UK’s FSA to Restrain Pay of Hedge Fund and Investment Managers

Why oh why is it that the US media treats financial services compensation levels as a third rail issue? Rent extraction was the driver of the financial crisis, and the financial services sector made it clear in 2009, by paying itself record bonuses on the heels of being saved from certain death, that it had no intention of exercising any self restraint. The entire sector received massive explicit and back-door bailouts, from equity injections to fancy facilities to engineering a steep yield curve. The UK’s FSA, getting some cover from EU regulations that require curbs on industry compensations structures, is moving forward on the compensation front (by contrast, US pay czar Ken Feinberg’s efforts to shame a narcissistic industry was destined to be only a PR exercise).

The FSA’s efforts arguably fall short of what is needed. As we and others have noted, banks did not start running off cliffs en masse until the sovereign debt crisis of the late 1970s, one of the first misadventures of the deregulated era. And the savvy, high rolling parts of the industry did not exhibit this sort of costly behavior until investment banks had gone public and were working with other people’s money. As we discussed in ECONNED, partnerships provided for vastly better incentives. The most obvious inhibitor of reckless behavior was the unlimited liability (if the firms lost money, its partners were on the hook personally). But that wasn’t the only one. Partners typically had the vast majority of their wealth tied up in business, and they could withdraw it, only gradually, after they retired. This illiquidity produced a long-term perspective and conservatism about who was made partner. While it would be well nigh impossible to dial the clock back, measures that defer payout and increase individual liability are steps in the right direction.

Now some readers may argue that the FSA’s latest move, which expand the reach of its efforts to curb out-of-line compensation to hedge funds and investment managers, is overreaching. But that perspective is too narrow. In a world of a government-backstopped financial sector, combined with tightly coupled financial firms and markets, any firm close enough to the financial water mains can do damage. Pre-crisis, anyone who forecast that safety nets would be extended to money market funds, investment banks, and a big insurer, or that the CDS market would effectively be backstopped would have been deemed utterly daft.

The problem, ultimately, is that there is no neat cordon sanitarie between the firms enjoying explicit or presumed government support (anyone with an operating brain cell knows Goldman, for instance, will not be allowed to fail) and their counterparties. That was the lesson of the LTCM near-death in 1998, yet no effective measures were put in place then. And the fact that backstopped firms channel funds to non-backstopped firms and thus support risk-taking in less regulated parts of the system is a long-recognized problem. The most radical and effective measure is narrow banking, or restricting depositaries to investing in only very safe assets, first proposed by Irving Fisher and others during the Great Depression.

Put more simply, who benefits from the leverage provided by the backstopped financial firms? At a minimum, any market participant that uses leverage provided off exchanges (which means explicit borrowings, such as through prime brokers, say via repo, and by using OTC instruments that allow for leveraged exposure, such as options). And before readers start caviling that XYZ Fund doesn’t work that way and is being included unfairly, consider: every investor in risky assets is enjoying profits that are higher than they would otherwise be thanks to central bank (so far at best partly effective) efforts at pump-priming. That’s a de facto subsidy. All these restraints are achieving is at best partial blunting of corporate welfare programs.

From the Financial Times:

The Financial Services Authority, which has sought to set the global standard on responsible pay practices, is broadening the scope of its remuneration code from 27 large banks to more than 2,500 financial services companies, including the UK branches of many overseas businesses…..

The US, Switzerland and much of Asia have signed up to global principles linking pay to risk but their rules have been less onerous…

But the FSA’s interpretation of the EU law holds some comfort for the industry. That directive requires companies to defer 40 to 60 per cent of bonuses for three years or longer and does not specify who is covered.

As adopted by the FSA, the pay rules apply to senior managers and employees whose activities may have a “material impact” on the company’s risk profile. The higher 60 per cent deferral rate applies to bonuses over £500,000 (€596,000, $780,000).

The FSA also rejected an interpretation of the law being put forward by members of the European parliament that would have limited upfront cash to 20 per cent of the total package – the strictest rule of its kind in the world.

