The city is bleeding bankers

Increasing regulation (perceived to reduce innovation) combined with job insecurity and stricter remuneration structures are causing a brain drain in financial services. Meaning, the best and the brightest are now choosing start-ups, technology and other sectors –the chance to innovate and build business– over banking.

What does this realistically mean for the industry? In the short term, it is unlikely to be meaningful. Banks are consistently in the news cutting jobs, and reducing costs. Simply said, an exodus is apparent. In ten or fifteen years down the road, however, a lack of people will exist to step into executive and strategic positions.

On the other side, many argue there has been too much innovation in financial services. A brain drain, whereby the “creative” use their talents in other industries, and leave more conservative individuals in finance, is welcome.

Yet, we must remember that financial services currently:

• Account for 14.5% of UK economic output
• Offer a combined total of 63bn GBP in tax
• Have a 47.2bn GBP trade surplus; larger than all other net exporting UK export industries

If the industry continues to contract a lack of talent in the future will mean an even greater decline in the economy. We are currently on the cusp of our third recession in four years. If top talent continues to leave finance (or choose to not enter in the first place),  how can we drive growth?

We must consider that the movement of talent to other industries is unlikely to lead to an equivalent gain for the UK economy. Digital Shoreditch, for instance, cannot compare to Silicon Valley. Graduates are frequently choosing to move to other countries, where VC funding and government grants are easier to obtain. Additionally, if talented individuals leave the financial sector, what guarantee is there that those who will remain will act in a more conservative manner? Perhaps we will be left with a group of individuals who are unable to manage risk entirely.

Talent should remain in financial services – an industry where infrastructure is already developed and the UK is a recognized global leader. Policy makers and bank officials must begin to address issues of worker outflow now before it is too late.

Restructuring Executive Pay

Over the past months, shareholders have rebelled against company executives at annual meetings, forcing the reevaluation and restructuring of payment strategies.  On top of this, many banks are planning to claw back bonuses. HSBC, for instance, will rescind bonuses to pay fines associated with money laundering. JP Morgan will take away bonus payments from the London Whale to make up for trading losses.  

Compensation methodologies are currently being reformed. Ideally, the altered compensation strategies will ensure proper motivation for top executives; ensure a long-term perspective for investment/innovation/risk-taking; not adopt a simplistic view of how people will respond to financial incentives; and be simple enough for outsiders to understand.

Remuneration typically has three parts, a fixed salary, a cash bonus based on the year’s performance and a component based on long-term performance and incentives. In its current form, the annual bonus of FTSE 350 companies is typically around 200% of base pay salary. Bonuses are normally paid if certain benchmarks are met. Bonuses of this nature have also been criticized for encouraging risky behaviour in the short term, in order to meet or exceed benchmarks.

There are several strategies being considered to alter remuneration methodologies. 

1. The Kay review, a paper examining short-terminism in asset management, suggests that annual cash bonuses be abolished. Instead, companies should provide long term performance incentives and base pay only. Long term incentives should be given when leaving the company.
2. The European Commission has proposed limiting the bonus pay to 100% of base pay. 
3. Publish a single figure encompassing all forms of pay. 
4. Making shareholder votes more binding, such that shareholders must be consulted if a majority votes against the pay policy  

The problem with number one is that will likely lead to higher base pay.  If annual bonuses are 200%, base pay would be tripled in order to substitute what is lost. Yet, this option would at least increase transparency. Shareholders would vote on base salary and long-term incentives only.  By deferring long-term bonuses, companies would also align payouts with the overall results of a bank, rather than a single person’s track record (ideally).

The European Commission’s suggestion would likely have similar repercussions; base pay would increase to make up for the bonus limitation. It is also possible that companies paying out a bonus less than 100% of base pay would increase the bonus amount, as it would act as a form of anchoring.

Option three, which would increase transparency, could potentially hide the nuances associated with remuneration, and make it more difficult to determine the reasonableness of the pay. Yet, shareholders would have more power, which could be beneficial long term.

