Bonuses: The Essential Guide

Pot Of Gold

Everything you need to know about bonuses.

1. The issue at a glance
2. Why is it being talked about now?
3. A brief history
4. The arguments (and who's making them)
5. Why is this debate mostly about banks? What about other sectors?
6. What are British banks actually paying out?
7. What are other international banks doing about bonuses? Does anyone not pay them?
8. What are the authorities doing about bonuses?
9. What else could be done?
10. What happens next?
11. How does any of this affect me?
12. Glossary
13. FAQ
14. In greater depth (the best other pieces on the subject)

1. The issue at a glance

Bank bonuses have long been a cause of controversy but this has intensified since the financial crisis struck in 2008. There has been mounting public anger that investment or "casino" bankers, whose reckless risk-taking helped take the global financial system to the brink of collapse, are still taking bonus payments while the majority are suffering recession and austerity. The anger, at least in the UK, is directed particularly at bailed-out banks such as Royal Bank of Scotland, which has received £45bn of taxpayers' cash, but all banks paying bonuses have come under increasing fire.

• Back to the top

2. Why is it being talked about now?

The European Union has agreed on moves to slash the bonuses that may be paid to bankers, capping the payments at a year's salary – although there is a proviso that the bonus could be doubled subject to majority shareholder approval.

The legislation is highly complex and has been four years in gestation. Some details may yet be tweaked and it will need to be approved by EU governments before coming into force next year. Certain countries – such as Britain – oppose the move but cannot veto it.

• Back to the top

3. A brief history

Many of the world's largest banks started out life as partnerships, where the business was owned by the senior staff and the lending risk was held on the balance sheet. But as the world got smaller and the possibilities for international trade grew, this partnership model came under pressure. Surely, if a bank could increase its capital base, by raising money through a stock market listing, it would be stronger and more profitable?

The downside, it seemed to some partners, was that they would have to dilute, even surrender entirely, their ownership of the bank. But, it transpired, these worries were misplaced. Bankers were in effect able to strike a profit-sharing bargain with their new shareholders which ensured they remained very well-recompensed for their work, especially in times of booming profits. Big bank bonuses were born.

But this arrangement spawned another problem. Bankers were now incentivised not to build long-term prosperity for the bank itself, but to hit annual bonus targets. If that meant upsetting a client or otherwise risking the bank's reputation, no matter. A new generation of highly incentivised investment bankers was emerging. They were not tied to a particular employer, but were happy to sit at a trading desk of whichever bank demonstrated the most generous bonus pool.

As if these developments were not toxic enough, the 1980s saw the emergence in the US of a string of credit market innovations from bright bankers and mathematicians which rapidly revolutionised the banking business model yet again. What if the banks, instead of holding on to the risks they took, could slice them up and parcel them on to other buyers? This credit revolution, it was argued, allowed banks to neatly match the needs of investors and borrowers around the world more efficiently than ever imagined.

What did this mean for investment bankers and their bonuses? Well, without having to operate within the confines of the bank's own lending capacity, the business – and bonus – possibilities seemed almost limitless. In theory, the banks became loan processors, writing risk and selling it on. As a result, bank profits soared as levels of cheap credit around the world rose.

It was not until late 2006 that fears of a reckless lending bubble began to weigh on the market for US subprime home loans. Less than a year later, the global credit was in shock. After years of booming lending, two things became alarmingly clear: first, there was a lot more risk in the financial system; second, few people, if anyone, truly knew where that risk lay.

Those who assessed creditworthiness and wrote the risk had long since sent it off to be parcelled up and sold on. Bonuses on such business had already been paid out. But years of shoddy loans remained, coursing around the arteries of a bloated global financial system.

Bonuses first entered British corporate culture in the 1980s, the era of deregulation and privatisation. Bankers were not the only ones paid bonuses (although theirs were the most lucrative) and the largesse, usually financed with shareholders' money, spread across virtually every sector and profession. It was particularly marked in former state-owned companies.

