ANALYSIS:The banking inquiry must stamp out practices that pay huge bonuses to bankers for activities that destroy shareholder value, writes CORMAC BUTLER
TO THE relief of bank shareholders, not to mention the taxpayer, Central Bank governor Patrick Honohan is about to focus on what caused the banking crisis. He will identify what encouraged bankers to lend vast sums on speculative loss-making transactions.
Overseas, bankers in Britain and America were grilled for the same reason. Unfortunately, the true cause of the crisis still remains untold. While the risk that the Irish inquiry will turn into a similar whitewash remains high, it may reveal the dangerous Ponzi scheme that many banks operate.
People assume that high salaries and bonuses are only paid to bankers and traders who make genuine profits and increase shareholder wealth. Wrong. Poorly devised incentive schemes encourage them to ruin shareholder value. The lending to Irish developers is a case in point.
Once the shareholder is wiped out, the bankers proceed to exploit guarantees offered by various governments by gambling with the banks’ assets to such an extent that the taxpayer is forced to cover the bank’s losses for generations to come.
Institutional investors are partly responsible. They buy shares in banks but turn a blind eye to reckless incentive schemes because they can pass on their own losses to the pension funds and small investors. As these institutional shareholders are the only people with real voting power, the situation goes uncorrected.
However, there’s a more fundamental problem. Many apparently successful financial institutions operate a “Ponzi” scheme – an investment operation that pays returns to separate investors from their own money or money paid by subsequent investors, rather than from any actual profit earned. In this way shareholders have the illusion of profits, allowing bankers to pay themselves lavish incentives. Named after the Italian-American fraudster Charles Ponzi who perfected the scam in the 1920s, Ponzis arise because banks exploit what seems a minor – but is in fact a major – accounting flaw.
Irish banks often use “loss leader” strategies similar to supermarkets. They offer subsidised loans to build customer relationships or increase market share. Once the door is opened, the bank can then sell more lucrative treasury services. In the same way supermarkets may subsidise the cost of bread in the hope of luring customers to more high-margin product lines. Banks can easily hide the subsidy on the loss leader but supermarkets cannot.
Therefore supermarkets will use the strategy sparingly whereas banks will lend recklessly as long as they can show an accounting profit. Why else would the two major banks decide to follow the destructive model of Anglo Irish Bank, which was clearly an accident waiting to happen? Was it because Anglo was able to produce high accounting profits?
For almost 20 years, international banks, hungry for large bonuses, have exploited this flaw. Imagine interest rates are expected to be 4 per cent, 5 per cent and 6 per cent over the next three years. A bank borrowing €1,000,000 would have to pay interest of €150,000 over this period. If the bank used the borrowings to buy a bond which paid interest of 4.6 per cent, the total income from the bond would be only €138,000. There’s a shortfall of €12,000, that makes the bond unattractive for the bank’s shareholders.
Nevertheless, in the year of purchase, the bank could record an accounting profit of €6,000, from the difference between rates of 4.6 per cent and 4 per cent. Bonuses are often based on just such an accounting profit – yet the banker gets rewarded for destroying shareholder value.Structured product people made millions from the basic accounting flaw above. They developed lethal, leveraged structured products such as “inverse floaters”. Put simply, with a leverage of say 10, the accounting profit jumps from €6,000 to €60,000 – but the shareholders’ loss multiplies to €120,000.
The salespeople learned a lucrative lesson. Many bankers became willing to overpay for dangerous structured products as long as they could record an accounting profit and pay themselves bonuses.
Orange County in California suffered record losses of $1.7 billion as a result of a 70-year-old treasurer Robert Citron whose investment advice came from astrologers.
This sounds dangerous but it’s not as reckless as ill-devised bonus schemes that reward bankers when they deliberately overpay for dangerous loans, as in Ireland, or structured bonds. New accounting rules eventually curtained “inverse floater” abuses but – like most badly designed rules – created an even bigger problem. Once the salesmen found bankers were happy to ruin shareholders if they earned a bonus first, they devised complex, lethal securitisation portfolios, known now as toxic structured credit products. These produced a high return and therefore, high initial accounting profits.
Yet they were extremely difficult to value. The accounting rules for such risky products are hugely flawed. As the bankers simply didn’t care what they were buying, the salesmen packed hundreds of sub-prime – ie dodgy – loans into these overpriced structures and still they flew off the shelves. In the same vein, Irish banks queued up to acquire dodgy loans from property developers without any regard for the fact that these loans were overpriced.
Why would a Citibank trader comment as follows on credit/loan products? “They do not appear on the balance sheet – this makes them a more attractive way for [bankers] to take credit exposure”. The conclusion is worrying. Overpriced financial instruments are still attractive if they can enhance bonuses. Bankers’ responsibilities to their shareholders are ignored.
Irish banks offered cheap loans to property developers, knowing that they could create an accounting profit but hide losses. Those who are sceptical that a Ponzi scheme exists in banking should try to answer three questions.
- Why did the two major Irish banks adopt the flawed model of Anglo Irish Bank? Alan Dukes recently stated that the main banks were under no pressure or obligation to do so;
- Why did the Financial Crises Advisory Group in America recently recommend urgent significant changes in the rules on accounting for risky loans;
- Internationally, why are banks moving away from safe banking practices and instead flocking into complicated toxic assets?
Cormac Butler (ctkbutler@aol.com) is an equity and options trader and a former consultant with Lombard Risk Systems London and has also worked with Peat Marwick and PricewaterhouseCoopers. He is author of Accounting for Financial Instruments, published by Wiley