Europe, Swiss move to limit banker bonuses and control fraud, Boris howls and Osborne takes it in the neck

The European Parliament often gets a bad press, but they are at least proposing a solution to one of the problems infesting capitalism at the moment, though it seems to me the plucky Swiss are way out in front here.

It is the principal agent problem, and it started to arise in 1993 when Bill Clinton tried to cap executive pay. He made a right bugger’s muddle of the job, because the way he drafted this simply incentivised everybody to lie to get round the cap. He probably shouldn’t have been in this space anyway. It is the job of the shareholders of a firm to sort out pay, though twenty years of executive thievery has dulled our minds to this basic fact. In the end a joint stock company is about raising money from people to do something profitable and then distributing a share of the profits to them. It isn’t actually a charity to fund lavish executive lifestyles, and the easiest way to prevent this happening is to have transparency in pay. Not necessarily a matter of public record, but the firm itself should have some idea of its pay liabilities, and a method of setting pay that is independent of the people being paid.

In the past you’d pay an employee a wage, and a bonus depending on performance in some cases, particularly sales. What seems to have happened is people working in finance in particular have got it into their heads that they are so clever, so brilliant, that they should all be paid by performance. However, sneakily, they talk about more pay for good performance. They don’t talk about putting £10 million in an escrow account where the employer can suck out a wedge if their performance is crap. No sir, we just want performance related pay for good performance. Lest it be said that I’m picking on bankers in particular, I note fund managers don’t waive their fees if they make a mess of stock-picking, they just quietly close down the fund and start again. Hedge fund managers and some investment trusts like to charge an extra fee if they do well and the fund rises in value over a year, but remain curiously silent about not paying back the equivalent malus if the fund falls. Go figure.

Back to the more general case of executive pay. Clinton failed to include performance related pay in the cap, so obviously nearly all pay became performance related. What sort of performance – well, whatever could be fabricated to pay more. Once you base pay on a fabricated set of metrics in the control of the payee and/or people under the influence of the payee then the outcome is going to be excessive  pay. It’s like leaving the till open – it’s going to get looted! The results are easy enough to see

ratio of CEO pay to average
ratio of CEO pay to average. Looks like the third peak was cut short by the recession, but the trend is still well up

In the past, most of executive pay was basic pay, with a bonus that typically didn’t exceed basic pay – indeed twenty years ago it was rare for a bonus to get up to half basic pay. Nowadays this is obfuscated by being ‘performance related’. For most of us performance related pay is, as a contractor wryly observed to me, a way for companies to justfiy reducing pay for permies. At the top, however, it becomes a licence to print money. It also skews incentive timescales – to make the performance call at the end of the year you have to scan back at most a year’s worth of performance. So PRP inherently favours short-term metrics, but since large companies aren’t pop-up-shops, decisions made at Board level have an influence on the firm’s performance that can last for many years.

That multi-year performance is what the shareholders get, but since PRP has to be called out annually, the Board has an incentive to take actions that favour this year rather than the future, and this is worsened by the shortening of executive tenure to less than three years on average. Heck, I’ve held stocks in companies longer than many of their CEOs have stayed, and this leads to a disturbing fact.

The shareholders are taking long-term risk, which doesn’t impact executive pay because they’re outta there when the chickens come home to roost

I don’t have a problem with high pay. I do have a problem with perverse incentives

You don’t build a FTSE100 firm in three years, though you can trash one that quickly. There’s nothing wrong in paying top dollar for ‘talent’, as long as you know why you are doing it. I don’t have a problem in paying someone 1000 million pounds if they add more than that much in value to the firm per annum, and using someone at 10 million wouldn’t cut it. I can’t imagine the scenario where that extreme would apply, but it’s a perfectly reasonable thing to do, a classic ROI calculation, if you can define the variables and risks with enough confidence.

What I do have a problem with is anybody getting any form of performance related pay that is more than their basic salary, because they should have a stake in the long term as well as the short. And it seems that Europe agrees with me. Boris Johnson thinks it’s all to do with hiding the mess that is the Euro, but then he would say that. Looks like Osborne failed handsomely in his attempt to water this one down.

There is, of course, the usual hollering from the vested interests, about how they will all scarper to Somewhere Else. Not so fast, people. Once you have paid back every red cent of the taxpayer bailouts, then yes, on your bike.

So far the evidence is that the bonus culture has incentivized bankers (in this specific case though the rot is wider) to drive like drunks and crash the whole economy. How much tax has banking put into the British economy over the years compared to the bailout money it has sucked out of it, and do we really want more of this white-knuckle ride? And yes, governments have been complicit in permitting the TBTF company to rise. However, the TBTF operations had far more resources to hand to embed themselves into a position where they could call on a one-way bet on taxpayer money underwriting their risk-taking because the alternatives were deemed to hurt too many people.

Gnomes of Zurich reined in
Gnomes of Zurich reined in

Meanwhile, over in that hotbed of anti-capitalist communism formerly known as Switzerland, a quiet revolution seems to be taking shape to address the excesses of executive pay. Again, there’s no problem paying someone a shitload of money, just that in shouldn’t be obfuscated in golden hellos, golden goodbyes, massive lumps of performance related baksheesh. It is transparency and symmetry that need to return to pay in business – with great rewards should go great risks. And the risks should be shared by those getting the great rewards, not just by the hapless company owners (that’s you and I as shareholders, or you and I as taxpayers in the most egregious examples). There needs to be rules of business so that information is available to all the stakeholders, so that they can choose what to capitalise and what to stay away from.

Kamal Ahmed’s Telegraph article is the usual trope being trotted out – ‘banking will simply up sticks and leave’. That sort of thing didn’t wash with the Swiss, who still seem to have the quaint notion that you should take some responisbility for your actions and not just socialise the risks. Perhaps upping sticks would not be such a bad thing. The British taxpayer is probably not good for another banking bailout, and it hasn’t got its money back from the last one. It’s about time the good citizens of an economy in better shape than most of the Old World took on the risk and stepped up to the plate next time. Alternatively, it’s about time that the multifarious top agents of capitalism wind their necks in and start taking part in the risks as well as the rewards of their tremendous brilliance. At the moment they seem to treat the whole thing like a video car game, where crashing the vehicle ends up in a reboot and start again. The rest of us occupy the real world, where their crash involves lots of wreckage and real people getting hurt. Let ’em howl.

Most people who have an issue with executive pay have an issue with the  amount or the ratio to average salaries as such. I don’t – some of the rise in the level of CEO pay relative to the grunts may simply be the increasing scale of companies. However, I do have problems with executives acting like the robber barons looting shareholders money and using opaque metrics to award themselves rewards without risks. All hail to the Swiss for calling this out and flagging the excesses without falling into the Clinton trap of trying to cap reward.

It shouldn’t be capped – but it should be as transparent as possible, so that the true owners of a firm have enough information to make a judgement call. That’s what needs regulation – simple, understandable pay and incentive schemes, preferably where the balance between the carrot and the stick is a lot less uneven than it is now. Golden hellos, goodbyes and handcuffs need to be limited too, because these are simply used as disguised bungs. If the firm wants to pay a shedload of money, do it. Over the table, please, not under it by sleight of hand.

No doubt the peddlers of the Global Talent Pool meme will screech. Sod ’em. Capitalism has done perfectly well so far with pay and bonuses that were understandable. If anything the increasingly short tenure of CEOs shows they aren’t that special compared to the people of a previous generation who ran firms for decades, really understanding them as opposed to in and out for a fast buck. I’m chuffed to see that it is the Swiss who seem to be making moves to spike this charade.