It became the era of the "fat cat" and one of the first big pay rows involved a former state-owned company, British Gas. The chief executive, Cedric Brown, was awarded a 75% pay hike, taking his salary to £475,000, an incendiary move against the background of sharp increases in gas and electricity bills.

There was a huge public backlash, culminating in union leaders bringing a 280lb pig named Cedric to the company's annual meeting. Cedric, nose in trough, made all the front pages.

It took some time before the City's large institutional shareholders took action against excessive salaries and bonuses, but in the years running up to the financial crisis a growing number of leading companies, such as Sainsbury's and Vodafone, suffered sizeable protest votes against their remuneration reports.

In the banking sector, insensitive comments from the RBS chairman Sir George Matthewson – that a £750,000 bonus would not buy him "bragging power in a Soho wine bar" (made several years before the wheels fell off the global financial system) – further incensed public opinion and bankers regularly topped the lists of the nation's most hated professions.

The financial crisis, and the role played by risk-taking bankers gambling with other people's money, brought the simmering row over bonuses to a head. The fact that payments continued to be made, even as taxpayers bailed out the banks, enraged politicians and the public.

Politicians railed against the payments but seemed unable – or unwilling – to effectively curb them. The anger over excessive salaries and bonus payments was a factor in the founding of global Occupy protest movement.

In Britain Fred Goodwin of the Royal Bank of Scotland became the focus of the mounting backlash, as it emerged that he had a pension pot worth £16m and that it would pay out immediately – at some £700,000 a year – even though he was only 50 when he took early retirement. He quit the group just weeks before it reported the largest loss in British corporate history, £24bn. He was stripped of his knighthood – for "services to banking" – in 2012.

• Back to the top

4. The arguments (and who's making them)

The archbishop of Canterbury, Justin Welby, posed the simple question this month in his role as a member of parliament's banking commission: "What is it essentially about bankers that means they need skin in the game [bonuses]? We don't give skin in the game to civil servants, to surgeons, to teachers."

This question, he suggested, overshadowed an otherwise exhaustive litany of initiatives from banks designed to convince the rest of society that they were serious about reforming their behaviour.

A lot of campaign groups have attacked the bonus culture in investment banks, suggesting excessive payouts – especially in straitened times – are an affront to the rest of the population. In particular, they stick in the craw as it was ordinary taxpayers who were forced, in 2008, to shoulder the burden of rescuing "too-big-to-fail" banks – often the very same sick institutions still haemorrhaging bonus payouts to their staff.

Politicians of all colours are quick to fan the flames of outrage, believing there are few votes in defending the pay arrangements at banks. The UK government's founding coalition agreement (pdf) contains a pledge to "bring forward detailed proposals for robust action to tackle unacceptable bonuses in the financial services sector".

The outgoing governor of the Bank of England, Mervyn King, who played a leading role in the 2008 bank bailouts, has repeatedly aired his displeasure at investment banking bonuses, drawing a link between the payout culture and the continued poor health of many financial institutions. He has also warned that the banks risk provoking a public backlash.

His anointed successor, the former Goldman Sachs banker Mark Carney, has hinted he too believes excessive bank pay encouraged reckless risk-taking. He has talked of a need for banks to rebuild trust – earlier this week he said: "It has been said that trust arrives on foot, but leaves in a Ferrari."

One of the most credible and consistent critics of the financially – rather than socially – corrosive impact of bank bonuses is the New York hedge fund manager David Einhorn. Not only is he outspoken, but he is reputed to have made a fortune by betting in the markets on the failure of Lehman Brothers.

This is what he had to say (pdf) in April 2008 (five months before the implosion of Lehman) on the correlation between bonuses and excessive risk-taking: "The investment banks did exactly what they were incentivised to do: maximise employee compensation [pay and bonuses]. Investment banks pay out 50% of revenues as compensation. More leverage [borrowing] means more revenues, which means more compensation … The owners, employees and creditors of these institutions are rewarded when they succeed, but it is all of us, the taxpayers, who are left on the hook if they fail. This is called private profits and socialised risk. Heads, I win. Tails, you lose. It is a reverse-Robin-Hood system."

