BREAKINGVIEWS-Banker pay reform rests on ROE transparency

Mon Sep 10, 2012 8:49pm IST

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(The author is a Reuters Breakingviews columnist. The opinions expressed are his own)

By George Hay

LONDON, Sept 10 (Reuters Breakingviews) - Banks need to stop putting the cart before the horse on pay. Most universal lenders are still paying huge bonuses, even though it is commonly accepted that their investment banking businesses are not earning acceptable returns for shareholders. The obvious reform is for banks to work out whether they are exceeding their cost of equity, and pay out bonuses only if the answer is yes. But for that to happen, there would also need to be a revolution in transparency.

In dividing the profit pie, contractual salary payments ought to rank before returns to shareholders. But remunerating shareholders can also be seen as a quasi-fixed cost that should be met before additional staff bonuses.

As things stand, very few investment banks are earning their cost of equity after bonuses are paid out, or make it possible to discern whether that’s the case. Some, like Credit Suisse (CSGN.VX), don’t disclose divisional return on equity at all. Of those that do, Barclays Capital managed 10.4 percent in 2011, Royal Bank of Scotland’s (RBS.L) markets division mustered 7.7 percent, and UBS’s 7.2 percent. The cost of equity for these investment banks, if they were independent entities, would be appreciably above the levels for their overall groups.

The picture is further complicated by one-off charges, sometimes taken “below the line” once bonuses have been accrued. In 2011, RBS had over 1 billion pounds of “restructuring” charges caused by the reshaping of its business, as well as further hits from strategic disposals. But if one-offs happen with regularity, as seems to be the case in investment banking, they become ongoing expenses.

Second, universal banks can effectively choose what proportion of their equity base backs their investment banking arms. Both RBS and Barclays (BARC.L) work out their investment bank ROEs by somewhat randomly assuming they have 10 percent core Tier 1 ratios. If they were separate entities, they would almost certainly need to hold more capital, so returns would be lower.

Bank bosses, such as incoming Barclays chairman David Walker, may support setting a cost of equity hurdle for bonuses. The problem is that the lender that goes first risks sparking an exodus to firms still willing to tolerate shareholder subsidy of undeserved banker pay. Then again, the low rating of bank stocks shows that lenders risk an investor exodus if they don't reform.

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(Editing by Chris Hughes and Sarah Bailey)

((george.hay@thomsonreuters.com)) Keywords: BREAKINGVIEWS BANKS/PAY/

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