Friday, 15 May 2009

Bonuses again

Robert Peston reveals a report by MPs on bankers' bonuses. Of course they are calling for reform. But what should that reform look like?

Here are a couple of odd things about such bonuses:
  1. Behavioural economic theory indicates that it's not so much the absolute amount of money that acts as the reward, but the relative amount - if I get £5m to your £3m, it's just the same as me getting £500k and you £300k. The 'reward' seems to be the ego boost of being at the top of the tree.
  2. But unfortunately it's also not the amount of money that has led to the risk-taking behaviour. Even if banks had only paid their employees 1/10 of the bonuses, they would still have acted the same way.
So how to change behaviour, if that's what we want to do?

Certainly tying bonuses to long-term results instead of short-term is one option. But for motivational purposes, people should still receive performance bonuses relatively quickly, as this is how their mental association between action and reward is stimulated.

And please don't suggest that bankers do not need or deserve motivation - even if that were so, it's still in a bank's interest to offer it to them. Companies don't pay bonuses out of charity - it's because they believe that, in certain cases, this is the way to incentivise the performance that they want (though sometimes companies are subject to 'capture' by their management and end up paying employees an unwarranted proportion of their shareholders' money).

So perhaps we need to go back to a system with a bit of wisdom and human judgment, where an experienced manager makes decisions on whether the employee's actions have put the bank in a good position for the long term. There's some risk involved here, but probably less than rewarding either based on the immediate profit from a deal or waiting until four years have elapsed before paying anything.

Of course banks would still save a lot of money by cutting those bonuses by 90% and just relying on the motivational effect of positional utility. Maybe an exception to the competition laws would be justified here, to let the banks cooperate to arrange this? Or just an even higher tax rate on bonuses over £1m? After all, we don't necessarily just want the banks to keep the difference - ideally it should either contribute to the public good, or go into reduced fees or higher returns for bank customers.

And these sums would make quite a difference (at least in the investment banking world), - compensation tends to make up well over half of the costs of an investment bank, and a big chunk of that is usually bonuses.

Unfortunately there will still be a loophole: companies and people based offshore, or more specifically tax and regulatory competition between countries. But if governments do want to make an agreement that stops this happening, now is probably their best chance ever.

1 comment:

Andrew said...

Interesting.

I think a bonus tied to the 'wisdom' of managers could be interesting (http://www.ted.com/index.php/talks/barry_schwartz_on_our_loss_of_wisdom.html)

But I think relying on the 'wisdom' more likely leads to group think than the right answer in some of these situations.
http://www.ted.com/index.php/talks/dan_ariely_on_our_buggy_moral_code.html