End Bonuses for Bankers

 

Takeaway

  • Bonuses are problematic because they invite bankers to game the system by hiding risks
  • They also make the economy less efficient by giving the most talented people an incentive to become traders rather than start new businesses

Nassim Taleb (famous for The Black Swan) recently wrote an interesting op-ed piece in The New York Times titled “End Bonuses for Bankers.” He summed up his thoughts in his first sentence: “I have a solution for the problem of bankers who take risks that threaten the general public: Eliminate bonuses.”

Here were his thoughts (followed by a few of mine):

  1. “Any person who works for a company that, regardless of its current financial health, would require a taxpayer-financed bailout if it failed, should not get a bonus, ever.”
  2. The issue is not income inequality or fairness. “The greater problem is that it [bonuses] provides an incentive to take risks.” Bonuses have an asymmetric nature — heads I win, tails you lose.
  3. “Bonuses are particularly dangerous because they invite bankers to game the system by hiding the risks of rare and hard-to-predict consequential blow-ups.”
  4. “Consider that we trust military and homeland security personnel with our lives, yet we don’t give them lavish bonuses.” He continued by saying, “The question of talent is a red herring: Having worked with both groups, I can tell you that military and security people are not only more careful about safety, but also have far greater technical skill, than bankers.”
  5. We feel safer when we align the agent’s interest with the principal’s interest. We want a builder to be responsible if a house fails, we want to know that the pilot faces the same risks as the passenger and we want the chef to taste the food.
  6. “What would banking look like if bonuses were eliminated? It would not be too different from what it was like when I was a bank intern in the 1980s, before the wave of deregulation that culminated in the 1999 repeal of the Glass-Steagall Act, the Depression-era law that had separated investment and commercial banking. Before then, bankers and lenders were boring ‘lifers.’ Banking was bland and predictable; the chairman’s income was less than that of today’s junior trader. Investment banks, which paid bonuses and weren’t allowed to lend, were partnerships with skin in the game, not gamblers playing with other people’s money.”

My Thoughts

Amen, brother. I agree with Taleb — we can’t give people incentive to take risk (in order to obtain huge bonuses) and have the risk borne by others. But, to me, there’s also another issue at play — one that I’ve discussed before.

Many of our very best students from business school go to the big banks. It makes sense — it’s their best chance to maximize their wealth in the shortest time period (and also get great experience). Unfortunately, this leads to a much less efficient economy.

Would you rather have 100,000 of our smartest people enter banking or enter industry / start businesses? In other words, where is the value creation — is it in starting and running a company or is it in raising capital, creating securities and trading those securities? If we’re going to have the type of long-term growth that we need in the future (in order to re-employ people), it’s going to happen because our smartest and most aggressive people start businesses, manage existing businesses and help us compete. It’s not going to happen by giving people the incentive to become traders.

Of course, this type of social planning isn’t a justification for stopping bonuses. But, it would be a nice side benefit to Taleb’s solution for managing risk.

McCombs Senior Lecturer Sandy Leeds provides analysis of key market issues on his blog, Leeds on Finance, where this article originally appeared.

Disclaimer

The views expressed are those of the author and not necessarily The University of Texas at Austin.
 

About The Author

Sandy Leeds

Distinguished Senior Lecturer, Department of Finance, McCombs School of Business, The University of Texas at Austin

Sandy Leeds, CFA is a Distinguished Senior Lecturer at The University of Texas at Austin. He teaches graduate level classes in the MBA program and...

Comments

#1 Fantastic insights. Would

Fantastic insights. Would re-instating Glass-Steagall force this kind of change, or would this transformation require more than a regulatory solution?

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