Why do banks pay these bonuses anyway?

With all the flak that financial companies get for paying bonuses, one might wonder why the companies do it at all. The short answer is that they are legally obligated to honor the contracts they’ve written. But this just begs the question, why would companies sign these contracts in the first place? The answer is that bonuses are the most efficient way to rent an investment banker’s best judgment in order to increase the bank’s profitability.

What makes a bonus better than a salary or a commission? Different pay schemes attract different kinds of people, and the people who make the best investment bankers are the type who would be motivated by bonuses. To see why this is the case, we need a bit of background.

Due to a combination of upbringing, skill, experience, personality and responsibilities, different people have different levels of discomfort with financial risks. The technical term for this discomfort is risk aversion, and generally the risk that bothers someone is the risk that is outside of his or her control (if the person really wants something, there is no “risk” that he or she won’t put forth effort). The more one’s earning swing with these uncontrollable outside forces, the more he or she expects as a base salary to compensate for the uncertainty.

Compensation schemes can be split into four broad categories based on how risk averse the person is: entrepreneur, pure commission, salary + bonus, and pure salary. Of course the real world is a bit more complicated (for example, franchising is somewhere between entrepreneur and pure commission).

Entrepreneur. People who have really low risk aversion and high self-confidence will often become entrepreneurs. They put forth their best effort and compulsively micromanage all of the factors under their control, but acknowledge that there is a lot of uncertainty out there. This is a high-risk/high-reward endeavor.

Pure Commission. People with a little more risk aversion or a little less self-confidence want the thrill and sense of accomplishment that comes with entrepreneurial success, but without the possibility of financial ruin hanging over their heads. An employer thinks this is probably a real go-getter and is willing to bankroll the effort. The employer, however, wants to make sure he or she gets maximum effort by paying on commission. Now both the employer and employee do well if things go well, and if it turns out that the market really stinks this year, the employer bears the loss. For this insurance, the employer keeps a big cut of the profits.

Salary + Bonus. The next group is okay with ups and downs, but needs a safety net due to responsibilities, personality or other needs. A lean year means no vacation and no eating out, but at least it doesn’t mean losing the house. Since the employer is agreeing to pay a decent wage even if everything goes wrong, financial incentives are important to get maximum effort. The implied insurance is costly in the sense that even if there is a fantastic year, the employee only gets a small fraction of what he or she won for the company.

Pure salary. The last group values stability over thrills. They are so hesitant to stomach ups and downs, that it is easier for the company to just pay a flat wage and monitor him or her closely.

If this seems similar to investment decisions, that’s because it is. The person is investing effort and expecting a payoff in money.

Now put yourself in the shoes of a bank trying to hire investment bankers. Wild risk-taking will make the bank unstable, so something safe like a pure salary would be best. Since there is no financial incentive for success, the bank needs to monitor a salaried employee very carefully. Close monitoring implies that the company knows what would be “right” in each trade, and this is so subjective that it would lead to endless lawsuits. Pure salary is infeasible. The next step up the ladder is salary + bonus. Bank and banker can agree on what the investment is worth at the end of the year (and if they don’t agree then plenty of accounting firms will be happy to investigate the matter for a fee), so the bonus is based on this output.

In the rarified air of the ivory tower, this is the optimal incentive scheme. The reality is that no incentive plan is perfect; people can and do game the system. Another serious problem is what happens at the low end of the output spectrum. Big risks have huge potential payoffs, but if they don’t pay off the bonus doesn’t go negative. High rewards for success and low penalties for failure create a culture of excessive risk-taking even if that isn’t what the bank wanted.

The problem is not that people take risks. Without risk-taking, none of the conveniences of the modern world would have come to market. In a well-functioning market, a bank that took bad risks would go out of business, go through bankruptcy, get seized by the FDIC (which at least ensures that depositors get their money back), or otherwise get punished. The industry would learn from those mistakes, and everyone (except for a few unlucky bondholders) would be better off.

When the government bails out banks beyond the scope of FDIC insurance, a situation similar to the salary + bonus effect emerges. Banks get to keep huge profits if they make winning bets, and they get bailed out if the bets don’t pay off. This leads to excessive risk-taking.

If people are furious at banks for using a less-than-perfect contracts for investment bankers, maybe they should take a closer look at the incentives that government is setting up for the banks. The government has a choice in how it deals with bank failures: it can let ineffective institutions die off or it can prop them up and let them continue to damage the economy. On the other hand, banks have little choice in how they pay their bankers: using something other than bonuses would actually make things worse.