What Can Be Done About Excessive City Pay?

Tom Bulford - Thu 15 May, 2008

Tom Bulford has six ideas on how excessive City pay can be reined in.

Despite attempts to make us all celebrate the fact that the City is the world’s financial centre, where this country’s ‘enterprise culture’ makes multi-millionaires of hundreds of young men and women, nine people out of ten would agree that City pay is high to the point of obscenity.

This is not just down to last year’s £7bn bonuses, because even without them City salaries are high in the first place. Nor is it down to the £15bn of bad loans so far written off by the UK banks, equivalent to £40,000 for each of the Square Mile’s 350,000 workers, because these same banks could no doubt point to good years in which they have made huge profits rather than losses.

The reason that most of us believe that City remuneration is too high is because we fail to see how its contribution to the UK economy is worth the vast amount of money that ends up in its pocket.

After all if it was doing such a great job we should have a healthy and stable economy, companies should be able to raise finance on reasonable terms and the national savings should be looked after in such a way that our pensions are secure.

In fact the economy has lurched from boom to gloom in a matter of months; most of the companies that I talk to believe that their shares are very undervalued and complain of the difficulty of raising cash; and as for the pension situation it is seriously bad and only getting worse.

Most of us would agree with Mervyn King that it is a shame that so many of our brightest young people are lured into the City when they could be making their contribution in other areas. But delivering moral sermons will not solve the problem.

This year the bear market will cut both City pay and jobs, but once the bull takes over the dash for cash will resume in earnest – unless the rules of the game have changed.

So what can be done?

Economists struggle to come up with answers because the market for financial services is free – in other words it is competitive. According to economic theory this competition should bid down the cost of financial services, but in practice this does not seem to happen for at least three reasons.

The first is that many of the directors of public companies that pay the City’s biggest bills are loath to criticise City pay in case the spotlight is turned upon their own.

Next these directors are not spending money directly out of their own pocket. They are spending shareholders’ money, and are happy to shell out as much of this as is required to promote the interests of their companies and by extension their own reputations.

Finally the ultimate owners of the money that is bundled together and hurled around with gay abandon do not really have a voice. Small shareholders and savers are represented by City firms who are more interested in screwing large rewards from this pot of money for themselves than they are in providing a good, honest and inexpensive job for their customers.

If there once an element of service within the City it has long since died. Now it is all about making money, and perhaps that is understandable. After all any private sector business is driven to make money, at the very least for survival. So the City will do whatever it can within the rules of the game to make as much money as possible, and the only thing that will make a difference will be to change the rules. So here are some suggestions:

1) Shop Around

The City’s customers are far too ready to pay out millions of pounds for advice on ‘transactions’ such as flotations, capital raising, mergers and acquisitions.

Every day company directors raise their eyebrows at the bills with which they are presented, but they never seem to haggle or shop around. They should simply refuse to pay any more than a fair fee.

If their investment bank wants to charge them £1m for some piece of work, they should offer to pay, say £500,000, or threaten to go elsewhere. Or perhaps it is time for the CBI to decide what sort of fee scale is reasonable and present this to the City. Otherwise perhaps someone could start up a sort of professional ‘MoneySupermarket’, which would allow those looking for City services to find and negotiate the cheapest rate.

2) Publish Added Value

In the retail funds arena there has been some progress, with fund managers now obliged to publish long-term performance figures rather than the selective use of facts that we used to see.

I would like this to go further, and would like to see fund managers obliged to show not just the return to the fund member but also the return before all charges, and a figure showing what the return would have been if the fund manager had done absolutely nothing to the portfolio from the first day of the year to the last.

Hedge funds should be obliged to report these same figures, as well as one that shows the extent to which gearing had contributed to the total return. Such a spotlight upon the amount of value that the fund management industry truly adds would surely highlight the extent to which its fees are an absolute rip-off.

3) Performance Related Pay Should Be Symmetrical.

Without any exception that I have ever come across performance related bonuses only work in one direction. In other words if performance is good you get a bonus; if it is not you do not get a bonus.

This clearly encourages huge risk taking – heads you make millions, tails you make nothing. If the deal was ‘heads you make millions, tails you lose millions’ then investment managers and traders would clearly act very differently. I would have thought that the Financial Services Authority could make this a condition of approving any new investment fund.

4) Long Term Investment Needs a Long Term Mandate

Although the impact of hedge funds has grown hugely, the major shareholders in most companies are still pension and insurance funds that are interested in long-term performance. But because the performance of the managers of these funds is monitored on a quarterly if not monthly basis, they find themselves almost as interested in short term returns as the hedge funds.

I think the way to get round this is to give the manager of these funds rolling three-year mandates. Knowing that their performance will be judged over this relatively long time period should persuade them to be more concerned about the long term strategy of the companies in which they invest, and less concerned with short term returns.

This should improve the performance of pension and insurance funds, so vital for ordinary savers, and would reduce the volume of stock market trading and commission payments.

5) Do Not Allow Banks to Trade

I think it is perfectly reasonable that one of the conditions of a banking license should be that a bank acts like a bank. In other words it takes deposits and lends money. No more and no less. It does no proprietary trading, and is not allowed to sell its loans on to anybody else.

At the very least senior bankers might understand the true risks that the bank is taking, rather than having to cross their fingers that they are not harbouring another rogue trader. And it would also cut out a whole swathe of highly paid and incentivised ‘traders’ who simply punt around with a bank’s money in what is essentially a zero sum game paid for by the banks’ customers.

6) Bring Outsiders on to Remuneration Committees

The remuneration culture in an organisation starts at the top. The problem is that the remuneration committees of big financial organisations tend to consist of other highly paid financiers and business people who are basically living on a different planet to the rest of us.

They approve pay structures that are not only over generous, but which induce companies to go hell for leather for short-term profits growth, often as in the case of Northern Rock with disastrous results. If remuneration committees included, or indeed consisted entirely of people from other walks of life, we might see much more reasonable and sensible remuneration structures for boards of directors that would filter through the whole organisation.

Those are a few of my ideas. If you have any more, I would love to hear them.

Regards,

Tom Bulford
For The Daily Reckoning