I HAVE a solution for the problem of bankers who...

7:29 am - Wed, Nov 9, 2011: 26 notes

I HAVE a solution for the problem of bankers who take risks that threaten the general public: Eliminate bonuses.

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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.

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Critics like the Occupy Wall Street demonstrators decry the bonus system for its lack of fairness and its contribution to widening inequality. But the greater problem is that it provides an incentive to take risks. The asymmetric nature of the bonus (an incentive for success without a corresponding disincentive for failure) causes hidden risks to accumulate in the financial system and become a catalyst for disaster. 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.

Bonuses are particularly dangerous because they invite bankers to game the system by hiding the risks of rare and hard-to-predict but consequential blow-ups, which I have called “black swan” events.

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Banning bonuses addresses the principal-agent problem in economics: the separation between an agent’s interests and those of the client, or principal, he is supposed to represent.

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I believe that “less is more” — simple heuristics are necessary for complex problems. So instead of thousands of pages of regulation, we should enforce a basic principle: Bonuses and bailouts should never mix.

Nassim Nicholas Taleb’s NYT OpEd piece on abolishing the bonus system for banks. Talk about disruptive thinking.

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