On the back of the financial crisis, a number of politicians and regulators have made noises about having to rein in the financial services industry. Some of the noises that came out were particularly alarming:

Special top rate tax for people who earn above a certain threshold;

Special tax on banks that have made big profits and pay big bonuses;

High capital requirement for firms that pay out big bonuses;

New regulations on financial services industry; and

Standardizing derivatives that were previously over-the-counter to be traded on exchange.

Recently, it has been impossible to discuss banking without mentioning compensations to bankers. Let’s take away the arguments whether they are justified or not. In my opinion, how much you pay an employee which generates revenue for your company is entirely up to you, the shareholders. You, as the shareholders, have to come to a balanced view between rewarding your revenue generators, maintaining the level of capital in your organization (for growth and as a cushion) and extracting your profits through dividend payments. As a business, banking is a combination of people and technologies, and you have to invest in both. Unlike a plant that turns out widgets, technologies are constantly evolving and labor markets are flexible. So by not investing in these areas, you will end up killing your investments. As a result, you, as shareholders, should have very little to complain if your shareholding return a decent yield, certainly not the levels of compensation awarded to the revenue generators. Or alternatively, you view that the revenue generators are being paid excessive amounts and chooses to rein in their compensations, you risk losing the very people who are responsible for the return of your investment.

I my opinion, while awarding compensation to successful revenue generators cannot be argued, the nature of the compensation should be open to discussion. In the past, it is common for people who book long-term deals to take a present value of their potential profits so that they can boost their compensations in the current year. That has been the standard practice for many years. The problem is that for certain types of trades, selling protection under credit default swap being an obvious example, it is entirely possible the bank to lose significantly more than the revenue generated, yet future revenues were regularly ‘PVed’ so that the traders and salesmen got paid. Therefore, I propose the following:

Future revenues should not be recognized until they are actually received (no more ‘PVing’); and The nature of the compensation should reflect the nature of the risk involved (for revenue that has long-term risk, the reward should be paced to the longer-term).

The above arrangements will ensure that those who book long-dated trades on their banks’ books will only receive their rewards as the trades continue to perform or then the profits are realized. The traders naturally forgo those their revenues if the trades that were book years ago have turned out to be not profitable. There is an argument that such arrangement will mean more people will gravitate towards products that have maturities that fall within the current financial year. I would disagree with this line of argument because financial products exist because there are needs for existence, either for hedging or investment reasons. People don’t trade just for the sake of trading - trading takes place because it is client driven or because of a need to hedge or an investment opportunity has been spotted, either as an “outright” or as an arbitrage. We are merely changing the timing of the reward. An additional tool to tie bankers’ pay to the performance of their deals will be increase the proportion of equity in their total compensation. These shares will only be vested over a number of years, again discouraging the urge to ‘make a quick profit’.

Let’s now take a look at the tax angle. Tax is a double-edged sword. In a way, it is an argument about who is best placed to spend our money, the individual or the government. If a banker is paid a big bonus, the money is spent on goods and services that would otherwise not spent on. For every penny that is spent, that money is earned as revenue for the shop (or service provider), which in turn is revenue for the manufacturer and it may trickle down to suppliers to the manufacturer. The government has the opportunity to tax them at every stage - personal income tax on the banker, corporate income tax for all the companies and then personal income tax on the employees of the companies. It could be argued that if the product is made in a foreign country, the money ultimately benefits another country. While this may be true, the act of buying something, especially capital items, there are ancillary services being provided that the service providers will earn revenues and also pay tax on profits. Not only that tax revenues ultimately be extracted out of normal business activities, having these business activities will boost employment. On the other hand, governments are notoriously inefficient in performing their tasks which means tax revenues are wasted. This also applies to ‘capital projects’ that are essential to the functioning of the country, e.g. IT projects for governments, defense procurements, etc. Surely the individuals are far better placed to decide what to spend their money on than the governments. Therefore higher taxes for bankers and banks may not produce the desired effect in term of total tax revenue and the national economy.

Even if taxes are targeted at the top earners and ‘excess’ bank profits, it should be noted that it would prove ultimately self-defeating. Less not forget that competition on international financial centers is extremely ferocious. London currently is the financial hub for most of Europe, high individual tax and arbitrary tax on profits will drive away the talents and financial institutions that make London the premier financial center in Europe. Never forget that the talents that have driven London to the top of the European packing order can and will leave to more tax friendly locations if they feel their tax situations have deteriorated and the total cost of relocation is less than the tax impose upon them. Likewise, multinational financial institutions regularly carry out tax reviews to locate the most tax efficient locations for them to be based. Finally, never forget that the financial service industry accounts for a not insignificant portion of the UK GDP, while generating an above average GDP per capita. If companies choose to move their operations to another European base (and there are many competing cities like Paris, Zurich, Geneva, Frankfurt, to name a few), the economies of London and the UK will suffer significantly.

All kinds of proposals have been aired to rein in bankers’ bonuses and some, in my personal opinion, have been muddled up with improve regulation. Again, from a personal perspective, and as an insider to the investment banking world, bankers’ compensation/remuneration is strictly a problem for the shareholders of banks, but regulation is for a much wider audience to decide and debate.

Here’s my personal opinion on bonuses and banking remuneration in general. Banking, and in particular investment banking, is a highly profitable business, if you can get the management right, limit the cost base and have a focused strategy in the markets you want to be in. Some people a puzzled by the pay packages awarded to bankers, but there is a good reason, those awarded big bonuses are generally those who have generated the big revenues. Investment banking is a cruel environment but at the same time a realistic one: you produce revenue - you get paid, in general. No manager will reward those who have not produced. If you just see some of the revenue figures that are produced by individuals and teams, you would understand where their bonuses come from. If you find it unacceptable for bankers to be paid such exuberant amounts, you can always buy shares of the banks and make your vice heard. On the other hand, if you are a shareholder, you would demand your bankers to make loads of money for you. Shareholders are merely rewarding their workers for producing strong profits. If you don’t like the idea of someone betting away your money on some crazy trading strategy, but instead concentrate on long-term profitability, you can incentivize them by awarding the revenue producers compensation that is long-term in nature, ie. non cash, and with an option for claw-back. You can, if you choose, pay them less. However, there is no loyalty in investment banking and good revenue generators will leave to the highest bidder. The math is very simple: reward your revenue producers or you lose your revenue/profits.