I don\’t think this logic works actually

So, bankers\’ bonuses are too high. Something must be done to change this. That something possibly being:

The most promising scheme to circumvent this bonus ban is to replace it with vast base salaries and subject to strict clawback provisions. A rather smug sounding fictional letter in Lex puts it so:

Your fixed, cash salary will be increased from €500,000 to €10m per year…to be paid monthly into an escrow account. At year-end, you are entitled to the balance of your cash salary in the escrow account subject to strict clawback provisions detailed in this contract…

Theoretically this should produce precisely the same ex post payments and ex ante incentives that bankers currently enjoy (and we endure). The escrow account will be an accounting reality but an economic fiction. Meet the new system, same as the old system bankers will be told.

But, this misses a lot of the vital psychological differences between bonuses and fines. A bird in the hand is worth two in the bush is just folk psychology justification of endowment effects. This is how airlines get people to pay extra charge after charge while their booking. Once you have that plane ticket in your basket its “yours” and there is a psychological cost to giving it up.

The money in bankers’ escrow account is this plane ticket and this set up will produce a different set of incentives. Will this incentive structure improve the operations of the banking system? I would suggest it will. Chris Dillow pointed to research two years ago from the University of Nottingham which suggested that fines provide better incentives than bonuses.

And this is threfore good because fines produce better incentives than bonuses.

Which is sadly where the logic falls down. For what is the incentive that we abhor among bankers? That they are willing to take too much risk with other peoples\’ money in order to gain their bonuses. But we\’ve just said that fines are better incentives than bonuses: thus we have increased the incentive for bankers to take too many risks with other peoples\’ money.

Which is, I\’m pretty sure, not what Left Outside desires.

10 thoughts on “I don\’t think this logic works actually”

  1. Been [near] there, done [near] that.

    About 20 years ago, my company offered reductions in pay to managers in a few departments whose work was most quantifiable. My department was among the chosen.

    In return for accepting reductions in pay, we signed individual agreements that objectively specified our annual objectives. The agreements also objectively specified a formula for additional year-end payments we could receive based on performance against objectives. It was possible to “earn back” more – even much more – than our unreduced salaries at the beginning of the year.

    Well. we had a very good year. I and all 15 of the managers in my department significantly exceeded objectives, thus earning well above our prior, unreduced, salaries.

    What did the company do? The CEO reneged on its agreements and agreed to pay the amounts earned only to the top 13 of us 15. The other 2 got nothing additional.

    Why didn’t the other 2 sue? Because the rest of us got together and agreed to share a part of our “bonuses” with them, making them almost whole. How do I know this? Because I was the team’s senior manager, and facilitated the transfer so so one but I ever knew for certain who the 2 guys were.

    The company soon after decided to discontinue the arrangement.

    Everyone pretended to go on as before.

  2. Get each banker to work as an independent contractor working for their own PhonyCompany Ltd. Draw up a contract between bank and PhonyCompany Ltd. Pay PhonyCompany Ltd, including bonuses based on performance.

    Now, this is going to be subject to IR35 regulation as disguised employment, so they’ll have to pay what they do right now. But where’s the salary? Gone. The bank isn’t paying it. Problem solved.

  3. Not sure about this study cited, where fines work better than bonuses.
    In the real world you get reversion to the mean. Give someone a bollocking for poor performance, see an improvement. Give praise for high performance, outcome worse next time. But the bollocking or praise has nothing to do with it.

  4. The Left Outside piece isn’t entirely clear but the suggestion seems to be that a clawback system would be an incentive to avoid risky deals that could go wrong (so conversely an incentive to prudence). Though the Lex article implies this is just smoke and mirrors, LO is suggesting that there is a psychological shift due to the introduction of a material downside – i.e. your escrow wages being at risk.

    In theory, the current system entails a downside for a trader, i.e. zero bonus or being fired, but as people with high self-belief are employed in these jobs, they tend to discount this. Real money in the bank might be more effective.

    Having implemented a clawback system in a commission-based business I can confirm that this does moderate behaviour, leading to fewer risky deals that might “drop out”. Whether this would work in banking is another matter. The lesson from history (i.e. the days of partnerships and unlimited liability) suggests it might help.

  5. Tim A: I don’t think that would work in banking, would it? All the phony companies would have to be FSA-registered and regulated, which would be a gigantic and expensive pain in the arse. Even if that were feasible, you could simply stick “service companies which are classified as disguised employment for the purposes of IR35 are also classed as employment for the purposes of this legislation” in the bonus cap law.

    BiF: no, there’s a massive array of real-world studies showing that people’s attitude to loss is asymmetrical. Losing GBP500 you have makes you much more grumpy than gaining GBP500 you don’t have makes you happy.

    (agree with Tim W’s point, though. The asymmetric attitude to loss would mean this legislation would create more Leeson/Kervier types, sticking risky trades at the end of the year in the hope of not forfeiting their pay)

  6. Where has this obviously absurd notion that bankers are motivated to take risks by their paypackets come from? Very clearly, whatever the level of remuneration and pay structure, bankers are paid to respond to the incentives which apply to banks. If you don’t change the fundamental incentives the banks operate with, you’re not going to see any other changes.

    The problem with the banks isn’t a result of bankers doing the wrong things, but of banks having entirely the wrong set of incentives. After all, where’s the downside for banks in taking big risks, based on what we’ve seen in the last few years?

  7. I believe that what people are paid are of no business of any politician or law. Be that as it may, I think that most bonuses are now paid with deferred share awards (up to 80%), which are forfeited if you leave before a number of years. So this “ban” is really a lot about nothing.

  8. just notes that john B and everyone else ignore the real life example floated past their blind unseeing doctrinaire eyes….

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