None of these options seems to be perfect. Perhaps the best option is a combination of the various strategies. For instance, a binding vote on policy, together with increasing transparency by requiring companies to publish bonus-to-salary pay ratios, while eliminating short-term bonuses for the sake of long-term compensation, is worthy of consideration. It would increase transparency and shareholder power and help eliminate short-term incentives. 

The psychology of executive remuneration

Executive pay across industries is facing criticism surrounding high salaries. This condemnation is especially true in the financial services, both in wake of the financial crisis and in light of an increase in their share of the wage bill. Indeed, the pay gap in the UK has widened significantly over the past thirty years. Someone in the 90th percentile in 1979 earned 2.5 times more than someone in the 10th percentile, now he earns 3.7 times more. 60% of the increase among the top 10% of earners is accrued to those working in the financial sector.

Much of this increase takes the form of a bonus. Originally, bonuses (performance pay) were designed to align the incentives of the executive with that of shareholders. It was meant to eliminate the principal-agent problem by aligning executive incentives to increasing company value. By reaching a certain benchmark, executives were given additional remuneration. This bonus was often given in the form of stock options or shares, which was meant to further goal alignment. Yet, this has not necessarily worked as meant. Performance pay has led executives to take unnecessary risks. Bonuses have been continuously paid even when institutions are failing. Salaries became a way for executives to judge themselves against their peers, rather than used as a judgment of company performance. 

There are two main problems with this theory, however. One stems from an incorrect view of human motivation. The second problem is associated with payment relativity.

Money is not the only motivation for workers. While bonuses have long been used to incentivize performance, large bonuses when performing cognitive tasks are actually counter-productive to performance. Research has shown that while financial incentives can motivate people to work, very large bonuses can hinder performance by causing stress involved in attaining it, the fear of not receiving the bonus and focusing attention on the bonus rather than the job at hand. 

The problem of compensation relativity is two fold. First of all, executives judge themselves against one another, and compete for highest salary. This leads to higher compensation demands, without the performance to back it up; meaning there is sometimes inconsistency between economic value added and pay. Payment relativity is also problematic when peer group comparisons are used to determine pay. Pay groupings are meant to provide information on appropriate salaries, providing boards with benchmarks, but often result in the inflation of executive compensation when peer groups with higher salaries are chosen. 

A third issue surrounding performance surrounds the idea of crowding out. Monetary incentives have been found to impact the intrinsic motivation of people, as motivation now comes from something external. As a result, people perform less well after monetary incentives are given. This is true regardless of the form of the remuneration (base pay versus bonus).

The regulation of executive compensation is an area currently being considered by regulators, central bankers and more. While regulators are focusing on the structure of pay packages from an economic perspective, they must also be careful to consider the psychology and utility of remuneration before altering the structure of executive payment. 

Equity issuance

The Kay Review, which spent several paragraphs discussing the utility of equity markets in raising money for small and medium sized companies, concluded that the equity markets are “no longer a significant source of funding for new investment by UK companies.”

Personally, I find this disconcerting. Equity markets are meant to help companies raise capital, to further their research and development. Through the process of purchases and sales, they ensure money is efficiently allocated. But, it now seems that most companies generate enough money internally to fund R&D, lessening the need for equity markets (especially for large companies). Beyond this, it has become more costly for companies to raise capital through equity issuance. This follows from an increasing number of intermediaries, who must be paid (lawyers, exchange personnel, etc).

What else has prompted this change? For one, modern businesses are less dependent on physical assets, and therefor tend to require less capital. This is, of course, quite ironic given technology companies’ ability to raise capital (see footnote below). Secondly, there has been an increase in private equity and venture capital funds funding small and medium sized companies (this includes angel investors, business incubators and even specialized banks). Tax policies have also had a role, as debt is a more tax efficient method of raising capital.  At the same time, increasing regulation has made raising equity capital “burdensome.”

