How bank bonuses let us all down

http://www.ft.com/cms/s/0…0077b07658.html

More from Nassim Nicholas Taleb (See prior at tag nassim-taleb) on our current system that fosters the “free option,” which is most easily summed up as, “Heads I win, tails you lose.”

NNT has previously argued that our banking system is built to blow up, and how can you argue with the reality that banks steadily earn profits for years only to suddenly blow up, losing all past profits and more?

Why does this happen? I think there are two reasons, only one of which gets press generally. The other is at the root of Taleb’s discussion on a broken incentive structure (free options).

The widely accepted and discussed reason for our current mess is leverage — a.k.a. credit. By way of a simple example of the power of leverage, in a booming housing market, leverage enables a homeowner to turn little-to-no-equity into a hefty profit ($10k down, $90k loan to buy a house; sell in two years for $150k and you made 500%!). However, when that housing market goes bust (or even just stops booming), the levered homeowner suddenly can’t cash out or see his minimal equity position wiped out. Since he has little skin in the game, he lets the loss go fully to the bank. We are now seeing this happen en masse.

Heads I win. Tails you lose.

It is the same with banks, except in a monstrous, centralized, global, and ridiculously more complicated (thanks to derivatives) way.

So it is becoming widely understood how credit and leverage can muck things up.

The less (or not-at-all) acknowledged problem is our corporatist legal system whereby businesses can incorporate and separate personal loss from business loss. By default, creating a corporation is essentially creating a public negative externality. How so? Well, a corporation can only bear the cost of its failures to the extent of the capital invested. So even without any leverage, the corporation is incentivized to take on more risk than it has capital to cover in order to maximize profits. When times are good, this is incredibly profitable. When times are bad, corporations go bankrupt even as the CEOs and risk-taking managers who messed up get off with their wages and bonuses!

Tack onto this corporatist system the aforementioned system of leverage you key a system built to blow-up.

Despite all of the free option discussion, I’m not sure NNT understands the bald-faced simplicity of the problem of severing risk from loss. However, Taleb hints at a clearcut understanding when he makes mention of Roman soldiers. Soldiers have skin in the game – their lives. If they screw up, they risk their own life. When a CEO of a corporation screws up, they risk the wealth of their investors and that of general stakeholders in the event that their screw-up pushes waste onto society.

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. . . .

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. . . .

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. . . .

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.

Nassim Nicholas Taleb: “Bankers Designed Banks to Blow Up”

http://www.bloomberg.com/…mMd4PSxEKeE.asf

Just watched a fifteen minute interview by Bloomberg of Nassim Nicholas Taleb (The Black Swan). In the interview Taleb discusses the current crisis, robust systems, nationalizing the banks and the fallacy of using narratives of history to guide present-day policy/response.

Below are some quotes from NNT, which I’ve organized into like-nuggets of wisdom:

  • Looking at biology, things that survive have redundancy . . . we have spare parts, which is the exact opposite of leverage. . . . We have diversity and nothing is too big. Things fail early. . . . Banking is organized in a completely opposite way. . . . Complex systems have properties that banks don’t have. And biological systems have survived.
  • [We have an] Illusion of stability and then blow-ups are larger. Imagine if half-country was fed by one restaurant it’d be okay except one day people would starve.
  • Bad news travels immediately . . . This environment won’t tolerate the smallest mistake . . . I don’t know the system can allow for too much leverage.
  • People can invest in real things – they don’t have to invest in paper. . . .
  • What we have is a system of deposit where people buy a company, they borrow against it, and buy another company. . . . If that disappears we have less growth but it would be a more robust economic system.
  • The government is neither nationalizing the banks nor letting them break.
  • [With regard to banking,] separate the payment system from the risk taking system.
  • It looks like we have no control. The government has no control over what the banks are doing. The banks aren’t in control of what they are doing.
  • The press reports everything except the important stuff. September 18th . . . we had the run on money market funds and the government had to step in.
  • The situation is not comparable to the Great Depression. The situation is very different.
  • This crisis is not so much a Black Swan to me. It’s like saying you’ve got a pilot who doesn’t know about storms. . . . The Black Swan for me would be to emerge out unscathed and go back to normalcy.
  • We should be very careful when we make a historical analogy like the Great Depression because the world is not like it was in the Great Depression.
  • Capitalism is you let what’s breakable break fast.

Bloomberg also ran an article on the interview with Taleb, but it is spartan as far as quotes or insights from the actual interview.

From what I can tell, it seems Taleb views bank nationalization as similar to taking out plane hijackers. It’s an interesting, more palatable way to look at nationalization in that it frames the situation as one where the public will be harmed unless someone (in this case the government) steps in and takes drastic action.

Having said that, I don’t get the impression that Taleb is a proponent of long-term nationalization. NNT would prefer banking be structured similarly to a biological system where there are redundancies and fragile things “break early.” This system wouldn’t foster as much leverage and therefore would slow growth, but it would be considerably more robust.

This is more or less what I believe, as well. A free market is an organic, naturally forming system that is decentralized and redundant. It’s robust because market actions failing apart at any micro level will not break the entire system.

How do we get there from here? Good question.

(H/T to Jesse)