Raghuram Rajan from the Financial Times says YOU are compensated unduly. He says bogus “alpha” is created by hiding long-tail risks, as with structured products linked to subprime mortgages. He thinks the solution would be to hold in escrow a big chunk of bonuses “until the full risks play out”, meaning only true alpha gets jumbo rewards and reducing the hidden risks in the financial system.
We at Dealbreaker, think Rajan is woefully misguided. Here’s why:
First of all, what exactly does “until the full risks play out” really mean? If you underwrite a 30 year bond for GM does that mean you have to wait until you’re retired before you get compensated for that bond? Does this any sense at all? What if you create a new trading strategy? When would you know that “the full risks” of that strategy have “played out”. We don’t know too much about risk management here, but we’re pretty sure if you think your strategy no longer has any risks, then you’re about to blow up.
Anyway, there is already an incentive structure that exists which is designed to align the interests of the company, and employees. Its called EQUITY, friends. Bankers, traders, private equitiers and hedgies already get compensated in equity. Their goals are already shifted, to some degree, toward thinking about the long term prosperity of their firms. Sure some of them are mercenaries, but to quote Ben Affleck (in Boiler Room) “We’re not saving the fucking manatees here”. And by “we’re not saving manatees”, we mean you’re not. The Dealbreaker team saved three manatees and a goat on the way to work this morning.
The net result is that when positions pan out over the long run, the traders’ equity in the company becomes more valuable and goes up. When positions are shit and generate “fake alpha” employee equity drops as those position deteriorate. Get it? Got it? Good? There’s no need for escrow accounts to tie up compensation and add all sorts of other annoying hassles. You’d just be reinventing the wheel.
Further, i-banks are (or should be) inherently long volatility. Their derivatives desks and market making operation pick up more cash when the market is more volatile. So if some traders are generating “bogus” alpha being short vol, or “hiding long-tail risks” that is not necessarily bad for the bank. The banks want incentivize this type of risk taking, this is what generates all that ROE they’re so famous for.
Since banks are some of the most profitable enterprises on the planet, one has got to wonder if there isn’t some other area that would be better served by Rajan’s keen insight. Like maybe, figure out a better compensation system for the production department, so they’re not always fucking up the binding on the pitch books. Maybe they could use a little more equity.
–Everett Stuckey, DealBreaker correspondent.
And now your moment of Zen:
Bankers’ Pay Is Deeply Flawed [FT]
Why Goldman Sachs Should Implement a Clawback Mechanism [Portfolio]
BAC buys CFC
heard it here first (maybe)
Leave it to a Desi to ruin it for other Desi’s.
P.S. Write an article on the ultra-cheap car that my bretheren have come up with….please??
I’m with not Patel, write an article on the $2500 car…it’s India’s moment of glory
I’m with Patel, write an article on the $2500 car…it’s India’s moment of glory
I’m with Patel, write an article on the $2500 car. Rajan should be stripped of his UK citizenship and sent straight back to Calcutta
$2500 is a lot of money for some tata’s, u can get them up in ur face for $10 down at the club, of course you don’t get the same level of access if you know what i mean
I’m with Singh, Raghuram Rajan should be put on call center duty for the foreseeable future.
$2500 is a lot of money for some tata’s, u can get them up in ur face for $10 down at the club, of course you don’t get the same level of access if you know what i mean
speaking of tata’s, it’s hot and sweaty in this bra, let us out girlfriend.
Actually your analogy re the 30 GM bond is flawed. Theres little risk in the underwriting. Thats why the fees are so small.
Alpha is return in excess of market return (which is Beta). What hes getting at here is that hedgies take on a lot of risk in pursuit of Alpha. They win and they’re compensated very well, they loose and the client pays. That’s the flaw.
Further to 2:49: bet those GSAM guys that ran global alpha were compensated at the gazillion level for the past few years. Are they paying that back now that everything has blown up? At worst, they’re gonna be on the street.
