05/11/2010 05:12 am ET Updated May 25, 2011

The Uncosted Rewards of Bankers' Bonuses

This post originally appeared on the Financial Times' website,

A bank employee recently asked me: "As a trader, my bonus is derived directly from my profit and loss, which is accrued over the quarter and kept in a separate account. It does not go into the firm's bottom line and then back out to me. Also, like most traders, I accrue 2% of my gains in a loss provision account in case I have a major write-down in the year. My bonus is 10% of my profit for the year. If I make $50m for the year my bonus is $5m. What does my bonus have to do with the mortgage-backed securities [MBS] trader who is sitting on losses? Did I or did I not show a profit of $40m to the firm's bottom line?"

Main Street is absolutely flabbergasted that bankers do not understand the core issues of this bonus question. Allow me to clearly outline the problem and propose a solution. Assuming this trader works for a prominent US bank that received a bailout, he is not entitled to a $5m bonus if he made $50m for the year. Why not? Because he generated that 10% return from taxpayer capital, not firm capital. For example, Goldman Sachs would have had the drawdown from purgatory had it not been rescued from a $30bn credit default swap deal with AIG.

Let's assume AIG would have negotiated a 40% payout to Goldman Sachs, which is realistic given that litigation with an insolvent company that had many more contingent and direct claims would probably have resulted in a lower net receipt to Goldman. This alone would have resulted in a hole of about $7.8bn for the bank.

Taxpayer assistance

Combined with the Troubled Asset Relief Program, Federal Deposit Insurance Corporation bond guarantees, Public-Private Investment Programme for legacy assets and other alphabet programmes, not to mention hundreds of billions of dollars in MBS purchases that have put an artificial bid under toxic assets that abound on big bank balance sheets, it is clear to see that banks were undercapitalised and benefited greatly from taxpayer assistance. Without that assistance, the trader would not have had $50m to trade and may not have had an employer at all.

It really is that simple and there is no need to debate whether he deserves 10%. The real issue is 10% of what? He is relying on a 10% bookmakers' fee for betting with taxpayer contingent capital - not pure bank capital, and that is where the great misunderstanding lies. Even if one could justify getting paid from taxpayer capital in lieu of firm capital, the taxpayer capital should (as a product of prudent business practice) have been pegged to an appropriate 'cost', whose hurdle rate the trader would need to overcome. In other words, management should say: "This $50m costs us 14% in coupons on government-owned preference shares, thus you will not have positive return on investment until you break that 14% mark." If the trader failed to breach the 14% hurdle rate, he would not have received a bonus at all.

Simplifying risk and return

Now, I am sure many are quipping: "Well, how is a bank supposed to incentivise a trader if a negative return does not fund a bonus?" But think about it for just a moment, and you will see the implications. If the risk-adjusted cost of capital causes a business to become unprofitable - either for the employee or the firm - then neither the employee nor the firm should be in that particular line of business. The plan is ingenious in its simplicity and creates a self-regulating mechanism that prevents risks from being decoupled from rewards. This also applies to exotic derivatives transactions where in-built leverage allows for little or no upfront capital. You reserve properly for risks (counterparty, credit and market) and charge the cost of capital on the reserves.

This plan works for bankers too. Mergers and acquisition bankers use minimal firm capital, thus have relatively minimal economic hurdles to overcome. Hence, the banker would likely get a higher payout than the trader because he risked less capital, but he would still have to be paid via staggered or cliff vesting (depending on the nature of the deal) with restricted stock. In this scenario, bankers would not put together deals in a fashion that runs counter to the interests of the firm's stakeholders (at least not on purpose or through wilful negligence). Now bankers and traders become true economic partners in the firm, sharing both the reward and the risk of doing the deal - just like in the real world.

Reggie Middleton is an independent investor and financial analyst with experience ranging from insurance-linked securities structuring to real estate investment. See