banks probably don’t need an injunction to “be humble” and “engage with your community” – because they are deep within it already; those who still believe they are the masters of the universe and wish the rest of us would go away and let them celebrate their riches may however benefit from considering their role in society.

The idea of personalisation of products cropped up, but I am not sure this is necessarily positive – at least from the customers’ point of view. One of the reasons banks were created was the pooling of risk – I could lend money directly to an enterprise, but if I lend it to an intermediary – a bank – who lends to many enterprises, the risk of any one failing to repay my loan is greatly reduced. Excessive personalisation may reduce this – particularly with insurance products: if insurance companies personalise their products to a great degree, those who need insurance may become uninsurable, and those who don’t – well, they don’t need insurance!

This lead onto debate about mutuality. In the wake of the credit crunch and the “global financial crisis” (or GFC as it is known to its friends), mutuality seems to be making a comeback. Apparently, credit unions are more popular, and people feel safer with building societies than banks. This may just be anecdotal, but these institutions feel more local – more community-centric. Surprising since the community – all of in the UK – now own two banks and have a significant interest in others.

There was also a discussion about increased portability – being able to switch providers more easily. But should banks be concentrating on this rather than providing sufficiently good service that we don’t feel the need to move? It is said (though I can’t find any stats to support the assetion!) that we are more likely to get divorced than change our bank: maybe we just want banks to be more committed…

The final session I sat in on was perhaps the most creative: the group was asked to create a narrative for the future of finance – to pitch the movie “Banking 2.0”, if you like. At least, that was how we interpreted the task. The blind leading the visually impaired, we probably came up with as many narratives as there were contributors, despite some sterling facilitation. We tried to come up with a scenario in which banking was re-invented after a future financial crash: what would it look like?

Some envisaged mobile phone companies stepping into the breach left by the collapse of banking – they’d facilitate the transfers of cash between consenting handsets. Others saw bartering as an option. My take was much more apocalyptic, I’m afraid: in the wake of a catastrophic banking collapse – not just Lehman going, but the whole lot – I’m afraid I just saw a disaster movie. Phone companies wouldn’t provide credit, since they’d have no trust in us to pay (and vice versa) – indeed, they’d cancel our accounts when we couldn’t pay. With all our money tied up in failing banks, we couldn’t even buy energy to keep our phones charged. And with the financial system in meltdown, the oil-rich nations wouldn’t sell us the fossil fuel we need to keep the power stations running, so they’d be no electricity anyway.

What interests me is that it wasn’t a phone company which has innovated a banking app, but a bank. There may yet be life in these seemingly moribund institutions… (Though perhaps we should have conceived the movie as a zombie epic, the banks refusing to die…! And Umair Haque has written about the zombie economy.)

[Aden Davies has posted about his views of BarCampBank London 5, including information on some of the more technical aspects discussed.]