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."

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