Bonuses & arms races

There's an important economic principle behind the debate about bankers' bonuses. It's that individual self-interest sometimes conflicts with the collective interest.

What I mean is that it might well be rational for RBS to want to pay its bankers more to attract and retain good staff*. But the benefits to RBS of employing such people come at the expense of other banks. The star M&A banker wins business at the expense of rival banks; the good trader makes profits at other banks' expense and so on.

But what's true of RBS is true for any other bank. Each must offer big money to retain staff, the result of which is that aggregate banking profits are lower than they'd otherwise be. And over time, this means banks build up less capital than they would otherwise, with the result that the banking system as a whole is riskier than it'd otherwise be.

Banks are therefore engaged in a form of arms race. Just as if two rival nations compete to have the bigger military, the upshot will be that both are impoverished without any offsetting benefit, so banks are impoverished by high salaries.

There are several other examples of arms races, some of which are described by Robert Frank and Tom Slee, for example:

 - Any individual might want to work longer than his colleagues to increase his chances of promotion. But if everyone does so, they all end up working longer than they'd like (pdf), without any improvement in their prospects for advancement.  

 - If people spend money to keep up with the Joneses - and they do - the aggregate result can be more debt and financial fragility without any rise in well-being.

 - If education has a signalling benefit (it does), then each individual will feel the need to become at least as well credentialled as his peers. The result will be increased numbers getting degrees, but with a rising mountain of debt rather than an improvement in aggregate job prospects.   

What we have in these cases is a form of market failure - because what's rational for any individual is collectively self-defeating. There is, therefore, a case in principle for government action to restrain pay. Hence the EU's bonus cap**.

In this context, the government has a dilemma; policies which might maximize RBS's value - paying to get the "best people" - might merely exacerbate collectively harmful behaviour.

I don't pretend to have any easy answer to these issues. I merely note that the issue of bankers bonuses falls into a set of behaviours which contradict the invisible hand theorem: the pursuit of self-interest does not always increase the collective good.

* It's also possible that bonuses have adverse incentives for the individual bank. For the purposes of my story, I'm ignoring this.

** Whether such caps work or not is another matter. Capping bonuses might lead to higher base salaries, and capping salaries might lead to more non-cash rewards such as company jets, prostitutes and yachts.

Comments

[Luis Enrique]

"the pursuit of self-interest does not always increase the collective good"

this is why Game Theory is so important to economics, I can never understand its detractors.

The people who will jump ship if RBS doesn't cough up are those would take revenues with them. RBS is still in public hands isn't it? Has Ed thought about how much the value of RBS would decline if it's money makers walk out?

[Simon Reynolds]

This is the chance for a useful real world experiment.

Those RBS employees who would jump ship if bonuses are capped – well, let them go. Byeeee.

Let's see how their replacements perform under a bonus cap. Unlikely to be much different. But we could find out. Let's run the experiment over 10 years, and see what happens.

Daniel Kahneman describes looking at one aspect of a financial firm's business:

“...the investment outcomes of some 25 anonymous wealth advisers, for eight consecutive years. The advisers’ scores for each year were the main determinant of their year-end bonuses. It was a simple matter to rank the advisers by their performance and to answer a question: Did the same advisers consistently achieve better returns for their clients year after year? Did some advisers consistently display more skill than others?”

Answer. Er, no. The average of correlations between the rankings of advisers in different years was zero (well, 0.01).

“The results resembled what you would expect from a dice-rolling contest, not a game of skill.”

http://www.nytimes.com/2011/10/23/magazine/dont-blink-the-hazards-of-confidence.html?pagewanted=all&_r=0

[nm]

Game theory also suggests that in an arms race, one party who decides not to join in is in trouble, so you would think just looking at RBS bonuses rather than across the industry may not be a great policy.

[Owen]

Adam Smith understood this, which is why its a shame that so many mis-quote him in support of this theorem.
There is no invisible hand of the market, it works by very visible price signals, and unintended consequences have both positive and negative effects.
The reference in passing that Smith made to an invisible hand in TWN were the motives of a merchant to invest domestically as the percieved risk was lower.

[Frances Coppola]

Luis, I agree in theory.

But Miliband is playing to the gallery, not thinking logically or commercially. He is only interested in buying votes. He believes voters don't like RBS's staff receiving bonuses. Therefore he will ban RBS's staff from receiving bonuses, whatever the cost to RBS. Winning an election is more important.

I'm sure there is something in game theory that explains this, isn't there?

[Adam Jacobs]

I agree with your argument about an arms race not being of benefit for the collective good.

However, there is an assumption underpinning your argument, which you seem not to have questioned. I believe it is highly questionable.

That assumption is that the bankers are highly skilled individuals who are in limited supply, and banks need to recruit from that small pool of financial super-stars if they want to be successful.

Do we really believe that?

I see that Simon has posted some interesting empirical evidences as a comment above, which shows how unlikely that assumption is to be true.

But also, consider this: these are the same highly skilled people who were running the show when the banks failed spectacularly in 2008. Now, just how highly skilled are they?

