The Problems with Performance Related Pay in Finance

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Creative Commons License photo: ArtemFinland

I was asked today what I felt about performance related pay in the banking/financial sector and the huge bonuses given to the bankers who are responsible for the financial crisis.

To my general thoughts on the topic, I’ll point you towards Tim Harford’s wonderful article in his Undercover Economist column. He talks about some of the adverse incentives created:

If you hired me as a hedge fund manager and paid me “2 and 20” – a 2 per cent management fee, plus 20 per cent of any gains – then I’d be tempted to take your money to a roulette table and put it all on black. If I won, I’d get to keep 20 per cent of the gains. If I lost – well, I would have been sure to deduct the management fee first.

Fairly recently, I was invited to participate in a trading simulation and competition run by the bank JP Morgan. It was lots of good fun: we had a simulated market running in the room where everyone could buy and sell shares in technology companies. Everyone was given some virtual money to invest. Throughout the simulation, the ticker would update with news about what was happening in the industry (e.g. earnings reports, new products, etc.)

I think there was roughly 40 teams or so participating in the simulation. The top four teams (i.e. the teams which made the most money) won the competition and went through to the next round.

My teammate and I were fairly sensible investors: we invested in a portfolio of stock, we knew when to cut our losses and we hedged our risks. I think that would be a good strategy to follow for an investment fund manager: after all you don’t want to lose all of your clients money and you want performance to be pretty stable.

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Creative Commons License photo: Petrick2008

We came about 10th in the competition so we missed out on being in the top four. Anyway, it turned out that the winning teams which won the game had invested larger sums and taken much larger risks than we had. In retrospect, it made sense. Seeing as you wern’t playing with your own money (in this case it was virtual money), the whole game encouraged taking risks. A sensible investor who took fewer risks might make a good return on their portfolio but they would never be able to win it. An investor taking large risks would either come last (in which case, nothing has been lost) or first (in which case they would win the game).

The investors who took the most risks – a level of risk which you wouldn’t want to be exposed to if the money was your pension or savings – won the game. The prize is probably an internship or a job or something.

I think that illustrates the whole problem with the system of rewards in the financial sector and what caused the traders to take huge risks with our money.

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