Bonuses vs fines

Ben Chu says the system for paying bankers’ bonuses is “manifestly broken.” He might be right, in a different way than he thinks.
The question is: why pay bankers a bonus for doing well rather than fine them if they do badly? I ask because research at the University of Nottingham suggests that fines are better incentives than bonuses.
Economists got subjects to play an inspection game. This comprises two players - an employer and a worker. The worker can choose either high or low effort. The employer chooses whether to inspect the worker’s effort or not. Both inspection and effort are costly. The game was played under three different payoffs:
1. The control group. Workers’ payoff to high effort was 25, whether or not the boss inspected. 40 if he shirked and the boss didn’t inspect, but only 20 if he shirked and was caught.
2. The fine treatment. The payoff to high effort was the same 25. But the payoff to shirking if caught was zero.
3. The bonus treatment, the payoff to low effort was the same as in the control group, but the payoff to high effort was 45 if the boss inspected and 25 if he didn’t.
The result of this experiment were clear. Fines induce more effort than bonuses. The joint earnings of bosses and workers were 18.6% higher in the fine experiment than in the control one, and 18.1% higher than in the bonus one. Bosses’ earnings in the fine experiment were 36.5% higher than in the control test, and 80% higher than in the bonus test.
The message seems clear. Fines are more efficient in aggregate than bonuses. The effect of bonuses is not to induce more effort, but rather to siphon off cash from bosses to workers.
Which leaves the question: what possible material difference might there be between this experiment and banking?
One possibility is that in inspection games there is a probability of effort not being observed, which leads to an under-supply of it. In banking, though, effort is monitored.
I’m not sure. Yes, there is more inspection in real workplaces than experimental ones. But there is not necessarily more effective inspection. The City is full of sob stories of good hard work going unrewarded, and not all of them are self-serving pish. Bonuses are not always tied to good work; even where returns are observed, risk is often badly measured; and the allocation of overheads between departments is always a source of dispute, to name but two issues.
Another possibility is that this experiment simplifies the labour input into high and low effort. But in the real world, things are more complex. What employers want is not merely to reduce shirking, but to induce ingenuity or creativity. Perhaps bonuses are better than fines at this.
Maybe. But I’d welcome hard evidence. And I’d point you to this new paper from Dan Ariely and Francesca Gino, which says there is a correlation between creativity and dishonesty.
Perhaps, then, fines would be better than bonuses.
This issue, I stress, is independent of the question of bankers’ pay overall.  Instead of paying a man £1m a year plus a £1m bonus for meeting certain criteria, he could be paid £2m a year, with but with £1m withheld if he fails to meet those criteria.
The question is: why is the former system so much more common than the latter? It can’t be that banks are run for the benefit of employees, can it?

Comments

[Marcin]

Would you choose a job with 2m pay, but a chance of a fine? What if the fine goes up?

With the bonus system, workers know what their guaranteed minimum earning is.

[Nigel]

Same reason sales commission isn't paid in advance and then clawed back - the performance has to generate the revenue before there's anything extra to give out.

Plus there's not the sharp distinction between bonus and fine that you make out. People often have a level of bonus expectation based on history.

[chris]

@ Marcin - the maximum fine can be set contractually, thus setting a minimum wage.
@ Nigel - I can believe that some firms are credit-constrained, but saurely not banks; the essence of banking is that they do borrow big and cheap.

[CharlieMcMenamin]

May I propose a small amendment to your third to last sentence? Perhaps, if you want to illustrate (via your rhetorical ending question) that there are grounds for believing that banks are run in the interests of their (higher) staff, not shareholders, you might have written:

"Instead of paying a man £1m a year plus a £1m bonus for meeting certain criteria, he could be paid £100,000 a year, with but with £50,000 withheld if he fails to meet those criteria."

[SimonB]

Dan Pink's work seems relevant to this. He suggests that you cannot get more out of someone by simply paying more, the relationship cannot be linear. There's a great little summary here: http://www.youtube.com/watch?v=u6XAPnuFjJc .

Of course, we are told there's a market rate for these top jobs. Funnily when it comes to banking the markets seem to go into reverse, making them cost more. It's almost as though there was a chummy cartel operating.

Of course, question 1 must be how banks make such profits when they are supposedly competing in an open market. Could someone create a bank that undercut them while remaining viable but with slightly lower profits? Why isn't there room for such an entity?

[BG]

It feels like the fines would still be really hard to implement though. This forgets one of the 2 main reasons why there are bonuses: the bonus reflects both general firm performance (by determining the total amount allocated) and individual performance (through the percentage a person gets). Given that a firm can't really know what it will earn in advance, it lets it slash costs in a bad situation. In this situation, if you had fines, you'd need to "fine" everybody, which people would most likely view as very unfair.

Which leaves the slightly puzzling - and I'd imagine too some extent true - that banks might indeed ben run to some extent to the benefit of employees (and more than just a handful of executives)...

[Phil Ruse]

So presumably you'd have to fine the person who does "well" in order to differentiate them from the person who does "exceptionally"?

[James Delingtwat]

Employers look at pay in terms of the total package, including variable pay such as bonuses. And so do most employees. So not getting a no bonus or getting a lower than expected/usual/peers one will feel just like a fine.