Banking bonuses work

Two articles yesterday claimed that bonuses don’t work. One from Simon Caulkin in the Daily Mail and the other from Aditya Chakrabortty in the Guardian. Both cite high bonuses in the financial sector, and the subsequent catastrophic collapse of many banks, as evidence that such remuneration schemes are counterproductive.

I’m not up to date with the latest studies on remuneration systems. (When I’ve read up on it I’ll post about it.) Aditya Chakrabortty claims to have “been through stacks of the research on bonuses” but, disappointingly, doesn’t quote any of it in support of his arguments. What I remember from when I last looked into it in any detail was that the results were inconclusive. Certain types of incentive scheme worked in certain organisations and others were completely useless. For every researcher arguing that bonuses don’t work you’ll find one that reckons they do. Much seems to depend on the context.

However, looking at the financial crisis, it appears that the remuneration schemes of the mid-2000s were a roaring success. Banks wanted their employees to make as much money in as short a time as possible. The remuneration schemes were set up to encourage them to do so. And guess what? The bankers did just that. It is almost a textbook case study of the remuneration policy driving the behaviour that the employer wanted. The bonus schemes did exactly what they said on the tin.

The financial crisis wasn’t caused by a few employees behaving badly and pushing their luck to get a bit more bonus. It was the result of business strategies pursued by the banks. They set up their remuneration schemes to encourage employees to execute these strategies and the employees behaved accordingly.

None of this is to say that huge banking bonuses are fair or moral or that they should not be curbed. But it is clear that the bonus schemes of the mid-2000s worked. Banks encouraged their employees to drive ever faster and so that’s what they did. By the time they discovered that they were driving towards a cliff edge it was too late.

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9 Responses to Banking bonuses work

  1. Pingback: Banking bonuses work - Rick - Member Blogs - HR Blogs - HR Space from Personnel Today and Xpert HR

  2. Luis Enrqiue says:

    what counts as “working” is rather poorly defined – it could be a) increasing returns to bank shareholders in aggregate or b) increasing returns to shareholders of an individual bank relative to not paying bonuses of c) “working” from some social point of view, including but not limited to encouraging good behavior, systemic stability etc.

    the difference between a) and b) is important. If you regard bonuses purely as a bargain in which the banker agrees not to jump ship and take revenue with them, then they can work from perspective b) – if the bonus was not paid, banker would jump ship, bank shareholder would suffer – without working from point of view a) – the fact that every bank has to pay its bankers to stay put means in aggregate bankers capture the surplus and bank shareholders suffer.

    as for the encouraging behaviour that “the employer wanted” – who is the employer, bonus-earning bank directors, or bank shareholders? Properly speaking, the behaviour of the agent (banker) should be serving the ends of the principal (shareholder) and it does appear here that bonuses may have encouraged behaviour of the picking up pennies in front of a steamroller variety that is emphatically not in the long-term interests of shareholders… quite why they encouraged remuneration schemes that ended up acting against their own interests is the mystery. I reckon it was mostly that people didn’t realize what was going on.

  3. Rick says:

    Luis, the purpose of City bonuses is a combination of retention and motivation. Some of it is about keeping bankers in place and some about encouraging them to behave in a certain way.

    As you say, only a few people saw where this was leading and even fewer spoke out. Shareholders, like the employees, the directors and the government, were happy to tolerate the high bonuses and short-termism provided the profits rolled in. Few suspected that it would trash their investment so thoroughly.

    As I said in my 12 January post shareholders have seen the proportion of revenues going in bonuses continue to rise. If they were angry about this they wern’t angry enough to rebel or sell their shares. Presumably, then, while the short-term profits were rolling in, they were as happy as everyone else.

  4. CharlieMcMenamin says:

    I know I’d hideously no-expert in all this, but I can’t help but think that ‘driving one’s organisation to the brink of collapse’ and ‘almost bankrupting one’s host country when they had to bail out one’s employer’ are not usually the marks of ‘success’. The Credit Crunch didn’t appear out of the blue one day – it was a naturally development of what went before.

