Bonuses & ideology

Why is there still a row about bankers’ bonuses? What I mean is that the issue should by now be settled against them. There’s abundant evidence that large bonus “incentives” are not only not justified (pdf) by efficiency considerations, but can actually backfire, with the result that intelligent observers are demanding an end to them.
If we were serious about designing high-powered incentives, we’d consider abandoning bonuses and instead simply killing under-performing bankers. After all, the threat of death works perfectly well in motivating airline pilots or soldiers. So why not apply it more generally?*
Let’s be clear. Bankers’ bonuses have less to do with rational incentive mechanisms than with the fact that bankers have power. It’s a form of legal extortion.
Which raises the question; why is this not more clear? It’s because any power structure is sustained by ideology - a set of cognitive biases which might have a grain of truth but which serve to defend vested interests. In the case of bonuses, there are four such biases:
1. The fallacy of composition. If any one banker doesn’t get a big bonus, it’s possible he might flounce off in a huff to another firm. But it’s not possible for all bankers to do so; only a tiny handful of British bankers could get good jobs in New York or  Switzerland. In this sense, a blanket nationwide ban on big bonuses wouldn’t do much harm.
What’s true for an individual needn’t be true for a group.
There’s a parallel here with one of the errors that got us into this mess - what Keynes called the “fetish of liquidity”. An asset might be liquid from the point of view of an individual, but there is no such thing as liquidity for al investors.
2. Mental accounting. Last year’s banks’ losses seem to have been put into a separate mental box, and are regarded as an exceptional item now that business is back to normal. But this shouldn’t be the case. Those losses vindicate Nassim Nicholas Taleb’s point that banks, on average, don’t make money because occasional huge losses wipe out years of profits. Which suggests bankers don’t have the skill they pretend to.
3. The fundamental attribution error. The belief that banks’ profits come from skilled individuals is in part due to the common error of attributing to individual agency what is in fact the result of situational or environmental factors. It’s trivially true that today’s banks’ profits are due to cheap money, government guarantees and state bail-outs. But it’s always been the case that profits have risen and fallen according to environmental forces such as monetary policy, waves of takeovers and general investor sentiment.
4. The impossible/difficult conflation. Throughout history necromancers, witch-doctors alchemists and ju-ju men have extracted high incomes. They’ve done so because their patrons have believed their job to be very difficult, demanding supreme skills. But in truth, the jobs of foretelling the future, controlling the weather and turning base metals into gold  haven’t been difficult ones. They’ve been impossible.
So it is, perhaps, with banking. Making high risk-free returns isn’t difficult, but impossible. In failing to see this, we give bankers the fortunes our ancestors gave other charlatans.
* Of course, the same reasoning applies to politicians, as they too can make huge errors which cost society dearly. This probably explains why they are not proposing the idea.

Comments

[Tode]

You have omitted an important factor: which group of people decide on these bonuses. It appears that they are also people who receive very large salaries and/or make large amounts of money in other ways. It is in the interest of this group to keep salaries of top earners in general as high as possible as this is the group that their own rewards are compared with.

[Chromatistes]

... not to mention the hopelessly-conflicted HR consultants.

Something lingering, with boiling oil in it, I fancy.

[May]

The problem is not the bonuses, the problem is the too-big-to-fail scam, that forces taxpayers to bail out banks that have made bad bets. Instead they should be allowed to go out of business.

[Laura]

Banks will continue to pay bonuses while they can, because everyone does it, and in banking, you keep your job better if you go with the crowd and are wrong (http://www.fool.com/investing/small-cap/2009/07/31/succeed-by-being-unconventional.aspx) than if you go against the crowd and are right, but this takes a while to reveal itself (or worse still, if you go against the crowd and you are actually wrong).

I suspect that the government will fail to impose a cap on pay or bonuses, as if it doesn't act, although commentators might grumble that it should, there is less of a story in the government failing to act in an area where commentators think it probably should, than in the government taking action and there being a negative event or events that commentators rightly or wrongly attribute to the government's action. (A positive outcome of such an action is very unlikely to make the news unless it's both very large and very obviously attributable to the action.)

