Bankers’ Bonuses – A Fairer Solution

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The media, both conventional and newer social media, is full of hysteria about bankers’ bonuses right now, but nobody seems to be suggesting solutions beyond either the status quo or stop them completely; neither offers a satisfactory solution.  For me, the only solution for the future is to look to the past and who this problem was addressed successfully for many generations.

Until the deregulation of the 1980s, there was clear demarcation between commercial banking, i.e. deposit taking and using those funds to make loans to individuals and businesses, and investment banking, i.e. the issuing and trading of securities and associated advisory activities, at least as far as the major Anglo-Saxon economies (Continental Europe had followed a different path, but one with less active securities markets.)  Those involved in investment banking (the US variant) or merchant banking (the UK variant that added trade finance but removed securities market trading from the business mix) were traditionally organised as partnerships, (just as other professions such as lawyers and accountants) and even when they converted to limited liability companies, they retained the basic partnership concepts: those who ran the business, owned the business and they shared both the profits and the risks.

The last 30 years have seen a dramatic change to this model; the people actively engaged in the business generally have little ownership of the business, share significantly in the upside but run little risk beyond that of losing a job.  The capital is now largely provided by large financial conglomerates, often with commercial banking at their heart, with management who have little understanding of the investment banking business.  The financial crisis of 2008 added a very dangerous new development; for the first time investment banks found themselves beneficiaries of tax-payer funded bail-outs.

The Vickers Report in the UK has recommended the ring-fencing of UK commercial banking from investment banking and international operations, and this has been generally accepted by George Osborne.  My suggestion is to take this one stage further, and to an element return investment banking to a partnership type structure, albeit one that accepts the reality of larger capital basis than was feasible in the days of partnerships.

The “classic” financial model for investment banks was for revenues to be split three ways: staff, capital and other costs, but it only makes sense if the staff that earn the large elements of the revenue also participate in any downsides.  My model, which is based on the British legal system and the assumption that the investment bank is part of a larger financial conglomerate, is as follows:

  • The investment banking activities are transferred into a limited liability partnership (“LLP”) where the existing owner (the financial conglomerate) is one member and the senior staff (the definition of which could relate to seniority and/or pay, but with the caveat that nobody could earn over £100,000 per annum unless they were a member of the LLP) at the investment bank are the other members.  
  • The voting rights of the LLP would be 50% to the financial conglomerate and 50% to the working members (split on internally agreed percentages).
  • The non-member staff would be paid salaries as normal, deducted, along with the costs of running the business before any profits were made.
  • The financial conglomerate would receive the first “slice” of the profits, receiving an agreed percentage of the capital it contributes, say 5% over the Bank of England Base Rate, (5.5% at current levels).
  • The remaining profits would then be split on the same proportions as voting rights, but with 50% of all profits being reinvested as member equity in order to grow the business.
  • If the business made a loss, this would be reflected in no remuneration for the working members and a reduction in the value of their equity stakes in the business.

Using this model, the investment bankers would be encouraged to act as entrepreneurial business people, rather than short term traders.  In good years they would see their remuneration rise and their equity stake increase in value, with the opposite in bad years.  At the same time, the parent financial conglomerate would be insulated from the activities of the investment bank, making it much easier to separate in the case of a catastrophe, and provide a barrier to the issues of “moral hazard” that became prevalent at the time of the 2008 crash.  This model would truly reward success and punish failure.

Nick

Nick Harriss @ Google+

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Will @Crowdcube&@FundingCircle create a genuine alternative to banks? http://reut.rs/wTBV5E I think they’ll have an Amazon/eBay like impact over the next decade, and as someone working in corporate finance, I’m certainly preparing for it.Small businesses seek crowds as funding alternative | ReutersLONDON (Reuters) – Just weeks before the birth of her first child, Gem Misa could be found handing out samples of her home-developed salad dressing range in a high-end London department store, an apro…

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An Englishman’s Home is his Castle

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“An Englishman’s home is his castle” is an old saying that reflects ancient liberties, but in the last forty years there has been a deep cultural change in the UK that you might imagine that it refers to some deep seated love of property investment.  Let us begin with a brief history lesson.