Instead the FSA’s revised code says that at least 50 per cent of the total package must be paid in shares or share-linked instruments.

Update 3:30 AM: Philip Stevens’ comment is germane:

Political resolve has given way to fear. No one waxed more eloquently than Mr Sarkozy about the iniquities of liberal markets. This was the moment, the French president told us, when capitalism would be remade in the image of the European social market. All this, though, was before the Greek sovereign debt crisis saw the eurozone under siege. Now Mr Sarkozy lies awake each night worrying that France might lose its triple A credit rating.

He is not alone. As they struggle to reduce huge budget deficits, western politicians almost everywhere are in thrall to global capital markets. David Cameron has made no bones about it – Britain’s prime minister says he is slashing spending on the welfare state and paring back the nation’s global role because the Bank of England has told him that the rating agencies would be satisfied with nothing less.

The rating agencies – remember them? Some may recall that these very same organisations were deeply complicit in the chicanery that saw worthless debt instruments repackaged as top-notch financial securities. I am sure I heard the politicians say they would be cut down to size. It never happened. The rating agencies never repented; and now they are masters again….

Financial institutions are still extracting large profits from trading activities described by Lord Turner, the head of Britain’s Financial Services Authority, as inherently useless. Lord Turner, however, has been almost a lone voice in suggesting a fundamental rethink.

The crisis in the eurozone shows how the herd instincts of capital markets can destabilise an entire continent. The consequence has been to push European governments into a premature, and risky, race to slash fiscal deficits before economic recovery is assured.

With a little help from the regulators, the big banks can now declare themselves duly stress-tested, but the systemic instabilities remain. International markets have moved far ahead of the capacity of political leaders to understand, let alone properly oversee them. This failure of political governance to keep pace with global economic integration is as apparent now as it was in 2007.

Even if politicians better recognise the risks of interdependence and the vulnerabilities of particular institutions and financial instruments, they are far from any consensus on how to share responsibility for global oversight. So, three years on, things are much as they were – except that most of us are poorer. The markets rule. OK?

Yves again. It’s worse than that. Not only are the non-banksters poorer, but the perps now have mechanisms in place to assure that the next round of looting will go more smoothly.

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  1. Francois T

    “Why oh why is it that the US media treats financial services compensation levels as a third rail issue?”

    Either ownership of the media or the amount of advertising dollars should provide a definitive answer to this question.

  2. Bill Michtom

    “Pre-crisis, anyone who forecast that safety nets would be extended to money market funds, investment banks, and a big insurer, or that the CDS market would effectively be backstopped would have been deemed utterly daft.”

    Personally, I would have deemed that person an honest observer … with a good handle on Marx.

  3. Wuls

    Your commentary is wide of the mark. If ‘implicit’ bailouts are the yardstick then every corporate and individual that has benefited from low interest rates, their deposits being saved and unemployment being lower than it otherwise would be, should also have their compensation deferred. Or should it just be taxed higher?

    Why are firms – after all it was they who went bust – not having their revenues or profits deferred? Why just deal with employees? Why can a 20% perf fee hedge fund still collect all 20% in 1 year?

    Why front run the rest of Europe? They’ve been aching to give London a good kicking and their implementation could now be subtly different to do this.

    What of the consequences of HMRC annual cash tax take? Or house prices? Might it be good if they fall? Or might it be bad that individuals take on more leverage based on their deferred pay which comes over the next 4 years?

    1. Yves Smith Post author


      Your argument is pure straw man. What justification is there for rescuing a sector that has destroyed, by the Bank of England’s estimates, 1 to 5 X global GDP and not reforming it? The costs of the wreckage are vast and will be with those of us who funded the rescue operation via taxes, lower returns on savings, job losses, cuts to retirement benefits, reduced government services (all real costs to investors you ignore, and your point on deposits is moot, those were backstopped before, and not part of the extraordinary emergency measures). And you are ignoring the point of the post, which is the terrible incentive structures, which include hedge fund fees (oh, which are enabled by fund consultants, a necessary element of liability avoidance for most fiduciaries). The companies have demonstrated that they are serial looters. Back door bailouts designed to address the undercapitalization of the industry is instead being syphoned off into bonuses and undue risk taking. Hence the need for more direct intervention.

