Bonus Arcitecture

Bonus Architecture We start from a position that in the large complex entities that the regulators most want to incentivise, do not have coherent or even centrally understood processes for determining how people are awarded bonuses.

This is not an intuitive position, but it does affect the effectiveness of any change to bonus allocation and gives insight into how to make these changes more efficient.

Nearly all such firms are composed from mergers and acquisitions, and have inherited bonus systems that are not only difficult to change, but in order to keep the assimilated management on board, remuneration is often delegated.

This also is transposed upon the standard “silo” structure for most large banks where bonuses are allocated on the basis of asset class or market. This is to simplify the task of setting bonuses, since in a large firm there are not only a large number of workers, but there work is far more diverse than in most (if not all) other businesses of equivalent headcount.

When large firms have substantial offices in multiple countries and this too adds to the complexity, and each firm has its list of idiosyncratic bonus factors, of which “risk” is conspicuously absent.

This leads to outcomes such as fixed income and commodities being in closely related bonus pools and management. Without getting drawn into the detail of either business it is clear that the risks in these areas do not correlate well, making risk based remuneration at this granularity difficult, and as we shall see later, possibly counter-productive.

Such aggregation is the norm, and although the exact form varies, the practice does not, and represents what is believed to be an efficient allocation of management resources and internal political concerns.

This intersects with the traditional organisation tree where each level of management delegates part of the bonus allocation to the level below. The patronage that this gives is earnestly sought by all managers, who pass as little information as possible to others. They must of course report exact allocations, but the process itself is more opaque the more levels one peers down through, and from a lower level is almost wholly impenetrable to see upward.

There exist policies, set from the top with the support from compliance, legal and HR staff, but in conversation with managers who set bonuses these are barely even given lip service, much less seen as useful guidance. At non bonus setting level, they will be dimly aware that “something political is happening” and money that is roughly related to their performance appears (or fails to appear) as a result of a process of which they are intentionally kept ignorant. For the avoidance of doubt, not only do some feel wronged, but others (confidentially) share with me that they have no idea why this bonus was so large.

Before this current regulatory initiative, this was seen as an inevitable but relatively benign aspect of the management of financial firms.

This is why I have adopted the term “Bonus Architecture” as opposed to “scheme” or “policy”. The FSA, in common with other regulators wishes risk management to have an effective input into bonus allocation, and the most important precondition for this is that they have an adequate understanding of the process in their firms, beyond “policy”. This is a daunting task given the extreme diversity of such firms, and it follows that to be effective this cannot be effected centrally. I recommend that and risk weighting that is applied to bonuses should involve risk managers specific to a given silo and asset class. This itself is not without risks, since risk managers are always in peril of being captured by their business units. This is not beyond solution as I shall suggest elsewhere.

I do however suggest that attempting to deliver this in 2009 is not only overly ambitious, but possibly counter productive, something that deserves its own section.