The early 1970s saw the Heath government preside over a credit driven property boom, the so called “Barber Boom”, which came to a swift and painful end.  This end involved the “Secondary Banking Crisis” of 1973-75 when many smaller banks collapsed as the impact of a bursting property bubble, currency crisis and rising oil prices following war in the Middle East (sound familiar?) fed through to the wider economy.  The lessons of this crisis were swiftly forgotten as governments and the media swiftly moved on to what were seen as the greater issues of inflations, industrial decline and union militancy.

December 1977 saw a seminal moment in the housing sector, but one that receives very little mention.  Local authorities were for the first time required by law to house the homeless; slowly but surely council housing became something you moved into as a last resort, whereas previously it was something you were rewarded with.

Much better known were Margaret Thatcher’s reforms of the 1980s that saw the housing sector turned on its head.  Council housing stock was sold to tenants at discounted prices, substantially reducing the availability of council houses and generally leaving the poorer quality properties behind, while the private rented sector was deregulated.  At the same time the historic controls on the financial sector were substantially removed; banks were allowed to compete freely in the mortgage sector, building societies were allowed to enter new markets and macro controls on lending were removed.  This period ended in 1990 with another sharp recession, the Gulf War, record numbers of mortgage repossessions accompanying falling house prices, and ultimately in September 1992 with “Black Wednesday”, when the Pound was forced out of the European Monetary System.  Again, the lessons of this crisis were lost, governments and the media this time focussing on matters of European integration and problems with public services.

The cycle from 1973-75 to 1990-1992 appeared to be repeated 17 years later when Northern Rock collapsed, but this time there were two big differences: after two years there were no “green shoots of recovery” and real house prices had not seen a significant fall.  So what had changed?

The first of these is the easiest to explain, and although economists and politicians will argue until the cows come home about the details, there is general consensus that as the bubble was bigger it will take much longer to recover.  So why haven’t house prices fallen sharply as they have in America, which has suffered an otherwise similar recession?  I would argue that this has little to do with economics and more to the deep-seated psychological change that has taken place.  Houses have gained an almost mythical position in British society, something reinforced by an army of TV shows, magazines and newspaper articles; they are concurrently the ultimate store of value, the true expression of your personality and the demonstration that you have “made it”.

So the British economy finds itself in the midst of the worst decline since the 1930s, with little light at the end of the tunnel, but we cannot countenance a fall in house prices.  Banks have tightened lending practices sharply and developers are building record low levels of hew houses, but house prices remain at almost peak levels (and beyond peak in London), resulting in lending multiples way beyond anything either normal or sensible.  It is almost as if house prices are being kept up but by a process of collective will, or more properly, collective delusion.  By most realistic measures, UK houses remain 50% overvalued; such a decline would be inline with the US market.

The problem with collective delusion is that when the cracks come, they come big time; the collapse of the Soviet Union and the Arab Spring are good examples.  So my question is when will the rose-tinted spectacles of the UK housing market crack, because crack they surely must; when this happens the psychological impact may be even greater than the financial one.

 

 

 

Nuclear Bombs & No Water

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Iran is an enigma to most of us in the West.  It is not a democracy, a dictatorship, a Chinese-style one party state or a monarchy; the term normally used is “theocracy”, (although that implies something akin to the Vatican City rather than the reality of the situation) that appears to make highly irrational almost schizophrenic decisions.  It is a state that appears to suffer from paranoia, both about the West and Israel, (although when consideration is given to the previous activities of the British and American governments in its affairs and Israel’s threats to bomb its nuclear facilities, the paranoia becomes slightly more understandable) which has threatened to “drive the Zionists into the sea”.  It is a major oil producer, but little of the wealth generated has gone into building modern industry, spent instead on a ruinous war with Iraq, albeit a war they did not start, sponsoring overseas “revolutionary Islamic” movements such as Hezbollah in Lebanon, its own security structures and a nuclear programme.  Compare the economic progress that China has made during the last 20 years.  Like many countries in the middle east, it has an extremely high birth rate, with more than two-thirds of the population under 30, and the population having quadrupled over the last 60 years, reaching 75 million and set to rise to 105 million by 2050.  It also suffers from the other great problem of the middle east, a lack of water.  I saw this article today on protests in Iran about a salt water lake drying up – http://www.bbc.co.uk/news/world-middle-east-14780708 – a serious issue in itself, but more seriously it reflects the increasing desertification of the country; a country where thousands of villages have been abandoned due to the advancing deserts.