    Your argument appears to be that as shareholders didn’t revolt they must have been happy, even whilst conceding an increasing proportion of revenues to the so called ‘talent’. One could also plausibly claim it was evidence that they accepted the radical de facto separation of ownership and control in the financial world, and were simply accepting ( happily or otherwise) the crumbs from the table of the de facto ‘owners’, who creamed off most of the profit for themselves and who set the policy in most cases.

  5. Luis Enrique says:

    Rick,

    what I’m trying to get at is a game theory style idea, that you can be ‘happy’ with a situation, in the sense of not wanting to change, without being happy with the situation in a broader sense.

    Here’s an example I saw an economist present once. Consider disputes between employers and unions, an imagine that the probability of a settlement going in favour of either party be taken as given (to do with the specifics of the case). Now if one side hires a lawyer, they increase their probability of a favorable outcome. If both sides hire a lawyer, the probabilities go back to the original no-lawyer position, but now both sides are incurring big legal bills. But no side wants to deviate by not hiring a lawyer. They appear to be ‘happy’ with the situation. I think bonuses are a bit like that.

  6. Rick says:

    Charlie – I agree that the outcomes of the behaviour of bankers were disastrous but it didn’t happen because thy were paid high bonuses. They would have done the same if they were paid half or even a quarter of what they actually got (provided that was the going rate). It’s not that the bonus schemes were somehow manipulated, or that they ahd had unintended consequences, which is what Aditya Chakrabortty is saying. The bonus schemes simply encouraged people to carry out the company strategy – which was to make stacks of money by punting as many CDOs as they could.

    It’s not the bonuses that caused the crash – it’s the business models the banks were working to. All the bonueses did was to encourage people to execute those business models.

    As for the shareholders – yes they are probably as conditioned as everyone else to accept the crumbs – ‘Bankers always get huge salaries so we’ve just got to pay them – even if it screws our profits.’

    That said, if they don’t like the returns they are getting they can always sell their shares and put their money somewhere else.

    Love the head-in-the-hands avatar btw. I feel like that some days!

  7. CharlieMcmenamin says:

    Rick, the point isn’t bonuses per se – they’re just a detail of industry specific remuneration packages. The point is the sheer, Pharaohic size of the remuneration packages and what that suggests about precisely who sets ‘company strategy’.

  8. Mark Pawelek says:

    Read the the 4 paragraphs here (from page 78-79) beginning “This structure of compensation gave” …

    http://www.paecon.net/PAEReview/issue46/Baker46.pdf

    Your claim that “Banks encouraged their employees to drive ever faster and so that’s what they did” is superficial, giving the reader a false perspective. The banks were engineering a world-wide financial blowout based on creating false assets of about $9 trillion. The bonuses worked to wreck the economy. A bonus paid to a strawberry picker (to pick strawberries before they rot or are lost to pests) has the opposite effect – it enriches the economy by supplying more strawberries at a lower cost. You haven’t refuted Chakrabortty’s article in the least.

    They would have done the same if they were paid half or even a quarter of what they actually got (provided that was the going rate).

    There is no going rate. Apart from that, I agree with what I think you’re saying – that the financial blowout wasn’t specifically caused by bonuses. It was caused by a credit bubble blowing up. The move to increase credit among the populace was itself caused by increasing inequality in society (leaving those at the bottom with no spending power). So, in a sense, you are also wrong. Increased pay differentials led to the blowout; bonuses to financial speculators were part and parcel of the move to increase pay differentials.

  9. Rick says:

    Mark – Chakrabortty claimed (without actually quoting any research) that bonuses only worked as an incentive for simple tasks like fruit picking and therefore didn’t work for bankers. My argument was that, if anything, the incentive schemes in banking show the opposite, because they drove the behaviour the employers’ wanted. The article you link to says pretty much the same thing. That the employers were pursuing the wrong path is now self-evident (although it wasn’t when everyone was making money hand over fist). The bonuses might have worked to wreck the economy but only because the strategies of the banks were flawed.

    What do you mean when you say there is no going rate? Elaborate please.

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