Banks happy with Stephen Sedgwick review of pay structures

The big banks were falling over themselves to endorse Stephen Sedgwick’s report into their pay structures.

Would you want to be treated by a doctor “incentivised” by a bonus or his/her integrity? Would you trust journalists paid according to the number of clicks on their ­articles?

The big banks were falling over themselves to endorse former public service commissioner Stephen Sedgwick’s report into their pay structures this week. It’s easy to see why: the 21 recommendations create the atmosphere of reform without banks having to do much.

Bank boards will have three years to “visibly and effectively” pare back bonuses for lower-paid sales staff.

They will have to “reflect predominantly an ethical and customer focus” when handing them out. Just predominantly.

To be sure, the review didn’t touch on bonuses for higher-paid bankers. Phew.

Sedgwick, a successful public servant who didn’t himself need a bonus to advance, was too polite. In most professions, awarding a bonus for good performance would be an insult; the desire for colleagues’ respect is enough.

The “bonus culture” that has thrived in financial services since the 1990s (which typically means bankers are rewarded for good luck and not penalised for bad) has been a disaster, economically and morally, for everyone but the industry itself.

Bonuses sound good in theory — a way to coax more effort out of fundamentally lazy human beings.

But in reality performance hurdles can’t be written down to capture all the things employers would like their staff to excel at, and certainly not things that matter more broadly.

Offering bank staff bonuses to write more mortgages, for instance, has consequences for house prices, inflation and financial stability, which aren’t part of any bonus criteria. Bonuses tend to focus employees’ minds on money and themselves at the expense of their job and any intrinsic value it might add, more even than they naturally would.

In finance, bonuses honed the timeless incentive to exploit customers and manipulate prudential regulations, which contributed to the biggest economic crisis since the 1930s.

From last year’s Wells Fargo scandal in the US to the big four banks’ alleged rigging of wholesale interest rates in Australia, bonuses have been at the heart of bouts of banking fraud — what Bank of England governor Mark Carney delightfully called “ethical drift” in a speech recently.

“A series of scandals ranging from miss-selling to manipulation have undermined trust in banking, the financial system, and, to some degree, markets themselves,” he said, noting more than $US320 billion in fines had been issued since the financial crisis.

Diagnosing problems with bonuses is much easier than fixing them. The genie is well and truly out of the bottle. Government shouldn’t specify how workers are paid. The best hope is developments in fintech and technology increase competition on banks and erode the revenues that sustain perverse remuneration structures in the first place.

Illustration: Stephen Blair

The Sedgwick review’s call for a “customer service focus” reflects other regulatory work to align remuneration with customers’ interests. The Reserve Bank for instance has led global efforts to introduce a code of conduct for financial markets to try to stamp out self-interested manipulation of client information. This is window dressing.

In a genuine free market businesses that don’t serve their customers — retail or wholesale — fail, as customers turn elsewhere. Unfortunately, market forces don’t operate in banking.

Swathes of it is unproductive — banks’ returns on assets are pitifully low, their returns on equity respectable through high leverage. But banking remains lucrative because of the raft of implicit and explicit subsidies banks enjoy. The Commonwealth Bank, leveraged more than 16 times, borrows almost as cheaply as the Australian government.

Inflation just hot air

The biggest debate in economics over the past decade has been about productivity growth: where did it go? The conventional view blames “secular stagnation”: low rates of innovation have undermined growth, leading to sluggish wages and forcing policymakers to slash interest rates to spur demand.

One of the titans of economics, Martin Feldstein, Harvard professor and former chairman of Ronald Reagan’s Council of Economic Advisers, has attacked this idea in a March paper for the National Bureau of Economic ­Research.

He has questioned the truth of the very statistics that fuel the debate: gross domestic product and consumer price indices.

“Widespread references to slow economic growth reduce the public’s faith in the political and economic system,” he writes.

Feldstein argues inflation is actually much lower than people think. The scale and frequency of quality improvements in goods and services has changed from a generation ago and overwhelmed statisticians’ capacity to assess it.

When statistical agencies compare the prices of goods and services over time to measure inflation they try to strip out quality improvements. A computer or mobile phone might cost more but if it’s faster then some of that price increase is not inflation.

This was much easier to do in post-World War II economies with relatively few, simpler, and identifiable goods and services. Today there are magnitudes more — perhaps more mobile phone types alone than the entire grocery range of a 1970s corner store. And many more products are provided without financial payment — internet search engines, mobile phone apps etc — ensuring they aren’t included at all.

Even if quality never changed, new goods and services only find their way into price and GDP statistics when consumers start spending significant sums on them: fridges entered in 1934 and cars in 1940, for instance, long after their widespread use. And even then, their value is only what people are paying for them (stripping out any quality improvements, of course) — which bears no relationship with how much living standards might have improved as a result of them.

If price changes are much lower than official statistics say, then real GDP and real interest rates are much higher.

“It seems little point in having a precise inflation target when the true rate of inflation is measured with a great deal of uncertainty,” Feldstein says, arguing there is “a substantial and unknown upward bias in the measure of price inflation”.

Healthcare is a further problem. Because of pervasive government involvement, its value is measured at the cost of provision. If governments pay or subsidise doctors and nurses more, for whatever reason, statistics show they are producing more.

The actual output — life expectancies and morbidity rates — don’t figure in the price and output statistics.

This debate won’t be easily settled, though, as Commonwealth Bank economist Gareth Aird suggested in his research this week. Consumer price indices don’t include house prices, which are among the biggest components of households’ budgets.This is because land is considered an investment, not consumption. This factor could overwhelm Feldstein’s arguments.