So we have a country with an exploding birth rate, a paranoia (somewhat justified) regarding the intentions of the West and Israel, a strange government that no one really understands, a stalled economy, advancing deserts, a lack of water and a nuclear weapons programme.  This is not a good combination.

Nick

Anti-Social or Just Anti-Modern World? – A London Riot’s Update

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There is a smart guy I follow on Twitter called Symeon Bown (@symeonbrown) who made some of the most insightful comments on the recent London Riots and put many of the so called professional politicians and journalists to shame.  He recently  tweeted “Is there really a debate to post soldiers in classrooms & turn schools into boot camps? Cannot imagine two professions more polar opposite.”.  It got me thinking about a posting I wrote a year ago, which could probably do with an update in the light of these recent events.  The original text is below, with the update to follow.  

Anti-Social or Just Anti-Modern World?

A friend of mine posted on her Facebook page a link to a disturbing report about youth gang violence in the area of London where I live.  Such reports usually lead to views dividing along traditional Left-Right lines: either the issue is caused by poverty, lack of opportunity, lack of facilities, discrimination etc. or they lack discipline, should be locked-up, bring back National Service, corporal punishment etc.  I would like to suggest an alternative view: the kids in gangs, just like people who climb mountains and join the army, are merely searching for a way of life more akin to the way that humans have lived for the vast majority of the time they have spent on this Earth?

I’m sure most people who are reading this (if anybody is) will be thinking I’ve taken a beating from the crazy stick, so let me explain.  Modern humans have been around for some 140,000 years, (and more primitive ancestors for around 4 million years in total) and for over 90% of this time they lived the life of nomadic hunter gatherers.  This was a harsh and dangerous life, but a life for which the human species had evolved.  Then around 12,000 years ago the first settled agriculture began, followed 2,000 years later by the first towns, and around 5,000 ago the first recognisable cities appeared.  Since then, everything has speeded up hugely, with nomadic hunter gatherers now confined to a few unwanted corners of the Earth and the recent revelation that the majority of the planet’s population now lives in urban environments.  Humans are adaptable, we have an enormous capacity to learn, and in many ways modern life as far preferable to that of ancient times, but in historical terms, it is a very recent innovation, and certainly too short a period for nature to have made evolutionary advances

But what if you don’t want to live a modern life?  What if you wish to live like humans traditionally lived?  It is possible, but it is certainly not easy.  What if you wish to live like humans traditionally lived, but don’t realise it, and actually have no idea how they lived; you just know you don’t fit in to the way things are?

   
There was a comment in the report that my friend posted that I thought was particularly telling; it comes from a school friend of some gang members, “they don’t listen and they won’t learn”. I think to blame a lack of either youth facilities or discipline is too easy; people don’t join gangs because there isn’t a youth club nearby or someone’s not making them do their homework. It strikes me as more part of a cycle of self-destruction, alongside such activities as drug/alcohol abuse, smoking, eating junk food etc. These kids know it is bad for them, (I’ve never seen any evidence to suggest that most of them are educationally sub-normal) they know that it puts them at risk, but they choose to do it. I don’t think you can look to solve the problem until you understand why the choice is being made in the first place. 


My hypothesis, for which I have no proof, other than looking back on 4m years of human evolution, is that the modern world lacks risk, it lacks adrenaline-pumping excitement, it lacks camaraderie, it lacks clear, unambiguous direction; it is the reason why so many young people around the word join armed forces, both formal and informal; it is why people climb mountains and trek across the Antarctic. For most of human history, such stimulation was provided by the instinct to survive; now survival is easy, so their only option is to create an environment where survival becomes difficult again. 

These kids have no interest in the world of offices, schools, shops, churches and hospitals they see around them, and “improving their opportunities” for a job in such an environ is not going to help. Most people can happily exist and prosper in the modern world, but those that can’t are viewed as delinquents and failures; maybe we should accept that the modern world does not work for everyone and how we might adjust it so there are alternatives; we might even find that some people return to “normal” society once they have had a sufficient exposure to the alternative.  

