With financial firms still self-destructing more than three years after the beginning of the financial crisis—witness MF Global—the only way to engineer reform that will actually have an impact is to eliminate banker bonuses, says Nassim Nicholas Taleb, professor of risk engineering at New York University Polytechnic Institute and author of The Black Swan: The Impact of the Highly Improbable.
In an op-ed piece in Tuesday’s New York Times, Taleb said the bonus system “provides an incentive to take risks.” In fact, he said, “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.” The reason is that bonuses are asymmetric in nature: they reward risk-taking without providing a disincentive if the risk results in loss. As a result, said Taleb, no one who works for a company that would get a taxpayer-financed bailout should it fail should be allowed—ever—to get a bonus.
Rewarding risk without punishing loss is unacceptable, said Taleb, while ancient methods managed risk quite effectively, if perhaps in a more deadly fashion: He pointed to examples from Hammurabi’s Code to rules used by the Roman Empire. The Code, which Taleb called “simply the best risk-management rule ever,” decreed some 4,000 years ago, “If a builder builds a house for a man and does not make its construction firm, and the house which he has built collapses and causes the death of the owner of the house, that builder shall be put to death.”
The Romans could be even more bloodthirsty in their quest to manage risk effectively, through decimation: “If a legion lost a battle and there was suspicion of cowardice, 10% of the soldiers and commanders—usually chosen at random—were put to death.”
While Taleb did not advocate such extreme measures, he did say that those who take risks must be made accountable if they fail. Pre-deregulation, he pointed out, banking was both safe and boring, even if salaries were not on a scale with that of “today’s junior trader.”
Hedge funds, he said, could take over some of the risks banks would no longer be allowed to engage in, particularly since they typically ensure “that the manager is hurt more than any of his investors in the event of a blowup.” In short, he said, rather than “thousands of pages of regulation, we should enforce a basic principle: Bonuses and bailouts should never mix.”