Why bankers’ bonuses are important

For years now we’ve heard about bankers’ bonuses.  What most of the discussions seem to be saying are that they aren’t fair and that bankers must be doing something bad in order to earn that kind of money.  While that may be the case in some instances, the more important issue is that in most cases, we pay bankers for the wrong reasons.  The more risk they take, the more money we pay them.  Because of this incentive structure, banks operate in a strange hierarchical system which goes along the following lines:  Pay people to take risk; fire people when they lose too much money, and promote people when they make money.  (For more on this incentive system please see previous post.)  While that follows a very simple capitalist approach of “eat what you kill”, it doesn’t make sense in a large financial organization (which provides a crucial service) and creates three huge problems.  The first is that it encourages a “superstar” system which can make the work environment a very difficult place for everyone else.  The second is that it promotes people who are not necessarily any good at management, strategy or organization.  The third is that it marginalizes effective risk management.

The superstar system emerged around 30 years ago when research shows that the pay difference between the top performer and the average performer in organizations grew above 100%.  Amazingly, the banking industry isn’t the worst offender in terms of this difference but it’s still an offender.  What the superstar system causes is a food fight around profitable businesses and a pretence of teamwork.  Training up junior people is secondary to making money and possibly negative because it could create another competitor.  Getting another internal business unit involved because the transaction might have some relevance to that other business is too risky because they might want some of the profits.  The list of negative situations is endless.

Promoting these superstars on the basis of how much money they make is baffling to anyone who has any knowledge of sound management principals.  When people are good at making money in a very narrow sales or trading role on the trading floor, it doesn’t necessarily follow that they will be good at management of any sort.  Whether this is by providing sound strategy or organizational structure around a sales team or by providing risk taking and risk management direction to a trading team it is a different skillset than just being a sales person or a trader.  Promoting individuals who don’t have management skills creates organizational chaos and a difficult work environment for everyone, not to mention loss of profits from missed opportunity as a result.

Finally, the risk management teams and principals get marginalized.  The focus is on risk taking and risk takers, not on risk managers and sound risk management principals.  This results in risk management teams being wary of offending the superstars on the trading floors and not sure of the right questions to even ask.  They are not part of senior decision making and thus given no respect as individuals or as representatives of a crucial function within the bank.  They are running to keep up with innovation in a similar way that the regulators are because they aren’t even at the table when innovation occurs.

Overall, banker’s bonuses create a lose lose lose situation for the bank and a win win win situation for the recipients.  No wonder they are loath to change the system.