Performance pay is a tricky business. If you hired me as a hedge fund manager and paid me “2 and 20” – a 2 per cent management fee, plus 20 per cent of any gains – then I’d be tempted to take your money to a roulette table and put it all on black. If I won, I’d get to keep 20 per cent of the gains. If I lost – well, I would have been sure to deduct the management fee first.
If I were instead aiming to top a league table of investment managers, worse awaits. This time, instead of betting on black, perhaps I’d put the money on lucky number seven. If the rewards go to the most successful investment managers, then I need to go for broke – especially since “broke” is more likely to describe my investors than me.
All this is an exaggeration, of course, but discussions of bankers’ bonuses are haunted by visions of this kind of perverse “compensation” scheme. (Annoyingly, we use the word “compensation” as though bankers were being awarded damages after the trauma of executive life.) The popular view of bankers’ bonuses is simple enough: they never deserved to be paid millions anyway, and the fact that they seem to have blown up the world’s economy proves it.
A more sophisticated view does not worry about the size of bonuses, as long as they attract sufficiently brilliant people. If they do, they are worth paying; that is true whether they are paid by shareholders or by taxpayers. But it now seems likely that bonuses do not do these wonderful things, and may simply encourage gambling.
I was writing about these risks before the credit crunch, and I was hardly alone – in September 2005, Raghuram Rajan, then chief economist of the International Monetary Fund, was warning that “skewed incentives for investment managers may be adding to global financial risk”.
I fear this is a problem easier to identify than fix, but it may be possible to design sensible bonus schemes. Research from three German economists, Thomas Gehrig, Torben Lütje and Lukas Menkhoff, shows that bonuses for fund managers seem to produce harder work and more attention to fundamentals, but not greater risk-taking. The study did not look at banking, but it does suggest that sensible bonuses are feasible.
Politicians are beginning to take note. Gordon Brown now says that regulators “should be given the right in regulation to penalise a bank which is basing its reward system on short-term deal-making rather than long-term performance”. Fine, but I would expect no miracles.
Shareholders also prefer long-term performance to short-term deals, and if they did not previously realise the risks that bankers were taking with their money, they do now.
But there is a reason that regulators might do a better job than shareholders. The typical shareholder owns a tiny portion of any one company, and is unlikely to find it worth the trouble trying to organise a rebellion against irresponsible pay awards. Like the hapless restaurant diner at a big party, facing a menu in the full knowledge that the bill will be split between 30 or 40 other people, the shareholder realises that there is little point in scrimping when everyone else will order steak and champagne. A regulator could bring more discipline – if a sufficiently capable one exists.
So could a large shareholder: the economists Sendhil Mullainathan and Marianne Bertrand have found that CEO pay is linked much more tightly to credible measures of performance when there is at least one substantial shareholder to take the policing role.
For the banking industry, governments can no longer escape that responsibility.
Tim Harford’s ‘The Logic of Life’ is published in paperback on March 5