It is curious to reflect that in the London market of 25 years ago, last week’s decision by UBS to maintain investment banking bonuses in the face of a thumping loss would have been literally incomprehensible. Back then, bonuses were paid out of profits. So without profits, where might the money come from?
The question is not as naive as it sounds. Before the Big Bang of 1986, which transformed investment banking and broking in the UK, business was done through partnerships.
That restricted access to capital in ways which today seem hard to grasp. The contrast is nevertheless relevant.
Before pursuing that, let us inspect the UBS case more closely. In its third quarter, as a result of the alleged trading scam that cost it SFr1.85bn (£1.33bn), the investment banking division made a pre-tax loss of SFr337m.
The figure reported – a profit of SFr1.43bn – was somewhat rosier. But that resulted from a profit of SFr1.77bn on the fall in value of UBS’s own bonds.
I have written on this hallucinatory procedure before (April 27, 2009). Suffice it to say that whereas any corporation could in theory adopt it, only the banks have had the brass neck to do so. Then again, only the banks paid bonuses based on imaginary profits of various kinds throughout the bubble years.
It is worth noting, though, that the fall in the value of UBS bonds is almost identical to the loss on the unauthorised trade. Indeed, since virtually all the fall came in the latest quarter – during which the loss was divulged – this might be seen as cause and effect.
There is a kind of magic here. If any loss incurred by investment bankers gives rise to a corresponding profit, it follows that they can maintain their bonuses right up to the grand final profit that accompanies the bank’s dissolution.
That apart, where did the UBS bonuses of SFr1.35bn come from? The bank would doubtless argue they came from other profitable divisions. But in the end, of course, they came from the shareholders’ pockets.
This brings us back to the pre-Big Bang regime. Many of those old partnerships had unlimited liability, which is a fearsome thing. One broking firm I knew opened an expensive London office just before the great bear market of 1973-74. By the time the market turned in January 1975, some of the partners were weeks away from personal bankruptcy.
In such a system, outside capital has no place. No equity, since that resided with the partners. And no debt, since – as in the above example – that would only make a precarious existence worse.
As Andrew Haldane of the Bank of England reminded us in a speech last week, unlimited liability was once the norm. Limited liability for companies was only made legal in the UK in 1855, and commercial banks were slow to adopt it. For as Mr Haldane put it, unlimited liability “served as a safety certificate for depositors, a badge of prudenceâ€.
That said, the old regime was scarcely ideal. It was riddled with restrictive practices, of which the 1.5 per cent fixed commission charged by brokers was only the most glaring.
It was also in various ways corrupt. A slice of the income of its practitioners, for instance, came from insider trading which, though officially frowned upon, was not then illegal in the UK.
The present system, though, is also run for the benefit of insiders, if in slightly different ways. And the old regime had the great advantage of viewing human nature with a sceptical eye.
No one would have thought to trust brokers with outside capital on today’s basis. Indeed, the system of single capacity – whereby brokers were not allowed to own stock, and the jobbers who owned it could not give advice – was based on the presumption that no one was saintly enough to give a fair opinion on his own goods.
Indeed, there is limited point in chastising people for taking what the system affords. London’s tube drivers have just won a generous pay award, based – some would allege – on the implicit threat of a strike bringing the capital to a halt during next summer’s London Olympics.
If true, the fault lies mainly with those who allowed them to accumulate that power in the first place.
It is similarly unattractive for investment bankers to issue the implicit threat that if shareholders do not pay up, they will jump ship and leave the business worthless. But again, what did the shareholders expect?
There is no returning to the pre-Big Bang state. But its perception of human frailty contains an essential lesson. In the end, if bankers take us to the cleaners we have mainly ourselves to blame.
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