Merryn's Blog

The real scandal over bankers' bonuses is how banks can afford to pay them

It's no surprise that bankers get huge bonuses when you consider the billions banks rake in. The real scandal is how the banks get away with making such enormous profits in the first place.

Why do top bankers get paid so much money? The obvious answer is that they are manipulative and delusional beneficiaries of the talent myth.

But a better answer is "because it is there". Bankers get paid millions because banks make billions the average big bank makes more in profit than a business in any other sector could ever dare to dream of. So the question we should really be asking is "Why do investment banks make so much money?"

The answer? Mostly it comes down to the fact that they charge very high prices for their services, and for a variety of reasons, they get away with it. Take the traditional businesses of investment banks advising businesses and facilitating deals (putting buyers together with sellers and floating companies on the stock market). As Anthony Hilton points out in the Evening Standard, they will usually charge "five to eight percent on a deal and the client pays. No questions asked."

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If that sounds high it is because it is. There are two major reasons for this neither good. The first, says Hilton, is down to the fact that so many clients are "dazzled in the headlights" of dapper bankers. The deep carpets, the fine dining, the art on the walls, the mentions of previous deals it all "plays upon the client's insecurity and the desire to be part of the herd".

The second and I think this is the real problem in investment banking is that most CEOs signing up for deals aren't doing so with their own money. £100m on a takeover might be a lot, but it isn't his £100m, and if the takeover gets through, odds are he'll make a killing regardless. Same goes for "£50m on a clever bit of engineering that improves the strength of the balance sheet". He isn't paying himself, but he'll make a good bit out of taking the credit. The client isn't necessarily price sensitive.

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It is also worth noting that the investment banker hasn't much in the way of expenses. He has no factories, not very many employees and all his travel costs and £200 dinners are paid for by his clients. You also have to remember that barriers to entry in many of these businesses are vast. Anyone can get into the coffee shop business. But you can't wake up of a morning and think you fancy starting a small company managing FTSE 100 mergers and floats of Ocado-style businesses. No wonder the profits are so big.

The big banks' fund management businesses and hedge funds make a killing for much the same reasons: they charge high commissions in the form of management fees and performance fees (which they get away with for reasons I will never fathom); a great deal of money goes through their hands; and their expenses are relatively low.

Then there is retail banking. Six big banks dominate our high streets. Between them, they control 85% of our mortgage market. As such, they have, as the analysts at Citibank like to put it, "significant pricing power".

There is much talk about new entrants to the market, but they face pretty nasty barriers to entry. There is a problem with data: it seems the big banks have access to credit information they don't fancy sharing with new entrants. But the main barrier for new entrants is getting their hands on the cash they need to become players: a few years ago they would have relied on the securitisation market for money. But that market doesn't really exist any more.

That means that for now at least our retail banking industry, just like the global investment banking industry, will stay an oligopoly. Year after year they will get away with the kind of cartel pricing everyone else gets done for. And the Bob Diamonds of the world will continue to get very, very rich.

For an idea of how investment banks earn their vast profits, see Tim Bennett's video tutorial: What investment banks actually do

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