Sunday 30 January 2011

The Search for Symmetry: How bankers' bonuses can set-up the wrong incentives

In my last post I described how the Scalability of transactions allows banks to pay large sums to attract the best people. But there is another feature of the bonus system that is equally fascinating, and goes some way to explain why banks suffered such massive losses in the 2008-09 financial crisis.

Bonuses are, by their nature, asymmetric. Employees get paid a base salary. Then those who perform particularly well may get a bonus on top. The ones who perform particularly poorly do not, as a rule, get a fine, or an ‘anti-bonus.’ The worst that can happen to them is they lose their jobs.

In non-financial jobs this asymmetry is not such a problem, as the contribution the employee makes to their company is also asymmetric. A great employee can create a lot of value for their firm, but a bad employee doesn’t destroy equivalent amounts of value. Take a law firm for example: highly productive associates may work lots of billable hours doing quality work. Their firm benefits from the work and pays them a large bonus to try and retain them. A poor associate, who works few billable hours and does poor quality work, will get no bonus, and may get the boot. But the poor performer is unlikely to lose the law firm a lot of money, as the work is quality-checked before it goes to a client – the deficiencies are noticed and rectified by the good performers.

However the financial sector, or more particularly the trading sector, doesn’t work this way. On investment banks’ trading desks, the banks’ own funds are put at risk by traders taking positions on the financial markets. If the desk makes a profit, the traders get a cut, which can lead to multi-million pound bonuses for ‘top performers’. However, if the desk makes a loss, the traders are not exposed to the downside. They may lose their jobs, but it is the bank that has to foot the millions or billions of pounds of losses. This asymmetry gives traders an incentive to make large and risky bets, whether or not they are the best thing for the investment bank’s bottom line.

This kind of behaviour is a key cause of trading scandals such as Jerome Kerviel’s €4.9bn loss at Société Générale. But moreover, it led to an accumulation of risky assets (such as securitised loans) on banks’ balance sheets, and helped sustain the over-valuation of these assets in the run up to the recent financial crash.

In the wake of the crash, banks and regulators are looking hard at how performance ought to be rewarded. Multi-year guaranteed signing-on bonuses for star performers are being phased out. More bonuses are being issued as restricted stock, which becomes worthless if a trader leaves the firm; this gives them a financial penalty if they lose their job, a kind of ‘anti-bonus’ if they perform particularly badly. Likewise with ‘clawback clauses’ that can retrospectively reduce a trader’s bonus if the positions they take turn out to make a loss in the long-term. These kinds of a reforms are a promising step in avoiding a repeat of the crisis; though they also add an element of the unknown and untried: I would not be surprised if the new set of incentives for bankers leads to some unintended consequences further down the line.

Sunday 23 January 2011

How the Scalability Principle can lead to a massive bonus

It’s bonus season again, so the media have rolled out their usual commentary on whether bankers really deserve the millions of pounds or dollars they are likely to be awarded. Alongside the emotional opinion pieces (both pro- and anti- the bonus culture) there are a few more analytical columns, trying to get underneath just why such large bonuses get paid and whether they work.

I find the easiest way to understand bonuses is the concept of ‘scalability’ which is explained very well in Nassim Taleb’s book The Black Swan. In most jobs, Taleb points out, the economic value produced is proportional to the ability of employee and the time they put in. A shelf stacker who is 10% faster than average can stack 10% more shelves in a one day shift, or finish an ‘average’ day’s work in 90% of the time. This is a job that isn’t scalable: even if you were much better than average you could not re-stock a whole store in less than one minute due simply to the physical constraints of the situation. It’s not just low-skilled jobs that fit in this category: Accountants, Lawyers and Management Consultants all do non-scalable work as the fees they are paid depend on the time they put in.

Scalability means that the work you do can be magnified or replicated many times over with no additional cost. A classic example of this would be an author, who, once they have written a book, can sell it thousands or millions of times over. However: people are picky about what they read, and only the very best authors are commercially successful. An average writer may not make enough money to live on. But one who is much better than average can make millions from a single book. This replicability is why singers, actors and footballers can earn such vast sums of money in relatively short periods of time. It is also why bankers can earn such large bonuses.

All the activities carried out by the ‘front office’ staff at an investment bank involve organising financial transactions. Transactions are easily scalable: if bond trader is able to make a profit by trading a volume of £10,000 then they could make one thousand times the profit just by multiplying the size of their trades. Similarly, in merger and acquisition activity, the effort required in a £10 billion deal is much less than 1000 times the effort required in a £10 million deal. This means that a banker who is only slightly better than average can make a massive difference to a bank’s bottom line.

Because all the banks understand this principle, the forces of supply, demand, and competition then kick in. The ‘going-rate’ for talented and experienced staff is established, and banks that don’t keep up with it will see their best performers jump ship to a competitor. This is the justification for bonuses most frequently cited by CEOs such as Bob Diamond. However without an understanding of the principle of scalability, it can be difficult to comprehend.


Nassim Taleb writes about the scalability of professions with the following health warning:
"If I myself had to give advice, I would recommend someone pick a profession that is not scalable! A scalable profession is good only if you are successful; they are more competitive, produce monstrous inequalities, and are far more random, with huge disparities between efforts and rewards – a few can take a large share of the pie, leaving other out entirely at no fault of their own."

Sunday 9 January 2011

Next generation entrepreneurs: coupling the growth of emerging markets with business ideas from the West

How do you become a successful entrepreneur? Amongst the many answers to this question, one thing that undoubtedly helps is starting your business in a growing market. Nearly all of the biggest entrepreneurial success stories involve rapidly growing markets: think of Microsoft (founded 1975) and Apple (1976) growing in the 1980s Computing boom; Amazon (1994) and EBay (1995) in the 1990s eCommerce boom, and Skype (2003) and Facebook (2004) in the 2000s Social Networking boom. Success in tackling mature industries is much rarer, though not impossible as proved by Sir Richard Branson, whose Virgin group has had major successes in both the Retail and Airline industries.

Many growth markets (those growing over 20% p.a.) in the Western world are the result of technological innovation. Except when a new technology triggers a wave of entrepreneurial activity, most business in the West is done by old and well-established firms (which typically grow less than 10% p.a.). The business hierarchy and supply chain structure is well understood; most corporate strategies are honed and fairly constant, and winners and losers emerge over decades. As a result, success as an entrepreneur is, for the most part, limited to the tech-savvy.

In comparison, in emerging markets the economic order is in a state of flux. A whole host of industries which are mature in the West are still in the process of being formed. In many cases, there are no ‘old and well-established firms,’ with new entrants appearing regularly. The winners and losers in these markets are far from clear.

One particular opportunity is to introduce business ideas that have proved successful in the West but do not exist in the emerging market you are targeting. For example, the most popular search engine in China is Baidu, a company often seen as an imitating Google’s successful search functionality. Last year the FT published an article about a group of entrepreneurs in Shanghai setting up a bar with the ‘Cheers’ theme, taken from Western popular culture. To me these are both effective examples of ‘Cross Cultural Arbitrage,’ where the value-add is in transferring a business model from one locality to another. It doesn’t involve doing anything ground-breaking, but it can lead to strong success. It requires a familiarity with several cultures, which a growing proportion of young people are developing through an education that spans two or three continents. I expect to see a great deal more of these kinds of business success stories, a positive impact of ever-increasing globalization.