The amount paid to bankers will continue to be a hot topic while we wait for more of the banks to report their 2010 results. But less time is spent on why investment banks in particular continue to be able to pay large bonuses, and the implications for UK and global plc.
A question receiving no attention is – why are the banks pre-salary profits so high year-after-year? It is only because the bank’s underlying operations are so profitable that bonuses can be paid. In a normal market, we would expect high profits to lead to new market players, which drive down the banks’ fees and in turn bring down bonuses if post-salary profits are to be sustained. This is not occurring and there are several possible reasons that go to the heart of how the banking market actually works.
The consolidation of the banking marketplace since 2008 has reduced the level of competition. When seeking a major bank to supply finance, there are now fewer choices. In many circumstances, the choice is more limited than it might seem. Given there are usually two parties in deals such as an acquisition, both sides will have banks representing them and as the buyer or seller probably do not want the same bank representing both sides there may only be limited options available.
I think this underestimates the problem. Constrained competition is further limited by pre-existing relationships. Commercial banking remains heavily relationship based and most large FTSE firms have a small number of key banking contacts. The banks typically have an inside track to CEOs and CFOs, and employ world-class salespeople to exploit this. The combination of the scale of the monies dealt with and the relationships means there is often little connection between the cost of providing the service or the value-add of the service, and the fee.
An ex-FTSE 250 finance director recently recounted how he had been told by his chairman his company was going to use a particular investment bank for a transaction. No competition, no tender, the 40-page, close-type contract simply turned up. The terms were that the bank was going to be paid whatever it deemed appropriate for the fee - the bank set its own fees. When the CFO complained to his chairman, he was told: “We are going to use this bank,” and that was that.
For many reasons the buyers of banking services are not as innovative or commercial in their approach to their acquisition as they should be.
In many other sectors, such as insurance broking or media buying, buying services has evolved and moved away from pricing norms and fixed percentages for particular activities. These accepted practices broke down because there was a fundamental disconnect between the price charged and the value provided by the supplier. This has yet to happen in banking.
These problems go to the heart of the reason why it is more costly to raise capital than it should be. The most commodified product in the world is money. Why the price of money (the margin and set-up fees charged by a bank) has not fallen as a result of the recession is not clear. This matters because unduly high costs of raising finance means that investing in UK plc is more costly, and so – when we have just seen a slow down in the most recent growth figures published - businesses have less to invest.
Rather than worry about the banker and his Porsche, we should think how to make the buying of financial services work better because this will help UK and international business to be more successful.