It may seem odd to the vast majority of people who live happily in the modern world, but a life where risk has been minimalised by laws and health and safety rules and where the pursuit of a career, nicer house, spouse+2.4 children is not for everybody.  But what is the alternative?  Can us humans cope with multiple society models existing side-by-side?  Our historic record on this has been poor, and the recent trend towards globalisation has pushed more and more people around the world towards the standard modern Western model.  For generations, Romany and other travellers have been demonised for reasons that boil down to society at large being uncomfortable with people who want to live their life in a different way.  Look also at the way that Native Americans and Australian Aborigines have been treated, peoples who wished to live a traditional life. Of course, some “alternative lifestyles” are positively encouraged by the State, (or perhaps that should be the broader “System” or even the “Man”) notably the Armed Forces, but most are regarded with deep suspicion.

Maybe the example of the Armed Forces might even provide a model.  They provide a society that is more “parallel but separate” rather than “side-by-side” with mainstream society.  Could such a system exist in a scenario where the State was not paying for it; I doubt it.  Would wider society be prepared to pay for such an alternative society?  It strikes me that it may well be both a superior and more cost effective alternative to the current structures of prisons, social workers.  It may seem an unthinkable option, having similarities to the film, “Escape from New York”, but I am not suggesting some kind of giant prison camp, but an alternative structure that people could join and leave, but with different rules and laws inside the structure.

Update Post London Riots


London recently suffered its most serious riots in 25 years in which a significant (but no way close to a majority) element of the city’s young people rose up.  Although the initial spark was a contentious police fatal shooting in Tottenham, there appears to be little evidence that any but the initial riot in Tottenham around the police station can be linked directly to these events.  Many of the people subsequently convicted of offences relating to the riots have claimed “they just got caught up” in the events, claims that have been widely ridiculed, but ones that I believe deserve wider consideration.  Stealing trainers from Foot Locker may not have the the same evolutionary imperative as hunting an animal for food, but I would suggest that it provides a similar emotional response among the participants.

In terms of the political arguments, I believe that the options being presented will have little effect.  The government’s “tough” approach won’t address matters beyond making “law abiding society” happy that “justice” has been done and the criminals punished, while those on the left, proffering a smorgasbord of social/support/youth workers, leisure activities and reports will just result in yet another expansion of the “poverty industry” among the ever increasing number of graduates who cannot find find jobs in more productive activities, rather than improving the life chances and economic position of those directly effected by the position they find themselves in.

So, returning to the starting point Symeon’s Tweet about soldiers in classroom, I offer one final thought.  Perhaps what we need is the option of a new type of “alternative” lifestyle for young people who find themselves “lost” in modern society.  Similar to the armed forces or religious order in that it provides a community, accommodation, purpose, structure, discipline, education and vocation, but neither military or religious in nature.  Such a proposal would not attract nor desire government funding, so would need to be self-sustaining, producing goods/services that would be desired by the outside world; the closest existing example I can think of  is the kibbutz movement is Israel.  It would have to be provide an element of excitement, buzz, risk, however you might want to describe it, but that cannot be beyond the whit of man; the world still has adventures to offer and many of them can be useful and productive.  Two months one year building a school in Mozambique?  The following year an irrigation project in Peru?  I open it the floor to comments and questions.

Nick

Did Rising Oil Prices Cause the Recession?

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There is a clever blogger out their, Enoch Smith, (http://enochsmith23.blogspot.com/) who recently wrote a great post on the largely unrecognised contributing impact of rising petrol (gas in American terms) prices on the US recession.  Although I can’t disagree with much of what he says about the subject, (prior to the Lehman crash, I remember a lot of people commenting about the impact of $140 bbl oil on the world economy and Goldman Sachs were forecast $200 bbl in a relatively short term, but then it rapidly became old news as prices fell back).  My main comment however is that I see the rise in gas prices as being a a symptom rather than the cause of the recession, in just the way that defaulting mortgages (which Enoch commented and I agree as being the more widely reported cause) were a symptom in my view.  Let me explain.

In my view the cause can be traced back much further and what happened in 2008 with both mortgage defaults and gas prices were effectively just straws that broke the camel’s back.  By the 1980s, the economic consensus that had existed in the western economies since the end of WW2 was starting to fall apart.  The economic theories of Keynes, which had held the high ground for almost 40 years were now seen as outdated, as was the social compact between unions, the government and employers, and globalization was starting to take hold as a concept.  As many industries started to “modernise”, typically involving big reductions in labour forces and plant closures, one of the most traditional and old fashioned industries embarked on a different approach; that industry was banking and finance, more correctly defined as “financial intermediation”.  For perspective I have worked in the sector since 1987, the first 12 years in stockbroking and investment management and the more recent years in corporate finance.

