When Bonuses And Bailouts Mix

Nassim Taleb wrote an interesting op-ed in the NYT about bonuses in banking. I’ve taken the liberty, below, of boiling it down.

Pairing big bonuses with “too big to fail” has lead to catastrophe. The change needed to stop bankers from taking risks that threaten the general public is to eliminate the bankers’ bonuses.

Bonuses in banking are incentives to take risks. The bonuses encourage bankers to game the system by hiding the risks of rare and hard-to-predict but consequential blow-ups. For bankers, there’s a bonus if they make short-term profits and a bailout if they go bust, violating the effect of liability that’s so fundamental to capitalism.

The promise of “no more bailouts” in last year’s Wall Street reform law, is just that – a promise. The financiers (and their lawyers) always stay one step ahead of the regulators. And financial institutions are still blowing themselves up; look at MF Global and Jon S. Corzine.

Anyone working 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. In fact, all pay at systemically important financial institutions like big banks, some insurance companies, and even huge hedge funds should be strictly regulated.

We trust military and homeland security personnel with our lives, yet we don’t give them lavish bonuses. They get promotions and the honor of a job well done if they succeed, and the severe disincentive of shame if they fail.

Banning bonuses would go a long way in reducing the separation between an agent’s and his client’s interests. Nearly 4,000 years ago, Hammurabi’s code specified: “If a builder builds a house for a man and does not make its construction firm, and the house which he has built collapses and causes the death of the owner of the house, that builder shall be put to death.”

The Babylonians understood the builder will always know more about the risks than the client, and can hide fragilities to improve his profits, by cutting corners in the foundation, for example. The builder can also fool an inspector; the person hiding risk has a large informational advantage over the person trying to find it.

From 2000 to 2008 there was a very large accumulation of hidden exposures in the financial system. But, 2010 brought the largest bank compensation in history. Supervision, regulation and other forms of monitoring are necessary, but are insufficient considering the Federal Reserve insisted, as late as 2007, that the rapidly escalating subprime mortgage crisis was likely to be “contained.”

What would banking look like if bonuses are eliminated? It wouldn’t be too different from what it was like in the 1980s before the gutting of regulations, culminating in the 1999 repeal of the Glass-Steagall Act, the law separating investment and commercial banking. Back then, bankers and lenders were boring “lifers.” 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.

Hedge funds, which are loosely regulated, could take on some of the risks that banks would shed. While we hear about the successful hedge fund, the great majority fail without making the front page. Typically, their investors manage the governance and ensure the manager is hurt more than any of his investors if there’s a blowup.

Simple processes are necessary for some complex problems. So instead of thousands of pages of regulations, we should enforce a basic principle: bonuses and bailouts should never mix.