Tuesday, May 5, 2009

Time to tackle this culture of rewarding the risk-takers

Posted in the Financial Times by John Coates:

What do you pay a trader who has made $100m?

A bank chief executive may recommend a 20 per cent pay-out, to prevent this money-making trader from going to a hedge fund. A politician may demand a bonus cap, perhaps around $500,000. While a member of the public, incensed by the decadent culture on Wall Street, may howl that the trader should get nothing at all, his profits being made at the cost of financial stability.

To understand the controversy surrounding banker pay it helps to consider a tale of two traders, let us call them "Tortoise" and "Hare".

Tortoise makes $20m a year for five years and receives an annual pay-out of maybe $2m. Hare makes $100m a year for four years, receives an annual pay-out of, say, $20m, but on the fifth year loses $500m and receives no bonus.

At the end of five years Tortoise has made $100m for the bank and has been paid $10m. Meanwhile, Hare has lost the bank $100m yet has pocketed $80m.

Which of these traders would you rather be? And do not assume Hare is out of a job. Losing a lot of money is often taken as a sign you are a "hitter" and can be rewarded with a large guarantee from another bank or hedge fund. If you are going to lose money on Wall Street, lose big.

The fable of the two traders is simple enough, yet the strategic calculations underlying Hare's choice of trading style have undermined our financial system. Anyone taking risk soon realises their interests lie in maximising the volatility of their trading results and the frequency of their pay-outs. This strategy increases their chances of being paid at "high-water marks", like the years when Hare made $100m.

If we are to stabilise our financial system we have to change the incentives affecting traders' choice of trading style. Most policies under discussion fail to do so; they try to legislate merely against the effects of the incentives.

Regulations to curb excessive leverage, for example, will always remain one step behind financial innovation, which is usually designed to get around such rules. Besides, a draconian set of regulations may, as Keynes once commented, frighten the penguins of finance and "arouse these frigid creatures to flap away from our shores with their golden eggs".

A cap on bonuses will also prove unworkable. The policy, moreover, is likely to be dropped because trading desks are once again making money. Governments are so desperate to return banks to health that they will not interfere for long in any activity that helps do so.

Finally, Lloyd Blankfein, chief executive of Goldman Sachs, has proposed increasing the deferred stock portion of bonus payments as a way of rewarding long-term results. Deferred stock normally vests over a three-year period, and if traders voluntarily leave the firm they must forfeit their stock. However, if they are fired for losing a lot of money, they miraculously keep their stock. This bonus scheme ends up encouraging the very high variance in trading it was supposed to cure.

Besides, most banks already pay 50 per cent in deferred stock and it has done little to curb reckless trading.

How can banks remove the incentive for excessive risk taking? They could, I believe, accomplish this goal by replacing the deferred stock programme with a bonus scheme that pays traders once a business cycle (approximately three to four years) instead of once a year. All or part of a trader's bonus would be paid out with a lag.

If traders are profitable over a few years they begin to draw on previous bonuses. But if, like Hare, they lose all their profits after a few years then they lose previous bonuses. Banks could also increase deferred bonuses the longer a trader remained profitable, effectively paying, say, 5 per cent on one-year returns, 8 per cent on two-year, 12 per cent on three-year, and so on. By making these changes to compensation, traders would recognise their interests lie in smoothing their profitability over the long run rather than maximising its short-run variability. The effects would be felt in the quality of securities positioned, the amount of leverage used, and the morale among prudent traders.

John Coates, a research fellow in neuroscience and finance at the University of Cambridge, ran a trading desk on Wall Street

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