Einhorn was among the first to publicly agitate against the informal pact between fund managers and investment bankers that would see them split the profits 50-50. Few, however, were prepared to listen during the boom years. It was not until bank revenues collapsed – threatening not only the solvency of institutions, but the basic functioning of the wider economy – that the true strength of the high-paid bankers' hand was shown. Even at the end of 2008, as governments around the world poured hundreds of billions into bank bailouts, the firms themselves were still preparing for major bonus payouts. By October the top six Wall Street firms alone had earmarked $70bn for salary and bonuses.

Many high-risk-taking banks, including lots who did not directly receive state bailouts, were saved from collapse by an unprecedented co-ordinated deployment of taxpayer funds by governments around the world. In some cases, institutions failed – Lehman in America, several Icelandic banks – but many other banks were deemed too large for governments to allow them to fail. In Ireland and Spain stricken banks were nationalised, while in the US and Britain governments injected billions in taxpayer funds into the industry to stave off failures. As a result, ministers were left with major interests in some of the most overstretched lenders.

When it comes to bonus season, this created a fresh problem for politicians. No longer armchair critics, the likes of George Osborne are now responsible for managing the taxpayer's major economic interest in banking success. What investment banker bonuses, for example, are appropriate at the loss-making, state-controlled Royal Bank of Scotland? Should they be competitive with rival investment banks? Or somewhere closer to pay in the civil service?

Osborne's answer so far has largely been to duck these direct questions, suggesting – where it suits him – that the government's stake in RBS and Lloyds banking group are overseen by an independent quango, UKFI.

In the background, he has been encouraging these still embattled banks to jettison the more controversial businesses, including investment banking operations where excessive pay is at its most rife.

• Back to the top

5. Why is this debate mostly about banks? What about other sectors?

Two main reasons: the scale of the rewards and the fact that they have been directly linked to the financial crisis of five years ago.

Other bosses in public companies get big pay packages, but they are usually at the top of organisations and identifiable. However, thousands of bankers earn millions every year, and the big payments stretch way down the organisation. Barclays Bank, for instance, is expected to reveal next week that about 600 of its staff earned more than £1m last year. New York officials estimated in February 2013 that Wall Street's bankers earned $20bn in 2012. The top bankers regularly earn tens of millions every year.

Unlike most other businesses, banks set aside cash to pay bonuses as a cost of running their business and before they arrive at profits. Most other companies decide on bonus payouts after they have calculated their profits.

There is also widespread criticism that bankers take far more out of the business than the shareholders who own it. For instance, Barclays recently announced it was handing £800m to shareholders, but £1.8bn to its bankers as bonuses. That imbalance is rarely the case in businesses other than banking.

The Turner review, conducted by Lord Turner in the wake of the 2007-08 financial crash, squarely laid some of the blame for the crisis on bankers' bonuses and the encouragement they provided for bankers to take excessive risks.

Turner said: "Some bankers have been encouraged by the promise of big bonuses to take excessive risks with other people's money," and in the future risk management policies had to be integrated into pay policies. "This has not been done before in the UK or elsewhere in the world, either by individual firms or by regulators," he said.

MPs have also made it clear that they hold bankers, and their pay, at least partly responsible for the crisis. In 2009 they said the crisis had "exposed serious flaws and shortcomings" in remuneration policies. They criticised bonus schemes for putting personal rewards ahead of the interests of the bank shareholders and the long-term stability of the banks themselves.

