Bonuses are a problem diet for financiers

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Heads, we win; tails, they lose! Managers, traders and advisers who take more of gains than of losses have incentives to support risky courses of action that are not in the best interests of the principals they represent. John explains why this scheme can never really align the rewards of the individual with the objectives of the organisation.

The excesses of the past decade have imposed many different kinds of losses on companies in and around the financial services industry. Some result from poor investments where they acted as principal – holdings of Enron shares or Parmalat bonds. Companies must also pay up to settle with Eliot Spitzer, compensate for mis-selling or pay fines to the Financial Services Authority. And, as with Andersen, the indirect damage to reputation may be the largest penalty of all.

Some of these losses result from judgments that seemed good at the time but went wrong. But in many instances only reflection, not hindsight, is needed to demonstrate that the potential losses were disproportionate to any likely gain. The problem lies within the structure of organisations. Risky decisions in the financial services sector are ultimately made by individuals, whose interests are never quite the same as those of the organisations they serve. The paradox of the past decade, however, is that measures taken to overcome this problem often had the opposite effect.

The idea that rewards should be more closely linked to individual performance seems compelling. And in a vigorous market economy, it may be unavoidable. Investment banks always promoted an internally competitive environment, but competition between institutions meant that bonuses increasingly reflected profits earned by the individual rather than the achievements of the firm. Professional firms such as lawyers and accountants once linked salaries and partnership shares to seniority. But this ethos has changed dramatically: the slogan today is that you eat what you kill.

But incentive schemes, however ingenious, can never perfectly align the rewards of the individual with the objectives of the organisation. Inevitably, participants share more of the upside than the downside. Many systems – such as executive share options – were simply crude devices to pay people more, so this feature is not surprising. But even with the best of intentions, it is hard to avoid this asymmetry of outcome. Few individuals have the personal resources to share the losses from a falling share price, an unsuccessful trading programme or an underperforming investment fund.

But managers, traders and advisers who take more of gains than of losses have incentives to advocate or pursue risky courses of action that are not in the best interests of the principals they represent. Heads, we win; tails, they lose. We have seen the different but equally disastrous results of such actions at Barings, in Andersen and in the costly unwinding of overpriced acquisitions.

The metaphor of “eat what you kill” is illuminating. People who were once called clients are reclassified as prey. But generations of hunters learnt that if they hunted aggressively and thoughtlessly this year there would be nothing left for their offspring to eat next year. That is why wise hunters learnt to regulate their killing, or switched to farming and the careful management of their herds. The horizons of individuals are always nearer than those of businesses, because people mostly retire and always die. Organisations can reasonably hope not to die and strive to avoid retirement.

Job mobility aggravates the mismatch between the time scales appropriate to the individual and to the organisation. Lifetime employment was once a common feature of professional firms and the financial services industry as a whole. Workers who moved from one firm to another were regarded with suspicion.

This was not entirely the product of irrational conservatism. People were generally still in the service of the same employer when the results of their previous activities came in. Success was mainly rewarded through promotion and advancement, not bonuses; and its recognition was slow and cumulative. These practices alleviated both the problems of asymmetry and of differing time scales.

The accounting firms, banks and investment houses of that era had a staying power that is hard to reproduce in today’s fast-changing marketplace. We can’t go back to these old ways of doing business. But sometimes, customers and shareholders and even people who work in financial services might wish we could.

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