Osborne: What he’s missing on bonuses
I’ve now had a chance to read George Osborne’s speech from yesterday.
It’s a curious beast, the opening full of strange contradictions of previous Tory lines. Osborne mentions:
the radical monetary action taken by the independent Bank of England, which we were urging and welcomed
And there was me thinking that Cameron thought that ‘printing money’ led to inflation and had to be stopped.
He moves on to note:
According to the independent Institute for Fiscal Studies, a study of last week’s public finance figures shows that the Government are currently on course to spend £10 billion less on public services than they claimed in the Budget – offsetting half of the £20 billion discretionary stimulus.
But I thought Brown was vastly, and recklessly, over spending?
Of course the meat of the speech was the section on bonuses. And here we got lots of soundbites and real sense of confusion. For example:
I am today calling on the Treasury and the FSA to combine forces and stop retail banks – in other words the banks that lend directly to businesses and families – paying out profits in significant cash bonuses. Full stop.
That includes their investment banking arms.
RBS is a large retail bank with an investment banking arm but Barclays is a large investment bank with a retail arm, how will Mr Osborne classify it?
He goes on to note:
So where banks do want to pay bonuses this year to those senior staff who have earned them, those bonuses should take the form of new equity capital – shares in the business.
This equity capital will strengthen the balance sheet and support new lending. (My emphasis)
Now this bit confused me.
Banks currently have very high ‘leverage ratios’ (broadly put the ratio of assets to equity). This is a problem because it makes banks vulnerable. For example imagine a bank with a leverage ratio of 20x, it has assets of £1,000mn but equity of only £50mn. If 5% of its assets turn bad then it’s equity is wiped out and the bank is insolvent.
Banks are currently (sensibly) trying to reduce these ratios. There are two ways to do that, the first is to reduce assets. This generally means shrinking the amount of loans that they issue and isn’t helpful to the wider economy.
The second way is to increase equity.
So, going back to our fictional bank with assets of £1,000mn and equity of £50mn – if it wants to reduce its equity ratio to 10x it could either cut its assets to £500mn or raise its equity to £100mn. Or some combination of the two (cut assets to £750mn and raise equity to £75mn, for example).
Osborne is arguing that if banks pay their bonuses in shares then not only will this encourage a longer term approach but it will also help reduce leverage ratios 9’strengthen balance sheets’) and mean that assets (loans) don’t have to be reduced so much and so support the economy .
The Tories claim this could free-up up to £20bn which could then be lent to businesses and consumers.
The Tories seem to be implying that their plan cunning reduces leverage whilst alternatives don’t. Very neat.
Sadly though it’s not quite that straight forward.
Banks can’t just make equity out of thin air. There is a cost. If they could then there would be no banking crisis – the banks could simply issue to their staff (or anyone else for that matter) in return for nothing and claim they were well capitalised (i.e. had a low leverage ratio). New equity (if it’s not retained profits) needs to be paid for. New shares require new money.
Let’s go back to our imaginary bank with assets of £1,000mn and equity of £50mn. Say that this year it makes profit of £10mn before bonuses (but after other costs). If it chooses in the extreme to pay all of this out as bonuses (option i) , then the £10mn profit vanishes from the balance sheet (into bank accounts) and the bank still has a leverage ratio of 20x. If on the other hand it pays no bonuses (option ii) , than that £10mn profit flows into equity (as retained profits). So equity increases to £60mn and the leverage ratio falls from 20x to 16.7x.
If £10mn was paid entirely as shares (option iii) then the bank issues £10mn worth of new shares and buys them for its staff. So equity rises to £60mn (thorugh new equity rather than retained profits).
Notice that options (ii) and (iii) have the same effect on leverage ratios.
But that’s not the whole story. Option (iii) involves the issuance of new shares and so we need to consider the concept of dilution.
Let’s make our fictional bank more realistic. Let’s say that it needed bailing out in 2008 and is now 50% owned by the government. Now let’s look at out three options again.
Bank pays out all the £10mn in cash bonuses. Leverage ratio stays at 20x. Government still owns 50%.).
Bank pays no bonuses at all. Leverage ratio falls to 16.7x. Government still owns 50% of what is now a safer bank -as no new shares are issued and ‘retained profits’ is attributed to the current owners. (Equity increases from £50mn to £60mn, the Government’s share from £25mn to £30mn).
Banks pays out £10mn to staff as new shares (by issuing new shares, buying them itself and giving them to staff). Leverage ratio falls to 16.7x. The Government, which previously owned £25mn of the £50mn equity, now owns £25mn of £60mn (41.6%) equity in a safer bank.
And this is the real difference between options (ii) and (iii). They both reduce leverage but one rewards staff whilst punishing existing owners (the Government in the case of Lloyds and RBS) whilst other reduces leverage whilst safeguarding owners’ (Government) money.
I lean towards option (ii). Banks need to reduce leverage and i don’t think the Government needs to be diluted to do that. And I’m not alone. Two the financial sectors most successful figures agree with me.
I get paid enormously, and it’s no great credit to me, I was just lucky at birth. It’s nice to give me a fair amount of the benefits from that but I shouldn’t delude myself into thinking that I’m some superior individual because of that.
“Those earnings are not the achievement of risk-takers. These are gifts, hidden gifts, from the government, so I don’t think that those monies should be used to pay bonuses,” the paper quoted him as saying in its Saturday edition. “There’s a resentment which I think is justified.”
The U.S. government committed hundreds of billions of dollars to bailing out financial firms, some of which have since reported surging profits.
Soros said there was a need to regulate payments to employees, even if that meant banks found it difficult to retain talented risk-takers.
“That would push the risk-takers who are good at taking risks out of Goldman Sachs into hedge funds, where they actually belong, because hedge funds take risks with their own capital, not with deposits and not with government guarantees.”
Financial sector professionals are very well paid before we even consider bonuses. Why do we think they need even more? Why should existing owners bear the costs of deleveraging?