Luck-based pay makes decision making a lottery – it doesn’t improve it

Jamie Whyte
MY NEIGHBOUR Debbie buys Lotto tickets. At least, she pays for them. She deputises the job of going to the corner store and selecting the numbers to her ten-year-old son Wayne.

Wayne receives a base wage of 50p for putting in the time and he can also earn a performance-related bonus. If he successfully returns from the store with ten Lotto tickets, Debbie pays him another 50p (without this incentive, he was inclined to come home with no ticket and sticky fingers).

Or she used to pay him this bonus. Last week Debbie came to notice that Wayne has never selected jackpot-winning numbers. So she has changed his incentive scheme. The 50p bonus is now withheld until the results are announced. Only if Debbie wins over £1m will Wayne receive his bonus. She expects this to improve his number selection.

Debbie may seem to be an unusually foolish woman. But she is no more foolish than financial sector regulators. Keen to improve the decision making of bankers, regulators now demand that their performance-related pay be deferred until we can know for sure how their decisions have turned out. Or, as they like to put it, “compensation payout schedules must be sensitive to the time horizon of the risks”.

To keep matters simple, imagine two corporate bankers, Jack and Jill. Both make £100m five-year loans to firms rated BBB: that is, firms with a 0.4 per cent chance of defaulting in the five-year period. Assuming that they also priced these loans the same, Jack and Jill’s performance is identical.

Now suppose that Jack’s client turns out to be one of the few BBB firms that defaults. Then Jill will get her bonus but Jack will not. Their bonuses are not performance-based but luck-based. Which makes this incentive scheme as silly as Debbie’s scheme for Wayne. You cannot improve decision making by basing rewards on facts that are unknowable when the decision is made.

Banks insure themselves against the risks of the business they do, mainly by holding capital as a buffer against potential losses. The cost of this insurance is charged to loans or other risky deals when they are made. If a deal still registers a profit, then the employee who arranged it has done all he can. There is no point deferring his bonus; everything that might affect his performance is over and done with.

Wayne has reacted to Debbie’s revised bonus scheme by demanding higher base pay. Since his chance of winning a 50p bonus is now 1 in 15m, he has completely discounted it and is back to a base wage of £1. On Monday he returned home without a Lotto ticket. Similarly, under their new bonus regime, bankers have demanded base salaries that make up a greater portion of their total pay. Hooray for the regulators’ new and improved performance-related pay!

Jamie Whyte is a senior fellow of the Cobden Centre.