I read on BBC yesterday that the richest 62 people in the world now earn as much as the poorest half, which would be about 3.5 billion people! Although there is some confusion about the methodology, it is clear that the wealth and income have been getting more and more polarized. The rich are certainly getting richer. Income inequality is more acute than ever.
The financial crisis was a veritable gold mine for columnists like me. I, 하나, published at least five articles on the subject, including its causes, the lessons learned, 및, most self-deprecating of all, our excesses that contributed to it.
Looking back at these writings of mine, I feel as though I may have been a bit unfair on us. I did try to blunt my accusations of avarice (and perhaps decadence) by pointing out that it was the general air of insatiable greed of the era that we live in that spawned the obscenities and the likes of Madoff. But I did concede the existence of a higher level of greed (또는, more to the point, a more sated kind of greed) among us bankers and quantitative professionals. I am not recanting my words in this piece now, but I want to point out another aspect, a justification if not an absolution.
Why would I want to defend bonuses and other excesses when another wave of public hatred is washing over the global corporations, thanks to the potentially unstoppable oil spill? 음, I guess I am a sucker for lost causes, much like Rhett Butler, as our quant way of tranquil life with insane bonuses is all but gone with the wind now. Unlike Mr. Butler, 그러나, I have to battle and debunk my own arguments presented here previously.
One of the arguments that I wanted to poke holes in was the fair compensation angle. It was argued in our circles that the fat paycheck was merely an adequate compensation for the long hours of hard work that people in our line of work put in. I quashed it, 나는 생각한다, by pointing out other thankless professions where people work harder and longer with no rewards to write home about. Hard work has no correlation with what one is entitled to. The second argument that I made fun of was the ubiquitous “talent” 각도. At the height of the financial crisis, it was easy to laugh off the talent argument. 게다가, there was little demand for the talent and a lot of supply, so that the basic principle of economics could apply, as our cover story shows in this issue.
Of all the arguments for large compensation packages, the most convincing one was the profit-sharing one. When the top talents take huge risks and generate profit, they need to be given a fair share of the loot. 그렇지 않으면, where is the incentive to generate even more profits? This argument lost a bit of its bite when the negative profits (by which I indeed mean losses) needed to be subsidized. This whole saga reminded me of something that Scott Adams once said of risk takers. He said that risk takers, 정의에 의해, often fail. So do morons. 실제로, it is hard to tell them apart. Should the morons reap handsome rewards? That is the question.
Having said all this in my previous articles, now it is time to find some arguments in our defense. I left out one important argument in my previous columns because it did not support my general thesis — that the generous bonuses were not all that justifiable. Now that I have switched allegiance to the lost cause, allow me to present it as forcefully as I can. In order to see compensation packages and performance bonuses in a different light, we first look at any traditional brick-and-mortar company. Let’s consider a hardware manufacturer, 예를 들어. Suppose this hardware shop of ours does extremely well one year. What does it do with the profit? 물론 이죠, the shareholders take a healthy bite out of it in terms of dividends. The employees get decent bonuses, 희망. But what do we do to ensure continued profitability?
We could perhaps see employee bonuses as an investment in future profitability. But the real investment in this case is much more physical and tangible than that. We could invest in hardware manufacturing machinery and technology improving the productivity for years to come. We could even invest in research and development, if we subscribe to a longer temporal horizon.
Looking along these lines, we might ask ourselves what the corresponding investment would be for a financial institution. How exactly do we reinvest so that we can reap benefits in the future?
We can think of better buildings, computer and software technologies etc. But given the scale of the profits involved, and the cost and benefit of these incremental improvements, these investments don’t measure up. Somehow, the impact of these tiny investments is not as impressive in the performance of a financial institution compared to a brick-and-mortar company. The reason behind this phenomenon is that the “hardware” we are dealing with (in the case of a financial institution) is really human resources — 사람들 — 당신과 나. So the only sensible reinvestment option is in people.
So we come to the next question — how do we invest in people? We could use any number of euphemistic epithets, but at the end of the day, it is the bottom line that counts. We invest in people by rewarding them. Monetarily. Money talks. We can dress it up by saying that we are rewarding performance, sharing profits, retaining talents etc. 그러나 궁극적으로, it all boils down to ensuring future productivity, much like our hardware shop buying a fancy new piece of equipment.
