We should be fining bankers, not paying them bonuses

Bonuses. Amid all the fuss about who should be paid what, comes news from Nottingham University: they’ve conducted new research that suggests incentive payments in the form of cash bonuses don’t work. At all.

You can read about the mechanics of the experiment here. But the basic findings are twofold. First, knowing that we will get extra money if we do well, “doesn’t make us work harder”. And second, knowing we will be fined if we don’t, does.

If you have children this won’t surprise you: “if you don’t stop hitting your sister I will take your biscuit away” always works better than “if you are nice to your sister I will give you a biscuit later.” But it should make sense even if you don’t. It chimes well with previous academic work by Dan Ariely on the nature of incentives, but more obviously study after study has shown that we usually fear loss much more than we crave gain.

Consider the ‘endowment effect’ or ‘status quo bias‘ – the idea that people place an extra value, beyond the market value, on things they already own. In one of the better-known experiments on this, researchers gave groups either a bar of chocolate or a mug, having first checked who actually wanted what. After the trinkets were distributed randomly the students who hadn’t got what they wanted were allowed to trade.

But here’s the odd thing. 50% had the wrong thing. But only 10% traded, and those who did demanded a much higher price to sell the trinkets they already owned than to buy those they did not. Even after a matter of minutes their sense of ownership had trumped their original preference – and warped their financial rationality.

What does all this mean for bankers? The obvious answer is that instead of giving them bonuses (extra money for doing well) we should be fining them (taking money away when they do badly). But how? This question kept my family happily occupied during a long wait in a Glasgow traffic jam yesterday, but in the end the answer seems pretty simple.

Bankers are forever telling us that their bonuses, as part of their expected total remuneration, are just part of their salaries. So why not start by making that official? Take a middling investment banker on a salary of £150,000. He will be expecting a bonus of around the same. So let’s tell him at the beginning of the year that his salary is to be £300,000. However, we’ll also tell him he won’t get it all right away. The first £150,000 will be paid in monthly instalments as usual. The second £150,000 will be looked after by his bank for him until the end of the year (or even better, until the end of a five-year period). It will then be handed over, minus any fines he might incur along the way for things such as making rubbish deals; bringing the bank into disrepute by spending £10,000 on bottles of wine at client dinners; using Facebook in the office; or inventing complicated derivatives that bring down the world economy. That sort of thing.

I can’t see this happening any time soon, given the sense of entitlement at large in the financial sector. But I suspect that if it did, we would find our banking system a great deal more satisfactory.