New York and London, the two major centres for global finance were run more like gentlemen’s clubs to that point; legislation/regulation kept different firms from competing too closely.  The Glass-Steagall Act in the US prevented commercial banks being investment banks and vice versa and inter state banking was severely restricted, while in the UK, brokers, jobbers (I believe the term specialist is used on the NYSE for wholesale stock dealers that trade on their own book) and merchant banks were kept separate, not only from each other but also from commercial banks.  Stockbroking commissions were fixed, commodity markets were restricted to participants from the relevant industries and institutional investors were conventional pension, insurance and mutual funds.  Mutual and/or local institutions dominated the savings and housing finance markets, again operating on highly regulated, quasi-utility model.  Then over a 20 year period, nearly all the old rules and regulations were removed and replaced by regulations focussed almost entirely on “investor protection” and “disclosure”, i.e. you can pretty much anything you want as long as you tell everybody what you are doing and you don’t sell the products directly to Joe Public.


Financial intermediation does not add value in itself, but it helps everything else work better.  It is like oil in a car engine; the fuel and air push the pistons and drive the crankshaft but if there was no oil it would soon seize up.  The problem over the last 30 years has been that financial intermediation has become viewed as a method of value creation, but in reality it can only do this by charging more and taking value from those who actually do add value (the businesses being invested in) or the providers of the capital (the savers and investors).  And this has what they have done very successfully during that period.  The risk management models of the banks have been widely criticised, but I would suggest they were very successful; they managed to keep an inherently unstable system stabilised for much longer than it really should have done.  Using the car analogy again, they were a bit like holding an exhaust pipe together with duck tape; not recommended but can work for quite some time.

So they fed the furnaces of the money making machine, creating more and more leverage in order to generate greater numbers of transactions, slicing and dicing the economic pie (but not actually increasing it) in new and ever more ingenious ways that was meant to better allocate risk to those who can cope (which eventually meant socialising it but having the taxpayer underwrite the banks) and along the way take higher fees more often.  As an example, a typical old style mutual fund will charge a 5% upfront fee and a 1% management fee, while a typical hedge fund or private equity fund will take 2% annual management fee, a 20% performance fee once a hurdle rate has been achieved and a 10% carried interest for the management.

So how does this relate to gas prices?  The increasing involvement of financial investors in the oil market will certainly have contributed to increased volatility and have probably exacerbated prices rises, particularly recently when investors have been scrabbling to to find investments in the commodities sector, but I believe it is deeper than that.   Oil is a limited resource and by all reasonable measures I have seen, we have reached the “peak oil” point, i.e. production levels are falling, not collapsing, but gradually reducing.  This is at a time that demand is growing in economies such as China and India.  I believe that many financial investors identified this same issue and have seen the attraction of holding oil assets at a time of reducing supply are just another example of what I said 2 paragraphs back, i.e. taking an increasing slice of the economic pie.  In economic terms it is another example of “rent taking”, in just the same way as charging interest on a loan, a management fee on fund or rent on a property.

So what does this mean; in simple terms a larger slice of the economic pie is finding itself to fewer people and the rise in gas prices is just another aspect of it.  For most of the last thousand years, the general population has been in some form of “service” to the elite of the day, whether it is medieval fedalism, Tsarist serfdom, colonial slavery or the “dark satanic mills” of Britain’s industrial revolution.  The first half of the 20th century seemed to changed this; two apocalyptic world wars, the great depression and the rise of both fascism and communism appeared to result in the “masses” in western democracies getting a larger slice of the pie, almost as a reward for their earlier great sacrifices.  I ask the question as to whether that period of increased equality was a historical aberration and are we now moving to a 21st century version of feudalism, with CEOs and hedge fund managers the barons of their age? 

The Best Thing From Spain Since Chorizo

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I love this – http://huff.to/eLbiZN – This makes me feel positive about the future when such a lot of other things don’t.  It shows the essential ability of humans to think through clever solutions for problems if they put their minds to it.  Perhaps if we all spent more time thinking about such solutions rather chasing fame, fortune or meaningless rubbish???  I wonder if Spain’s economy would be in such a hole if it had focussed on clean energy rather than building ever more apartment buildings on a speculative basis that were not needed and couldn’t be afforded???