Should government-owned banks pay big bonuses?

I have written previously that it was a bad idea for the government to take over banks, but given that they have, they ought to be run in taxpayers’ interest.

A good starting point is UKFI, the UK government’s investment vehicle’s first objective of “maximising sustainable value for the taxpayer, taking account of risk”. So, what would this mean in practice? From the government’s perspective, I must realise that banks play a pivotal role in the economy. So maximising the value and minimising the risk to the taxpayer is very different from if I were I private sector shareholder.

As we have seen, if a bank becomes insolvent in the future, it is likely that government will be unable to resist the temptation to bail the bank out. If you are a private sector actor, you’re loss is limited to the value of the shares. But the taxpayer could have to bail the bank out at any time in the future, bearing the whole loss. So, from this perspective, a government-owned bank should be much more cautious. The reward package should therefore incentivise the senior executives to ensure that the bank is solvent in the future. For example, senior executives could be rewarded through bank loan stock and equity in their pension fund which could not be sold until they retired. That way they have an interest in the long-term prospects of the company, not just short-term shareholder value.

So what incentives have the senior executives of state owned banks, under the watchful eye of UKFI, awarded themselves? The RBS chief executive has been awarded a remuneration package that encourages him to maximise the value of the bank’s shares of the sort that is widely blamed for their collapse in the first place.

Clearly banks should not be bailed out by governments so that incentives are properly aligned in the first place. But the value of a share at a particular time does reflect the market’s view of the long-term sustainability of profits. Now, I understand that it might be possible for a manager to do things that lead to share prices going up but where damage is somehow hidden from the market until after the manager has gone (and the share price subsequently falls). However, we are talking of a matter of one or two years here. So it would seem reasonable to prevent the manager from trading for some time after he has left (but not until he retires). This is a matter of contract, not regulation.

The government should be very careful before seeking to issue ‘orders’ to the directors of the banks in which the government has an interest. Unless a bank is 100 per cent ‘nationalised’, there are minority shareholders — who are owed a duty both by any majority shareholder and by the directors. I am a minority shareholder myself, in both Lloyds Banking Group and the Royal Bank of Scotland. To me, maximising the value of the ordinary shares seems a splendid objective, and I wish the directors every success!

The problem with claiming that such and such ought to be made in to legislation is that one cannot do that without falling in to the same trap as the legislators themselves.It may well be the case that the future of a particelar bank is best served by restricting Senior Executives ability to trade their stocks till reitrement, but then again it may be the case that executives would be in turn overly cautious and would miss out on profit-seeking activities that could have better served the taxpayer cum shareholder.Decisions will have unintended and unforeseen consequences, and of all the people that are qualified to make a decision with that risk in mind, a legislator is close to lasu

If a bank is government-owned having become insolvent in the private sector, then the government should put it under a special insolvency regime for the protection of depositors and the continuity of routine banking operations. That done, the bank should be put to a “controlled demolition” in which the shareholders would be cleaned out and the directors given their P45s and told to get entry-level jobs at Burger King. The the government should hang on to the physical assets and sell them as a going concern to another undertaking if possible.

UKFI are a private company owned by the government which is charged with acting in taxpayers interest; they are acting as owners not legislators & best practice is to be an active owner (i.e. vote at AGMs, etc). I am proposing what taxpayers interest might be, which is subtly different to a private sector shareholder, and should therefore use their influence on the company to act in the taxpayer’s interest, just as a normal shareholder would do. The example I used was RBS in which they are a majority shareholder. Re comment about “overtly cautious”; I am arguing that as the taxpayer’s potential loss is greater than shareholder, therefore they should be more cautious.

I want to illustrate with simple example: Bank has £1bn assets and liabilities, and share capital of £100m. It can invest all assets in an investment which have a 90% chance of making a 5% return, and 10% chance of total loss. From a shareholders point of view, expected return is 90% of 50m – 10% of 100m, which is £40m, as the shareholder is limited to losing share capital. If taxpayer has to pick up tab for liabilities, he can lose £1bn, so expected return is 90% of 50m – 10% of 1.1bn = expected loss of £65m. So it is not a case of “manager somehow hiding damage from the market” as Philip argues, it is a simple case of the risk/return being different for the taxpayer to other shareholders.

Clearly banks should not be bailed out by governments so that incentives are properly aligned in the first place. But the value of a share at a particular time does reflect the market’s view of the long-term sustainability of profits. Now, I understand that it might be possible for a manager to do things that lead to share prices going up but where damage is somehow hidden from the market until after the manager has gone (and the share price subsequently falls). However, we are talking of a matter of one or two years here. So it would seem reasonable to prevent the manager from trading for some time after he has left (but not until he retires). This is a matter of contract, not regulation.

The government should be very careful before seeking to issue ‘orders’ to the directors of the banks in which the government has an interest. Unless a bank is 100 per cent ‘nationalised’, there are minority shareholders — who are owed a duty both by any majority shareholder and by the directors. I am a minority shareholder myself, in both Lloyds Banking Group and the Royal Bank of Scotland. To me, maximising the value of the ordinary shares seems a splendid objective, and I wish the directors every success!

The problem with claiming that such and such ought to be made in to legislation is that one cannot do that without falling in to the same trap as the legislators themselves.It may well be the case that the future of a particelar bank is best served by restricting Senior Executives ability to trade their stocks till reitrement, but then again it may be the case that executives would be in turn overly cautious and would miss out on profit-seeking activities that could have better served the taxpayer cum shareholder.Decisions will have unintended and unforeseen consequences, and of all the people that are qualified to make a decision with that risk in mind, a legislator is close to lasu

If a bank is government-owned having become insolvent in the private sector, then the government should put it under a special insolvency regime for the protection of depositors and the continuity of routine banking operations. That done, the bank should be put to a “controlled demolition” in which the shareholders would be cleaned out and the directors given their P45s and told to get entry-level jobs at Burger King. The the government should hang on to the physical assets and sell them as a going concern to another undertaking if possible.

UKFI are a private company owned by the government which is charged with acting in taxpayers interest; they are acting as owners not legislators & best practice is to be an active owner (i.e. vote at AGMs, etc). I am proposing what taxpayers interest might be, which is subtly different to a private sector shareholder, and should therefore use their influence on the company to act in the taxpayer’s interest, just as a normal shareholder would do. The example I used was RBS in which they are a majority shareholder. Re comment about “overtly cautious”; I am arguing that as the taxpayer’s potential loss is greater than shareholder, therefore they should be more cautious.

I want to illustrate with simple example: Bank has £1bn assets and liabilities, and share capital of £100m. It can invest all assets in an investment which have a 90% chance of making a 5% return, and 10% chance of total loss. From a shareholders point of view, expected return is 90% of 50m – 10% of 100m, which is £40m, as the shareholder is limited to losing share capital. If taxpayer has to pick up tab for liabilities, he can lose £1bn, so expected return is 90% of 50m – 10% of 1.1bn = expected loss of £65m. So it is not a case of “manager somehow hiding damage from the market” as Philip argues, it is a simple case of the risk/return being different for the taxpayer to other shareholders.

Post new comment

The content of this field is kept private and will not be shown publicly.
Type the characters you see in this picture. (verify using audio)
Type the characters you see in the picture above; if you can't read them, submit the form and a new image will be generated. Not case sensitive.

IEA Brexit prize

Invest in the IEA. We are the catalyst for changing consensus and influencing public debate.

Donate now

Thank you for
your support

Subscribe to
publications

Subscribe

eNEWSLETTER