Tag Archives: Compensation

Black swans? Or black crows?

Nassim Taleb is moving along just fine with an elegant critique of banking’s misaligned incentives . . .

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 that incentive scheme that got us in the current mess.

Take two bankers. The first is conservative. He produces one annual dollar of sound returns, with no risk of blow-up. The second looks no less conservative, but makes $2 by making complicated transactions that make a steady income, but are bound to blow up on occasion, losing everything made and more. So while the first banker might end up out of business, under competitive strains, the second is going to do a lot better for himself. Why? Because banking is not about true risks but perceived volatility of returns: you earn a stream of steady bonuses for seven or eight years, then when the losses take place, you are not asked to disburse anything. You might even start again, after blaming a “systemic crisis” or a “black swan” for your losses.

. . . But then, after showing how easy it is for bank management to capture short-term gains without worrying about long-term risks, Taleb concludes that 

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.

It’s a big leap from misaligned incentives to only the government can run banks. Doesn’t the expert theoretician of the highly improbable Black Swan understand that highly centralized governments are most often the cause of devastating Black Swan events? The only difference being: we shouldn’t really even call them Black Swans in the case of government failure. These events are not uncommon or unpredictable. The inherent difficulty and high-frequency failure of highly centralized bureaucracies managing dynamic systems is so common and predictable, in fact, that we might call them Black Crows. 

We can do much better than nationalizing the banks. Boards should obviously reform compensation practices. Today’s shareholders have been mostly wiped out. The shareholders of the “next banks” won’t soon forget. But most crucially we should amend the wildly incoherent monetary policy regime that does more than any other private or government action to misalign incentives. During credit bubbles, dollars are easily vacuumed up by the financial industry. In a very real sense, they would be irresponsible not to exploit the Fed’s explicit free-lunch program of accommodation “for a considerable period.” Remember, Chairman Greenspan virtually ordered Wall Street to lever up.

A stable currency is the ultimate disciplinarian, the incentive aligner par excellence.

Update: See Taleb and Nobel psychologist/behavioral economist Daniel Kahneman discuss these topics at length here.