Gene Expression

Shoot the bankers in the knees?

How bank bonuses let us all down:

…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.

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.

One of the issues that comes up in predictions about political prospects is that the party in power tends to be buffeted by the business cycle, and receives both the credit and the blame, even though they may only control the dynamic to a modest extent. In this way many of the large financial firms resembled governments; they blew up on the bubble, and now with the collapse it’s rather clear that they didn’t add all the value that they claimed. But as readers have pointed out on an individual level those who received windfalls through a winner-take-all-system have no incentive to avoid risks. I think the chance of non-trivial clawbacks is close to zero (I’ll be happy to be proven wrong!).

The contrast with entrepreneurs is telling. The .com bubble & burst was tragic, but it did produce notable technologies, the seed of later gains in economic productivity. The asset and finance bubble seem unlikely to generate the same positive externalities in the wake of correction of irrational exuberance. But all that being said, even though we are moving past an age of massive economic parasitism due to principle-agent problems the potential engines of productivity through innovation remain. There are still entrepreneurs, and with the shrinking of the financial industry the pool of those who engage in the real game of risk and reward is increasing in size.


  1. #1 Greg Laden
    February 25, 2009

    This is totally an agency problem, and can be solved using market forces. We just need to introduce a market whereby you buy yourself a lottery ticket for a kneecapping a part of the bonus structure.

  2. #2 razib
    February 25, 2009

    well, kneecapping is kind of either/or. there are tweener levels of losses. how about simply cutting fingers proportionality to the losses? i.e., 100 million dollar = 1 finger? 1 billion = all fingers? then you can move to kneecaping.

    of course, the romans practiced decimation in their army, and ended up conquering the known world…. how’s that for an “incent”?

  3. #3 John Emerson
    February 25, 2009

    Looting: the Economic Underworld of Bankruptcy for Profit. A full version of this exists somewhere, but I can’t find it.

    The perverse incentives of our economic institutions have been understood for a long time, but nothing was done, mostly because a lot of people were on the gravy train and both parties were cashing in.

    But all that being said, even though we are moving past an age of massive economic parasitism due to principle-agent problems the potential engines of productivity through innovation remain. There are still entrepreneurs, and with the shrinking of the financial industry the pool of those who engage in the real game of risk and reward is increasing in size.

    This seems too optimistic, more the definition of a hope or a goal than a reasonable expectation.

    I think that deregulation, promoted by most but not all Republicans and about half the Democrats, was a big part of the problem.

    Hopefully free-marketers will now sober up and try to understand the requisites of a healthy free market system, rather than just setting the market against the state and doing as much as possible to sabotage, discredit, and sabotage the latter.

    Actually, I wish that freemarketers would just put paper bags over their heads and shut up for about five years, but you can’t always get what you want.

  4. #4 Thorfinn
    February 25, 2009

    Another interesting principal agent problem is the bank capital structure. Asking banks to hold a certain amount of capital in reserve, but never permitting them to wear that capital down, is a somewhat puzzling policy and one that generates significant incentives to ‘cheat’ during a boom. Analogously, the solution for a homeowner who faces a small chance of fire is not to keep a portion of the value of the house in reserve, but to get fire insurance (especially if he is likely to raid that fund); similarly for banks. A proposal by Rajan (who called out the problems of bad incentives and tail risks years ago) would force banks to take on capital insurance, to be paid out during a crisis.

  5. #5 Thorfinn
    February 25, 2009


    Can you name any acts of financial deregulation that happened during the Bush administration? The last that I can recall is the repeal of Glass-Steagall under Clinton–and the impact of that is highly mixed. It’s worth noting that European countries–with drastically different regulatory regimes–are also facing severe problems with their financial companies. The European countries which saw asset booms do, however, share with the US high current account deficits, and EU-wide monetary policy was loose for these areas as well.

  6. #6 Dunc
    February 26, 2009

    The other problem that you have to consider is that the people who designed the incentive systems were largely the people benefiting from them. Why would any sane person design a system that would expose them to to a risk of “non-trivial clawbacks” if they didn’t have to? The asymmetry of risk and reward was a feature, not a bug, as far as the people designing the system were concerned.

