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The hidden cost of curbing banker bonuses

The lights are on; is anyone home? Lefteris Pitarakis/AP

The hidden cost of curbing banker bonuses

This week sees the large investment banks start to announce their quarterly earnings and reveal the bonuses paid to staff. When the public see amounts of money they would not dream of earning in decades being distributed in a single year once again, they might rightly ask if the banks – and the people that caused the financial crisis – have changed at all.

It is no surprise the Labour party thinks there might be some votes in it with activists on Wednesday morning busily plugging a #blockthebonus hashtag on Twitter. But the reality is that banks have gone some way to recognising the errors of the past, and are engaged in a tricky balancing act.

One of the findings of the postmortem into financial institutions after the crisis was that the way employees got paid was an [important contributing factor](http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1673250](http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1673250) to the problems which followed. Rewarding bankers with cash bonuses for short-term performance did not align the interests of shareholders with those of the bankers. Rather, it created what economists call moral hazard: during the good times, bankers got a significant cut of the gains, but during bad times they did not have to take the same kind of hit on losses.

We all know what happened next.

It was rational to take high risk positions, and so people did, ramping up their bank’s risk profile in the process. That sent many banks to their grave.

Reports examining the failure of HBOS noted how the rise of widespread emphasis on bonuses for short term performance led employees at all levels of the organisation to engage in increasingly risky behaviour in order to deliver short term results. A similar pattern is evident in investment banks such as Bear Sterns and Lehmans. Key staff were given incentives to take significant risks without having to put their own capital at stake.

Financial regulators have taken these insights into account. There seems to be a welcome consensus that paying large cash bonuses for short-term performance is a recipe for disaster. This has led to all manner of attempts to redesign the way bankers are compensated. The UK parliamentary committee on banks standards recommended locking up bonuses over a longer time horizon; anything up to ten years. [The EU has recommended](http://www.freshfields.com/uploadedFiles/SiteWide/Knowledge/New%20EU%20rules%20on%20bankers%20pay.pdf](http://www.freshfields.com/uploadedFiles/SiteWide/Knowledge/New%20EU%20rules%20on%20bankers%20pay.pdf) that bonuses can only be a maximum of 100% of base pay or 200% with explicit shareholder approval. Many banks have been experimenting with offering shares or options which their employees are unable to sell for a significant period of time. All of which is aimed at reducing the percentage of compensation accrued as a bonus and to extend the time horizons across which benefits are offered.

Hankies at the ready …

Given the continued opprobrium targeted at banks and bankers, you might think not enough has been done. But these changes are already creating some significant problems in practice, particularly if we assume that it’s not in our interest to dismantle the industry.

Bankers have feelings too. Lefteris Pitarakis/AP

The first and perhaps most obvious is that the changes have upset many bankers. Many feel they have been unfairly targeted, and attempts to meddle with bonuses by regulators will undermine one of the principal drivers of the industry. When speaking about bonus caps, Jaspal Bindra, Asia CEO at Standard Chartered, said, “the last thing we would like to do is give up on performance-oriented culture we have cultivated over a long time”.

In addition, the lengthened time horizon on bonuses could mean they become less motivating for bankers. Research in behavioural economics shows we have a strong preference for smaller rewards which are offered right away than large rewards which are deferred. Offering a bonus in two, five or ten years time is unlikely to be anywhere near as enticing or motivating.

Finally, offering bonuses in the form of shares or options which employees are locked into for a long period of time could prove to be very risky, at least for them. This is because it is rational for an individual to have a diversified portfolio of assets – this spreads the risk. Forcing a banker to hold a significant chunk of their assets in one place (shares or options in the firm), means their risk is heavily concentrated. What this means is that if their bank fails through no fault of their own, they not only lose their job, they also lose their investment.

Changes in the way bonuses are paid makes it far less motivating and more risky for individual bankers. This might not gain much sympathy from wider society. Indeed, some might point to the fact that if bankers are actually invested in their own institutions over the long term, then they are likely to be far more careful in their actions.

This idea is borne out by Svenska Handelsbanken, a Swedish bank which has famously outperformed competitors over four decades. What is so unusual about this bank is not just its radically decentralised structure, but also its employee ownership programme. This means employees in the bank are rewarded with shares which they cash in at the age of 60. Such a personal investment in a long time horizon means that banks tend to be far more careful about risk.

Although this system has worked at Handelsbanken, it could potentially backfire in many of the global investment banks. Recent investigative work by Joris Luyendijk has revealed a widespread culture of insecurity within most of the large UK banks. The employees he interviewed routinely reported the fear of returning from the gym and finding the person in the desk next to them had been fired. The irony is that this palpable sense of insecurity tended to lead to a focus on immediate and tangible rewards.

There are three probable responses for a banker stuck in this quandary. Some might leave the large investment banks and go in search of less regulated corners of the global or financial sector where they can get large cash bonuses in return for short term results. If such an exodus takes place, it is likely to swell the size of the shadow banking sector. In the process, it will push systemic risks to the murky margins where even senior central bankers fear that danger lurks. Other bankers might accept the longer term compensation, but ask for more secure and humane working conditions in return.

The final response might be that bankers simply accept the longer term rewards and insecure employment. The result is that they may become as disgruntled and cynical as the rest of the workforce who has had to endure such conditions for some time.