If you’re an entrepreneur and you borrow £1m from a bank to launch a new business idea, you’d not expect your dividends to be capped. So, if a banker uses £1m of their employer’s money and speculates successfully in the market, why shouldn't the banker have their bonus and the amount merely reflect their success?
The critical difference for the entrepreneur is that, of course the downside is real. If the £1m loan’s not repaid, the bank will have security in the form of a personal guarantee or collateral so the entrepreneur could lose their business, house and be pursued to bankruptcy. Entrepreneurs carry the risk of their speculation and that, in turn controls their appetite for risk in using the banks' money.
The debate about bankers’ bonuses seems to focus on capping the upside because the amounts are so big. For bank shareholders who see profits go to employees rather than to them as dividends that’s understandable. For the government, at a time of austerity it’s also an embarrassment.
But the real issue is not the upside.
Morgan Stanley CEO, James Gorman put his finger on it at a conference last year when he said, as a banker “...you can put on a large trade, and if it works, you make out like a bandit, and if it doesn’t, you might get fired, but you’re not paying back. So you have asymmetric risk, you either come out zero or you come out positive. That’s imbalance.”
That's the problem - there’s no balance between the upside and downside for bankers. The lack of downside means insufficient restraint on their appetite for risk. That creates a dangerous scenario as Matthew Lynn observed in MoneyWeek, where bankers can “...speculate with huge sums of other people’s money. When that goes well, they take a big share of the profits for themselves. When it goes badly, they pass the bill onto shareholders. When it goes really badly, and shareholders can’t afford to pick up the tab, it gets passed onto the taxpayer.”
The downside that makes banker, entrepreneur or anyone think twice about what they do with other people’s money is personal risk. Many recognise the problem, including the Governor of the Bank of England, Mervyn King who said, “What we cannot countenance is a continuation of the system in which bank executives trade and take risks on their own account, and yet those who finance them are protected from loss by the implicit taxpayer guarantees. The difficulty is in finding the right practical way to achieve that.”
It does seem hard to achieve. Governments, regulators and shareholders are trying to work it out, but public indignation has not abated that Sir Fred Goodwin can run RBS to the point of insolvency, be bailed out by the government and never face the scrutiny of a liquidator who, in normal circumstances would trawl through the wreckage and pursue personally those negligent in running the business. People struggle to see how a society, be it big or small, can be fair if someone running a corner-shop has no protection if they run it while insolvent, yet Sir Fred Goodwin can run a bank the size of RBS while insolvent and walk into the sunset with a £700K per annum pension.
So I have a proposal for bankers that may help restore their public image and achieve some correlation between bonuses and risk. It involves supporting entrepreneurs and innovators developing new ideas. The fact is they invariably don’t need a £1m from the bank. In the early, high-risk phase of developing new ideas the amounts are smaller, but the courage and determination required to take the risk is huge.
I’ll give you an example. I recently interviewed an inventor who’d developed a new household product. To build the prototype took him over two years and cost, including market research, patent applications and launching the product more than £60,000 of his own cash, not including the value of his time. He took the product to trade fairs, where an American saw the product, copied it without his permission and launched it in the US. The inventor had to hire US lawyers and incur legal fees sending out cease and desist letters. This fortunately resulted in the American licensing the product from the inventor, who now receives a royalty stream from sales of his invention in the US where he’d have struggled to launch the product himself.
The story has a happy ending, but the point (aside from the fact many such stories don’t have happy endings), is that the inventor had to carry the entire financial risk himself. While the total amount at stake was around £75,000, you ask the average earner in the UK how they’d feel about adding that to their personal debt. They wouldn’t be keen - it takes real guts.
The fact is few jobs pay bonuses of the size paid to bankers and the downside for entrepreneurs, inventors and creative people launching new ideas is disproportionately high compared to the upside. The problem with banking is the upside is disproportionately high compared to the downside.
So in an effort to restore the balance, and a fairer equilibrium of risk, my proposal is to launch a new fund for the development of ideas: An “Ideas Bonus Fund”.
Bankers would be encouraged to invest 10% of their annual bonuses in the fund. This would not be a philanthropic gesture. It would be an EIS-qualifying investment with a commercial goal. The money would be applied to the development of new business ideas, new technology and new creative initiatives. It would be spent on developing prototypes, R&D and maximising IP protection through patent and trademark applications and copyright. So, while the risk would be real, the upside and ROI in the form of assets, IP and new businesses would also be real.
The amounts initially allocated would be smaller than those available from VC funds or even angels, and while there are plenty of such incubator funds in places like Palo Alto where innovation has a momentum at the heart of their culture, it’s hard to find those amounts here. We need innovation to restore growth in the private sector so politicians from all parties and senior bankers should be able to support this. Project Merlin encourages banks to lend more to SMEs, but a fund for new ideas is about individual bankers putting up risk money from bonuses earned, admittedly with skill and hard work, but without much real risk.
We need successful, high-earning bankers in the UK; we don’t need high-earning bandits. An Ideas Bonus Fund won’t control bankers’ appetite for risk when they speculate with the banks' money, but while others work on that issue, this fund may contribute to the current imbalance of risk.
© 2011 John Woollcombe – All Rights Reserved