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Bankers’ Bonuses: A Force For Good Or Evil

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Question:

Evaluate and describe the difficulties that arise in business and political scenarios where the information held by groups differs. Critically examine the benefits of various mechanisms for allocating resources amongst competing groups. Appraise the effectiveness and desirability of alternative methods of overcoming asymmetric information.

 

Answer:

Understanding the Issue

The banking sector all over the world is working under tremendous pressure. The pressure comes from the authorities, the stakeholders, the regulators, competitors, and the least from the customers, unless they are influential. To keep a semblance of efficiency, productivity and progression in the organisation, managements, says McCain, (2015), try to keep the employees satisfied through extra pay packages in the form of bonuses. These bonuses are linked to the performance, output, productive results and customer satisfaction shown by the employee. This is a vicious cyclic pattern, where the tussle between the employee and the management keeps going up and down, resulting in little respite for the affected parties, asserts McCain, (2015).

Understanding the Situation

If the whole issue is given a depth analysis, the results show that the situation is a perfect illustration of the Game Theory. The participants in this game are not after control, nor are they concerned about the end-result. All they are concerned is the Mechanism Design which each faction is trying to formulate as per its own rules. Each party is least concerned about the financial burden these mechanisms and theories, which are propagated every other year, bring about on the customer, who is unknowingly financing all this factionalism in the hope of getting a fair deal, as per Narahari, (2014).

Employment Contracts

Financial services market in the UK is among the largest in the world. To protect the legal rights of the parties entering into service contracts in UK, many regulatory provisions have been introduced through the Rome Convention. In this context, The Financial Services Act 2012 is an Act which has introduced a new regulatory framework for financial services in the UK with effect from April 1, 2013. It has replaced the Financial Services Authority with two new regulators, the Financial Conduct Authority and the Prudential Regulation Authority, and these are controlled by the Financial Policy Committee of the Bank of England. Unfair Terms in Consumer Contracts Regulations, 1999 has been controlling unfair means adopted by one party against the other and may include –

  • An obligation on the part of one party to fulfil all of its contractual obligations and letting the other party avoid its obligations.
  • Binding one party to the contract while the other decides the services to be provided.
  • Automatic renewal of a fixed-length contract whereas the deadline for one party to cancel the contract is unreasonably short.
  • Changing the terms of the contract by one party, without describing the circumstances under which these can be done.
  • Excluding or limiting the legal rights of any one party using unfair means.

This paper takes a sneak preview of the Game Theory and the impact of the Mechanism Designs being played and enacted by both factions, as explained by Myerson, (2013).

Game Theory

Purpose of the Game Theory is to look at relationships between two participants, who are in a particular situation, and predict the optimal decisions which they shall take. The theory takes into consideration not only the benefits, but also the costs, which may result because of the decisions taken by the participants.

GAME TREE

A Game Tree, which is also known as the extensive form, is the graphical representation of the Game Theory. It helps in providing information about the parties and the payoff involved, the strategies and order of moves adopted. A game tree consists of nodes, which denote the points from where the parties can plan their next action. These are connected by edges, which represent those actions which the parties have decided to take while at that node. Starting from the root node, every set of edges followed by the parties eventually leads to the terminal node, which represents the end of the game. In the sequence, every terminal node denotes the payoffs which are earned by each player, assert Parsons, Gymtrasiewicz & Wooldridge (ed.), (2012).

Mechanism Design

Once the theory has been put in place, the participants move ahead to decide the mechanism by which to implement the theory. Leonid Hurwicz, the noted economist explains that in the design problem, the goal known, while the mechanism remains unknown, as shown by Parsons, Gymtrasiewicz & Wooldridge (ed.), (2012). Hence, economists also believe that Mechanism Design is inverse of the traditional economic theory. Two very distinguishing features of the game theory and mechanism design are:

  • The game theorist shall select a new game structure instead of using an inherited one.
  • The designer shall be interested in the outcome of the game.

Bringing up the Issue

In a recent development regarding the payment of large amounts of bonus to bank employees in the UK, the text of CRD 4 was approved by the European Parliament. The basic purpose of this document, say Borgers, Krahmer & Strausz, (2015), was to stop paying high bonuses to bank employees by implementing the following four points –

  1. The basic ratio of fixed pay to variable pay shall be 1:1, although some flexibility shall be allowed to increase it to 1:2, provided the shareholders approve.
  2. Managements can pay up to 25% of the bonus amount through long term instruments. In case amount paid is above the 25% limit, the excess amount over the 25% limit will not be eligible for payment through long term instruments.
  3. The rules shall be applicable to all banks operating in the EU and shall even cover employees which are based outside EU.
  4. This ratio between the fixed and variable pay shall be applicable only in respect to duties performed from 2014 onwards. Hence, any bonus amount pertaining to 2013 duty period but paid in 2014 shall not be eligible for the ratio. On the other hand, all performances of 2014 shall comply with this new rule, irrespective of the fact that the arrangement was entered into before the enforcement of CRD 4.

Developing a Solution

The agreement signed between the representatives of the employee federations, managements of banks and the EU Council Members can be represented by a Game Tree while taking into account the four points mentioned above. These points can be treated as the nodes and each node can be described in context to the timing, scale of implementation and the actual financial effect on the banking industry as a whole, says Lambertini, (2011). This paper draws a detailed comparison of the nodes mentions above.

