Bank Bonuses, Competition and Regulation

Bonuses paid to bank employees -- executives and investment bankers -- have become a contentious issue in many countries, especially in the US and in the UK, though much less so in Canada. However, there is a message for those of us who use banking services in Canada (everyone!). I'll come to that after a brief survey of what's going on.

While bank-employee bonuses have been high for many years, it is now a matter for public and political debate since governments (and therefore taxpayers) kept these private companies solvent during the financial crisis. Even where the bank boards and managements are now willing to reign in these multi-million dollar bonuses, they feel compelled to pay since they will otherwise lose their key employees (those responsible for generating the lion's share of investment banking revenue) to competitors that either did not receive a bailout or have already repaid their government bailouts.

Many of these high-value employees have already switched employers, and some of them are suing for previously-promised bonuses. There are also good arguments for better ways to structure pay and bonuses, and also why these attempts annoy those receiving the bonuses. It's a real mess.

One article drew a comparison between employees receiving large bonuses and professional athletes: they are the very best at what they do and so deserve large payments. Of course, as the article notes, athletes' performances are more measurable than that of bankers: you cannot simply look at a few numbers -- especially profit and deal flow -- and conclude that these bankers have ability. Too often they are merely in the right place at the right time. That is, when the corporate world is replete with equity offerings (including IPOs), bond issues and M & A, the deals will be there and there are only so many firms with the abilities and connections to do the work.

It is also worthwhile at this point to mention the two major avenues these companies have for making money: fee for service and debt. Fee for service is the simplest one to understand. The bank performs a service and they get paid. The transaction ends there since the bank has no direct tie to the payers success or failure. Examples include the previously-described financing deals, and a wide range of consumer banking and transaction fees, merchant fees for credit card transactions, and mutual fund management fees. In all these cases the banks gets their revenue from the transaction, not whether the transaction benefits the customer; their interest in the customer is limited to getting return business, including keeping customers' money in their mutual funds. Poor performance is often countered with more marketing, not better performance! Bonuses and compensation paid from these profitable businesses have little to do with how their customers fare.

The debt business is more interesting since the bank is betting on the customer's ability to pay the interest and eventually repay the principal. This is as true for residential mortgages as it is for corporate financing. Here is where there is a need for some ability and hard work to manage risk in a perpetually uncertain economy and future, and of course researching each debtor's ability to perform. Banks manage and hedge their risk very carefully, most of the time; the recent financial crisis shows how they can be very, very wrong.

So far what I've written is very uninteresting in that it is (or should be) well understood by everyone. I now want to bring the discussion around to the ongoing role of government, especially here in Canada.

One aspect to the large compensation these bankers demand and get that is like the case for athletes is its artificiality. Athletes can only get their high salaries because we the viewing public is willing to pay to see them perform. Stop that and salaries must implode. That is the motivation behind salary caps in professional leagues, in that many have finally tested the limits of the public's willingness to pay: as popular as sports are, the revenue they can garner is finite. The other limiting factor is scarcity: if you flood the market with more teams and leagues, the finite revenue available must be spread more thinly.

Scarcity in the corporate world is simply one of competition. With more competition, prices trend downward, driven by ordinary supply and demand. In investment banking the possibility of competition has been limited in part by closed relationships among the key market enablers. This makes it difficult for a new company to get into investment banking by starting from scratch; new outfits are therefore typically started by individuals and teams that already have those connections. If you want to do an IPO for your company, going to the banker with better connections means you do the deal faster, easier and at a higher offering price, and so you are willing to pay the fee they demand.

In consumer banking there is also scarcity, but this scarcity is artificially maintained by heavy government regulation. It is very difficult for a new bank to get registered to operate in Canada. Lack of competition keeps fees for services high. Government balances this undesirable trait against the stability and reliability of the country's banking system, which -- whether we like it or not -- determines to a great extent our economic well-being. Seen in that light, high banking fees and high bank profits are the price of economic stability and access to credit.

If the government were to allow more banks to enter the market, competition would certainly drive down prices. It would also raise the cost of regulation and raise the risk of something going wrong (bank crisis or failure). Regardless of ideological leanings, no federal government has been eager to open the gates; they are fine with the status quo. There have been exceptions of course, such as Amex Bank of Canada.

Also, personal bonuses are less controversial in Canada since our investment banking sector is smaller and more disciplined. Like with athletes and entertainers, ambitious and capable bankers go south to work in the US. The current governor of the Bank of Canada, Mark Carney, is one example. Further, we all have the ability to tap into bank profits, ex-bonuses, by investing in those companies.

This latest financial scare has likely only firmed up confidence in the status quo of Canadian banking. We can expect banking fees to be a continuing source of complaint for the foreseeable future.