Still wrong on bankers’ bonuses

What is wrong with a bonus culture in banking?

The European Union parliament will vote next week on new legislation to curb bankers’ bonuses. The rules on bonuses are included within a larger proposal on capital requirements. According to the Financial Times, ‘lawmakers and EU officials welcomed the agreement and said it should help to reduce the “bonus culture” in the banking sector.’

Well here at Vox Sapiens, at risk of repeating ourselves (see Bankers’ bonuses – wrong target) we think the bonus culture should be increased, not reduced. This is because a properly designed bonus structure should align a banking employee’s goals with those of the employer. The problem is not one of a bonus culture, it is one of misalignment.

First, let’s consider where we find the most extreme bonus cultures. Is it in banking? Absolutely not. Instead, take a look at the “little man in the street” (or “little woman” – for reasons of brevity I will use only the masculine henceforth, but references to males should be read as equally applicable to females) that the authorities believe they are protecting by reducing his liability to bail out banks. Let us assume that this “little man” is self employed. So this “little man” generates business, performs some services, and receives payment. The business therefore generates a profit. How much of this profit is attributable to the “little man”? Well clearly, in the case of a sole trader, 100%. And for the vast majority of small limited liability businesses, also 100%.

Now let’s think about bankers. Typically around 50% of a bank’s profits are paid out to employees.

So where is the bonus culture strongest? Actually in the hundreds of thousands of “little men.”

So all this hot air about the banking bonus culture is completely wrong.

What is wrong, is the misalignment – paying bonuses from non-existent profits (not possible in the “little man” scenario), and/or developing bonus calculation mechanisms that reward employees for taking risks where the employee’s downside does not balance his upside (possible to a degree for the “little man” although the typical downside might be bankruptcy, which is far worse than being fired).

There will continue to be a clash while politicians and mandarins continue to pander to barely-informed populist agendas and rail against the bonus culture per se, rather than work on a serious framework to induce alignment between risk-based performance and reward.

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