Does this mean that the fundamental reason for the stock market has changed? That instead of a place to raise capital, it has become a location primarily for easy transfer of ownership? Indeed, that is possible. Exchanges allow for mergers and acquisitions to occur with more ease, through the majority ownership of shares. While this transformation is possible, and seems likely, it is not desired - it turns out that acquisitions do not typically add value to a company.

A third reason exists, and that is the mismatch in expectations between companies raising capital and investors. Again according to Kay, there is a “wide gap between what banks expect to pay for new equity and what savers expect to receive from such an investment.”  This makes investors and companies alike hesitant to raise equity.

So, what should companies do and how should exchanges be used? A focus on developing and maintaining the competitive advantages of British companies is one suggestion by Kay. We must also change our perceptions and see equity markets today “as a means of getting money out of companies rather than a means of putting it in.” While it is hard to fault these recommendations, one must wonder if something more drastic should be done.

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[1] Google, raised $1.67bn US at their IPO, and gave them a market capitalization of $23bn US. Google’s share price increased 18% on its first trading day. Other technology companies that have IPOd since Google have done even better – Linkedin, for example, gained 108% on its first trading day (closing at $94.25 US, up from its initial offering of $45 US). Let us not forget the Instagram purchase by Facebook for $1bn US. Given these prices, it also seems prudent to mention worries about a tech bubble. 

Trusting the financial markets

Former Bank of Canada governor, David Doge, said trust “is more than a simple belief in something or someone without supporting evidence. Trust is what develops when a group of people share an understanding that the rules for behaviour governing their system or society work well and make things better for everyone.” 

Unfortunately, this shared understanding of rules and behaviour is seemingly missing in financial services. According to the Edelman trust barometer (2012), a yearly survey monitoring public trust in institutions, only 40% of people trust banks. Trust in the more general “financial institutions” sits only slightly higher at 45%.

Trust is not a unitary concept, however.  There are many forms of trust, and the various forms are malleable. All follow the basic premis that an agent will act in a consumers best interest. But, problems of performance based executive compensation, commission fees and a focus on short-terminism means this is rarely the case. 

A loss of trust in financial services is problematic for several reasons. Trust helps the functioning of the financial system, which positively impacts the real economy. With trust, less effort is expended on “keeping tabs, so systems can run more efficiently,” and transaction costs are reduced.  There is less of a chance of bank runs and capital is allocated more efficiently.

While all three forms of trust can and have been broken in recent history, the most common breach of trust occurs in an agency relationship. An agency relationship is a contract where “one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf, which involves delegating some decision making authority to the agent.”  Unfortunately, “there is a good reason to believe the agent will not always act in the best interest of the principle,” if both parties are utility maximizers.1

Agents in financial firms are particularly well placed to maximize their own utility because of asymmetric information, moral hazard and complexity inherent in the financial system. In fact, financial firms exist, in part, because of asymmetric information. Financial agents, be it investment advisors, fund managers or bankers, are employed to utilize this superior information on behalf of the consumer. Agency relationships are fraught with moral hazard, as the agent is not typically responsible for the costs associated with risk taking. The complexity of the financial system is, in part, is what makes agents able to maximize in this way. Together, these three issues create a severe principal-agent problem.

How can regulators help bring trust back into financial services? You can’t, really. Trust develops slowly but surely over time. But, here are some recommendations to develop and maintain trust into the future.

1. Increase transparency
2. Principles over rules based regulation
3. Increase competition in the financial sector while reducing switching costs (consider portability of account numbers)
4. Only allow certain products that meet risk requirements
5. Criminalise breeches of trust
6. Increase financial literacy

Some of these are already occuring, or at least there are movements in this direction. After LIBOR, for instance, criminal charges are being levied against perpetrators. Think tanks and educational instituitions are attempting to encourage literacy. But, its not enough.