Could it be that bonuses, far from incentivizing people, actually lead to lower effort and output? There’s already some evidence that they are inferior to fines. But here’s a separate line of thinking that yields the same conclusion, that bonuses backfire.
It’s what Eyal Winter has called incentive reversal (pdf). Imagine a team of workers who jointly produce outputs. An individual worker might decide that it is only worth working hard if others do so too. He might figure: “if I work hard whilst others slack off, the team won’t make its targets anyway and I’ll be just a mug.” Under this arrangement, workers collectively might or might not work hard.
But then imagine that high bonuses are introduced. Individual thinking might then change: “My colleagues will work hard to chase their bonus whatever I do, so I might as well slack off. That way, I get the bonus without effort.”
In this way, it’s possible that the introduction of bonuses might reduce effort and output.
This is just a hypothesis. But some laboratory experiments at the Hebrew University of Jerusalem have shown that it can apply in practice. They’ve shown that even quite modest increases in bonuses can lead to a halving of effort.
There’s an important theoretical point here. The glibertarian cliché that incentives matter is true, but not in the sense they intend; sometimes, incentives can backfire, as in the now well-known instance (pdf) of the introduction of fines for parents who are late picking up their kids from kindergarten.
But does this have practical relevance? It hinges on whether an individual’s effort is directly observable - that is, whether he can get away with free-riding.
This in turn will depend upon management structure. If managers, who decide bonuses, can closely monitor individual workers, the problem won’t arise. If, however, managers sit remotely in their boardrooms then it might.
And herein lies a curious fact about bonuses in investment banking. In the old days - especially before Big Bang but also for some time afterwards - bonuses were set by the firms’ partners who worked on dealing floors alongside their staff and could monitor them closely. This system worked tolerably well: many of the old English broking firms had survived for decades. However, when investment banks became units of larger firms, with more remote management, they quite soon collapsed.
Isn’t it a strange coincidence how this story of investment banking is consistent with the theory and laboratory evidence for incentive reversal?
A note: by “slacking off” I don’t mean merely obvious tactics such as taking sickies. There are more subtle means of doing so, such as going for easy risky trades rather than putting in the effort to find risk-adjusted profits.