Outrage is apparently the name of the game in political and media circles in debating the matter of banking bonus compensation. For the large banks, even moral hazard is brought into play in condemning bonuses that are seen as excessive, promoting high risk and abusing the financial bailouts and market conditions provided by governments in America and Europe especially. Investment banks are now benefitting from renewed and often substantial profits and allocating significant shares to employee bonuses. The taxpayer is picking up the tab and apparently sees no reward in doing so.
Goldman Sachs, Morgan Stanley, Merrill Lynch, JP Morgan Chase, Citicorp and Bank of America are in particular singled out as the “bad guys”. Even the Economist (“Banks are booming on the back of public support. That subsidy should be clawed back”, October 24, 2009, pp. 16 & 18), known for its stout liberal positions, has jumped on the bandwagon, condemning “Worst of all, bonuses are being paid in part from subsidies: this is not a free market, but a perversion of it”.
With the new world of increased government intervention involving enforced regulation and oversight, banking as other financial services are now operating in the competitive-market economy paradigm. Its danger is the temptation of legislators and governments to micromanage firms, and so to distort the benefits of competitive forces that lead to efficient markets. There is obvious need for a level playing field in which all are treated equally and fairly without undue burden of the state.
Should high-performing employees paid large bonuses be singled out in one country or the other for retribution in their contributions to a firm’s bottom line that benefits owners or shareholders of that firm, as well as governments through taxes levied? How do you reconcile a bank’s financial performance with the need to recognize the public support provided to it in facilitating such financial performance? These are reasonable questions that need to be addressed with reason.
Bonuses are ultimately taxed as employee income or capital gains depending on how they ultimately reach the employee. The question then is how bonuses are treated within accounting standards and financial reporting of banks and other financial services. A proposal worth considering is to treat bonuses as a distribution of net income after taxes (NIAT), as dividends are treated. Banks therefore pay corporate taxes on net income or income before taxes (NIBT) that include the employee bonuses. (How bonuses are effectively transferred to employees as cash or stock options etc. over some time horizon is another matter requiring further rules for treatment in accounting practices.)
As the larger-than-normal profits of investment banking are perceived as being at least in part the product of the exceptional benefits of public support, then the taxes so levied on the “excess” of profits by government can be seen as a claw back of subsidies received. This does not exclude other measures as considered for instance in the aforementioned Economist’s article.
Under such rules proposed here, banks can choose freely the policies and strategies pertaining to employee performance compensation, owner or shareholder pay outs in the form of dividends and earnings retained to support future corporate development. Banks can thus act freely in the best interest of the firm and the general interest of their owners or shareholders.
As an example, consider a “too big to fail” US bank having a net income of $ 40 billion paying corporate taxes at the statutory federal and state rate of 39,1%. That would leave net earnings (net income after tax – NIAT) of $ 24,4 billion, following the tax deduction of $ 15,6 billion. Assume the bank pays out $ 19 billion in bonuses (thus leaving £ 5,4 billion for dividend payouts and retained earnings). If on average the employees are taxed at the 1988 top 50% average federal and state rate of 23,83%, they pay $ 4,8 billion in taxes. The bank and its high-performing employees would thus contribute together $ 20,4 billion to public finances in taxes on revenues associated with the bank’s financial performance, of which $ 12,2 billion of the tax money are directly related to bonuses.
It seems reasonable to assume that the amount of taxes in question would contain a fair share of the support and financial benefits gained by the bank through its status in the government’s financial assistance program. In other words, the “subsidy” received through public support has been fully or partially “clawed back” through taxes paid on the bank’s and its employees’ “superior” financial performance. The figures used in the example are somewhat similar to the numbers of Goldman Sachs as indicated in the media and for whom Joe Nocera, in his New York Times article (“Short memories at Goldman”, October 24, 2009), cites $ 2 to 3 billion as the likely amount of Goldman’s financial performance attributable to government assistance in one form or another.
The policies and procedures by which bonuses are treated within the bank or other financial services require the rigorous application of the principles of integrity to assure financial ethical behavior. Such policies and procedures need to be contained in the bank’s continually updated Corporate Governance Charter that must absolutely be approved each year by owners or shareholders at the Annual General Meeting. The table below sets out how banking bonus compensation could be treated following the principles of integrity.
The basic principle proposed is that bonuses be tied to net income (net income before tax – NIBT) and treated as a net earnings (NIAT) distribution. No bonuses then if no net income. It seems reasonable that employees benefit from bonuses only if their performance is captured in the bank’s bottom line. And that is indubitably in the best interest of the bank and its owners or shareholders.
What about banks in need to compensate employees with bonuses that have some divisions that are high performers and others non performers? Well, it is up to the bank to organize itself accordingly, by setting up for instance self-standing subsidiaries. An advantage of that would be to separate out high risk activities from others.
The advantage of the approach proposed is to recognize that the banking sector must be able to compete with all due freedom in a competitive-market economy, while ending the bonus culture based on bonuses whatever the bank’s financial performance. That bonus culture is an open door to abuse.
What do you think?
