Financial Times: How bank bonuses let us all down

[marmar]

How bank bonuses let us all down
By Nassim Nicholas Taleb

Published: February 24 2009 19:53 | Last updated: February 24 2009 19:53


One of the arguments one hears in the compensation debate is that the bonus system used by Wall Street – as John Thain, former Merrill Lynch chief executive, put it – is there to “reward talent”. While I find this notion of “talent” debatable, I fully agree that incentives are the heart of capitalism and free markets – but certainly not that incentive scheme.

In fact, the incentive scheme commonly in place does the exact opposite of what an “incentive” system should be about: it encourages a certain class of risk-hiding and deferred blow-up. It is the reason banks have never made money in the history of banking, losing the equivalent of all their past profits periodically – while bankers strike it rich. Furthermore, it is thatincentive scheme that got us in the current mess.

Take two bankers. The first is conservative. He produces one annual dollar of sound returns, with no risk of blow-up. The second looks no less conservative, but makes $2 by making complicated transactions that make a steady income, but are bound to blow up on occasion, losing everything made and more. So while the first banker might end up out of business, under competitive strains, the second is going to do a lot better for himself. Why? Because banking is not about true risks but perceived volatility of returns: you earn a stream of steady bonuses for seven or eight years, then when the losses take place, you are not asked to disburse anything. You might even start again, after blaming a “systemic crisis” or a “black swan” for your losses. As you do not disgorge previous compensation, the incentive is to engage in trades that explode rarely, after a period of steady gains.

Here you can see that this mismatch between the bonus payment frequency (typically, one year) and the time to blow up (about five to 20 years) is the cause of the accumulation of positions that hide risk by betting massively against small odds. As traders say, they have the “free option” on their performance: they get the profits, not the losses. I hold that this vicious asymmetry is the driving factor behind investment banking. ........(more)

The complete piece is at: http://www.ft.com/cms/s/0/fa89be08-02aa-11de-b58b-000077b07658.html

[burythehatchet]

1. This is why Lloyd's of London has always been the ideal insurance market

the syndicates are owned by individuals who are at risk for their own money.