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, which I have called “black swan” events. The meltdown in the United States subprime mortgage market, which set off the global financial crisis, is only the latest example of such disasters.
Consider that 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. For bankers, it is the opposite: a bonus if they make short-term profits and a bailout if they go bust. 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.
The ancients were fully aware of this upside-without-downside asymmetry, and they built simple rules in response. 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.”
This was simply the best risk-management rule ever. The Babylonians 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.
Continue reading here. I also recommend reading Nassim Taleb’s Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets which I consider one of the most thought provoking books on financial markets. Most books about trading and financial markets lack depth because they are thinly veiled attempts to sell some additional products to the reader. Or they are written in a way to maximize sales of the book. Most books are written with the assumption that the reader has little background in financial markets. Nassim Taleb’s book suffers from none of these flaws. I hope to write a series of posts on certain excerpts from the book in the near future.
Posting has been sparse recently due to increased activity at my day job. I hope to return to my regular posting schedule soon.