How to fix banker pay

Well I've heard it all now.

Apparently the big UK banks have just hired a crack team of lawyers. And get this they have instructed them to look into suing the EU if Brussels moves to cap their pay.

Talk about biting the hand that feeds you! The authorities are practically the only thing that's kept banks from a disastrous implosion. This should be one hell of a showdown.

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I spent years working in the City. And to be honest, I was paid well for my work. But over the years I've watched as banker pay has spiralled out of all control. And it just doesn't sit well with me.

Today I want to show you why I think banker pay has gone completely bonkers. I'll talk about how to fix it and most importantly how there may even be an opportunity to profit from the whole debacle.

How the Bosman rule changed everything

European politicians are talking about new laws capping banker bonuses. And clearly the bankers aren't happy. The thing is as far as they're concerned, the law is on their side.

It was the Bosman ruling on footballers pay that set the standard. The idea is that an individual must be free to transfer between clubs/employers withinthe EUand at whatever salary they can get. And it kind of makes sense, nobody's a slave after all. We should all be free to choose who to work for and at what price.

But the 1995 ruling sparked a surge in footballers wages and the now inflated wage bill has pushed many clubs to the brink. So I guess it's apt that it's now bankers that are hoping to use the same ruling as an excuse to keep their wages bill high too. And once again, it could probably push them high enough to send many of their employers over the brink!

So what is the answer? Should we back free markets? Or should we back the eurocrats in their bid to strangle banker bonuses?

I struggled with this issue for a little while. I tend to take the Adam Smith approach of laissez faire for markets. Politicians should be held back as the fixers' purely because they have a nasty habit of doing precisely the wrong thing at precisely the wrong time. Let the bankers get on with their business in a free market was my gut feeling.

But then again the pay for many of these bankers looks ridiculously inflated. I mean is an average investment banker really worth ten, or twenty times the price of a top surgeon?

And these are the guys that have destabilised the financial system to the point of break-down. Many savers (though most don't know it yet) are sitting on a potential financial precipice. The financial system got stretched to its limits in 2008; and I suspect we may not be far away from another cataclysmic event.

After a bit of contemplation, I came to the conclusion that this is all down to these wretched politicians and bungling authorities in the first place.

Big Bang = Big bust

There are very few rules to running a successful capitalist economy. But there's one fundamental balance that needs to be put in place and maintained at all times. And that is competition.

Without competition, free markets and capitalism doesn't work. What you need in a market is lots of competing players.

The unfortunate thing is that over time a capitalist system tends to erode competition. Big players emerge and drive out smaller players. Nowhere has this been more prevalent than in banking.

It was called Big Bang' in the UK and it came along in 1986. As well as other changes, institutions were allowed more freedom to merge and acquire competition. A similar deregulatory state of affairs occurred in the US.

Basically the politicians took their eye off the ball. Competition is the central plank of capitalism and this deregulation throttled it.

Before Big Bang, there were thousands of small City institutions, many owned in partnerships, or by individuals. They were small enough to fail, and thus their owners tried everything in their powers to make sure they didn't.

That included keeping wages at a sensible level. I worked for one such City partnership. The business was run very conservatively by (and for) the partners. Wages were generally low for the industry. Sure there were bonuses, but nothing like some of the City crew see today.

Ultimately this partnership couldn't survive in a world stuffed full of too big to fails'. Alas its glory days have passed and it too has been merged with an American goliath.

Things have gone from bad to considerably worse

Having mucked up free markets in the City, the politicians had sown the seeds of the great financial crisis of 2008.

And when it came, they made matters even worse!

Rather than reverse the Big Bang damage; the authorities backed plans to concentrate the banks even further.

JP Morgan snapped up the failed Bear Sterns. Barclays mopped up the left-overs after the Lehman collapse. Bank of America took Merrill's and of course Lloyds was strong-armed into taking on HBOS (and they actually paid for this junk!)

These firms are all massive publicly quoted companies. They're owned by shareholders that barely get a say in the running of the business. There are precious few checks on risk-taking, and little more balance when it comes to staff pay.

Had the authorities taken the 2008 crisis as an initiative to bust the bust banks and restore order things could have been very different. Remember, a bust business doesn't necessarily cease to exist. It's just the ownership that changes.

Shareholders and bondholders could have been forced to face the music, and a new set of owners could have injected capital into the remaining businesses. NOT the taxpayer!

The banks could have been carved up into manageable (and competitive) units and sold off to private owners.

And those new owners would want to manage risk and staff wages with a great deal more conservatism than what's going on today.

But it ain't going to happen

Right, but that didn't happen did it?

What's happened is we've built up an even more dangerous and uncompetitive banking industry. And ultimately poor risk management and fly-away wage bills can only be bad news for shareholders.

Since the end of 2011 (when the ECB introduced the LTRO Long Term Re-financing Operation), the banks have put in a decent rally. I'd consider selling into it. Just consider the problems in peripheral Europe. Problems in Greece, Italy or Spain could easily cause serious damage to banks in the year ahead. As I said: we could be headed for a cataclysmic banking event.

How should you do that? Well I've talked about shorting the banking sector using a spread betting account before. Here's a chart of the UK banking sector provided by spread betting company IG Index. As you can see it seems to have rolled-over. It could be ready to head back down to earth.

Source IG Index

You can use a spread bet to short the banking industry. But please be aware of the risks.

First and foremost, I may be wrong! If the economy is genuinely on the mend and the politicians keep fudging their way through the euro crisis, then maybe the banks will get back into recovery mode.

And with a spread bet, you're only asked to put down a fraction of your full exposure. That means you can lose more money than you put in.

But I like the idea of shorting the banking sector. It's always nice to have something that goes up on big down days in the market. And in my opinion, the whole industry needs to be broken down and rebuilt.

This article is taken from the free investment email The Right side. Sign up to The Right Side here.

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