12^th May 2014

Bankers Bonuses

Where does the profit come from?

Banker's bonuses have been in the news again with the Barclays shareholders revolt and the cap at RBS. Whilst the RBS decision is theoretical victory for those who want to see such excesses curb the claims that this rule is easily bypassed highlights that bankers are a law unto themselves. The reasons for this are varied but the principal reason is that banking is highly profitable. On the face of it this is a little surprising for an industry that does not produce anything. Its supporters will highlight the role that banks play as a mediator between borrowers and those with capital but this is a red herring as much of the activity and reward is in the trading of derivatives. It was their proliferation that led to the financial crises in 2008-9 but derivatives are not bad per say; futures and options are important cogs in the supply all sorts of commodities. The problem comes with high frequency trading. To understand the issue look at a conventional investment such as house for rental. If an investor buys a house, the profit will be the monthly rent minus any costs. The longer the investor holds, the greater the profit. If the investor buys and then sells on before any rent is paid then there is notionally no profit. Our current housing market would suggest otherwise but this should be the exception rather than the rule.

This same apparently unsustainable system also applies to high frequency trading. Shares that pay dividends once or twice a year are now traded in microseconds along with their derivatives that generally have a time limited value with no yield. So where does the profit come from. In this instance it is through arbitrage; comparing the prices in different markets with any realisable difference in buying and selling providing the mark-up. As with the rise in the housing market prices this cannot go on for ever so periodically they fall which coincides with the payment of the dividend giving share prices a saw shape movement. One way is to look at this is for the share profit to be distributed over a longer period of time but its impact is on all shares not just those being traded, devaluing the worth of those who choose to hold it. A second source of profit is the new money constantly entering the market from saving products which can disguise this profit taking from the general public who have pensions invested in the stock exchange.

However there is an even more important source of funds that is totally invisible and that is the contribution of interest payments. As noted elsewhere in this blog and my book Wealth Creation and Wealth Destruction the primary mechanism for an increase in the money supply is the interest paid on loans and as the financial markets are highly dependent on leverage or borrowing this can be considerable. What's more with asset markets defying the normal rules regarding yield it is an almost risk free. In such conditions all a bank needs to do is lend into this market to guarantee a profit sometimes even to itself. This explains the highly lucrative tie up between retails and investment banks and the profits made by such institutions during the toughest years of the recession. So rather than being reward for the best, bankers bonuses are just another scam. As always with the financial industry this is not a victimless crime; the value of our savings is being diluted and more worryingly the real world is deprived of investment funds it needs.