Since the financial crisis over five years ago, regulation has tightened in the financial sector globally. Whilst this for the most part is positive, there must be a balance of effective regulation without significantly hindering firms in the financial markets. Christine Lagarde, Managing Director of the IMF phrased it somewhat succinctly such that, the regulation must be implemented in such a way without:
“Inhibiting the creativity of the financial markets”
Coupled with regulation is the theme of banker bonuses. The FT describes the issue as a political hot potato as public pressures push for a cut. Some may argue that bankers’ bonuses were in many cases excessive, meaning that bankers were being compensated beyond the justification of their marginal revenue product of labour. Pre crisis bonuses were predominantly paid in cash. This is particularly important as we consider the dynamics with which banks are altering remuneration structures.
Depending on the position of the employee within a bank, salary is generally paid often in both cash and firm equity, which has restrictions on when it can be sold. This aligns the incentives of the bank with those of employees, as both wish to therefore maximise shareholder value.
In addition to bonuses being partly paid through shares, the time at which the bonus is paid is also changing, through a deferral process. This method still rewards bankers for what they individually contribute to the firm beyond their base salary, however acts as a lock in device. This incentivises employees to stay at the firm over a longer period of time in order to receive their bonuses in full, thus discouraging them from making the stereotypical ‘brash’ and ‘high risk’ deals that the media portrays.
The Trading Floor
Moving away from the management side of the bank, traders have a different experience. They are set an annual target for profits they must generate for the company and if they do not meet this target often find themselves underperforming and thus potentially out of the job.
As a trader your trades are split into two main categories, proprietary trading and market making. ‘Prop trading’ is directly taking exposure to a market, where a trader actively makes a decision as to the movement of a security and risks capital of the institution they represent. For example, an FX trader would be long in EUR/USD, if he believed that the value of the EUR was going to increase against the USD.
Market making is the more predominant role of trader, which is essentially creating a market for other clients. The FX sales desk will be contacted by a client and will then ask the traders for a price, which they are obliged to give, if the client chooses to trade on this price, the traders will execute the trade. The trader will either buy the security from another institution in order to transact with the client or they may already hold the security from a previous transaction. In the role of market making, the trader makes money from the bid/offer spread quoted to clients. Thus the bonus issued to traders depends on how much money they have generated for the bank.
Bonuses should remain in place as they are in general a method of rewarding individuals on individual performance. Recently implemented regulation has altered the size, nature and duration of the bonus, however Investment Banks tend to attract the best and brightest, due to the complex and challenging nature of the job, coupled with the long hours worked. It is often anecdotally said that on a per hour basis, bankers are paid minimum wage. If regulation continues to scrutinise the remuneration of such individuals, perhaps the ‘brain drain’ into other industries, such as tech many ensue.