The paradox of incentives
David Davis MP 9:21amBanker bashing has become something of a national pastime, and politicians have been quick to join in. But rather than devoting their energy to avenging past sins, our political leaders might be better off learning the lessons of Dan Ariely’s book, The Upside of Irrationality.
In this valuable work, Ariely shows that the incentive of big bonuses can actually damage performance, not improve it.
He cites a century-old experiment in which rats were placed in a cage with two pathways. One led to a reward, the other to a device which gave the rats an electric shock. The aim of the experiment was to see how quickly the rats learned which path to take.
As an added twist, the scientists varied the size of the electric shock. Some rats who took the wrong pathway received a low level shock, which produced a tickling sensation. Others received a medium shock, while a third group received a high level shock, which was almost fatal.
The results seem eminently predictable. The higher the electric shock received, the greater the motivation there is for the rat to learn the rules of the cage, and therefore those rats who
receive the strongest shock are the quickest to learn which pathway to take out of the cage. It is obvious.
But wrong.
The rats which received the biggest shock — in effect the most severe punishment for making a poor decision — were slower to figure out which pathway was right than all the other rats. In other words, the group with the biggest incentive to succeed were the least successful.
Perhaps I’m being uncharitable by drawing parallels between rats and bankers, but Ariely’s own work suggests that humans react in the same way as rats do when it comes to motivators.
In a different experiment, this time conducted in India, Ariely offered volunteers bonuses for winning games which tested their reasoning skills and cognitive ability. The volunteers were divided into three groups. For the first group, the bonus on offer was equivalent to a day’s pay for the average local worker. Winners in the second group received a bonus worth two weeks’ pay, and in the third group, 5 months’ pay.
The results would make bankers quiver.
You would expect those with the most to gain to be the most motivated and perform best. In fact, those in line for the biggest bonus performed more slowly and less successfully than those chasing more modest windfalls.
Instinctively we think large monetary incentives must encourage individuals to go the extra mile. But Ariely draws our attention to the psychology of bonuses and the dangers huge rewards can create. The frantic pursuit of riches can heighten feelings of workplace stress and encourage recklessness and poor decision making.
Unsurprisingly the banks don’t want to hear this.
After presenting his findings to leading banking executives, Ariely describes how they agreed that large bonuses may have a negative effect for others but certainly not for them! It is unfortunate that they refused an opportunity to take part in a study themselves.
The promise of vast rewards has led many bankers to take enormous risks with people’s money. Banks like Goldman Sachs and Barclays have been fined for their poor practices. At the very least they behaved imprudently and took unjustified risks. At worst, their behaviour triggered the financial crash of 2008 from which the Western world will take years to recover.
Most of us Tories view with equanimity people who make large sums of money in pursuit of wealth and job creation. That’s an entirely virtuous outcome, and one which benefits society as a whole. But we should distinguish a little more between wealth creation and the activities of some of our bankers, which amount to wealth extraction, and wealth extraction in their own interests at that.
David Davis is the Conservative MP for Haltemprice and Howden
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LibertarianLou
January 27th, 2012 9:41am Report this commentExcellent piece.
Jebediah
January 27th, 2012 10:00am Report this commentPerhaps it's about time we stopped bashing Britain's biggest business. One of the few in which we are world leaders.
Most people that work in the city or for banks are normal. The tax receipts from these activities are vast.
The companies that run these businesses can ultimately run them out of China, Singapore the US, Switzerland... it's a long list. They will if we continue to persecute the many for the sins of the few.
The Chinese and Indians are laughing at us. If we go on like this the tax receipts from the industries we drive out of Britain will be building schools and hospitals there.
Olaf
January 27th, 2012 10:20am Report this commentWhat you have described is called negative reinforcement.
Perform the same experiment with heroin at the end of the right pathway and the rats will learn which path to take faster than if an electric shock is at the end of the wrong path.
Positive reinforcement is more powerful that negative reinforcement. It's all down to the reward pathways in the brain. Not much difference between rats and bankers at that level.
Taking it back to the bankers they should be rewarded for carrying out their business in a way which does not beggar the country. That will reinforce that strategy more strongly than punishment after taking 'the wrong path'.
The current strategy of reward for failure is stupid right down to a cellular level.
anyfool
January 27th, 2012 10:23am Report this commentThis is a very good comment on bankers. but the polititians have done an excellent job of deflecting attention from any part they played in this catastrophy that is just starting to unfold, the press have been there handmaidens in this with there yapping about bankers bonuses as though sorting that out will make everything right. it is also time people stopped yakking about bankers bungs and started to think logically about who should be running the country for the countries sake and not who bribes them the most with benefits the future generations are going to have to pay for.
Hexhamgeezer
January 27th, 2012 10:35am Report this commentIncentive is just a label given to a bit of money. As are expenses and allowances. Perhaps a reduction in MPs' incentives - sorry allowances - will improve performance.
Worth a try don't you think?
mongoose
January 27th, 2012 11:07am Report this commentIncentives in banking are competitive, unlike for the rats described. That can make them dysfunctional at the level of the banking system as a whole. Alex's cartoon in the Telegraph often reflect this feature and lampoons its plausible implications.
