The Corpus Callosum

Psychiatrists of old, never gave advice.  But here’s some advice:

And never trust with your money anyone making a potential
bonus.

From href="http://www.ft.com/cms/s/0/fa89be08-02aa-11de-b58b-000077b07658.html">Nassim
Nicholas Taleb, author of Black Swan; HT: href="http://theautomaticearth.blogspot.com/2009/02/february-25-2009-put-it-all-on-red.html">Automatic
Earth.

How bank bonuses let us all down
By Nassim Nicholas Taleb
Published: 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.

If capitalism is about incentives, it should be about true incentives,
those resistant to blow-ups. And there should be disincentives to
remove the asymmetry of the free option. Entrepreneurs are rewarded for
their gains; they are also penalised for their losses. Now, by
comparison, consider that Robert Rubin, the former US Treasury
secretary, earned close to $115m (€90m, £80m) from Citigroup for
taking risks that we are paying for. So far no attempt has been made to
claw it back from him – only UBS, the Swiss bank, has managed to
reclaim some past bonuses from its former executives.

For hedge funds and medium-sized companies, the incentive problem might
be a simple governance issue between private entities free to choose
their contract terms. However, when it comes to banks and other “too
big to fail” entities, the problem is severe: we taxpayers in our
respective countries are funding these global monsters and are coughing
up money for mistakes made by bankers who retain their bonuses and are
hijacking us because, as we are discovering (a little late), banking is
a utility and we need them to clean up their mess. We, in fact, are the
seller of that free option. We should claim it back.

The Obama administration has been trying to set compensation limits for
banks under the troubled asset relief programme. But this is
insufficient. We need to remove the free option. Beware the following
situations.

First, those who are taking risks even outside Tarp or society’s
protection can still be gaming the system – since their risk-taking can
result in a collapse, with the taxpayer having to step in. For
instance, Goldman Sachs, the US bank, might want to avoid the limits on
executive compensation for its managers. That should be fine so long as
society does not have to bail out Goldman Sachs (or, worse, its
creditors) in the future.

Second, Vikram Pandit, Citigroup’s chief executive, while claiming to
want to earn one single dollar a year in compensation unless the bank
returns to profitability, is still getting a free option given to him
by society. He does not partake of further losses; we do.

Third, leveraged buy-out companies used the free option by borrowing
heavily from the banks and taking monstrous risks: they get the upside,
banks (hence we taxpayers) get the downside. These partnerships made
fortunes in the past on deals that society will have to bail out. They
too should have their past profits clawed back.

Indeed, the incentive system put in place by financial companies has
produced the worst possible economic system mankind can imagine:
capitalism for the profits and socialism for the losses.

Finally, I was involved in trading for 21 years and I can testify that
traders consciously play the free option game. On the other hand, I
worked (in my other job as risk adviser) with various military
organisations and people watching over our safety. We trust military
and homeland security people with our lives, yet they do not get a
bonus. They get promotions, the honour of a job well done and the
disincentive of shame if they fail. Roman soldiers signed a sacramentum
accepting punishment in the event of failure. This is prompting me to
call for the nationalisation of the utility part of banking as the only
solution in which society does not grant individuals free options to
look after its risks.

No incentive without disincentive. And never trust with your money
anyone making a potential bonus.

The writer is distinguished professor of risk engineering at New York
University and the author of The Black Swan: The Impact of the Highly
Improbable

This is an essential point.  In all thediscussion about what Obama
should do, we need to keep this one point in mind.  Banking serves
a utility function, not unlike an elctrical utility.  Utilities
are regulated because people die if they fail.  The economic
collapse already is killing Americans.  We are stuck because
certain banks are too big to fail. 

It does not have to be that way.  Separate out the utility
function.  Have banks that do only that.  Take deposits and
make loans.  Regulate them, the way you would regulate a
utility.  If someone else wants to gamble, invest in the stock
market, whatever, then fine.  Do that.  But not with a
bank. 

Comments

  1. #1 stumpy
    February 26, 2009

    sounds like communism

  2. #2 t-money
    February 27, 2009

    Yes, Stumpy, his call for nationalizing the utility function of banks is communism.

    In the same sense that national highways are communism. In the same sense that federal food and drug regulation is communism. In the same sense that strict regulation of electric, water, and telecommunications industries is communism.

    I call Shenanigans and/or Troll.

  3. #3 stumpy
    February 27, 2009

    I meant to say “communistic”, and I wasn’t being ironical either.

  4. #4 Joseph j7uy5
    February 27, 2009

    Stumpy and I have a long-running semi-dialog. Running since 1987, I think. Or was it 1988?

    We live in a country with a mixed economy. When it is working, it has the right balance between capitalism and socialism.

    Right now, the balance is off. I think Stumpy’s point is that we need to accept this, and ignore the name-calling.