• Back to the top

6. What are British banks actually paying out?

Barclays bonus pool: £1.8bn

The chief executive, Antony Jenkins, waived his bonus

Royal Bank of Scotland bonus pool: £670m

The chief executive, Stephen Hester, waived his bonus

Lloyds Banking Group bonus pool announced on Friday

The chief executive, Antonio Horta-Osorio, is expected to take a bonus of at least £1.4m

HSBC bonus pool announced on Monday

No decision has yet been revealed on the bonus of the chief executive, Stuart Gulliver

• Back to the top

7. What are other international banks doing about bonuses? Does anyone not pay them?

Banks around the world have for decades been locked in a bonus-paying arms race – the bigger your bonuses, the better the staff you can attract. The pace setters have long been Wall Street's investment banks, led by the likes of Goldman Sachs, Merrill Lynch, Citigroup, JP Morgan, Morgan Stanley and the since failed Lehman Brothers.

Wall Street is expected to pay out cash bonuses alone of $20bn in performance awards for 2012, up 8% on the previous year.

The figure is still much lower than the $34.3bn paid out in cash bonuses five years ago. But what looks like a trend in sharp reverse is misleading. While cash bonuses are increasingly being reduced, other forms of bonuses are ballooning – including deferred payments, rising salaries and payouts in stock rather than cash.

Goldman Sachs alone revealed in its company filings last month that it had set aside $13bn for salaries and bonus payouts – an average of $400,000 for its staff.

There are banks that refuse to take part in the bonus bidding war. The Swedish firm Handelsbanken, for example, has not handed out bonuses for 40 years. Instead it has a profit-sharing system called the Oktogonen foundation, which only distributes the proceeds when the individual turns 60.

A rare example of bonuses not being paid to investment bankers was seen at Germany's Commerzbank in 2009. After posting a €4.5bn loss it did not pay a penny in performance rewards to its investment bankers.

Another trend to emerge from European banks on the continent is the introduction of the concept of "malus" into performance awards. This involves allowing the bank to claw back deferred bonuses if a banker's performance for a particular year turns out not to have been quite as stellar as it first appeared. The Swiss bank UBS was among the first to experiment in this area.

• Back to the top

8. What are the authorities doing about bonuses?

UK government

The UK government has exercised its influence over bonuses through UK Financial Investments, set up to control the bailed-out banks from "arm's length". Its influence has been most notable at RBS, because of its large investment bank, where it has put a cap on cash bonuses at £2,000 and required the remainder of any bonuses to be paid in shares, or an instrument equivalent to shares, which can be deferred over three years.

Labour put a tax on bankers' bonuses but the coalition has not repeated the exercise.

UK regulators

In the wake of the 2008 crisis, the Financial Services Authority set out its first code on remuneration for bankers. This set out for the first time how much of bonuses could be awarded in cash and how much could be deferred in shares over three years to enable bonuses to be clawed back if performance turned sour. Until 2008 it was commonplace for bonuses to be paid almost entirely in cash, which proved controversial after the 2008 bailout of RBS when it became clear that there were no bonuses that could be clawed back. Originally just 27 major firms were required to comply with the FSA remuneration code but that had now risen to more than 2,500.

EU

The 27-nation bloc's Capital Requirements Directive built upon much of the first FSA's first code on remuneration and now requires banks to publish information about how staff are paid through what are known as "pillar 3" disclosures. These banks also include the European arms of international banks, including those in the US. The banks must disclose the pay of "code staff" – those responsible for taking and managing risk – whose bonuses must also be partially paid in shares and deferred over three years to enable claw-back to take place. This does not capture all members of staff.

Other countries/international bodies

In the US, regulatory intervention on bonuses has largely been confined to those companies that were forced to take taxpayer bailout funds in order to survive the banking crisis.

In 2009 the president, Barack Obama, attacked what he called the "shameful" Wall Street bonuses claimed by the bosses of some firms that had been kept alive with taxpayer funds, describing such rewards as the "height of irresponsibility".

He imposed a salary cap of $500,000 for these firms, but companies and regulators have since found ways around this rule, allowing for far greater payouts. In any case, US investment banks have now largely repaid taxpayer funds. And as the economy has started to recover public hostility in the US towards bankers and their big salaries has started to abate.

