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Bankers’ remuneration: kleptocracy and the wages of sin

8 June 2013

The reports in today’s Financial Times that the Banking Standards Commission is considering recommending that bankers’ bonuses are deferred for 10 years is disappointing, not merely because they have ignored my evidence to them (at paragraph 22) but because it indicates that, for all their determination to confront the cultural issues that exacerbated, if not created, the banking crash, they have still not fully understood the insidious rhetoric on which the bankers’ kleptocracy depends.

Let me therefore spell it out.

You do not need to pay bankers bonuses to create alignment – they do not need to have “skin in the game” to use the phrase aptly employed by Dr Welby: bankers will take exactly the same decisions with our money as they would with their own, motivated just as powerfully by their ambition for recognition as the alpha male of the trading floor as by personal reward. The example of Lehmans proves that alignment is completely ineffective in deterring bankers from risk taking.

If all bankers’ total compensation were fixed at an identical level, they would still compete for this recognition. Variable “merit”-related bonuses get confused with this recognition and create the arms-race which has now destroyed the City once already (and will do so again). The only valid reason (from the shareholders’ perspective) to pay bonuses is to retain staff when other banks offer more money (the “walk threat”). (Setting up their own boutiques is not a realistic threat for traders who can only make serious money with access to banks’ vast balance sheets. Unregulated hedge funds that attract such capital through promises of super returns raise another question.)

So, even within the Realpolitik of alternative employment offers from other banks, what, from the shareholders’ perspective, is the optimal compensation structure, i.e. what combination of fixed salary and variable bonus will provide the minimum required by the employee at minimal cost to the shareholder?

The question is not completely trivial, because the variable bonus behaves a little oddly. Firstly, bonuses have been paid even when performance targets have not been met: this is because employees turn the walk threat to their advantage, arguing that they’re still “worth it” prospectively despite their history. Secondly, clever trading strategies (rolling carry trades and other martingale schemes) have a habit of blowing up only after bonuses have been paid (and the Commission is right to set a timescale longer than most of the fuses currently available).

But thirdly, and most importantly (and this is what the Commission seems not to have grasped), the uncertainty with which variable bonuses are valued by employees is not the same as the way in which they should be costed by shareholders. This is not simply a mathematical computation of expectation (although even the arithmetic of the one-sided optionality of bankers’ remuneration seems to be beyond shareholders and politicians), but is overlayed with a psychological evaluation first explained in the eighteenth century by Daniel Bernoulli. It will be familiar to many of you (although not it seems to the Commission) from the pages of Daniel Kahneman’s Thinking, Fast and Slow. In essence we are all averse to risk, and will always prefer £50 to a 50% chance of £100. And when you stretch out the timeframe for receiving the payout instead of the stake, you increase the psychological discounting.

In other words, the best deal for shareholders will always be to pay employees a fixed cash salary. Conditionality, even if properly linked to profits, and deferral, to overcome accounting deficiencies, both lead to employees requiring much larger packages (i.e. more than pro tanto) so that, even when risk adjusted, the burden on the shareholders is higher than with fixed cash.

One further, more subtle point. Among individual bankers there are also differences in psychological profiles. A package with a heavy reliance on conditionality and deferral will differentially appeal more to optimistic, over-confident people, so that you will thereby end up hiring more of this type. We have too many of those already in charge of our banks.

  1. Excellent point. As to your views on the optimistic banker, I recall our three-year deferral package (with the newly-introduced prospect of clawback) being treated by the vast majority of my colleagues as tantamount to getting no bonus at all. Not a very optimistic lot. The biggest contribution to this – as you aptly put it – “more than pro tanto” reduction in perceived value was (and probay remains) the immediate realisation that it would, more than likely, be someone else’s mistake, a year or two down the line, which would cost the expectant banker his bonus. Being dependent on the performance of a bunch of strangers who might not even work for the bank yet was a killer.

    • Quite right. From the shareholders’ perspective, aggregated like an insurer, the burden is quite different. Welby was right, although he probably got there without the maths.

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