The trader’s option

Posted by Marc Hodak on March 2, 2009 under Executive compensation, Invisible trade-offs, Unintended consequences | 2 Comments to Read

Nassim Nicholas Taleb has written a good description of what is now widely understood to be one of the key perverse incentives that fueled the recent credit bubble–i.e., the trader’s option:

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.

Like like many others cognizant of the moral hazards of the trader’s option, Taleb throws up his hands and recommends hiving off the risky portions of banking from the “utility” parts of banking, and heavily regulating the compensation of the latter.  So easily said, isn’t it?

Unfortunately, getting it done is another matter entirely.  Taleb’s proposal is basically a revival of Glass-Steagall in drag.  For those who are familiar with the real history of Glass-Steagall’s repeal, as opposed to the mythology of “deregulation that got us into this mess,” you know that the mandatory separation of commercial and investment banking/trading was full of unresolvable contradictions.  G-S presumed a bright line between debt and equity that simply no longer exists.

In fact, G-S itself, by trying to maintain a viable, and ultimately futile separation of commercial and investment banking, actually spurred the proliferation of instruments that blurred the division of debt and equity.  G-S was the godparent of the convertible warrants, junk bonds, credit default swaps, and plethora of fixed-income instruments that eventually made it obsolete.

Besides the self-defeating nature of such a regulatory split, the idea of reintroducing this form of regulation presumes that the perverse incentives that give traders an asymmetrical risk/reward profile can’t creep into ordinary lending, even though that is what clearly occurred in the bond markets of the last six years.  The only difference between the traders option and the perverse incentives for lending is that the former existed purely within organizations while the latter existed (and continues to exist) between separate institutions, with one institution behind them all that is impervious to the losses of its residual claimants, i.e., the government.

Rather than reestablish a complicated and, in the end, hopelessly unworkable regulatory regime based on arbitrarily defined banking activities, why not just fix the root causes of the perverse incentives themselves?  Within firms, one can create better risk-adjusted measures of performance as the basis for variable compensation, and at the same time effectively extend management’s time horizon.  We have successfully implemented sophisticated bonus mechanisms that do just that outside of the corporate financial services sector (and are starting to do it within that sector, now).

The problem between firms is more intractable.  Those incentives are the unintended results of policies driven  by political considerations in the one place where financial accountability is of little consequence–Washington, D.C.  We could certainly improve the situation of inter-firm incentives if we were asked to do so, but that would first require revamping the incentives of the legislators, which resemble the trader’s option on steroids.  That may have to await the next Constitutional Convention.