 

Timing

The text of the document has been voted for approval by the European Parliament so there is no scope for any changes in the text. But, the lacuna lies in the implementation time. The authorities have created ambiguity by keeping the compliance date open – it can be 1 January 2014 or 1 July 2014. Even for fulfilling the provisions of the existing CRD 3, the provisions clearly state that bonuses shall be paid in 2014 with respect to duty performed in 2013. Here again, according to Myerson, (2013), the implementation has been deferred to 1 January 2015 for the provisions covering the capping of ratio. In this respect, article 151 of CRD 4 clearly mention that provisions concerning the fixation of ratio between fixed and variable remuneration, as detailed under article 90 (1) (f) shall apply only to those remunerations which are for services provided from year 2014 onwards, assert McCarty & Meirowitz, (2007).

Scope

CRD 4 shall cover all banks and institutions, however, the introduction of the ratio between the fixed and variable pay may be given wider coverage to other parts of the financial services industry. In this respect, The Alternative Investment Fund Managers Directive is already been cited for implementation from July and in a recent vote, the Economic and Monetary Affairs Committee of the European Parliament has shown its support for a similar ratio in its revised UCITS directive. Thus, if this ratio gets confirmed through UCITS, its impact would be felt by asset managers running retail funds in whole of Europe, as per Parsons, Gymtrasiewicz & Wooldridge (ed.), (2012).

Parties Involved

The Identified Staff defined in CRD4 states it as risk takers in senior management and staff which is engaged in control functions. Any employee who receives a total remuneration which takes him into the remuneration bracket of the risk takers in senior management and whose professional activities may have a material impact on their performance shall also be considered as Identified Staff , as per Narahari, (2014).


The above figure shows how the participants can make their choice game as this game tree relies on perfect information. Every node is associated with a participant who makes the move by selecting the next node and the connecting lines have been labelled according to the choices made by the participant. The game starts at the root of the tree and ends at that terminal node, which shows the outcome of the participant’s payoffs.

Recent UK Legislations

In the UK banks, such categories shall be recognised as Code Staff and shall fall within the existing FCA Remuneration Code. Here again, ambiguity has been created by EBA (the European Banking Authority) which has published a directive on 21 May and this suggests a very radical shift in the approach to apply this test to the identification of Code Staff comparative to the current rules. Under these circumstances, another Game Tree emerges, which involves the banks under the EBA as one party and the employees, who are covered under this revised proposal and to whom the ‘bonus cap’ and other provisions of CRD4 may therefore become applicable, as party of the second part according to Hurwicz & Reiter, (2006). The following can be treated as the nodes of this Game Tree.

Deferral

Another ambiguity arises when the rules say that at least 50% of the variable remuneration should be in the form of shares or its equivalent ownership interest or should be of instruments which should reflect the credit quality that the institution is a going concern or such an instrument should be convertible into equity in case of adverse circumstances.

Variable Remuneration

The ambiguity increases when the rules say that at least 40% of the variable remuneration should be deferred over a period which is not less than three to five years. In the UK at present, this variable remuneration component is of high amount, currently set at £500,000, and the rules say that at least 60% of this must be deferred, assert Borgers, Krahmer & Strausz, (2015).

Conclusion

So one can easily surmise that not only the policy makers are engaged in the Game Theory, they are also managing the whole system through the devious Mechanism Design which they are propagating under the disguise of rules which are ambiguous in nature and leave lot of scope for legal challenges in the near future. However, the Commission is out rightly denying any such allegations and charges are being forthright dismissed. One of the most obvious ground for legal challenge, as per McCain, (2015) is the fact that the remuneration provisions being proposed are not compatible with Article 153(5) of the Treaty under the EU law being promulgated for the Functioning of the European Union. This article clearly excludes any kind of pay from the competency of EU laws. Now, the Commission is proposing that CRD 4 has been promoted as a provision which is to address the activities being carried out by credit institutions and investment banks and its purpose is to keep a check on their governance policies and is not meant to cover the social provisions of the EU Treaty, assert Parsons, Gymtrasiewicz & Wooldridge (ed.).

 

References

Borgers, T., Krahmer, D. and Strausz, R. 2015 An Introduction to the Theory of Mechanism Design. Oxford University Press, New York.

Hurwicz, L. and Reiter, S. 2006 Designing Economic Mechanisms. Cambridge University Press, Cambridge.

Lambertini, L. 2011 Game Theory in the Social Sciences: A Reader-friendly Guide. Taylor & Francis, London.

McCain, R.A. 2015 Game Theory and Public Policy, 2nd ed. Edward Elgar Publishing, Cheltenham.

McCarty, N. and Meirowitz, A. 2007 Political Game Theory: An Introduction. Cambridge University Press, Cambridge.

Myerson, R.B. 2013 Game Theory. Harvard University Press, London.

Narahari, Y. 2014 Game Theory and Mechanism Design. World Scientific, Singapore.

Parsons, S.D., Gymtrasiewicz, P. and Wooldridge, M.J. (ed.) 2012 Game Theory and Decision Theory in Agent-Based Systems. Springer Science & Business Media, New York.

Tadelis, S. 2013 Game Theory: An Introduction. Princeton University Press, Princeton, NJ.

OR

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