      1. Wuls

        Pure straw man. eh. Unfortunately not.

        1-5x GDP? Eh? Come again? Global Financial Assets to Global GDP peaked at about 4x, so I cannot fathom your numbers

        As for bailed out, you didn’t read my post. Those ‘implicitly’ bailed out are many. Those explicitly bailed out are few.

        You simply are making a political decision if you think that an entity which happens to be regulated by the FSA but was never explicitly bailed out is treated any differently to an unregulated business or individual who was also never explicitly bailed out but ‘enjoyed’ the implicit bailout experience too.

        Selective on your view on deposits too. They were never backstopped and indeed in many jurisdictions rank with senior bondholders. In fact in the US, the FDIC had to introduce a non-interest bearing unlimited guarantee so convince corporates their working capital cash wouldn’t be vaporised. The decision to bailout IceSave individual deposit holders was a political decision – and clearly part of the emergency measures.

        You miss the point. People would be delighted if they were regulating the firms – i.e. a 20% performance fee payable to xyz LLP has to paid over 3 years not 1 year. Instead they have gone for the easy targets of regulating the individuals and just passed (in Europe at least) the ‘firms’ with a stress test which wouldn’t stand up in a million years.

        ON that we are agreed.

        1. Anonymous Jones

          I see these kind of responses a lot. At some point, we must focus not just on similarity of actions but upon degree of harm caused by those actions. Sure, yes, many people would seem to have benefited from a bailout, most notably those invested in pension funds that didn’t blow up. But this is focusing on a mosquito buzzing around as the elephant sits down on your head.

          The primary issue here is *allocation*. Who gained and who lost? Sure, lots of people were “bailed out.” But if the pie is relatively fixed (and let me assure you, it is), the people who were bailed out more ended up ahead of those who were bailed out less. That’s the critical issue.

          And yes, you have set up a meaningless, trivial argument, whether or not it is explicitly a “straw man.”

  4. JD

    “… It’s worse than that. Not only are the non-banksters poorer, but the perps now have mechanisms in place to assure that the next round of looting will go more smoothly.” wonderful line, thanks!

  5. Bruce

    If compensation is capped for employees, i guess equity would get the excess. So you are saying that the owners of hedge funds (and banks) should earn more at the expense of their employees?

    1. attempter

      I think the idea is that if we cap extractions it removes some of the incentive for the most extreme criminal behavior.

      I thought you guys were the ones always saying if these parasites can’t make billions of dollars gambling with public money they’ll pack up and go home. John Galt and all that.

  6. i on the ball patriot

    Yes — the ‘pay’ compensation is a gross deflection from the real nuts and bolts problem of too many people having access to the ‘water mains’ — their own deregulated leverage pumps!

    Even the backstopping (safety net) arguments are really secondary and deflective from the real causative problem — the noble lie top down global orchestration of culture shaping and control carried out by the wealthy ruling elite in the last forty plus years. This WILL go down as the largest scam in the history of humanity. Never have so many been so slickly enlisted in their own demise.

    This is a GLOBAL problem.

    It can be solved with a Global — “Super Hair Cut For The Rich!”

    Let’s face it.

    We have hit the wall of the effects of decades long, propaganda legitimized, debt trap bubbles, coupled with; the creation of countless counterfeit over leveraged financial derivative products, corrupt government removal of regulations, and corrupt governmental collusion with central banks.

    The present usurious interest driven global debt structures are unsustainable. The TOTALLY OVER LEVERAGED GLOBAL CAN, can not be kicked down the road any further without die off and greater oppression and exploitation of the GLOBAL middle class and under class.

    We have two choices, a good choice and a bad choice.

