Wednesday, February 06, 2008

Banking bonuses

Incentives in banking have emerged as a key regulatory risk. Daniel Heller, writing in FT, has three proposals for dealing with bonuses in the banking sector. (Heller is director at Swiss National Bank). The first of these is one that I had myself proposed a couple of months ago:

First, bonus schemes need to be more long-term oriented. Instead of being primarily based on last year’s performance, the bonus should take the performance of several years into account. One way is to pay out only part of the bonus in profitable years. The non-distributed part would be set aside as “reserves” that could be used to cover any losses in the future.

Second, the level of the average bonus in investment banking should be reduced in order to take into account that potential losses are not borne by the employee. One way is to limit the maximum bonus in a bank to the bonus of the chief executive. The fact that in the past some rewards exceeded that of the chief executive illustrates that schemes were not designed in an economically efficient way. In a profit-maximising, privately owned company the chief executive is supposed to be the employee with the most skills, who adds the most value.

Third, guaranteed bonuses should be abolished. They are a contradiction in terms, since a bonus is by definition the variable component of the compensation. Guaranteeing bonuses releases the employee from the requirement to make at least a small contribution to cover the losses he may generate.

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