09/13/2009 05:12 am ET Updated May 25, 2011

What's Wrong With Bonuses?

As the furor over the Merrill Lynch bonuses brings into focus what many see as the greatest evil of the banking industry, it's worth questioning exactly what it is that gets us so angry.

In the Merrill Lynch case, the problems are fairly obvious -- a payment that appeared illogical (why should a bank making a multi-billion dollar loss pay out almost 4 billion in bonuses?), immoral (why did the bonuses equal more than a third of the government bail out?), and corrupt (why did Bank of America let the bonuses go through, and why the hell are they only being fined $33 million for doing so?)

But should we judge financial-sector bonuses only on what be the worst-case scenario? Back in my native England, a country that dined out on the good years as much as anywhere else, news that Goldman Sach's London staff would earn an average bonus of three quarters of a million dollars this year provoked shock and outrage. "What recession?" ran the bitterly sarcastic headline of the Daily Mail, perhaps Britain's most populist newspaper. This despite the fact that Goldman had actually managed to turn around its finances and start posting huge profits.

Bonuses deserve careful consideration.

A bonus is simply a form of performance-related pay, a concept that has been around for centuries, at least back to the Greeks. The practice became a popular concept in the late 19th century, when the industrial revolution caused a new interest in management. The idea was that if you paid people for their performance, they would perform better out of self-interest - a fairly logical conclusion.

It was not really until the 20th Century that the huge lump sums we have come to equate with the financial sector became widespread. As profits from investment banks got bigger, the logic was completely rational -- give someone a share of the profits and they will create more profits.

These incentive structures have unusual ubiquity within the financial industry. "A unique feature of banking is that it extends performance pay to almost all of its employees," wrote Tom Kirchmaier of London School of Economics in a paper last year. "In fact, it is not uncommon that investment banks pay out up to 40% of their net revenue to their employees."

Whilst plenty of industries use performance-related pay, the financial industry leans towards this form of remuneration for a couple of reasons. First, the industry is relatively unique in that individuals can be directly responsible for deals that earn millions of dollars. It's relatively logical that if someone closes a deal worth $100 million, they might expect to gain a share of it.

Secondly, a bank's most valuable resource, and thus their most significant of costs, is its staff. Banking itself tends to differ relatively little from company to company, so bonuses become not so much a reward for performance, but a sum to prevent the earner from moving to another company.

The bonus arms race began in the 80s, and has shown little sign of abating since. In practice this has meant that bonuses have ceased to be performance related at all, and instead just a guaranteed sum.

Even where the bonuses are performance related, they can act in ways that are counterproductive. The chief problem seems to be that whilst profits from the company are shared, losses are generally not -- short of losing out on a promotion or getting fired. At a personal level, losses are finite for an employee, whilst profits to all intents and purposes appear infinite. Couple this with the fact that most bonuses tend to be given out at the end of a year -- thus allowing bankers to earn huge bonuses on financial products that later make huge losses -- and you have a system that seems to perpetuate risk and short-sightedness.

Whilst it's clear in theory that the system is harmful, what is difficult, however, is actually working out the extent to which these problems caused the recession -- academia, business, and government all seem unable to come to a complete conclusion. "It's very difficult for an academic to get access," says Vicky Wright, a senior consultant at Watson Wyatt who deals with executive remuneration packages. "And practitioners can find it hard to see the bigger picture."

What's clear is that the bonus culture was certainly not the only thing to blame. When the British Financial Services Authority looked into bonus culture earlier this year, they concluded, "A reasonable judgment is that while inappropriate remuneration structures played a role, they were considerably less important than other factors."

Regardless, governments in the UK and the USA are now looking into ways to regulate bonus culture. Favored options include withholding bonuses for five years or so, or enabling banks to take back bonuses if deals go sour. Every solution would pose it's logistical problems.

It's clear that the bonuses doled out in recent years were not a good thing. As Andrew Clare of Cass Business School in London, told me, "If the bonus culture did anything at all, it was negative." Most worrying perhaps is the way they revealed a huge gap between thinking Wall Street and the rest of the world. Bonuses, for better or worse, were expected, and frankly dubious dealings, such as those between Bank of America and Merrill Lynch, show something of the unshakable belief that the bonuses were deserved -- even if your company failed on a huge scale.

But while it's very easy to find fault with the bonus system, their role in the recession is at best contributory. What is worrying is that bonuses may be an easy target for anger -- an easy scapegoat for wider problems. Its easy for a politician to point to huge bonuses and complain, rather then fix the complicated regulatory problems that lay at the core of the financial crisis. It's true, the bonus system in banking has reached illogical heights, but it was only one problem of a system that was screwed, on many, many levels.