Economic Policy

Corporate governance: the economic damage done by the bonus culture gives a focus for reform

  • Published: Jul 31, 2014
  • Author: Peter Kenway
  • Category: Economic Policy

The Bank of England wants to take bonuses back off misbehaving bankers; corporate governance reform could mean abolishing bonuses altogether.

The TUC’s multi-authored book on corporate governance sets out all sorts of reasons for changing the way that people at the top our biggest companies take their decisions. In this second post on the book, we look at one of the articles, by Andrew Smithers, in more depth. What stands out about the article is that it stars a powerful villain with blood on his hands. The challenge it poses, to other contributors (and would-be ministers) is what are we going to do about it?

The villain is the management bonus that takes the form of a share option. A share option is just a right to buy a packet of shares at the price they are (let’s say) today at some range of dates in the future (let’s say sometime next July). The recipient of the option will only exercise it if the share price then is higher than today. If it’s say £10 a share today and £20 next July, exercising the option when the time comes doubles the money put in overnight.

Smithers makes three points. First, if you award these options as bonuses to senior executives, you are giving them a huge incentive to take decisions that push up the share price.

Second, actions that push up the share price in the near term can harm the company in the longer term. The big threat to a company’s long term interest is a loss of market share. Holding prices down and keeping investment up are among the best ways to protect against this. By contrast, a near-term increase in the share price is better served by pushing prices up a bit while keeping investment down, spending the money instead to buy back shares. Summing up, bonuses linked to the share price represent incentives for senior managers to take decisions that are at odds with the long term interests of their companies.

Third, the claim that bonuses lower investment and raise profits (as well as creating more volatile profits) can be checked against the data: the article presents evidence on this for both the US and the UK. Whether the results are compelling depends on your yardstick but they are certainly suggestive.

What makes this villain especially threatening is that it doesn’t just account for lower investment and higher profits but also, according to the article, for lower productivity and (the old NPI favourite) the structural (or long lasting) corporate sector surplus. A single explanation for at least four self-evident “bads”, all of which are directly relevant to the challenges facing a Chancellor of the Exchequer, is not one that should be ignored.

So what’s to be done? Although the article doesn’t say, the obvious conclusion is “ban bonuses”. A less crude conclusion is “ban bonuses that relate to the share price” or alternatively, “if you must have bonuses like this, keep them small”.

For the most part, the other contributions to the book are much more concerned with changing either who makes the big decisions within companies or the “environment” of laws, codes, regulators and taxes within which those decisions are made. This argument doesn’t make them redundant since the since the question of how the bonus culture is going to be changed remains to answered. But what it does do is pose a challenge: whatever you choose to do, what are you going to do about this bonus culture?

In his speech to the Labour Party National Policy Forum this month, Ed Miliband announced that the next Labour government would “say that top pay committees should have an ordinary worker on them”. Although just “saying” this should be so is about as cautious as it gets, a proposal like this is in the TUC book. But once they’re on the committee, what do they do? The temptation to look at the part of pay – the PAYE bit – that “ordinary” workers are most familiar with might even lead to the wrong outcome, with lower salaries at the top and higher bonuses.

So more workers on the board can only be a step towards reforming governance. It’s not just a matter of who is taking those decisions at the top of companies, but what they should be aiming for too.

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