    1. The bad choice is to continue on in our ignorance and blame each other in the intentionally created divisive GLOBAL wars of prudent against the not so prudent (and all of the other divisive peripheral conflicts also intentionally set out for us, like compensation and who gets backstopped).

    2. The good choice is for all people to unite globally, throw off the wealthy ruling elite, and purge; their corrupt puppets from government, their corrupt media, their phony think tanks, their lackey ‘voodoo economists’ and work to put in effect a proportional debt jubilee.

    Give the filthy, my shit does not stink, elite rich — the top down orchestrators of this intentional chaos — a financial hair cut to zero that they will never forget! Make the bastards scream! Make the hair cut proportional for the rest of us, allowing credit to the prudent against the not so prudent, set some limits on greed, and create truly transparent DEMOCRATIC policy that balances the rights and needs of the individual with the rights and needs of the group. And yes, that will include very narrow, democratically controlled, banking.

    Its reset time — let’s do it right! All else is validating and legitimizing the status quo.

    Deception is the strongest political force on the planet.

  7. RichFam

    Wait – you’re saying the reason that hedge fund and asset management employees should have their pay capped or taxed is because the fed bailed out the market and they invest money for clients in the market? Seriously?

    By that logic we should cap or tax every bit of compensation in the economy. Most companies borrow money and use that leverage to grow. Small companies sell equity to grow. So I guess they benefited from the bailout as well? Many large companies use wall street for hedging activities so they are counter-parties, so lets cap and tax there as well? Larry Ellison got paid 1.8 billion selling nakedcapitalism approved products but I’m pretty sure Oracle benefited from the bailout in terms of corporate borrowings underwriting , advisory services and other rent seeking activities.

    Why is charging to much for an I-whatever not rent seeking activity on the part of Apple?

    1. DownSouth

      That’s just outright silly, and disingenuous to boot.

      You and Wuls are great at setting up straw men and then knocking them over.

      You need to read Econned, where Yves very clearly shows the link between the perverse compensation packages and the looting and predatory behaviors they cause.

      The compensation methodologies the financial services sector currently uses are like having a dysfunctional guidance system on a nuclear warhead.

      1. Siggy

        Full marks for that.

        As to the flaming straw man; The bonuses were unnecessary and more critically unearned. The bailout monies should have gone directly to retained earnings and from there right out the window as write downs against the worthless paper.

        The bonus system of the financial services industry has been distorted since the time of the great raid on other peoples money in 1970 when the NYSE permited member firms to go corporate.

        The great vulnerability of the corporate model is the veil that insulates corporate officers from personal liability. In this past and continuing balance sheet failure a very large number of institutions are insolvent or nearly so. In this circumstance the payment and acceptance of bonuses is effectively theft.

        It may well be that capping compensation by law is the wrong path. The better argument is for a claw back of the bonuses and the more rapid write down of the remaining trash paper. The sooner it is done the sooner we may be able to bring the global economy to balance. In that there is no safe haven, we shall all be made notably poorer.

        1. sgt_doom

          “The bonuses were unnecessary and more critically unearned.”

          Well said, Siggy, well said.

          When the modern day snake oil is securitized debt, and the outcome are all those godawful debt-financed billionaires, the solution should be obvious to all……

      2. RichFam

        That’s not what we are talking about here. If a bank gets bailed out and then uses the money to pay out-sized compensation then you have a valid point. This is the suggestion that a private partnership, that never asked for nor required a bailout not be able to pay out the profits from that partnership as agreed is somehow corrupt. The idea that because that partnership did business with a bailed out bank means that it should be restricted from reaping profits seems pretty unfair. It only follows that if you believe this that any person or company that does business with that bank should be similarly restricted, taxed, whatever. So if Oracle hedged a currency risk on sales overseas and a broad bank bailout somehow saved Oracle money on that hedge should we then restrict Larry Ellison’s compensation? same thing to me

        1. Yves Smith Post author

          To repeat DownSouth, you do need to read up on narrow banking as well as ECONNED, then we might have an intelligent conversation.