It seems to me that the enormous remuneration these people get is merely a form of shared rent-seeking. This concept (of which bankers' pay is admittedly an extreme version) was described in an interesting paper by Krueger & Summers in 1988:

http://www.jstor.org/discover/10.2307/1911072?uid=3738032&uid=2&uid=4&sid=21103345575073

So anyway, I don't think you're wrong about an arms race being an example of how the invisible hand theory can go wrong, but I don't think that's the main problem here.

[Simon Reynolds]

Frances,

I'm no Miliband supporter but surely he is not trying to “ban RBS's staff from receiving bonuses”? He's saying that bonuses at RBS should be capped at 1 x salary rather than 2 x salary.

I may be wrong, but Luis's and nm's comments to this post seem to be arguing that “game theory applies here”, that RBS is in some form of arms race, therefore RBS must not cap bonuses or there will be “people who will jump ship if RBS doesn't cough up” and therefore RBS “will be in trouble”.

But is that true?

Is it the case that if RBS employs a banker who will accept £x salary (plus £x bonus) then that person will perform worse at his or her job than someone who will only accept £x salary plus (2 * £x bonus)? Where is the evidence that bankers' performance is related to their pay?

[Luis Enrique]

people, with the exception of senior management I suppose, when it comes to investment banking, traders etc. bonuses are not about trying to recruit bankers who are good at their jobs, in the sense of giving good investment advice or running banks that don't implode and need bailing out.

It's just blackmail. In the main, you are talking about individuals who generate say £2m of business for the bank and are saying pay me £1m of it or I take my £2m elsewhere.

Of course there's more to say than that - it's not always clear who's actually generating the money, it's not always portable, there is team production etc. But in a way this only makes things worse - if you call their bluffs, it's the ones who really can take business with them who are more likely to be attractive to rival banks and you'll get left with bluffers.

[Luis Enrique]

although come to think of it, I have investment banking in mind, where it's all about income generation, but we are talking about RBS and I don't know if that applies.

If we are talking about managers and similar, where business would not follow them out the door, but what matters is whether they do their jobs well or badly in some sense, I would be more inclined agree, there's less at stake calling their bluffs.

and to be clear I am not defending this situation, it is a bad situation where individuals with bargaining power make out like bandits, but if individual banks try to take a stand against it they get screwed. That's why coordination in necessary as Chris says.

[Guano]

Why not increase the pool of people who have these skills? Why not identify these skills and ensure that there are many more people with them? If these skills are so valuable that those with them have to be paid so much, it is obviously worthwhile investing some of this money in training hundreds of people in these skills - why not go to scale on this? When we find we have to pay skilled craftsmen large bonuses to get the job done, we train more craftsmen and investigate how we can deskill the job - why not with banking?

[Paolo Siciliani]

I suppose there is a cap in the arm's race, that is, to poach a good trader a bank would offer a premium on top of average salaries only up to the incremental revenue that this trader can produce (over and above what is the average in the industry). So there are only two conditions where you can see an arm's race. By bidding up top traders salary, banks accidentally also bid up average traders salaries, so that it is always unilaterally rational to bid up incrementally to poach the formers. However, I am not sure how this would hold in practice as I suppose one must assume that labour market is tight also for average traders, which I suspect it's not the case.
The only other market configuration underpinning an arm's race is the presence of winner takes all dynamics driven by star traders, that is, the bank which can boast star traders among its ranks gets all the clients' business, who are chasing market-beating returns in a world of financial repression. This to me sounds like a more plausible explanation for a collective delusion that feeds arm's race dynamics. Here though the market failure lies in the biases of banks clients rather then in a coordination failure among banks.

[mat]

I am really not convinced by this analysis. Seems obvious that banks will not up pay beyond the productivity of the employee in question, they'd be better off not employing him. beyond that, we're really just arguing about the division of surplus between bank owners and bank employees. And it is far from obvious to me why I should care either way about that.

Ok. So you could (amd indeed do) say that some proportion of bank profits would be retained in the cap stack and support the institution. Again, not convinced, for various reasons. But even if I were, I'd say the simpler solution would be to mandate that a proportion of variable renumwration be paid as 10 year dated, tradeable, sub debt of the bank. Bingo, bonuses get to continue under market determination and the LAC of the instituion gets bolstered too.

[gastro george]

Isn't it worth pointing out that, until recently, such bonuses were not required. Why would this bonus escalation occur? Has the job changed considerably? Has the pool of expertise shrunk? If that was true, then you could argue that it's the market that is talking. If not, then the arms race becomes just another set of insiders, who believe their own stories, bidding up each others remuneration.

[joe]

Taleb in Fooled by Randomness gave the example that in a group of 100 novice traders there will be a tiny percentage left after 5 years who have made a profit in each year. That happens purely by chance but in banking the few become the star traders who if they are shrewd no longer trade any more. They run teams who do.
80% of traders lose over a year. 85% of trading is now carried out by computer algorithms.

Trading is a customer relations issue, not a skill nor technical one. Clients want to go with the star trader, not a computer algorithm. The trader is not paid for his work, nor annual success, but to negate his regular threat to leave and take the customers with him.

The real question that never gets asked is why in a zero sum game is financial trading so profitable? The market fails here completely.