Now the last question has to be asked. Who is doing the investing? Who benefits when the productivity (whether current or future) goes up? The answer may seem too obvious at first glance — it is clearly the shareholders, the owners of the financial institution who will benefit. But nothing is black and white in the murky world of global finance. The shareholders are not merely a bunch of people holding a piece of paper attesting their ownership. There are institutional investors, who mostly work for other financial institutions. They are people who move large pots of money from pension funds and bank deposits and such. 환언, it is the common man’s nest egg, whether or not explicitly linked to equities, that buys and sells the shares of large public companies. And it is the common man who benefits from the productivity improvements brought about by investments such as technology purchases or bonus payouts. 적어도, that is the theory.
This distributed ownership, the hallmark of capitalism, raises some interesting questions, 나는 생각한다. When a large oil company drills an unstoppable hole in the seabed, we find it easy to direct our ire at its executives, looking at their swanky jets and other unconscionable luxuries they allow themselves. Aren’t we conveniently forgetting the fact that all of us own a piece of the company? When the elected government of a democratic nation declares war on another country and kills a million people (speaking hypothetically, 물론), should the culpa be confined to the presidents and generals, or should it percolate down to the masses that directly or indirectly delegated and entrusted their collective power?
More to the point, when a bank doles out huge bonuses, isn’t it a reflection of what all of us demand in return for our little investments? 이러한 관점에서 볼, is it wrong that the taxpayers ultimately had to pick up the tab when everything went south? I rest my case.
하지만, this dictum of denying bonus to the whole firm during bad times doesn’t work quite right either, for a variety of interesting reasons. 첫 번째, let’s look at the case of the AIG EVP. AIG is a big firm, with business units that operate independently of each other, almost like distinct financial institutions. If I argued that AIG guys should get no bonus because the firm performed abysmally, one could point out that the financial markets as a whole did badly as well. Does it mean that no staff in any of the banks should make any bonus even if their particular bank did okay? And why stop there? The whole economy is doing badly. 그래서, should we even out all performance incentives? Once we start going down that road, we end up on a slippery slope toward socialism. And we all know that that idea didn’t pan out so well.
Another point about the current bonus scheme is that it already conceals in it the same time segmentation that I ridiculed in my earlier post. 참된, the time segmentation is by the year, rather than by the month. If a trader or an executive does well in one year, he reaps the rewards as huge bonus. If he messes up the next year, 확인, he doesn’t get any bonus, but he still has his basic salary till the time he is let go. It is like a free call option implied in all high-flying banking jobs.
Such free call options exist in all our time-segmented views of life. If you are a fraudulent, Ponzi-scheme billionaire, all you have to do is to escape detection till you die. The bane of capitalism is that fraud is a sin only when discovered, and until then, you enjoy a rich life. This time element paves the way for another slippery slope towards fraud and corruption. 다시, it is something like a call option with unlimited upside and a downside that is somehow floored, both in duration and intensity.
There must be a happy equilibrium between these two slippery slopes — one toward dysfunctional socialism, and the other toward cannibalistic corruption. It looks to me like the whole financial system was precariously perched on a meta-stable equilibrium between these two. It just slipped on to one of the slopes last year, and we are all trying to rope it back on to the perching point. In my romantic fancy, I imagine a happier and more stable equilibrium existed thirty or forty years ago. Was it in the opposing economic ideals of the cold war? Or was it in the welfare state concepts of Europe, where governments firmly controlled the commanding heights of their economies? 그렇다면, can we expect China (or India, or Latin America) to bring about a much needed counterweight?
Among all the arguments for hefty bonuses, the most convincing is the one on profit generation and sharing. Profit for the customers and stakeholders, if generated by a particular executive, should be shared with him. What is wrong with that?
