Sunday, 22 February 2009

A lack of clear thinking on bonuses

Via Owen I came across this article by Jamie Whyte, author of Bad Thoughts: a Guide to Clear Thinking. It's the second time he has written about financial incentives in the banking sector, and the second time I think he has failed to demonstrate clear thinking himself. His point this time can be summed up in these two paras:

Bank managers do not have short-term incentives. Most already receive a large proportion of their variable pay in bank shares or in cash bonuses that depend on the share price. Share prices provide a long-term view of a company’s performance, being determined by its expected profits from now until eternity.

Bank managers took excessive risks not because they had short-term incentives but because, in the years before 2007, the credit and stock markets failed to “price in” those risks. If not for this failure, banks’ cost of capital would have begun to rise, and their share prices to fall, much earlier. Bank managers seeking to maximise their bonuses would have reduced the risk-taking that caused the current crisis.

Given that he's a self-appointed clear thinker I'm surprised he failed to spot a few qualifications we need to make. First up, what do we mean by 'short-term'? If it's not defined then we are in trouble. For a pension fund investing in bank shares, short-term might be measured in terms of a few years. Given that bonuses and even long-term incentive plans often have a performance measurement period that is less than many fund management mandates awarded by pension funds, I think it is fair to describe the incentives provided as short-term, for those types of investors.

Second, we need to consider the scale of the incentives available. Not all bankers want to get to the top of the tree or spend their whole career in the industry. The scale of rewards on offer do sometimes enable individuals to think in terms of their retirement. And if they can make enough quickly enough to think about bailing out, again I think it's fair to talk about the incentives being short-term.

Third, the fact that some rewards are liniked to share prices doesn't necessarily prove anything. One could make the argument that actually rather than making the incentives long-term, it actually provides a further short-term incentive - to keep the share price up. This may involve... err... taking excessive risk, if the market isn't keeping too close an eye on how the bank is making money.

Finally he says the real story is that markets failed to price in risk. Probably this was a contributory factor, but how does that disprove that short-term incentives spurred on some of the reckless decision-making? Why does there have to be a single cause? Weak market pressure AND short-term incentives could have been drivers. And we could add that perhaps 'the markets' didn't price in risk because some of the participants also have short-term incentives, and therefore also wanted/needed to keep the party going as long as possible.

Far from clear-thinking, this article seems to be designed to let remuneration policy off the hook. I might have some sympathy with that, because I'm really undecided on what impact incentives have on behaviour, but that's an entirely different proposition. To me the argument in this article just doesn't hang together.


Nick Drew said...

perhaps 'the markets' didn't price in risk because some of the participants also have short-term incentives

if you replace 'short-term' with the broader 'dysfunctional' then you must be right

OK, you could say it's then almost tautological: but it's still a useful perspective / line of enquiry

Charlie Marks said...

Pesto's bigging up this idea of the malus - a kind of anti-bonus for when bankers' fuck-up. Sounds rather sensible, no? Can't see the bankers swallowing it. The market only rewards them you see, thankfully for them the malus has been socialised...

Tom P said...

actually UBS is already going ahead with a bonus malus system -