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European Tribune - Tiptoeing around the Anglo Disease
Another conflict of interest that has become pronounced is between banks' shareholders and their employees. This is the more cynical interpretation of Société Générale. If employees make profits they are paid bonuses; if they make losses, they are sacked. Their incentive, from graduate trainee up to chief executive, is to take more risk and so increase the potential profits. (...)
And the FT discovers this now?

This is from Nassim Taleb's Dynamic Hedging, published in 1997 and apparently sold very well in the 10+ years since.The book is peppered with things like

It is often easier to arbitrage one's accounting system than the market
But even without having to assume a failure of accounting systems, profit-based compensation is fraught with problems.
A trader with a "synthetic capital" of $10 million (i.e., the virtual capital allocated to him by the bank) has often more earning power than a manager with a higher amount of capital under him, because the manager will have to face the "diversification" - the offsetting returns from traders
This is a consequence of the lopsided performance-tied compensation: everyone profits from the upside but doesn't lose from the downside, and the individual trader has larger volatility than the manager of a team of traders.
At any rate, when the trader owns an option on his profits (i.e., gets a cut of the upside without having to share into the downside), as is the case with traders using other people's money, it is always optimal to take as much risk as possible. An option is worth the most when the volatility is highest.
Now, hasn't it occurred to anyone that the banks, who are in charge of money and credit on behalf of the economy at large, enjoy an option as well? When there are huge profits they get a cut. When the economy crashes because they inflated the money supply and ran extreme risks with it, they get bailed out or they go out of business, but they get to keep whatever fraction of their previous profit they didn't spend on oversized champagne bottles.


We have met the enemy, and he is us — Pogo
by Migeru (migeru at eurotrib dot com) on Sat Jan 26th, 2008 at 11:29:17 AM EST

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