One simple, but profound, explanation for the current crisis lies in the implicit misalignment of incentives in the financial services world: bankers make bonuses every year when things are good. In fact, their bonuses are bigger when they take huge risks that pay off.
But when these risks get out of control, then whole banks, and whole financial systems, collapse, giving back the gains that created these bonuses. The bankers, of course, keep their cash, but the taxpayer pays for the resultant meltdown.
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. You might even start again, after blaming a “systemic crisis” or a “black swan” for your losses. As you do not disgorge previous compensation, the incentive is to engage in trades that explode rarely, after a period of steady gains.
FT.com / Comment / Opinion - How bank bonuses let us all down