  7. #7 John Emerson
    February 26, 2009

    Rhetoric and impaled bankers: a revolutionary new trolley-car paradigm, together with an introduction to problematology. 600 words.

  8. #8 John Emerson
    February 26, 2009

    I don’t think that anyone else thinks of the Glass-Steagal results as mixed. People think that was a disaster. It may be true that there were initial good outcomes, but these are now called “The Bubble”.

    Ireland and Iceland are very hard hit, and they were free market success stories two years ago. Canada did not move in that direction, and they seem to have escaped some of the worst of it.

    When the world system collapses, obviously everyone suffers. So far Iceland is by far the worst hit, and Canada seems to be among the least hit. Deregulation and neoliberalism have been progressing everywhere in the world during the last 28 years or so, but at uneven rates.

    As far as Bush goes, he probably neither regulated nor deregulated nor enforced existing regulations. In the face of new and treacherous financial developments, he did nothing. Probably Greenspan is the biggest villain, but Bush did nothing good.

  9. #9 James
    February 26, 2009

    What “notable technologies?” All the software was in place before the bubble. The rest was either hype or just the inexorable improvements in chip fabrication that really had nothing to do with the bubble per se but rather were a contributing cause of it, eg. higher bandwidth networks.

  10. #10 greigos
    February 26, 2009

    Is the problem actually incentives for individual bank managers? My impression is that there are huge risks associated with failure to choose profitably for the organization: missed promotions, demotions, bad reviews, tricky office politics, within office shunning, firing, etc. No one wants a tarnished reputation.

    From my point of view, the problem appears to be the spreading of risk to others through derivative instruments, giving a false sense of security that apparently increased tolerance for risk to the point of recklessness.

    I am reminded of comments by a safety engineer for the auto industry who was dismayed to see the national death toll for auto accidents essentially remain the same with each new advance in safety. Drivers simply increased the amount of risk they would accept. His suggestion? Put an 8 inch spike in the middle of the steering wheel pointed directly at the driver.

  11. #11 John Emerson
    February 26, 2009

    There have been a lot of suggestions for improvements which in various ways would have greatly reduced risk — e.g., linking bonuses to five-year performance rather than annual performance. (Someone who worked only one year would get a bonus four years later based on the five-year performence of his buys/sells.) Forbidding some kinds of short-selling was another. A different kind of accounting was another. As far as I know, all of these were suggested before the plunge, but there was a lot of resistance. The mood was anti-regulation, and a lot of the players lobbied actively.

  12. #12 Thorfinn
    February 27, 2009


    Wachovia, WaMu, etc have done poorly while the unified banks BofA, Citi, etc. have held up relatively well. The ability of investment banks to get commercial operations saved Goldman Sachs. Some evidence suggests that unified banks are better. I’m not convinced either way but I don’t think the road to financial ruin starts here.

    I think it’s a mistake to equate “free markets” with financial deregulation, and take Bush’s rhetoric on the former to be proof that he actually held a financial deregulatory stance. In reality he espoused the rhetoric of free markets while doing the exact opposite and destroying the credibility of free markets (regulations actually increased during Bush–SOX among others). Maybe you think he should have regulated more (I do), but that’s different from saying that ‘liberalization’ has ruined us.

    Ireland doesn’t appear to me to have especially deregulated banks. They did, however, have the greatest deviation from the ‘taylor rule’ in terms of monetary policy and also tax housing much less (Clinton also reduced taxes on housing). The link between financial flows, monetary policy, and housing taxes on asset prices (and banker incentives and subsequent collapse) is clear. Deregulation, not so much.

    BTW, it’s worth noting that a substantial portion of banker compensation came in the form of company equity–which people generally hold for years and should give people some incentive to care about the future. Bear Sterns was notorious for this, but it doesn’t seem to have tangibly reduced their propensity to take on risk. It may be more effective to reduce the incentives to take on risk at the economy-wide level by not reducing interest rates to that degree and taxing capital equally.

  13. #13 John Emerson
    February 27, 2009

    Free marketers were holding Iceland and Ireland up as free market paradises only a year or two ago, and now those two countries are basket cases. (Iceland is documented at my URL). I know less about Ireland, but Iceland had an out-of-control, unregulated finance sector. Whether there was deregulation per se I don’t know; there was definitely a failure to regulate.

