Should We Care That Guaranteed Banker Bonuses Are Back?

It's back to business-as-usual on Wall Street. The job market for bankers is seeing its strongest level since 2008, and guaranteed bonuses are back too, according to Bloomberg. Surely, this will cause those living on Main Street to shake their heads. Some Wall Street critics blame guaranteed bonuses as leading to the poor choices of financial firm employees that led to the crisis. But in a competitive market, they're pretty unavoidable. It's also hard to understand how there's much systemic worry in a short-term guaranteed bonus.

The calculus is simple enough. If you are fairly confident a guy can bring $15 million per year to your firm, promising him $2 million bonus on top of a $200,000 salary is a no-brainer. There are two kinds of guaranteed bonuses: single-year and multi-year. The first is completely unavoidable on Wall Street. The second is nearly unavoidable.

Single Year Guaranteed Bonus

Imagine you're a senior vice president at fictitious mega-bank JPCiti Sachs. Your salary is $200,000 per year, and your bonus is usually in excess of $1 million, in a normal year. Bank of Gold Morgan wants to lure you away. It won't offer you a guaranteed bonus, but can promise you a salary of $250,000. Would you give up what your past experience dictates will be at least $950,000 more at your current bank to take up the potential bonus that the competitor says you can expect but doesn't promise? I know I wouldn't.

And things are further complicated by accrued bonuses. What if it's July? You've already earned six months of your bonus. If you switch firms now, your new bank might try to pay you a pro-rated bonus. You must then rely on an assurance that you'll get a full bonus, and give up what you've earned at your current bank. It's hard to accept the loss of the money you've earned without a guarantee in place.

So one-year bonuses are pretty unavoidable. And frankly, we would be worse off if they were eliminated. Gigantic signing bonuses would take their place. That would open up the possibility for even worse performance in year one. At least most banks say that the guarantee is contingent upon earning strong reviews.

Multi-Year Guarantees

It's a little harder to justify multi-year guarantees on the basis of pure logistics, however. After you've had a full year at a new firm, you should have the same bonus fate as everybody else. That makes the sole reason for these bonuses' existence a means for ultra-competitive hiring: "Oh yeah? Merrill Stanley of America is offering you a one-year guarantee? We'll give you two!" According to that Bloomberg article, two-year bonuses are regaining their popularity. While these aren't as bad as, say, three-or-more-year bonuses, they're still probably less than ideal.

In a highly competitive market, it's impossible to avoid them without some regulation, however. If eight banks agree to ban them, but one keeps them going, it can lure the employees of those eight. Colluding to be less competitive isn't what banks do best.

Of course, there is some indication that regulators could clamp down on such bonus behavior. The Federal Reserve is looking at pay practices. It could limit guarantees to one year for the banks it regulates. Yet, it's hard to see why they would bother eliminating short-term guarantees of a year or a few.

Where's the Harm?

The big problem some economists have with bank bonuses is that they may promote long-term risk for short-term gain. Prior to the crisis, you were paid based on a year's performance, and your compensation was immediate or vested over a few years. It couldn't be clawed back.

But how does eliminating guaranteed bonuses solve this problem? If you are guaranteed to make a certain amount of money for the next year or two, that wouldn't persuade you to pursue bigger short-term profits despite bigger long-term risk. Indeed, for the next few years, you're already set -- there's no reason for excessive risk taking. On the contrary: you might even care more about long-term performance, since you won't get more than is promised for the next year or two anyway. If the firm does better after your guarantee expires, so will you.

Guaranteed bonuses might seem like an annoying practice if a bank ends up doing badly and the government feels like bailing it out. But if bailouts are successfully prevented in the future, that shouldn't be an issue. When a firm fails, guaranteed bonuses are pretty low on the bankruptcy award priority totem pole.

So even though guaranteed bonuses seem pretty stupid from Main Street's perspective, let Wall Street use them if it likes. The key is making sure financial firms can fail, so that taxpayers don't have to pay for their promises.