The last argument for bonus incentives we will look at is this one in terms of profit (and therefore shareholder value) generation. 음, shareholder value in the current financial turmoil has taken such a beating that no sane bank executive would present it as an argument. What is left then is a rather narrow definition of profit. Here it gets tricky. The profits for most financial institutes were abysmal. The argument from the AIG executive is that he and his team had nothing to do with the loss making activities, and they should receive the promised bonus. They distance themselves from the debacle and carve out their tiny niche that didn’t contribute to it. Such segmentation, although it sounds like a logical stance, is not quite right. To see its fallacy, let’s try a time segmentation. Let’s say a trader did extremely well for a few months making huge profits, and messed up during the rest of the year ending up with an overall loss. 지금, suppose he argues, “음, I did well for January, March and August. Give me my 300% for those months.” Nobody is going to buy that argument. I think what applies to time should also apply to space (죄송합니다, business units or asset classes, 내 말은). If the firm performs poorly, perhaps all bonuses should disappear.
As we will see in the last post of the series, this argument for and against hefty incentives is a tricky one with some surprising implications.
Even after we discount hard work and inherent intelligence as the basis of generous compensation packages, we are not quite done yet.
The next argument in favour of hefty bonuses presents incentives as a means of retaining the afore-mentioned talent. Looking at the state of affairs of the financial markets, the general public may understandably quip, “What talent?” and wonder why anybody would want to retain it. That implied criticism notwithstanding, talent retention is a good argument.
As a friend of mine illustrated it with an example, suppose you have a great restaurant thanks mainly to a superlative chef. Everything is going honky dory. 다음, out of the blue, an idiot cook of yours burns down the whole establishment. 당신, 물론, sack the cook’s rear end, but would perhaps like to retain the chef on your payroll so that you have a chance of making it big again once the dust settles. 참된, you don’t have a restaurant to run, but you don’t want your competitor to get his hands on your ace chef. Good argument. My friend further conceded that once you took public funding, the equation changed. You probably no longer had any say over payables, because the money was not yours.
I think the equation changes for another reason as well. When all the restaurants in town are pretty much burned down, where is your precious chef going to go? Perhaps it doesn’t take huge bonuses to retain him now.
In the last post, I argued that how hard we work has nothing much to do with how much reward we should reap. 결국, there are taxi drivers who work longer and harder, and even more unfortunate souls in the slums of India and other poor countries.
하지만, I am threading on real thin ice when I compare, however obliquely, senior executives to cabbies and slum dogs. They are (the executives, 즉) clearly a lot more talented, which brings me to the famous talent argument for bonuses. What is this talent thing? Is it intelligence and articulation? I once met a taxi driver in Bangalore who was fluent in more than a dozen languages as disparate as English and Arabic. I discovered his hidden talent by accident when he cracked up at something my father said to me — a private joke in our vernacular, which I have seldom found a non-native speaker attempt. I couldn’t help thinking then — given another place and another time, this cabbie would have been a professor in linguistics or something. Talent may be a necessary condition for success (and bonus), but it certainly is not a sufficient one. Even among slum dogs, we might find ample talent, if the Oscar-winning movie is anything to go by. 비록, the protagonist in the movie does make his million dollar bonus, but it was only fiction.
실제 생활에서, 그러나, lucky accidents of circumstances play a more critical role than talent in putting us on the right side of the income divide. 나에게, it seems silly to claim a right to the rewards based on any perception of talent or intelligence. Heck, intelligence itself, however we define it, is nothing but a happy genetic accident.
One argument for big bonuses is that the executives work hard for it and earn it fair and square. It is true that some of these executives spend enormous amount of time (up to 10 에 14 hours a day, according the AIG executive under the spotlight here). 하지만, do long hours and hard work automatically make us “those who deserve the best in life,” as Tracy Chapman puts it?
I have met taxi drivers in Singapore who ply the streets hour after owl-shift hour before they can break even. Apparently the rentals the cabbies have to pay are quite high, and they end up working consistently longer than most executives. Farther beyond our moral horizon, human slum dogs forage garbage dumps for scraps they can eat or sell. Back-breaking labour, I imagine. Long hours, terrible working conditions, and hard-hard work — but no bonus.
It looks to me as though hard work has very little correlation with what one is entitled to. We have to look elsewhere to find justifications to what we consider our due.
Our best-laid plans often go awry. We see it all the time at a personal level — accidents (both good and bad), deaths (both of loved ones and rich uncles), births, and lotteries all conspire to reshuffle our priorities and render our plans null and void. 사실, there is nothing like a solid misfortune to get us to put things in perspective. This opportunity may be the proverbial silver lining we are constantly advised to see. What is true at a personal level holds true also at a larger scale. The industry-wide financial meltdown has imparted a philosophical clarity to our profession — a clarity that we might have been too busy to notice, but for the dire straits we are in right now.
