Knowing and Making

The BBC has reported that the chief executive of RBS, Stephen Hester, is about to be offered a new pay deal by the board . If one thing is predictable in life, it's the howls of outrage that will accompany the headline figure: £9.6 million. But the real figure is not £9.6 million - it's £1.2 million. Still a big salary, but on nothing like the same scale. The biggest chunk of the rest will be payable only if the share price of the bank hits 70p - double its current level and 40% up from the 50p at which the government originally invested - meaning that the taxpayer will have made an £8 billion profit on its RBS investment. So why is it being presented as a £9.6 million deal? Of course this might just be the BBC's spin. Perhaps they put together all the figures themselves and picked the highest figure, a natural thing for any reporter to do. But in fact it may be the bank who has decided to lead on this figure. If so, why would they do that? Surely they have an interest in k...

One of the primary criteria in designing any system of pay is to influence the recipients' behaviour. Traditional pay structures work on the assumption that people behave rationally. Thus, they will pay people for generating profits for their company; on the basis that if you pay them more for higher profits, they will generate more profits. This has the attraction of simplifying the manager's job - assume that the employee can figure out the best way to make profits, and leave it to them. However, this structure has at least three intrinsic problems. One is asymmetry: you can pay someone for making profits, but you can't penalise them for making losses. Virtually no employee will work for a company if there are circumstances in which they would have to pay  for the privilege. The other is the agency problem: the employee has control over the company's resources but does not get all of the benefits of using them in the most productive way. Thus, a temptation exists for ...