After the banking crisis much has been made of linking bankers’ bonuses to long-term performance. This is an attempt to overcome the short-termism that, in part, led to the crisis.
It won’t work.
Let’s look at this in terms of a game where bankers get to choose to either play a short-term or a long-term strategy.
In the old banking world, with short-term bonuses, the game looked like this:
(For an explanation of how these tables work, see yesterday’s post)
The numbers are arbitrary but let’s say they represent bonuses in millions of dollars.
If both bankers choose a short-term strategy then they will both do well and get their $3m bonuses. If they both choose a long-term strategy then they will still do ok and get $2m each, but, as the old banking system rewarded short-term profits they were better off both being short-term. To choose a long-term strategy when your rivals were choosing short-term just meant that you lost your job and they got even more of the available bonus.
Being short-term was the only sensible choice in the old system.
Now that long-term incentive bonuses have been introduced the game has been changed. Bankers will now only get some of their bonus after a number of years have passed and time has shown that they took good long-term decisions.
The new game looks like this:
Now, if both bankers choose a short-term strategy they get $1m bonus each. If you know your rivals are going to choose short-term then choosing long-term is bad. This is because, although you might do better in the end, you will be outperformed in the short-term and lose your job before you get a chance to prove yourself.
Both bankers choosing a long-term strategy is better because they will both benefit from the larger bonuses and get $3m each.
In the ‘old banking’ game to be short-term was the only option. In the ‘new banking’ game there are now two equilibria, either everyone is short-term or everyone is long-term. It has become a co-ordination problem.
The reason that long-term bonuses will fail is that it is impossible to co-ordinate the behaviour of thousands of bankers so that they all take a long-term view. Once a few start to take a short-term view then it is in the interest of all the others to do so. This is depsite the bonuses being bigger for taking a long-term view.
Today’s takeaway: Long-term incentives won’t work unless the temptation to still take a short-term view can be eliminated.