This philosophical clarity inspires analyses (and columns, 물론) that are at times self-serving and at times soul-searching. We now worry about the moral rectitude behind the insane bonus expectations of yesteryears, 예를 들어. The case in point is Jake DeSantis, the AIG executive vice president who resigned rather publicly on the New York Times, and donated his relatively modest bonus of a million dollars to charity. The reasons behind the resignation are interesting, and fodder to this series of posts.
Before I go any further, let me state it outright. I am going to try to shred his arguments the best I can. I am sure I would have sung a totally different tune if they had given me a million dollar bonus. Or if anybody had the temerity to suggest that I part with my own bonus, paltry as it may seem in comparison. I will keep that possibility beyond the scope of this column, ignoring the moral inconsistency others might maliciously perceive therein. I will talk only about other people’s bonuses. 결국, we are best in dealing with other people’s money. And it is always easier to risk and sacrifice something that doesn’t belong to us.
We are in dire straits — no doubt about it. Our banks and financial edifices are collapsing. Those left standing also look shaky. Financial industry as a whole is battling to survive. 그리고, as its front line warriors, we will bear the brunt of the bloodbath sure to ensue any minute now.
Ominous as it looks now, this dark hour will pass, as all the ones before it. How can we avoid such dark crises in the future? We can start by examining the root causes, the structural and systemic reasons, behind the current debacle. What are they? In my series of posts this month, I went through what I thought were the lessons to learn from the financial crisis. Here is what I think will happen.
The notion of risk management is sure to change in the coming years. Risk managers will have to be compensated enough so that top talent doesn’t always drift away from it into risk taking roles. Credit risk paradigms will be reviewed. Are credit limits and ratings the right tools? Will Off Balance Sheet instruments stay off the balance sheet? How will we account for leveraging?
Regulatory frameworks will change. They will become more intrusive, but hopefully more transparent and honest as well.
Upper management compensation schemes may change, but probably not much. Despite what the techies at the bottom think, those who reach the top are smart. They will think of some innovative ways of keeping their perks. 걱정하지 마세요; there will always be something to look forward to, as you climb the corporate ladder.
Nietzsche may be right, what doesn’t kill us, may eventually make us stronger. Hoping that this unprecedented financial crisis doesn’t kill us, let’s try to learn as much from it as possible.
Markets are not free, despite what the text books tell us. 수학에서, we verify the validity of equations by considering asymptotic or limiting cases. Let’s try the same trick on the statement about the markets being free.
If commodity markets were free, we would have no tariff restrictions, agricultural subsidies and other market skewing mechanisms at play. Heck, cocaine and heroine would be freely available. 결국, there are willing buyers and sellers for those drugs. 실제로, drug lords would be respectable citizens belonging in country clubs rather than gun-totting cartels.
If labor markets were free, nobody would need a visa to go and work anywhere in the world. 그리고, “equal pay for equal work” would be a true ideal across the globe, and nobody would whine about jobs being exported to third world countries.
Capital markets, at the receiving end of all the market turmoil of late, are highly regulated with capital adequacy and other Basel II requirements.
Derivatives markets, our neck of the woods, are a strange beast. It steps in and out of the capital markets as convenient and muddles up everything so that they will need us quants to explain it to them. We will get back to it in future columns.
So what exactly is free about the free market economy? It is free — as long as you deal in authorized commodities and products, operate within prescribed geographies, set aside as much capital as directed, and do not employ those you are not supposed to. By such creative redefinitions of terms like “free,” we can call even a high security prison free!
오해하지 마십시오. I wouldn’t advocate making all markets totally free. 결국, opening the flood gates to the formidable Indian and Chinese talent can only adversely affect my salary levels. Nor am I suggesting that we deregulate everything and hope for the best. Far from it. All I am saying is that we need to be honest about what we mean by “free” in free markets, and understand and implement its meaning in a transparent way. I don’t know if it will help avoid a future financial meltdown, but it certainly can’t hurt.