For a similar reason, I suspect no government will ever ditch economic advisers, as the political or financial cost to politicians (but not necessarily to the general public) of keeping them is much lower than the political or financial cost of ditching them, in case something then goes wrong and the press and public rightly or wrongly blame the removal of the advisers for this. The case for keeping economic advisers (if you're a politician) is further strengthened in that if you do keep economic advisers, you've got a ready made scape goat if something does go wrong.

[Paul Sagar]

Really good post. One of the best I've ever read here.

[Phbradley]

I have to agree with Paul, above - concise and almost completely convincing (though I would love to see the 'bankers won't go abroad' point covered in more depth in a later post, since that's a crucial fulcrum of the whole argument).
Super post.

[Luis Enrique]

right ... but if this power stems from a co-ordination problem*, and this problem still has not been solved, that's why there's still a row about bonuses because for all the truths about how bankers don't really merit this money etc. the fact of the matter still remains that if RBS investment banking arm doesn't pay to retain its revenue generators, it won't retain them and it will suffer. As things stand it is in the commercial interests of banks to cough up ... hence there's still something to argue about.

If there was some readily available solution to the problem, then there'd be less to row about.

* if no banks paid large bonuses, bankers couldn't blackmail their employers by defecting to rival banks. But banks cannot commit to not paying large bonuses because it's always in their individual interest to do so.

[Luis Enrique]

Also, I think the ''fallacy of composition'' is being misapplied here. It's true that all bankers cannot all flounce off at once, but that's not the point - individual bankers can always defect and individual banks cannot commit not to hire them, hence bonuses will be paid to bankers in strong bargaining positions. If the 'fallacy of composition' did mean you don't need to pay bonuses to retain bankers, why are they occur in the first place? You don't say ''footballers cannot all flounce off to other clubs at once, hence they don't need to be highly paid to retain their services''. What's more, did not the author of this very blog remind us off the difference between short-run and long run elasticities? Whole industries can move offshore, given time.

If this post means "why is there still a row about bankers' bonuses: it's obvious we need legislation to solve the coordination problem and stop them" then fine, but then we need to think about how to design that legislation so it cannot be subverted. But this post says nothing about how to design legislation.

[Dave]

The overwhelming problem is that those who make decisions, whether it be in government, or as a consultant/advisor never ever have to live with the consequences of the decisions they take. Unlike airline pilots or frontline soldiers.

It's easy to gamble when it's someone else's money.

In our town the Chief Executive and all the main officers live outside the area. If they screw the town over by introducing a disastrous traffic system and punitive parking charges so that no-one even goes shopping there, so that the town centre is a heady mix of charity shops and boarded up units.... well it's nothing to do with them is it? They never have to live with the consequences. Likewise bankers and government advisors.
A way must be found to make decision makers more accountable to us all.

[alanm crisps]

Shh...someone will realise that whatever it is I do isn't actually very difficult either!

(No bonuses or pay rise anyway).

[Sylvester]

Your argument may be correct to some extent however you fail to deal with the long term impact that an restrictive legislation will have on the banking system. Although the current crop of bankers may not move abroad, there will be little reason for the young to go into the profession. If this happens, in the future we could be importing bankers from other countries. Leaving racial prejudice out of this, there will still be negatives from importing labour; the main one is the amount of remmitence leaving the country. If our national income isnt at its full potential because of the increased remittances, the impact will be far greater than a couple of bankers getting bonuses for hardwork.

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Funny thing is, mental acounting can work to our benefit as well as detriment. If we label some funds as "for savings", we won't waste it on unimportant stuff.

But most of the time, mental accounting does us harm, especially when we consider income as "found money". I write more on this issue, specifically dealing with tax returns, here: http://www.bitesizeidea.com/bsi/your-tax-return-and-the-problem-with-found-money

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