Behavioral Economics for Leaders

CHAPTER 39Wall Street Bonuses Incentivize Unhealthy Risk Taking—and Increase Systemic Risk

Bonus payments are intended to motivate employees to make an extra effort. Performance‐based payments can have unintended side effects, however, because they change the decision‐making behavior if employees can receive bonus payments only by making overly risky decisions.

Albeit of ill repute, Jerome Caviel and Nick Leeson are well‐known names for this type of conduct in the financial sector. One man, Leeson, caused the bankruptcy of Barings Bank, founded in 1717, owing to excessive speculation and a loss of about $1.4 billion. Compared to this, the major French bank Societe Generale was “lucky” in that the risky speculative transactions of Jerome Caviel, which brought a loss of about EUR 4.8 billion in 2008, didn’t result in bankruptcy for the bank. Both cases received a great deal of public attention because they illustrated how risky investment strategies of individual investment bankers may lead to enormous losses and even the ruin of renowned financial institutions. Less attention was paid to the fact that, prior to the discovery of the huge losses, both bankers were seen as hugely successful in their field, earning enormous bonus payments with their deals. Is there a connection between risky investment behavior and bonus payments?

The financial sector is not the only industry in which employees are offered bonuses in addition to a fixed salary, which in many cases depends on corporate ...