No, Wall Street Bonuses Aren't Destroying the Economy

Bankers are going to make lots of money, with or without bonuses, and loading all that cash into guaranteed salaries might make matters even worse

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The news cycle must be slowing down, because the New York Times is recycling the flawed argument that banker bonuses are the cause of all of the economy's ills in an op-ed today. This time, the claim is made by Nassim Taleb, author of The Black Swan, risk engineering professor, and hedge fund investor. While some reforms of the system in place before the financial crisis were warranted, getting rid of bonuses altogether won't solve anything -- and could actually make the situation worse.

Ending Bonuses Won't End Lavish Banker Compensation

To determine whether or not ending bonuses could help to reduce risk, we need to first think about how a ending bonuses would change the situation. For starters, the amount of compensation that bankers are provided would not change significantly. These pay levels are based on the market value of the services that they provide. Instead of making lots of money with fat bonuses, these bankers and traders would make lots of money with giant salaries.

Not only does economic theory assert that this is true, but we have seen it in practice. A few years ago when banks came under fire for big bonuses, they began to shrink bonuses a bit and plow the difference into larger salaries. Taleb does not appear to dispute that compensation levels would remain very high for bankers, but instead argues that incentives would change. He's right about that, but they may change for the worse.

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What Is Your Incentive With a Salary?

Based on my experience working with and knowing a fairly large number of bankers, I can make one very safe assumption: those who work on Wall Street like money. If they didn't want to make lots of money, many of them would have chosen other career paths. They want to make as much money as they possibly can -- that is their central motivation. In some cases, it may be their only motivation.

With that assumption in mind, how would they make more money if they only had a salary? Remember, they'll still want to get as big a raise as possible each year. What do they do? They take the same risk they did before. In fact, they may take even more risk.

Under the bonus system, if they had a year when business was bad, then their bonuses would decline. Proof of this is clear enough in today's news -- after a rough 2011, banker bonuses are expected to be down 20 to 30%. But if they just get a salary instead, then there is no downside.

Think about it: if trades go bad, then shareholders will suffer by seeing dividends cut or shares diluted when more capital must be acquired. But every time banks have a good year, bankers will get a nice salary bump -- and that amount will be guaranteed even in bad years. Remember those guaranteed bonuses everybody was angry about a few years ago? If you were to pay a guaranteed bonus out over the course of a year in semimonthly installments, you could call it something else: a "salary."

Going Back to the Partnership Structure

Taleb suggests that investment banks go back to what they used to look like a few decades ago -- where they were partnerships instead of publicly traded companies. This idea does have some attractive features, as the employees all share in the losses. But that also makes it somewhat unattractive for certain employees: if one trading group has a miserable year, then everybody suffers.

Here's the problem: investors love financial firms. Taleb oddly points to the recent failure of MF Global as an example of the dangers of excessive risk-taking. But that situation actually demonstrates exactly what should happen. A financial firm took big risks that went bad, and it failed. Its investors lost money. No investor was coerced to put money into MF Global. If they didn't like risk taking, then they could have invested in a utility, a Dow component, or a U.S. Treasury. They knew what they were getting into and wanted a chance to reap the significant return that a company like MF Global offered.

The problem, however, is that some institutions are still probably "too big to fail," which means that they will get bailed out by taxpayers -- not just shareholders -- if they go bad. That is certainly a serious problem. But converting investment banks into partnerships won't help.

For example, if Lehman Brothers was a partnership back in 2008, would its failure have been any easier to handle? It's hard to see how. Instead, the employees -- and not shareholders -- would have taken all of the equity losses. Those equity losses didn't cause a financial crisis, however. The problems that caused the crisis stemmed from other firms having loaned it money and/or having derivatives exposure with the bank. Even if a bank is a partnership, its bailout may still be necessary if financial stability is threatened by its collapse.

What About Claw-Backs?

Still the idea that bankers should share in the losses they create seems logical enough. Indeed, that's the basis for the idea of bonus claw-backs. It should serve approximately the same purpose that a partnership would in terms of incentive. Bizarrely, however, Taleb claims: "It has become clear that merely 'clawing back' past bonuses after the fact is not enough." If this idea is so clear to Taleb, it would be helpful for him to share the evidence that supports his claim. The mere proposal of claw-backs has only been introduced over the past few years, and we haven't been in a situation where they would be employed yet. It isn't clear to anyone yet that claw-backs won't help.

Taleb is right that some bonus reform might help, but getting rid of bonuses altogether isn't the answer. Instead, all the problems that existed before bonuses are outlawed would continue to persist, and new ones might even arise. The real problem is that some banks are too big to fail. If they weren't, then their bankers and traders could take as much risk as they wanted and taxpayers would never face bailouts.

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