          This blog has discussed numerous times that correlation traders, which were often hedge funds or prop desks at major dealers, played a critical role in blowing up the subprime bubble, and worse, creating exposures that were a 10X the underlying BBB subprime risk. So called credit arb strategies were central to the crisis, and they depended on leverage from firms that were backstopped.

          1. Richfam

            Sure I’ll read it but I think we can have an intelligent conversation without it. It’s possible that I’ve worked at old time shops including Lazard, traded more than a little credit and default swaps, managed a fund, manage a fund, had to deal with a levered unwind, repo, and so on. Even maybe traded some of that aweful correlation stuff.

          2. Richfam

            Cut off by my i-phone yest, Steve Jobs must have seen me complain about his overpriced products… Anyway, I absolutely hear you on a number of points (and disagree on others but at least I read the blog and so hear another opinion). All I’m saying is that there is a place for speculation in financial markets but that it does not belong at a large bank with insured deposts. It all gets too big and so we blow up.

            On the subject of certain CDO’s, levered super seniors, and a bunch of other crap inovation: (Thank you ABN Amro for 10x levered super senior synthetics…) Citi creates a CDO, sells 20% of it, keeps the rest, finances it short term, everybody gets paid and the bank (and so the depositors aka the taxpayer) gets left holding the bag. Aweful, and no wonder people discuss clawbacks.

            Wall street partnerships and hedge funds, different yes but, no OPM at those partnerships? And no person money from the manger in the fund? You know those are both not true. I’m sure you know that a bunch of very “old fashioned” bond dealers have popped up over the last couple years. Some have capital from the founders but they all went out looking for outside equity and plenty of those old firms had outside equity. Some did not and were hugely successful but I think its unfair to make blanket statements on this.

            Pay and “shadow banking”: You make the point in the post that even an unlevered fund benefited from the bailout, but then so did Oracle. So if you want to control the pay of a hedge fund manager who uses no leverage then control Larry Ellison’s pay as well. Or do neither…

            Rent-seeking: oh man I hate this term…

        2. craazyman

          If the system hadn’t gotten bailed then many of those fellows and ladies would have sunk like the lead ships of leveraged lucky fools that they are. “talent”, puh-leeze.

          I make 0% on my savings thanks in part to their approach to finance and their purchase of congress, the Fed, the senate and the administration with their lobbyists and campaign cash. that’s a bailout in my book and on my back. and look at what they’ve done to the economy. what is looting, if that isn’t it.

          I say tax their assets off or send in Che Guevera. That’s about where I am with this stuff. No more patience for pettifoggery from rich dudes with too much money, too narrow minds, and too little soul.

    2. reslez

      You will know them by their fruit. Apple produces iPads and MP3 players. Wall Street produces misery and debt bondage.

      Is the ability to hedge currency a sideline for Apple, or its main enterprise? If you remove the ability to hedge currency could Apple continue to design iPods? If Wall Street were to disgorge its ill-gotten gains it would cease to exist; the financial firms as a group have failed so many times it cannot be argued they have ever turned a profit. They exist by the sufferance of government.

      You will know them by their fruit. The same hedge funds you defend bid up the price of food commodities in 2008 and directly caused global famine, mass riots and the toppling of governments. The financial firms you say pose no risk to the economy are the number one danger to the economy. The scouring of the middle class, the institution of debt peonage, the build up and smash down of bubbles for the enrichment of the rich, these lead directly to the economy’s destruction. Worse, they are the engine of destruction for our entire civilization. The relentless demand for continual growth, the sociopathic reliance on huge profits for individuals and mass losses for everyone else — no matter the cost, no matter the externalities — this is a system that cannot be defended and cannot last.

  8. RichFam

    Let me add this – I think that releasing the animal spirits of wall street on a bank’s balance sheet creates big problems but there is an important place for those spirits in finance. Most hedge funds have that spirit but do not have the ability to use taxpayer backed funds to make money and do not pose a risk to the economy as a whole. I don’t remember reading about any vital hedge fund bailouts. Most of the old wall street firm were private partnerships that took risk but it was partners capital,like a hedge fund, not leveraged bank deposits. Even as a public company this can exist – look for example at Lazard Freres – no bank deposits, no bailout, and the senior execs are owners and have a stake in risk adjusted success.