• Back to the top

9. What else could be done?

A bonus tax: in December 2009 the then chancellor, Alistair Darling, stunned the City by imposing a 50% tax on bankers' bonuses over £25,000. He had hoped to bring in £550m but it actually brought in £2bn. The problem, though, was that Darling had expected banks to reduce their bonus payments to avoid the tax, but the banks instead kept paying bonuses and hiked them by 25% on 2008-2009 levels.

Moral and political pressure: Antony Jenkins, the boss of Barclays, was quick to announce he would not take a £1m bonus for 2012 in the face of public criticism. Stephen Hester, the boss of Royal Bank of Scotland, has taken a bonus only once – in 2010 – since he was appointed to turn around the bank after its 2008 bailout.

Shareholder activism: the owners of the banks can themselves demand that banks pay smaller bonuses. One in three of the investors at Barclays failed to back its pay policies at last year's annual meeting and its new management team is now insisting that it "gets" the need for restraint. Just 45% of investors backed a £9m pay package for Citigroup's chief executive Vikram Pandit – who was ousted a few months later.

Make banks hold more capital: Lord Turner, the outgoing chief executive of the Financial Services Authority, has argued that if banks are forced to hold more capital they will be less profitable and have less to pay out in bonuses.

• Back to the top

10. What happens next?

The vote on the legislation in the European parliament is now scheduled for 21 May and countries have until 1 January 2014 to implement the rules.

Bankers could get big pay rises to compensate for the caps on bonuses, which can lead to payouts of eight times salaries. Pete Hahn of Cass Business School said: "Since bonuses became part of the legal and regulatory agenda in 2009-10, many of the highly paid at global banks have seen their salaries triple, and this in a global downturn. What could we see if we have a couple of good years? Remuneration consultants must already be working on flexible salaries and fixed bonus pay plans." Harvey Knight, financial regulation partner at the law firm Withers, added that policy makers "should beware of what they wish for". "Bankers and their sovereign bankers lose – ending up with much higher fixed costs which can't simply be shed in the next crisis," said Knight.

European banks will also argue they are being put at a disadvantage to US and Asian-based rivals. Jon Terry, remuneration partner at PricewaterhouseCoopers, said: "The proposals mean banks are more likely to build new capabilities in New York, Hong Kong or Singapore instead of Europe. This will harm employment, not just of bankers but in the wider economy".

• Back to the top

11. How does any of this affect me?

Taxpayers paid £66bn to buy shares in Royal Bank of Scotland and Lloyds Banking Group when they were rescued at the height of the financial crisis.

To put the £66bn rescue figure into context, it is equivalent to four-fifths of the £81bn programme of cuts over five years ordered by the coalition government at the outset of the government spending review in 2010. The wider cost of the bank bailout, including guarantees and indemnities, hit a peak of £955bn.

The collapse of the banks wiped billions off the value of pension funds held by millions of Britons. At their peak, shares in Lloyds were worth over £10, but today they are trading at only 55p. RBS was once worth more than £60bn compared to its current value of around £21bn, although not all of its stock was owned by pension funds.

Many small investors rely on dividends from banks as an income, and these dividends halted after the collapse. Investors argue that rather than shelling out bonuses to staff, banks should restore dividends instead. Pension funds are also missing out on dividend income.

Bonus culture in the investment banking arms of the banks spread into the bank's high street branches, with staff incentivised to sell products such as payment protection insurance.

In October last year, Barclays abolished commission bonuses for branch staff, and said that in future rewards would be based on customer satisfaction levels. Other banks are under pressure from the Financial Services Authority to do the same.

• Back to the top

12. Glossary

Base salary: fixed monthly salary, not including perks or bonuses. For top investment bankers, this can be relatively low; they expect to earn most of their money in the annual bonus round.

Cap: a ceiling put on payments.

Capital Requirements Directive: a broad initiative on bank regulation aimed at forcing Europe's financial sector to insure itself against the kind of weaknesses that triggered taxpayer bailouts.

