One Black Swan You’ll Never See

Nassim Nicholas Taleb of Black Swan fame has a provocative column this morning in the Financial Times—a little too provocative.

He’s excellent at explaining Wall Street’s skewed pay incentives that led to this crisis:

As you do not disgorge previous compensation, the incentive is to engage in trades that explode rarely, after a period of steady gains.

Here you can see that this mismatch between the bonus payment frequency (typically, one year) and the time to blow up (about five to 20 years) is the cause of the accumulation of positions that hide risk by betting massively against small odds. As traders say, they have the “free option” on their performance: they get the profits, not the losses. I hold that this vicious asymmetry is the driving factor behind investment banking.

If capitalism is about incentives, it should be about true incentives, those resistant to blow-ups. And there should be disincentives to remove the asymmetry of the free option.

Taleb nails it here, presenting the problem in traders’ terms—the “free option.” That’s otherwise known as “head I win, tails taxpayers lose.”

…when it comes to banks and other “too big to fail” entities, the problem is severe: we taxpayers in our respective countries are funding these global monsters and are coughing up money for mistakes made by bankers who retain their bonuses and are hijacking us because, as we are discovering (a little late), banking is a utility and we need them to clean up their mess. We, in fact, are the seller of that free option. We should claim it back.

And he expands that to private-equity, as well, though he leaves out hedge funds:

…leveraged buy-out companies used the free option by borrowing heavily from the banks and taking monstrous risks: they get the upside, banks (hence we taxpayers) get the downside. These partnerships made fortunes in the past on deals that society will have to bail out. They too should have their past profits clawed back.

But Taleb wanders off into fantasy land in his recommendation for how to rectify this problem:

Finally, I was involved in trading for 21 years and I can testify that traders consciously play the free option game. On the other hand, I worked (in my other job as risk adviser) with various military organisations and people watching over our safety. We trust military and homeland security people with our lives, yet they do not get a bonus. They get promotions, the honour of a job well done and the disincentive of shame if they fail. Roman soldiers signed a sacramentum accepting punishment in the event of failure. 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.

Good luck with that. I think we ought to nationalize insolvent banks temporarily and then sell them back to the private sector, but nationalize them permanently? That’s idiotic, and it will never happen here.

There’s a much better, much easier fix. Put a strict limit on the amount of debt that any bank or institution (including hedge funds) can have. No more thirty-five-times assets stuff. Raise capital requirements. That alone will put a big damper on excess (phantom) profits caused by excess risk-taking and thus put a big damper on pay.

Then require bonus pay to be deferred for several years, or require investment banks to be privately held partnerships like they used to be, something that worked much better than the current system, as Yves Smith of Nake Capitalism says here.

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Ryan Chittum is a former Wall Street Journal reporter, and deputy editor of The Audit, CJR's business section. If you see notable business journalism, give him a heads-up at Follow him on Twitter at @ryanchittum.