    1. Yves Smith Post author

      The old investment bank private partnerships bear absolutely no resemblance to hedge funds. I say that from having worked for two of the major firms in their heyday, and subsequently having both trading firms organized as principals (trading with their own money) versus hedge funds (trading with OPM). That difference seems stunningly lost on you. OPM creates terrible incentives, and now we’ve created an even deeper OPM pool by government intervention to save firms that would have otherwise failed.

      Where were you during the crisis? Hedge funds were failing and limiting redemptions; their actions were damaging liquidity to dealer firms. Dealers in turn raised haircuts, which led hedgies to dump positions, hitting markets, producing MTM losses at dealers, worsening their equity and more important, lowering value of repo that could be used as collateral for funding.

      1. sgt_doom

        And given the lack of transparency of hedge funds, and their off-balance sheet natures, perhaps only a few fully understand their structure:

        Paying equity dividends with virtually no cash flow available,

        The introduction of large spurious amounts of debt capital of unknown origin to augment cash flow, and the drawing down of fictional amounts of capital from

        The use of dual entries to disguise the non-amortization of project debt.

        Whether hedge funds, Private Equity LBO firms, public-private partnerships, the structure is the same.

      2. i on the ball patriot

        No waiting!
        Step right up!
        Instant profits!
        To fill your cup!

        Get a speedy return,
        Its all instant churn,
        Even a beginner,
        Can be a winner,

        You want money?
        No problem at all!
        We got a leverage spigot,
        On every wall,

        No more waiting,
        For years and years,
        No hard work,
        No struggle or tears,

        We bought the government,
        We blew out the rules,
        We own the system,
        And its media tools,

        Bubble em up,
        Blow em down,
        Its all formula now,
        They’ll soon all drown!

        Vanilla greed,
        Is a thing of the past,
        Pernicious greed,
        Is now unsurpassed,

        Life is sex and life is bread,
        All the rest is wasted power,
        Rush for the keys to the bread box door,
        And the maiden’s sex filled flower …

        Hurry! Hurry! Hurry! You don’t want to miss out!

        Deception is the strongest political force on the planet.

        1. craazyman

          the last stanza is very good, : ) — it sort of channels up William Blake’s Songs of Innocence and Experience, especially “the maiden’s sex-filled flower.” — a very taught but complex fusion of imagery and metaphor.

    1. DaRkJaWs

      oops, accidentally hit the enter key. Anyway, if you read this could you contact me? I want to talk to you about Reinhold Niebuhr and an idea I have in particular. I want to ask you what you think of it and what Niebuhr would think of it. Contact me at

  9. americangoy

    Let me repeat the following snippet of Yves, lest it be lost in the rest of the brilliance, as this is THE KEY point for me.

    “As we and others have noted, banks did not start running off cliffs en masse until the sovereign debt crisis of the late 1970s, one of the first misadventures of the deregulated era. And the savvy, high rolling parts of the industry did not exhibit this sort of costly behavior until investment banks had gone public and were working with other people’s money. As we discussed in ECONNED, partnerships provided for vastly better incentives. The most obvious inhibitor of reckless behavior was the unlimited liability (if the firms lost money, its partners were on the hook personally). But that wasn’t the only one. Partners typically had the vast majority of their wealth tied up in business, and they could withdraw it, only gradually, after they retired. This illiquidity produced a long-term perspective and conservatism about who was made partner.”

    This is so good that I will steal this verbatim in my own future post on the lack of risk and combine it with the free money at 0.X% available to “banks” like Goldman Sachs.

    Yves, what do you think about the American Royalty wedding of Princess Chelsea?

    Long time reader here, and am in awe of Yves ability to explain complicated issues using layman’s terms.

    Which is always what I aspire to do, just fail at it more so than Yves does.

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