• Back to the top

13. FAQ

How come the EU is capping bankers' bonuses?

The breakthrough deal achieved in Brussels in the small hours of Wednesday is a small but incendiary part of a lengthy and highly complex piece of draft legislation, CRD IV, or Capital Requirements Directive, intended to force all of Europe's banks into line with the so-called Basel III rules.

Agreement on the legislation, almost but not quite complete, has taken almost four years, in response to the international financial firestorm that followed the collapse of Lehman Brothers in 2008 which exposed the frailties and gross misdemeanours of the sector, leaving governments to spend billions in taxpayers' money to bail out, close down, or shore up toxic banks.

What happened and what does it do?

The 1,000-page draft law includes the most intrusive action to curb "fat cat" excess in the financial sector yet attempted, although the caps were not required to comply with the Basel III regime. The curbs were demanded by the European parliament in return for agreeing to the rest of the legislation. The result is a notable victory for the parliament over EU governments in the constant tug-of-war in Brussels.

The negotiations were a so-called "trilogue", Brussels-speak for bargaining between the parliament, the European commission and the 27 governments of the EU known as the council.

Britain and George Osborne lobbied furiously against the new caps regime but failed to muster enough allies.

Generally speaking, bankers' bonuses are to be capped at one year's salary. Bank shareholders are empowered to change that though. A majority of shareholders can decide to double that level of bonus.

The concession to Britain and the City was to allow also the use of longer-term share options as perks for bank employees, the UK argument being that this was better suited to encouraging better performance. The longer-term bonuses would discourage fast-buck short-term speculation and the equity value would also reflect a bank's performance – a share option would be worth a lot less if the bank's share price fell.

Market analysts may charge the EU with populism. Many others will see Brussels as launching an uncommonly popular policy in response to public revulsion at the mismanagement and profiteering perceived to have been running rampant in the financial sector.

Is it a done deal?

Pretty much. The draft still has to be voted on by the full parliament in May and then it has to be endorsed by another council meeting of officials from the 27 governments. It is expected to go to the ambassadors of the 27 this week.

But the parliament will certainly vote in favour. The deal cut by the governments with the parliament means that the governments will also stick with it. It is voted on by a qualified majority in any case, although these decisions are usually carried by consensus. The deal was brokered by the Irish, who currently hold the six-month rotating EU presidency. The Irish, of course, suffered grievously from the collapse of virtually their entire banking sector, with the then centre-right government pledging that the banks would not be allowed to fail and setting the entire bill before the Irish taxpayer.

Britain's place in Europe has seldom been more uncertain. Will this make a difference?

It certainly will. London is the EU's financial centre. Financial services play a disproportionately greater role in the UK economy than anywhere else in the EU. And it is very unusual for EU governments to overrule a country, at least one of the big member states, when issues affecting a strategic national industry are at stake. It's a bit like the rest of Europe overriding French objections and taking action that damages French farming. Or the rest ganging up on Germany to the disadvantage of the German car industry. Pretty inconceivable.

Therefore?

David Cameron's drive to rewrite the terms of Britain's settlement with the EU focuses on financial services. When he vetoed a eurozone fiscal pact 14 months ago at an EU summit, it was because he was unable to force concessions for the City from the rest of the EU. He is still seeking concessions, but on the evidence of early Wednesday morning he is still failing. UK-EU relations are bad. They have just got worse.

• Back to the top

14. In greater depth (the best other pieces on the subject)

Bonus cap is a bad omen for Britain (FT)

Powered by Guardian.co.ukThis article was written by Simon Bowers, Jill Treanor, Fiona Walsh, Julia Finch, Patrick Collinson and Ian Traynor, for guardian.co.uk on Thursday 28th February 2013 17.42 Europe/London

guardian.co.uk © Guardian News and Media Limited 2010

 

Best place to workThe Best Firm of the Last Decade is...

Register for Financial Markets News Alerts