The Point of [No Risk and] No Return

End Bonuses for Bankers

By NASSIM NICHOLAS TALEB

Published: November 7, 2011

I HAVE a solution for the problem of bankers who take risks that threaten the general public: Eliminate bonuses.

I have a solution for the problem of declining newspaper circulation: stop publishing this sort of tripe.

More than three years since the global financial crisis started, financial institutions are still blowing themselves up.

Bankruptcies are part of the rejuvenation intrinsic to the business cycle. This is particularly true in an environment of prolonged recession that has been characterized by central planners’ attempts to divorce cause from effect.

The latest, MF Global, filed for bankruptcy protection last week after its chief executive, Jon S. Corzine, made risky investments in European bonds. So far, lenders and shareholders have been paying the price, not taxpayers.

Lo and behold, the market is working as it should. It’s also worth noting that Corzine is a Democrat, and also probably guilty of fraud.

But it is only a matter of time before private risk-taking leads to another giant bailout like the ones the United States was forced to provide in 2008.

The United States was forced to provide a bailout in 2008? If memory serves, the government was the one forcing the banks to take a bailout because an unpopular sitting duck president and a Congress in the throes of a political dust-up decided that the risks of inaction were a greater threat to their legacy than the risk of failed policy.

The promise of “no more bailouts,” enshrined in last year’s Wall Street reform law, is just that — a promise.

While I believe that a promise from a politician to a constituent ranks somewhere below “iron-clad,” the solution is to make bailouts and crony capitalism so politically poisonous that no politician could do it and retain their job. By blaming banks for the bailout—indeed by claiming that the banks forced government’s hand—you have absolved all responsibility from our public officials. Congratulations, Taleb. In a mere paragraph you have a) shown historical illiteracy of events that happened a mere three years ago, b) misdiagnosed the problem, c) blamed the wrong people for the problem, and d) given poorly thought-out cover to those who are actually responsible. Is “quadfecta” a word?

The financiers (and their lawyers)

We hate financiers enough without bringing lawyers into it. Let’s not incite another OWS riot, big guy.

will always stay one step ahead of the regulators.

Despite acknowledging that there will always be a way around regulations, he proposes more regulations. Fucking brilliant.

No one really knows what will happen the next time a giant bank goes bust because of its misunderstanding of risk.

We do indeed live in an uncertain world. Trying to protect from the infinite possibilities of existence will have you shadowboxing in no time (this is Mr. Taleb’s fundamental misunderstanding of the difference between uncertainty and risk). The public policy question is much simpler: what should happen? The answer is simpler, too. The firm should enter bankruptcy court and liquidate assets where necessary to emerge as a fiscally solvent entity.

Instead, it’s time for a fundamental reform: Any person who works for a company that, regardless of its current financial health, would require a taxpayer-financed bailout if it failed,

I could make a very good argument that this either applies to either no companies or to all companies. This standard is purely asinine.

should not get a bonus, ever.

In this instance, compensation will either occur in other, less transparent ways, or talent will flee these industries. Get ready for a world where your bank’s employees are all compensated like the IRS.

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

Why is it that despite the demonstrable financial inefficiency of literally every governmental agency ever created (military included) that Mr. Taleb’s particular class of morons still insist on turning our most profitable and functional industries into extensions of the government bloat?

Critics like the Occupy Wall Street demonstrators decry the bonus system for its lack of fairness

Which is, on it’s face, laughable. Wall Street bonuses are the purest form of fairness still in existence in America. The better you perform—as judged by the stone-cold metric of profit—the more you make. Period.

and its contribution to widening inequality.

Stop pretending like the OWS protesters are people with policy goals; they’re a mob of malcontents with the corresponding propensity towards violence and incoherent rationalizations.

But the greater problem is that it provides an incentive to take risks.

Bonuses do not provide an incentive to take risks. All risks have downside. That feature is encapsulated nicely in the definition of risk. Performance-based compensation provides an incentive to succeed. While greater risk carries a greater chance of huge returns, it also carries a greater chance of poor performance reviews, socially stigmatizing derision, and sleeping in a cardboard box.

The asymmetric nature of the bonus (an incentive for success without a corresponding disincentive for failure)

The disincentive is a lack of pay, lack of status, and eventual termination, you colossal jackass. The bonus is the carrot. The stick comes from the boss when he realizes that your portfolio has performed 53 basis points under market averages over the last three years and boots your ass while trying to stifle a giggle as you plead through your job through gasping sobs.

Wow. That got dark.

causes hidden risks to accumulate in the financial system and become a catalyst for disaster.

