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: