The lib dems and bankers

Posted on 13 April 2010

I don't like banker's bonuses. They have two problems: 1) Someone is
getting paid lots of money to do something which can't be that hard,
and 2) Someone is incentivised to take more risks than is good for the
bank, since greater risk gives greater potential reward and greater
potential bonus. The solution to 1) is to get over it; it's the way
the world works, and bankers are hardly unique in this position
(footballers, opera singers, chief executives also spring to mind).
The solution to 2) is to have a system where the banks aren't
incentivising excessive risk-taking.

Consider that I am a banker, with a bonus scheme where I am rewarded
more for earning more for the bank. Consider that in a given year, I
have a 1/4 chance of losing £1m and a 3/4 chance of making £1m for the
bank. If I am lucky and make the £1m, I get a bonus of £X; if I make a
loss for the bank, I get nothing.

But suppose I also have the option to gear up my trading strategy by a
factor of 10. Then I have a 1/4 chance of a £10m loss and a 3/4 chance
of a £10m gain. If I have made £10m for the bank, I should be getting
quite a bit more than £X bonus, while if I make a £10m loss I can't
get a smaller bonus than zero, so I'm quids in either way. But the
bank is now running the very real risk of losing £10m on my trades. It
might have considered the £1m risk acceptable, but the £10m risk as
unacceptable, but the bonus structure does not reflect this fact at
all.

This is what is meant when it is said that bonuses encourage excessive
risk-taking. The problem is exacerbated by the fact that there is so
much randomness involved -- if I might make a huge loss due to a
market crash beyond my control, I'm not going to be terribly motivated
to work hard on a marginally better strategy unless the potential
bonus is pretty huge [2] -- and in many cases, bankers' bonuses are as
big as or bigger than their salaries.

What is the solution? Well, if you curtail banker's bonuses, the banks
will maintain remuneration packages by pushing salaries up instead.
And without bonuses, bankers have no incentive to take excessive risks
-- but they also have no great incentive to make money for the bank
either. If you made £10m for your employer, wouldn't you want a slice
of that pie?

The lib dems' proposals just seem to be a grand "up yours" to the
bankers without actually trying to understand and solve the problems
represented here.

[1]http://www.bbc.co.uk/blogs/thereporters/robertpeston/2010/04/lib_dems_smaller...
[2]http://www.forbes.com/2006/05/20/executive-compensation-tournament_cx_th_06wo...