    My context in talking about this stuff is that I think that we’re going into the hardest times since WWII because something big went wrong. I have my ideas about what. You don’t seem to be dealing with the magnitude of the collapse. You seem to be talking as though this is one of those periodic recessions we’ve always had and we can compare one bank to another, etc. It’s really a system collapse.

    All bets are off and all the cards are on the table. I don’t think that the free-marketers and neoliberals are going to come off very well, nor is the economics profession. If you disagree, you’re going to have to propose a different idea of what happened and what to do, because this is big enough to shock people out of their routines. My take from the economists I read is that they’re all scared and are scrambling improvising what to do.

    So really, it’s an all new ball game and if you guys (I assume you’re an ideological free-marketer) can make your case you can win a lot. Something is going to have to change. But you have to make your case.

  14. #14 Tom Bri
    February 27, 2009

    I recall Bush wanting to re-regulate Fannie and Fredie. He didn’t try very hard though, and a few unkind words from the Dems in Congress and he folded. Pretty much his entire domestic legacy can be summed up that way.

    McCain tried to claim credit for sounding a warning on Fannie and Fredie during his run last year. The news industry wasn’t interested.

    This is very much a bi-partisan political failure as much as it is an economic one. Our noble betters want to keep their personal gravy trains more than they want a good economy. For Democrats the last eight years has been one long fight to ruin the economy, for their electoral benefit. The great mystery for me is why the Repubs went along with it. Just stupid, I guess.

    As for free market vs. anti free market, you will have to show me a few examples in history where greater regulatory control has resulted in greater long-term economic benefit.

  15. #15 Thorfinn
    February 27, 2009


    I’ll agree that the economy is in bad shape, but I really see this crisis as the result of overall macro policy gone awry. Greenspan has been goosing the money supply for years (first out of fear from LTCM, the Asian markets, then deflation, then…). The impact of large capital flows and low interest rates causes bankers to search for yields where they can find them, and forget about risk. This is a Hayekian misallocation of capital, and the resulting shocks are not so different from the regular wave of financial panics that we feel every ten years or so. I agree this should be fixed and I can stomach any degree of further regulation if it helps; but the systemic, widespread, and common nature of these financial problems to me suggests underlying causes that are perhaps easier fixed through monetary base and capital restrictions.

    America recovered eventually from the Great Depression–but bad monetary handling hurt, as did extreme policy shifts. In the end, America went back to the long-term growth line, and are probably no worse off because of it. Dozens of countries, however, took a cue that free markets were not the answer, and we ended up with horrible planning policy worldwide. The duration and scale of the problem, combined with our relative ignorance of the causes, for me militates against fear-mongering and large-scale technocratic meddling with the economy,

  16. #16 ChristianK
    February 27, 2009

    Nassim Taleb, the writer of that article started a facebook group to further discuss how we can make bankers accountable:

  17. #17 John Emerson
    February 27, 2009

    Thorfinn: You can call it fear-mongering if you want, but unfortunately it’s accurate. Talk to me in three years.

    Fannie Mae and Freddy Mac were not the biggest part of the housing bubble, and the effects of the housing bubble was magnified by leveraging. That’s why the stock market’s loss of value, close to 50%, was substantially greater than housing’s loss of value.

    Tom, it’s effing stupid to claim that the Democrats were responsible for things that happened when Republicans controlled both House of Congress and the Presidency. I’m not even sure you’re right about the issue, and as I just said, Fanny Mae was only a medium sized part of the problem.

    Most Republicans and many Democrats have been pushing deregulation of finance and everything else for decades, and I don’t think that any of them are going to come out looking good.

    As I’ve said, this all wide open now. But you’re going to have to make your points, not just repeat slogans and blame others, because (fear-mongering alert) we have a massive problem, and people are soon going to be completely unreceptive to ideological chat.

