Unintended consequences

Head of Research, John Royden looks at the unintended consequences of consumer protection and suggests an alternative approach to banker’s remuneration.

by Sir John Royden

Head of Research


I often find myself defending the seemingly indefensible; that is the often excessive and tone-deaf bonuses paid to bankers, one of several policy issues that placed our previous chancellor in a bit of a pickle. And in turn, I don’t think we should lay the blame for the last financial crisis solely at the door of these bankers, as our policy makers must surely take some of the heat.

Why? It’s all thanks to bank deposit protection schemes.  These schemes, which are of course designed to protect the end consumer, allowed bank managers to do as much high risk / high interest rate lending as they wanted and finance the risk with high paying deposit accounts. They were allowed to get away with this as, thanks to the deposit protection schemes, depositors cared little about the risks taken because they knew they would get bailed out by the government guarantee.

The politicians thought that if they limited bankers’ bonuses, the problem would go away. 

To explore this point further, consider these choices for a bank manager:

  • Choice A: High risk banking with a 75% chance of success with a £2 million bonus or a 25% chance of failure with a nil bonus. Probability adjusted outcome of £1.5 million (75% * £2 million = £1.5 million)
  • Choice B: Low risk banking:  90% chance of success with a £300,000 bonus or a 10% chance of failure with a nil bonus.  Probability adjusted outcome of £270,000 (90% * £300,000 = £270,000)

These choices help explain why Fred Goodwin took such massive risks as CEO of RBS; he went for Choice A.  The problem was that Choice A included £billions of losses for the bank in the failure outcome. But all the time, we, the depositors, did not care a jot what Fred Godwin was up to, because we knew we would always get bailed out by the government compensation scheme.

The post-Global Financial Crisis mistake the politicians then made was to address the symptoms and not tackle the root cause of the moral hazard born from government bank guarantees. The politicians thought that if they limited bankers’ bonuses, the problem would go away.  Politicians thought that Choice A became: High risk banking a 75% chance of success with a capped £300,000 bonus or a 25% chance of failure with a nil bonus.  Probability adjusted outcome of £225,000. (75% * £300,000 = £225,000).

And hey presto … Safe banking Choice B with a £270,000 bonus becomes the most rewarding option and banking supervisors can all relax. Politicians also thought that they could avoid pumping any more public money into banks by asking banks to hold more spare cash or more capital. 

But as we all know, always be careful what you wish for as the unintended consequences can often surprise.  There is evidence that banks just adjusted their base salaries higher to compensate for the lack of bonus, but that just made banks more risky because they took on higher fixed cost bases than they might have otherwise done:  not a great recipe for a recession.  And there are suspicions that the limit on bonuses drove the best bankers across the Atlantic to bonus-unlimited America.  In our post-Brexit Britain, politicians want to rebuild London as the European financial capital of the world and scaring away the best bankers is not a great start.

Higher capital requirements arguably meant that banks started earning the same profit on a higher capital base so that the yield went down, which in turn contributed to poor share price performance. As seen in the chart below, banks have significantly underperformed the FTSE100 since the start of 2009.

Bank performance since 2009

What I think we need now, is a structure that properly punishes banks for throwing too much risk at the bank guarantee scheme. My solution would see banks being forced to issue £1 billion of bonds with identical terms and conditions. Bonds that convert to zero value if the bank “gets into difficulty” and where the interest rate demanded by the market would be used to price the risk; let’s call these “Royden Bonds.”

”Gets into difficulty” could be defined as drawing on Bank of England support or the Financial Services Compensation Scheme paying out.  Banks already have bonds that get close to converting to zero value if the bank gets into difficulty; they are called CoCos, but these have different terms and conditions, such that comparisons are difficult.

Contingent Convertibles or CoCos
CoCos are debt instruments often issued by banks which work in a fashion similar to traditional convertible bonds. They have a specific condition that, once breached, converts the bond into shares. CoCos are high-yield, high-risk products often called an enhanced capital note (ECN). These hybrid debt securities carry specialised options that help the issuing financial institution absorb a capital loss. Their use helps to shore up a bank's balance sheet by allowing it to convert its debt to shares if specific capital conditions arise. Contingent convertibles were created to help undercapitalised banks and prevent another financial crisis like the 2007-2008 global financial crisis.  By the time a CoCo is converted into shares, the shares are probably going to be worthless which means the CoCo converts into £nil when the bank is in trouble.

The FCA views the risks involved in investing in CoCos and the complexity of the instruments of such a nature that they prohibit firms from selling them to retail clients. As such, you are not able to purchase CoCo bonds through JM Finn. 

The current government guarantee is free to banks and I would be reluctant to see this go and competitively disadvantage London.  I would therefore suggest that Royden Bonds be used to drive payments from more risky banks to less risky banks such that the net effect of payments was £0. In a world of Royden bonds, risky banks that pay a fair price for excessive risk should be able to pay bonuses if their risks generate strong revenues.

The key to Royden Bonds is that risk gets priced by market forces and the perception of risk by the crowd of professional investors. And the wisdom of crowds, as nineteenth century statistician Francis Galton observed, comes closer to getting things right much more often than not.  And it is certainly, in my opinion, a better approach than letting regulation based civil servants run their slide rules over accounting based metrics.


Illustration by Emily Nault

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Winter Issue Forty One