Counter-party risk in derivative contracts were indeed undervalued in the models that led up to the 2008 crash. I fail to see how the modeling shortcomings of a few analysts somehow subordinates the entire financial sector to the federal government or invites nationalization.

This violates the fundamental rules of capitalism;

The bailouts violate the fundamental rules of capitalism.

Nationalizing the banks violates the fundamental rules of capitalism.

Regulating employee compensation violates the fundamental rules of capitalism.

Compensating employees based on performance-based metrics does not—in any conceivable form—violate the fundamental rules of capitalsm.

Adam Smith himself was wary of the effect of limiting liability, a bedrock principle of the modern corporation.

If you want to eliminate bankruptcy proceedings and reinstate debtors prisons, and low usury interest rate ceilings, you’re welcome to present an argument, but for most of us, those issues were settled even before the issue of American slavery.

Bonuses are particularly dangerous because they invite bankers to game the system by hiding the risks of rare and hard-to-predict but consequential blow-ups,

You speak, of course, about the agency problem as it pertains to risk. This is a relevant and sober topic that corporations have worked to minimize for decades. Yet you believe that the solution is to compensate the men with their hands on the switches of the global economy like a DC paper-pusher. Not only does this asinine “solution” have the dubious honor of not solving the agency problem it was specifically designed to address, but by legally prohibiting compensation for financial professionals commensurate with their responsibilities and competence, it encourages the outsourcing of an entire industry worth trillions of dollars and hundreds of thousands of jobs. In short, fuck you, Mr. Taleb.

which I have called “black swan” events.

The irony of promoting your own book while undermining the capitalistic system makes me want to punch a swan out of spite. See, jackass? It’s the swan that bears the consequence of your shamelessness.

The meltdown in the United States subprime mortgage market, which set off the global financial crisis, is only the latest example of such disasters.

This is an academic’s smarmy way of saying “shit happens.”

Consider that we trust military and homeland security personnel with our lives, yet we don’t give them lavish bonuses.

The military is a lifestyle, not a job. Soldiers are often contractually compelled to continue service. Quitting will get them jail time. Likewise, not obeying orders will get them jail time. That combination is a pretty damn big stick that market-based employers don’t (and can’t and shouldn’t) have.

They get promotions and the honor of a job well done if they succeed, and the severe disincentive of shame if they fail.

This is why the military (and for that matter, the police force as well) is more of a vocation than a profession. Priests aren’t compensated by market factors. Social workers, artists, and writers are all usually undercompensated by virtue of their qualifications (most have postgraduate degrees), yet there is no shortage in any of these fields because they are intrinsically rewarding. Banking, however, is not.

For bankers, it is the opposite: a bonus if they make short-term profits

It is reasonable that bonuses should reflect a longer period of time, but this isn’t exactly a matter of public policy. That’s between employer and employee.

and a bailout if they go bust.

I still don’t understand how the bailout is a fait accompli when virtually everyone acknowledges that it is unfair crony capitalism and very few believe that it worked to alleviate the impact of recession.

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.

That’s not what talent actually means. The military does not recruit talent. It creates it through massive training organizations because it is divorced from the profit motive. Private industries have to hire talent—often from the military—because training is cost prohibitive.

The ancients were fully aware of this upside-without-downside asymmetry, and they built simple rules in response.

So why, instead of re-instating a downside, are you instead eliminating the upside?

Nearly 4,000 years ago, Hammurabi’s code specified this: “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.”

Which, in Ancient Wherever-The-Fuck, caused the great housing bubble of 2000BC as building prices ballooned. This principle hasn’t been abandoned; we have mountains of tort case law for these situations. Here’s the rub: with few exceptions, the actions of banks--both before, during, and after the housing bust--were neither criminal nor tortious.

This was simply the best risk-management rule ever.

We can’t get liberals to support capital punishment for murder. Imagine trying to put someone for death for mere incompetence (which they generally support).

The Babylonians

I prefer to call Babylon “Ancient Wherever-The-Fuck.”

understood that the builder will always know more about the risks than the client, and can hide fragilities and improve his profitability by cutting corners — in, say, the foundation. The builder can also fool the inspector; the person hiding risk has a large informational advantage over the one who has to find it.

You’ll get no argument from me. The question is not why we should punish poor performance, but why you insist on not rewarding good performance.

