Bankers’ Bonuses: How should bankers be paid? How much should they be paid?
It is now three years in a row that the bankers’ remuneration packages have received a lot of attention in the public and political sphere. For the past two years the heads of Britain’s five big firms have tried to be seen to exercise pay restraint, for instance waiving their bonuses or donating them to charity. That ceasefire will end this year1. This season promises to be as gory as ever. An expected £7 billion ($11 billion) bonus round in the City of London will be paid just as a wave of public-spending cuts are about to bite2.
I usually tend to think performance pay is essential for incentivizing workers in order to exert unobservable effort. In the case of financiers the unobservable effort may not be single dimensional meaning that they are choosing both the returns on investment and levels of risk3. Looking at bonuses this way raises some specific questions:
- Who is responsible for the decision of how much to be paid to bankers?
Some would say the government since bonuses are paid from profits buoyed by public subsidies (direct bailouts, bailout guarantee and implicit zero interest subsidy)4.
Others would argue it is in our interest to let the banks decide this because good managers must be paid to clean up the mess and maximize the value of public share and also tightening rules domestically leads to outflow of capital5.
- How should the optimal compensation package look like?
Some argue that bonuses are essential but they should be paid as shares of the company or should be based on long term performance measures. Thinking in favor of this argument we should bear in mind that managers at Lehman Brothers and Bear Stearns owned lots of shares yet ran their firms aground6.
Other might argue that maybe we don’t need this much of innovation in the banking sector and caps and taxes on the bankers are in the public interest even if they lead to a shrinking of the talents in the sector.
References:
1. http://www.economist.com/node/17909825?story_id=17909825
2. http://www.economist.com/node/17902729?story_id=17902729
3. This idea is originally from Tim and Maitreesh recent working paper on the optimal structure of bonuses.
4. http://www.economist.com/node/17417754?story_id=17417754
5. http://www.economist.com/node/17902729?story_id=17902729
6. Ibid.
Other sources:
http://www.johnkay.com/2011/01/26/the-war-on-moral-hazards-begins-at-home
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