2:49,
This has nothing to do with hedge funds. Please read the article before you bless us with your attempts to educate people on this board about basic financial concepts.
idiot.
2:32 not Calcutta/Kolkata buddy, he should go to Chennai or Bangalore since he’s obviously South Indian..
2:32 not Calcutta/Kolkata buddy, he should go to Chennai or Bangalore since he’s obviously South Indian..
I have a fantastic idea! Let’s get all of the analysts and associates and tell them they’re getting half of their bonuses now and half in five years! This will DEFINITELY inspire them to work harder next year!
There’s already a system for dealing with people who take on risky positions that deteriorate – it’s called firing them. Maybe you’ve heard of it? Citi is going to be doing a lot of that on Tuesday.
Banks must take on risk to earn money. If every trader got into T-Bills for the next year, the risk would be minimal but so would the profits. Why would anyone work at a place where they were required to take on risk and then penalized for doing so?
I hope the FT starts hiring people who actually understand banks in the future.
“Best case, I make eight figures this year. Worst case, I get fired.”
Can you spot the asymmetry in these payouts?
2:59,
Tuesday is the day? We all thought it would be yesterday but nothing happened…
Hey I have an even better idea. Instead of slashing bonuses, why don’t we just send them all to the Hyderabad IT office, that will teach them a lesson for screwing up…
It is only funny when Bess cusses – see The Dilbert Principle
Lukas,
Everyone is taught from day one to go for the gold. People won’t take the risks that these companies need them to take if the worst case is losing money. That’s an inherent flaw in asking people to trade other people’s money – no matter how much you try and tie them together, the trader and the investor will always have different goals, to some degree. There’s a reason that some people don’t make it as traders and that the best get paid as well as they do and are in demand.
Something most people are missing out on (especially those outside of Hedgestonia) is that most funds (at least the good ones) have a substantial portion of the PM’s money in them (usually around 20%). That is how they attempt to better align incentives. If the fund takes a dive, then so does the partners’ equity.
Basically, a very flawed analysis by someone who just doesnt get the US system. Anyone who works for a corp, can take outsize risk and get paid if correct, fired if wrong. Its the purpose of a corp, to shift risk from individuals (who are risk adverse) to an entity that can take risk and collapse if it fails. corps exist to take risk. of course, the assholes who simply buy a zillion contracts praying it goes up, may be what he refers to.
3:07
Yes, Tuesday
Gotta be quicker than this, Everett. Old news by 1:53 pm today. At DB, the news must POP! POP! POP!
Gotta be quicker than this, Everett. This was old news at 1:53 pm this afternoon. The news at DB must POP! POP! POP!
HAHAHA..I can’t wait to watch all you losers get fired today. Oh wait…what bank do I work for…oh shit…does it say H-S-B-C on my business card…aren’t we the bank that took $10B now and another $10B next year in subprime writedowns?
Ap = Rp – ( Rf + Bp ( Rm – Rf ) )
ccs, what is this day 1 of F101? freeman’s equation. so what.
Here’s an idea. Hold all bonuses in escrow. I’ll start a shop that pays out the bonuses for a fraction of their ultimate payout, after quantifying all the risks, then own the receivable all legal. then I’ll securitize them and write AAA paper, because God knows the RA’s pixie dust will get me good CE. I’ll package the bonus receivables with some atuo, mortgages, some CDS, and cause the next meltdown in 2015. thank you Rajan.
@3:21 Good point but remember that doesn’t necessarily align my interests as an investor with yours. I’m in many funds (im an institutional investor here, not merely a rich guy), so I want you to take a lot of risk with your best ideas cause I’ve diversified my overall risk away. Definately something thats considered when choosing funds.
@5:13 Another example of how irony rarely translates well on the net
That’s the Raghuram Rajan referenced in this post:
http://rodrik.typepad.com/dani_rodriks_weblog/2008/01/why-i-dont-do-p.html
He spoke about the idea at the AEA, and it would have been nice to have a link to the FT piece to see if he was consistent.