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Guaranteed bonuses in high finance: to reward or retain?

7 November 2018

The article at a glance

by Dr Scott B. Guernsey, Research Associate, Cambridge Centre for Finance and Cambridge Endowment for Research in Finance Public distaste for high …

by Dr Scott B. Guernsey, Research Associate, Cambridge Centre for Finance and Cambridge Endowment for Research in Finance

Entrepreneur giving a speech in a lecture hall. Audience visible in the background.
Scott B. Guernsey
Dr Scott B. Guernsey

Public distaste for high finance reached an all-time high in March of 2009, as the American International Group (AIG) insurance corporation announced it had paid out roughly $165 million dollars in bonuses to employees of its London-based financial services division (AIG Financial Products). Only months earlier, the same company had received roughly $170 million in US taxpayer-funded bailout money and suffered a quarterly loss of $61.7 billion – the largest corporate loss on record. Then Chairman of the US House Financial Services Committee, Barney Frank, remarked that payment of these bonuses was “rewarding incompetence”.

AIG countered, arguing that the bonuses had been pledged well before the start of the financial crisis and that it was legally committed to make good on the promised compensation. Additionally, Edward Liddy, who had been appointed chairman and CEO of AIG by the US government, said the company could not “attract and retain” highly skilled labour if they believed “their compensation was subject to continued… adjustment by the US Treasury.” And AIG wasn’t the only financial firm paying out large bonuses in 2009, as at least nine other large financial institutions, which had similarly received US government assistance, distributed bonuses in excess of $1 million each to nearly 5,000 of its bankers and traders.

But why would these financial corporations risk their reputational capital to pay out bonuses? And why not condition the size and timing of bonus payments on circumstances like that experienced during the 2008 financial crisis rather than to simply guarantee large bonuses a year or more in advance?

A recent research article presented at this year’s Cambridge Corporate Finance Theory Symposium by Assistant Professor Brian Waters (University of Colorado Boulder) offers some interesting insight on these questions. To begin, the paper highlights three unique features of bonuses in the financial industry. First, unlike most other industries, bonus payments to high finance professionals (e.g. traders, bankers, analysts) comprises a large share of their total compensation. In fact, as described in the paper, more than 35 per cent of a first-year analyst’s total pay is in the form of a bonus. This is further evidence by the hefty bonuses of $1 million or more dispensed to bankers, traders and executives by large financial institutions (AIG included) in 2009.

Second, it seems as if bonus payments are largely guaranteed. For example, according to the paper, third-year analysts expect to receive a bonus of at least $75,000, with the possibility of earning a higher $95,000 bonus only if they performed exceptionally well. Moreover, as summarised above, AIG defended payment of its bonuses in March of 2009 by arguing they had been committed in advance and were obligated by law to fulfil this pledge. Third, observation of practice suggests financial institutions coordinate the timing of their bonuses by geography. For instance, in Europe almost all big banks determine bonuses in late February and early March, while US banks do so in January. Again, this is consistent with AIG, although an American insurer, distributing bonuses to its London-based Financial Products division in March.

Considering these three stylised facts, Professor Waters (and co-author, Professor Edward D. Van Wesep) construct a mathematical model to explain why bonuses in high finance are both large and guaranteed. The general setup of the model flows in the following manner. First, the authors assume that financial firms might find it difficult to recruit employees during certain months of the year (e.g. perhaps it is easy to replace employees in March, but difficult to do so in October). Second, in response to this periodic scarcity of labour, firms design contracts whereby large bonuses are paid during months with an abundance of talent (e.g. March), but condition the contracts such that employees must remain with the company until bonuses are paid to be eligible for this form of compensation.

Third, since financial firms operating in the same geography face similar labour market conditions, many of the firms will respond similarly, paying bonuses at the same time. Fourth, because employees are incentivised to remain with the firm until bonuses are paid, they will delay quitting until this point in time (i.e. this is when most employees leave their employers). Therefore, finally, this suggests labour markets will be flooded with talent after bonuses are paid (e.g. March), but will be relatively shallow in other months (e.g. October). Hence, arriving back at the initial step in the model and the game repeats, providing an intuitive explanation for why large and guaranteed bonuses are observed in high finance, irrespective of macroeconomic conditions and own firm performance.