Other people’s money: more on bankers’ ‘free option’
My item explaining why bankers can be relied on to bet the bank, because it is not their money, was echoed by an insightful piece from Nassim Taleb in the FT on 25th February. As a finance professor with over 20 years experience as a trader, Taleb is an authority on strategies with regular positive payoffs but occasional catastrophic losses, a central theme of his well-received book ‘The Black Swan: the Impact of the Highly Improbable’. Provided the blow-up can be put off for a few years, traders with participation in the profits and no participation in losses have every incentive to bet the bank. If large bonuses are paid every year it may only requires a few years of deferral of the blow-up to make it pay to play. Moreover, in finance the basis of the profit participation is often only an accounting recognition of a theoretical profit stream spread over a long period, not an actual realised gain.
Taleb is not judgemental about perverse incentive deals freely struck between private entities but he draws the line when banks are involved. This is because the unwritten guarantee provided by governments to protect their banking system means it is the taxpayer that is effectively granting the free option to bankers. ‘Indeed, the incentive system put in place by financial companies has produced the worst possible economic system mankind can imagine: capitalism for the profits and socialism for the losses.’
Moral: never trust your money with anyone who is paid a bonus. Or commission. Or performance fee. Or carried interest. They may claim to align interests but they all create agenda conflicts.