Nassim Taleb, author of “The Black Swan: The Impact of the Highly Improbable,” says the solution to the problem of bankers who take risks that threaten the general public is simple: Eliminate bonuses. (“End Bonuses for Bankers,” New York Times). He cites as the latest example of the excessive risk taking problem MF Global and its CEO Jon Corzine. MF Global filed for bankruptcy after Corzine made risky investments in European bonds. There has been no taxpayer funded bailout of MF Global, but Taleb warns it is only a matter of time before private risk-taking leads to another one.
Despite politicians’ promises of “no more bailouts,” no one really knows what will happen the next time a giant bank goes bust because of its excessive risk taking, Taleb writes. Better than relying on a politician’s promise would be eliminating a fundamental reason for excessive risk taking on Wall Street ? big executive bonuses.
Taleb’s solution is: “Any person who works for a company that, regardless of its current financial health, would require a taxpayer-financed bailout if it failed should not get a bonus, ever. In fact, all pay at systemically important financial institutions ? big banks, but also some insurance companies and even huge hedge funds ? should be strictly regulated.”
The current bonus system provides an incentive to take risks. The incentive for success without any penalty for failure causes potentially disastrous risks to accumulate in the financial system. “This violates the fundamental rules of capitalism; Adam Smith himself was wary of the effect of limiting liability, a bedrock principle of the modern corporation,” according to Taleb.
Bonuses encourage bankers to hide the risks of “black swan” events, Taleb writes, adding: “The meltdown in the United States subprime mortgage market, which set off the global financial crisis, is only the latest example of such disasters.” (If Taleb is saying that the subprime mortgage meltdown was an unpredictable “black swan,” we disagree.)
The current formula ? a bonus if they make short-term profits and a bailout if they go bust ?has led and will likely continue to lead to excessive risk taking, asset bubbles and busts.
Another fundamental reform that many experts say is needed, which Taleb hints at, is reversing the 1999 repeal of the Glass-Steagall Act, the Depression-era law that had separated investment and commercial banking. “Investment banks, which paid bonuses and weren’t allowed to lend, were partnerships with skin in the game, not gamblers playing with other people’s money.”
In any event, Taleb concludes, “we should enforce a basic principle: Bonuses and bailouts should never mix.”
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