  18. #18 JM
    February 28, 2009

    Thorffin: “it’s worth noting that a substantial portion of banker compensation came in the form of company equity”

    You’re off with the pixies. Directors compensation is strongly linked to stock (but even there a lot is in the form of options which only have a weak relationship to long term performance). Lower down, bonus’s are the primary if not the only form of incentive (although some banks such as the zombie Japanese banks did/do place a strong emphasis on stock)

    But. Haven’t you read the papers? Multi-billion dollars in bonus’s reported every day amounting to very substantial fractions of the company worth – are you saying that stock holdings by trading employees dwarf those bonus’s? Not true, it just isn’t true.

    One thing I think you’re missing here is the change in the structure of the investment banks from partnerships to public companies. In partnership structures retiring partners (ie. the people who previously earned the bonus’s on short term performance) retain (and are required to retain) an equity interest. In the event of trouble they can then be tapped for capital injections.

    In public structures they just take the money and run. Exactly the same thing happened during the 20’s/30’s when Goldman Sachs sold part of itself off to the public and promptly came unstuck.

    I also disagree with your earlier comment re. the utility of capital reserves vs. insurance. The immediate function of capital reserves is to limit the creation of credit to some reasonable degree of leverage. Substituting insurance would simply allow infinite creation of credit and would be much, much more dangerous.

    Besides, what do you think a CDS is if it isn’t insurance? Besides being at the center of the disaster that is. Your proposal would have made things a great deal worse.

    The normal incentive when I buy (say) household insurance is that I have the same motivation as the insurer – to avoid loss (emotional reasons for me, financial for the insurer) and our interests are aligned.

    In a CDS (or any type of policy that insures against market loss) my interests are opposite to those of the insurer. I don’t care about a loss making deal as someone will make me whole, which gives me free rein to pursue profit no matter what the risk.

    In fact if I buy a CDS and structure my portfolio just right I have a positive incentive for the thing to pay off and can apply financial pressure on the reference security to ensure that I win.

  19. #19 Tom Bri
    February 28, 2009


    I believe my point was that both the Dems and Repubs are complicit in the recent troubles. The Repubs because they are stupid and venal. The Dems because they knew that with Bush in the White House nothing they did would come back to them. They could vote for any damn thing they wanted and face no consequences politically.

  20. #20 John Emerson
    February 28, 2009

    My suspicion is that when you look at the whole range of the case (not specifically Fanny Mae, etc. which was only a medium-size part) some of the Democrats (the less neoliberal / less deregulationist / more old-fashioned ones), together with their fellow spirits out side the party, are going to look better than the rest.

    But I’ll say it again: most of us have been chatting about ideology for much of out lives. But I think that this downturn will be, for better or worse, a massive game changer, meaning that our old slogans won’t be any good any more. People are going to have to go down to the bottom and start over. And whoever does that the best should win.

  21. #21 Thorfinn
    February 28, 2009


    The value of stock compensation programs is higher the greater the stock price is in the future, and bankers have lost a substantial portion of their net worth held in company equity. It may be true that bankers are still better off relative to a world in which everything is privately owned (Ibanks would certainly have been better off private and without a daily barometer of trust); my point is that existing compensation packages still contain sizable incentives to think long-term, and that did not seem to help. It suggests to me that denial rather than fraud looms larger, and bankers were respnding to environmental incentives. So while clawback programs, etc. are undoubtably important, I also worry about regenerating those same overall conditions.

    As for capital insurance, many of your objections were dealt in the original proposal. It would only pay out in response to a general (not bank specific) collapse, and leverage restrictions can be applied. Capital reserves function to give banks a cushion against losses, but minimum capital requirements prevent banks from really using money this way (creating solvency crises) and they are incentized to cheat and under-save in good times. Having dedicated money available in the event of a crisis makes more sense to me (though it may cause additional problems).


    Housing losses were substantial! When you lose five trillion dollars in housing wealth, households feel poorer and cut consmption by hundreds of millions, while the banks have serious balance sheet problems. Clearly leverage amplified the problem, and should be reduced, but levering up was also the rational response of banks to make money in a world of cheap credit. I’m not anti-regulation here–more leverage requirements are desirable. But I’m skeptical about the capacity of regulation to fully prevent any sort of future risky activity when regulations just failed at this task worldwide. You can tell banks not to lever up–but if it was in their interest (as it was) they took on off-balance sheet obligations. Limiting the monetary base limits the desire of people to make these kinds of bets and take these risks in the first place.

New comments have been disabled.