Blame it on the Bonus?

It seems to me that politicians are very keen on blaming the recent financial crisis on the bankers who earn big bonuses.

I rather think it is a little more complicated than that but before I stray too far into why, I’ll give a basic example of why a trader may tempted to take a risk.

I recently found out that Scottish Power have overcharged me on my direct debit by so much for so long that they owe me £1,000 and have to send me a cheque. I could invest this in a savings account with a high street bank. I may get an interest rate of 1% on such a deposit, meaning in 1 year’s time I will have £1,010. The £10 I have made doesn’t really set my world on fire (especially when taking inflation into consideration I will have made a loss) but the upside is my money is safe. It is so safe that it is even guaranteed by the UK government in the event of the bank going bust.

Alternatively I could invest my £1,000 in the stock market. The stock market is much less predictable – my money in a year’s time could easily be £1,250. It could easily be £800. If things went really badly for the company I invested in it could be worth £0. In fact I have very little idea about how much it is going to be worth but returns in the stock market historically outperform returns on a bank account so I may be tempted by the risk.

This is also the reason why a trader takes risks in a bank. Simply, risky investments are more likely to yield a larger return. If there were a risky investment which had a likely lower return than a safe investment no one would bother going near it. Therefore we can say that when a trader takes a risk they think it is more likely to yield a larger reward than the safer option.

Now let’s extend this principle to Evelyn. Evelyn is an evil, heartless trader who, when she isn’t out running over old ladies in her Ferrari, has a bonus scheme which pays her according to the profit she makes for the bank. If she put all of her available funds into a safe bank account she’s going to get no bonus – anyone could have done that. In order for her to get the new Lamborghini she’s got her eye on she is going to have to take some risks.

Evelyn has taken risks with the money for the last few years and every year the risks have worked out and she has made a fortune for the bank and a fortune for herself. Until 2008. In 2008 everything didn’t work out and she lost 100 fortunes for the bank. The bank couldn’t foot the bill and the tax payer had to bail it out. Therefore Evelyn caused the financial crisis.

It was all Evelyn! Case closed, right? Wrong. Who spotted the real problem in the above paragraph?

“…and the tax payer had to bail it out.”

It may not seem immediately obvious but Evelyn hasn’t actually done anything wrong in all of this. All she has done is respond to her incentives. She knows the riskier the strategy the more chance she has of making the big bucks. The smallest her bonus can be is zero – if her strategy doesn’t come off it’s not like she has to fund the loss herself. She has simply responded to the incentives the bank gave her.

In a bank as well as the traders, they have people called risk managers. Risk managers are responsible for determining what traders are allowed to invest in and how much they are allowed to invest in it. They do lots of complicated maths and put in place policies to police the traders. If I were going to start pointing fingers at bank employees I would probably have a good look at them before the traders. I’m not though.

Recently @WH1SKS, (one of the greatest people on Twitter, follow him) said he thought that the banks didn’t seem to have really paid for their failure, although everyone else did seem to be paying for it. He was completely right.

Banks, you see, are “too big to fail.”

“Too big to fail.” It drives me nuts. Outside the financial sector you will find no one “too big to fail” and you will find no one who could possibly fail in such a big way as they have.

I work in a small company. If we made enough bad decisions we could probably make ourselves go bust. At that point we could go to the chancellor and ask for a bailout but we won’t get one because outside our staff and our clients no one gives a stuff whether we’re there or not. Our company therefore has a massive incentive not to take unnecessary risks – a bunch of risky strategies could be the end of us. A risky strategy for a bank now means either a massive profit or, if it all goes tits up, a handout to keep it going. The bank is now no different to Evelyn – in the good years make a bundle and in the bad ones know your maximum downside is you keep going anyway and someone else pays for it.

The banks could not be allowed to go bust because the impact on the global economy would have been far worse than it was to bail them out. They each had so much in the way of liabilities that them going bust would not only have taken out the finances of many individuals and companies, it would also have taken out other banks and the whole thing would have gone down like dominoes.

So what’s changed? If RBS tomorrow were to announce they were in a pickle they’d get bailed out again because the same problem is true today. If the banks were too big to fail before, it’s even worse now because due to the mergers which followed the financial crisis, they are bigger now than they were before.

All this has proved is that it is a completely unworkable system to have organisations which cannot be allowed to go bust when they make bad enough decisions. If that is the case, they have no incentive to abandon risky strategies and they will continually need to be bailed out when the strategies don’t come off.

So what’s the solution? There are several contenders. Perhaps banks should have to provide the impact of their potential bankruptcy as part of their financial reporting and auditors should have to verify they could go bust without causing financial meltdown and if they can’t prove it they would be broken up. Perhaps they just need to hold more capital? Perhaps there should be legislation forcing them to raise more money through equity rather than debt?

It’s a debate that needs to happen because it is a problem that must be solved and has not been solved. By bailing them out all we have done is put an Elastoplast over the underlying problem. There are still financial behemoths out there with incentive to take risks and nothing to guarantee it won’t result in a bailout. I don’t know the full solution, but I do know one thing:

If a bank is too big to fail – it’s too big.

RedEaredRabbit