At the height of the financial crisis, it has become popular to blame bonuses as the main culprit, luring top bankers into socially wasteful investments. Bonuses are readily seen as the main drivers of greed and irresponsibly short-sighted behaviour. The new US President Barack Obama has publicly expressed his consternation and disapproval of the “shameful” bonus payments of Wall Street banks totalling $18 billion for the year 2008 – the very year, in which the financial industry required a bailout of more than $1 trillion from US taxpayers.
Given this public outrage, the German government moved in October to cap CEOs’ salaries at €500,000 for banks applying for government support. The new US administration plans to limit top manager compensation to $500,000 for institutions requiring governmental support. The British government plans on capping bonus payments. The G20 leaders are aware of the need to coordinate their actions – bonuses rank highly on the agenda of the London G20-summit.
There seems to be consensus that the asymmetric payoff structure makes bonuses a vehicle to privatise profits and socialise losses. This popular view neglects the fact that bonuses are based on performance criteria typically – and ideally – outside of management control. The original intention is to reward good performance. Not all decisions in the financial sector have been bad. For example the investment banking arm of Deutsche Bank produced losses for 2008, but the foreign exchange desk was unusually successful, limiting the overall losses; both were largely incentivised by generous bonuses. Should such instruments to reward good performance really be banned?
Now what has gone wrong with bonuses? Why were they created and what is their role in normal times? Is the current wave in favour of eliminating bonus payments just a way to penalise managers for bad performance? Are bonus payments the real culprits of this crisis? Before taking action, it may be useful to step back and ponder the consequences of heeding popular calls.
How do bonuses affect investment behaviour?
As a first observation, there is wide agreement that bonuses do affect behaviour of managers and traders. However, the issue about the impact of bonuses is far more controversial, if not ideologically charged.
For example, there is a widespread feeling that bonuses invite risk-taking by fund managers and bankers because of their asymmetric payoff structure. If the risky investment succeeds, the manager is awarded a handsome compensation and if it fails he stills enjoys a fixed salary. In other words, a bonus-based compensation package does not seem to penalise unfavourable realisations of risky investments.
Scholarly work, in contrast, finds that the implications of financial incentives in investment decisions tend to be more subtle. Brunnermeier and Nagel (2004) find strong evidence of hedge fund managers herding during the technology bubble of 1996-2000. They document that a weak bonus system provides stronger incentives for short-term reputational concerns. In such an environment, contrarian strategies to exploit the bubble are risky for individual managers, since they may impose substantial losses for a couple of quarters as long as the bubble is progressing. Hence, taking a fundamental view and riding a contrarian strategy may be misinterpreted as bad management by the public. As long as fund managers are not rewarded for such risks, taking a short-term view and joining the herd is a rational response. According to their study, this is precisely what happened among US hedge funds.
For mutual fund managers, surprisingly, just the opposite could be observed for the same period. Dass, Massa and Patgiri (2008) find that mutual fund managers actually implemented contrarian strategies towards the end of the technology bubble. They argue that their behaviour was in line with their more long-term-oriented incentive schemes. According to their study, mutual fund managers had a stronger financial interest to take risky positions against the herding behaviour of the market because they could trade off their reputational risks against financial risks. Hence, bonus-based mutual funds actually contributed to the correction of market mispricing and the dissolution of the technology bubble.
In an international comparison for the years 2003-4, we find that these favourable effects of bonuses also carry over across the Atlantic to fund managers in Germany and Switzerland (Gehrig, Lütje and Menkhoff 2009). While bonuses typically play a much larger role in the United States, they have desirable effects on effort, risk-taking, and fundamental orientation on both sides of the Atlantic. Our study establishes that bonuses are the dominant factor in eliciting working effort, while other standard factors are not.
Surprisingly, on both sides of the Atlantic, risk choice is not affected by the magnitude of bonus payments. Moreover, fund managers’ risk choices do not differ widely across the Atlantic. This finding flatly rejects the popular view that bonuses favour excessive risk-taking, at least in the case of fund managers.
Finally, our study establishes that larger bonuses are correlated with a stronger fundamental orientation. Accordingly, bonus reward payments contribute to a more rational and more fact-based investment strategy. Put differently, in the absence of bonus payments, investment behaviour is based less on information about fundamentals, and, hence more prone to uninformed behaviour and possibly herding.
Taken together, these results strongly suggest that bonuses are valuable for investment funds and – even more so – society. Banning bonuses would have a detrimental affect on societal information acquisition in the fund management industry. Of course, these results need to be interpreted with care, since by its very design, a cross-sectional study cannot control for implicit dynamic incentives such as career concerns. The precise role of bonuses will certainly have to be judged against the overall institutional framework. Nevertheless, the finding that bonuses seem to affect individual behaviour alike in as diverse market environments as the US, Germany, and Switzerland confers some confidence on the robustness of the empirical regularities.
Why a debate about bonuses?
The current public debate seems to be dominated by the search for culprits for the financial disaster. The financial elite is an obvious candidate. From an economic point of view, the central critiques about bonuses, however, seem to be concerns about risk-taking and short-term orientation. Here again, the evidence suggests that it is not the bonus system per se that creates myopia but rather the design of the overall compensation package. Moreover, a well designed compensation package may actually take advantage of explicit bonuses. Hence, banning bonuses could be very detrimental at large.
In fact, banks themselves are trying to correct their internal incentive schemes in order to re-adjust incentives on longer horizons. They seem to largely agree that, prior to the crisis, their systems may have been excessively short-sighted, and they are now trying to base rewards on more sustainable performance criteria such as average growth rates and volumes across longer sampling periods. However, they are right in not dispensing with bonuses altogether. Interestingly, semi-public banks such as the German state banks were not saved from bad investments, despite the fact that their bonus systems were lower powered than those of private banks.
Lessons for policy
Which lessons can be learned for the current debate about the role of bonuses?
- First, bonuses can be very effective instruments to guide manager behaviour.
- Second, bonuses are useful complements of compensation packages to award good performance in terms of the underlying goals. However, they are only useful, when the underlying goals are clearly specified. Bonuses are only useful in achieving precisely those pre-specified goals. Potential incentives towards short-term orientation are primarily a problem of the underlying goals and compensation packages rather than bonus payments per se.
- Third, compensation packages and company goals are defined by their owners, typically their shareholders.
- Fourth, a debate about bonuses should really be a debate about performance criteria and sustainable goals.
- Fifth, suspending bonus payments should, at most, be a temporary crisis management measure imposed on banks and institutions that are otherwise technically insolvent. This measure should be revoked when those institutions are viable again. And even before, incentives may speed up the turnaround. In the longer run, stability-oriented compensation packages should be on the agenda of the discussion about a stable financial architecture.
Brunnermeier, M. and S. Nagel (2004): “Hedge Funds and the Technology Bubble”, Journal of Finance 59, 2013-2040.
Dass, N., M. Mass, and R. Patgiri (2008): “Mutual Funds and Bubbles: The Surprising Role of Contractual Incentives”, The Review of Financial Studies, 21:1, 2008, 51-99.
Gehrig, T., T. Lütje and L. Menkhoff (2009): “Bonus Payments and Fund Managers’ Behavior: Trans-Atlantic Evidence”, CEPR-DP. 7118.