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
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 that incentive scheme that got us in the current
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
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
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