Study: Banker Bonus Deferrals Won't Help

Some financial industry critics have loudly complained that a big reason for the crisis was the giant bonuses paid to bankers. Although incentive compensation is generally a good idea, they believe that big banks paid too much money out immediately, encouraging excessive long-term risk taking for short-term gain. The proposed solution is then easy enough: just defer some of that bonus money. Unfortunately, a new study suggests that simple strategy might not work.

Megan Murphy from the Financial Times reports:

However, a study by PwC, the professional services firm, and the London School of Economics suggests that the longer employees are made to wait for pay, the less it is worth to them.

Asked whether they would prefer a 75 per cent chance of receiving £250,000 immediately, or a 75 per cent chance of receiving £400,000 in three years' time, more than half the 100 executives surveyed chose the smaller sum.

In fact, deferred pay awards were discounted by an average of more than 20 per cent a year - meaning a £500,000 bonus payable only after five years would be worth next to nothing in the minds of most bankers.

This is a pretty interesting revelation. It tells us a few things.

First, money not in bankers' hands is viewed as more worthless with each year that passes. This is a problem for regulators who hoped deferred bonuses were the answer. If all bankers care about is what they get up-front, then they'll continue to seek short-term profit and ignore long-term risk: they'll consider any deferred payments marginal anyway, so they won't care of they're lost.

Second, it appears to provide a surprising observation on bankers' risk adversity when it comes to their own money. Their risk tolerance appears very low. Think about the example above where there's a 75% chance of receiving some money now or more money later. If you are more risk adverse, then you would prefer less money now, because you would not want to factor future uncertainty in as a variable for pay out. Bankers don't appear to be comfortable with the risk time poses, even though the expected value of the payout is nearly double.

There are alternate explanations to this second observation, however. One could be that bankers have more information than we do, and that gives them little faith that the financial system to run smoothly for five years or more. As a result, they are adverse to this risk because they understand how real it is. Alternatively, they might consider themselves to have more ability to invest the money immediately and make it worth much more than it would be if not obtained for several years. This could be the reason for their high discounting.

This study shouldn't necessarily be interpreted as saying that any attempted reforms to bonus reform are completely hopeless. First, keep in mind that "more than half of the 100 executives surveyed chose the smaller sum." In other words, less than half would still rather have larger deferred bonuses. This also means that some don't have as high a discounting rate assigned to future payouts and would be more concerned with long-term risk under a deferred bonus framework. It's certainly possible that even if only around 40% of bank executives had been more concerned with long-term risk, the crisis would have been less severe.

Moreover, this poll doesn't appear to take another bonus reform method into consideration: claw backs. Bankers might love current compensation far more than deferred compensation, but if they know that even some amount of current or past compensation can be clawed back if things go bad, then they would certainly be more prudent when evaluating risk. For example, if some reasonable liability standard were to exist, then bank shareholders could seize some assets of bankers who lost an institution millions or billions of dollars.

This study also shows something we already knew -- there's no simple, easy way to prevent excessive risk-taking in financial services firms. While a combination of reforms might help, bankers and traders must make a willful, conscious decision to be more careful with their deals and trades. On some level, this boils down to ethics. Risk taking is only bad if it's haphazard and without concern for consequences.