Simon Stephenson.
January 27th, 2012 11:39am Report this commentI think the difference between rats and bankers is that bankers are capable of intelligent reasoning. What has happened is that the dangling of bonuses in front of top executives has to no small extent triggered the thought "they're prepared to pay me this extra money". The reaction of many, to this, has been "what's the easiest way of getting this extra money", and in many cases the answer to this is "use my power to rig the rules so that I get it without having to do much more than I'd be doing otherwise".
The bulk of the bonus structure is little more than a confidence trick to disguise higher remuneration by introducing an element of fake conditionality into the "bonus" element of it - and it has been comprehensively "gamed" by the people to whom it was supposed to bring enhanced motivation.
philodoc
January 27th, 2012 11:57am Report this commentWhy limit the debate to Bankers? Premier footballers, Hollywood and TV celebrities, etc. all receive obscene remuneration packages. What is even more surprising is that the so called "squeezed middle", who largely fund the celebrity bonanza do not utter a peep of indignation. Perhaps the "fragile resources" of this squeezed middle are not as fragile as we think?
I would much rather pay a top banker to look after my nest egg than fund celebrity lifestyles
El Sid
January 27th, 2012 1:01pm Report this commentWhere to begin with the flaws in that rat experiment? It just proves that near-fatal electric shocks frazzle rodent brains. I wouldn't be myself after something like that. More to the point, it's not clear how it incentivises them to be more effective at searching a maze, how it "costs" them more. I could see an analogy if it was a situation where humans could "buy" a map for £10 or a satnav for £100 in order to find a prize of £110 in the maze, but I just don't think we learn much from the rat experiment as described above.
The promise of vast rewards has led many bankers to take enormous risks with people's money
It's not the vast rewards so much, as the absence of penalties which leads to risky behaviour. Humans hate loss much more than they like gains, but share options or the typical 2+20 reward structure are a one way bet that encourages maximum risk. People should have skin in the game, that's where things went wrong. (along with stupidly simplistic financial models that didn't handle black swans well)
Peter Jackson
January 27th, 2012 1:27pm Report this commentExcluding those bankers who work on some kind of commission basis, why, if one is paid a six figure salary, should one receive any bonus at all? What more is going to be done for that company that would not be done for the six figure salary.
If the answer is anything at all, then surely one should be dismissed.
E Hart
January 27th, 2012 2:31pm Report this commentIt is quite evident that the market doesn't do rationality. If it did it wouldn't have come up with these hideously asymmetrical remuneration packages which ignore inflation, equity, performance, prevailing market conditions, proportion and reality.
You should have kept out that twaddle about the rats as they work on biological imperatives and don't have recourse to reason. What separate the best of rats from the worst of bankers, is that the banker can imagine his bonus in the abstract before it appears in reality (with apologies to bees, architects et al).
Simon Stephenson.
January 27th, 2012 2:31pm Report this commentPeter Jackson : 1.27pm
I think you're confusing the individual with the general. In general, what you suggest may be true - incentives do little to encourage people to do more than they're already paid to do - but the situation is that incentives are the norm, and if you decide unilaterally not to pay them, you will find it difficult to recruit/retain staff of a quality such that they are able to demand incentives elsewhere. You are likely to end up with the wrong people on the right salaries.
Peter Jackson
January 27th, 2012 2:56pm Report this commentSimon Stephenson 2.31pm
No Stephen, I don't believe I am confused, or at least not on this issue.
If a director is not willing to do his utmost and work with every fibre of his being for a salary of, shall we say £1m per annum, then I am certain there are plenty of competent individuals who will.
If it proves difficult to retain staff of the quality of, for example, Sir Fred Goodwin (RBS) or Adam Applegarth (Northern Rock), without further incentive, then we must bite the bullet and make the best of it.
Doppelganger
January 27th, 2012 5:15pm Report this commentI used to be an "investment" banker and found the culture unpleasant to say the least. Far too many people with few "hard" skills exhibited an immense sense of entitlement and greed. I wouldn't have minded so much if they were properietors of the businesses which paid them with all the attendant risks but they were not; they were mere employees paid large sums of money by shareholders to shove other people's money around.
Simon Stephenson.
January 27th, 2012 6:17pm Report this commentPeter Jackson
What you are confusing, I believe, is two separate questions:-
1. Is it necessary to pay million-plus salaries in order to stimulate those at the top of industry to do their best?
and
2. As things stand, is it good sense for any sizeable organisation to attempt to recruit its top executives on the offer of a lesser level of remuneration than the industry norm?
This is not to say either that everyone who's been paid top dollar is at the top of the tree in terms of ability, or that everyone of very high ability is motivated entirely by levels of remuneration. Just that if you're not prepared to pay the going rate, you cannot complain when people whose abilities you admire turn you down in favour of those who are prepared to follow the market. I'm sorry, but if a business the size of RBS determines to recruit its executives on the cheap it will end up with a load of people who aren't good enough to command the higher rewards on offer elsewhere.
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