Banning bonuses addresses the principal-agent problem in economics:

Yeah. I know. I was talking about this paragraphs ago. Let’s wrap this shit up. I’ve got things to do.

the separation between an agent’s interests and those of the client, or principal, he is supposed to represent. The potency of my

[bat-shit crazy]

solution lies in the idea that people do not consciously wish to harm themselves;

Holy fuck! This dude just cracked the code on the mystery of why self-mutilation isn’t socially acceptable behavior! Let’s give him a Nobel Prize!

I feel much safer on a plane because the pilot, and not a drone, is at the controls. Similarly, cooks should taste their own cooking; engineers should stand under the bridges they have designed when the bridges are tested; the captain should be the last to leave the ship.

Yes, the argument for commensurate consequences is well taken. But you’re not arguing for commensurate consequences. You’re arguing for no consequences. The fact that you’re also arguing for no rewards is, I suppose, logically consistent, but it’s still mildly retarded.

The Romans even figured out how to deter cowardice that causes the death of others with the technique called decimation: If a legion lost a battle and there was suspicion of cowardice, 10 percent of the soldiers and commanders — usually chosen at random — were put to death.

Nothing says “justice” like the cold rationality of arbitrary killings.

No such pain faces bailed-out, bonus-taking bankers.

A more sensitive reader might infer that he’s calling for the death of 10% of bankers.

The period from 2000 to 2008 saw a very large accumulation of hidden exposures in the financial system. And yet the year 2010 brought the largest bank compensation in history.

It’s almost like there was a prolonged, multi-year period in between those two events in which all the other stuff got sorted out. Oh wait.

It has become clear that merely “clawing back” past bonuses after the fact is not enough.

Nothing like passive verbs for issuing blanket statements of unassailable fact. No, Mr. Wizard, it has not become clear at all.

Supervision, regulation and other forms of monitoring are necessary, but insufficient — consider that the Federal Reserve insisted, as late as 2007, that the rapidly escalating subprime mortgage crisis was likely to be “contained.”

Oh come on. The Fed doesn’t exactly use the same language as the rest of us and you know it. They lie all the time so as to not undermine investor confidence.

What would banking look like if bonuses were eliminated?

Bleak and unprofitable.

It would not be too different from what it was like when I was a bank intern in the 1980s,

The time-frame is nothing short of pure hilarity. Go back to the Reagan years by reregulating!

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.

The problem was undervalued risk. That problem would have persisted whether or not commercial and investment banks remained separated.

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.

Thanks for the nostalgia. I’m depressed already.

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.

Again, the argument that there should be skin in the game flies in the face of the assertion that there should be no skin in the game. That is, after all, this article’s central thesis of regulating bankers pay. (For the record, there is nary a whiff of Constitutional justification for this gross overreach of federal authority anywhere. After all, we need new laws to stop all of these violations of non-laws.)

Hedge funds, which are loosely regulated, could take on some of the risks that banks would shed under my proposal.

I agree. But here’s the kicker: there’s no good reason to divorce investment institutions from lending institutions. The risk is still there.

While we tend to hear about the successful ones, the great majority fail and their failures rarely make the front page.

Taleb’s plan: boatloads of underpublicized failure!

The principal-agent problem they have isn’t a problem for taxpayers: Typically their investors manage the governance of hedge funds by ensuring that the manager is hurt more than any of his investors in the event of a blowup.

Now, explain how the principal-agent problem is an issue if you allow firms to go bankrupt. Managers and executives lose their jobs and get a giant black mark on their resumes, impairing future employment. Shareholders (including managers and executives with equity compensation) lose most of their investment. The taxpayers, quite literally, have no place in this event.

I believe that “less is more” — simple heuristics are necessary for complex problems.

No you don’t, you arrogant fuck. You believe that more regulation is more. What’s more, this isn’t a complex problem.

So instead of thousands of pages of regulation, we should enforce a basic principle: Bonuses and bailouts should never mix.

That’s not what you argued. You argued that bailouts are inevitable and that bonuses are nonsensical means of compensation. Bailouts are purely in the public sphere. Bonuses are purely in the private sphere. In order for you to balance your silly little equation, you have decided that the private needs to become public, not that the public needs to stay out of the private. It is in this point, the first one that you made, that you ignored all questions about the proper role of government and discounted the plausibility of effective, minimalistic government in favor nationalization.

You want to go back to the 80s in banking? The hours are 9-5, Monday through Friday, closed all holidays, including arbor day and secretary’s day. Employees are unfriendly and unyielding. ATMs are sporadic and inconvenient. Product lines are thin and uncustomizable. Customer service is a joke. Margins are high because overhead is high. Barriers to entry for new competitors are higher. Congratulations, Nassim Taleb. You’ve turned the most profitable sector in the American economy into the DMV.