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, 30 January 2011
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.
Afterword
Nassim Taleb writes about the scalability of professions with the following health warning:
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.
Afterword
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.
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.
Thursday, 30 December 2010
Why China's trade surplus is a strategic opportunity
The economic growth in China over the last 20 years has been one of the biggest forces for reducing global poverty, as tens of millions of people have gone from subsistence farming to industrialised production jobs. The wealth that has been created from this trend has transformed China, and now cities such as Shanghai and Beijing are catching up with Hong Kong and Singapore in their level of development. The growth in China looks set to continue, with the economy forecast to surpass the USA’s in size within the decade, according to a new interactive tool published by The Economist.
During its period of growth, China has benefitted from being a low cost economy by exporting manufactured products to the rest of the world. Now, its low levels of domestic consumption have been brought into the spotlight by the sovereign debt crisis. “How can developed countries deal with their trade deficits while China runs such a large surplus?” is the question Western politicians and economists are asking. China’s ability to export is propped up by its cheap currency, which results from the Chinese government selling Yuan and buying US-dollar denominated Treasury Bonds.
Some American economists decry this as manipulation of the Chinese currency, at odds with a free-market philosophy of world trade (this is a view I see as rather hypocritical: as long as the Chinese government is buying Treasury bonds on the free market it is up to them how to spend their Yuan). However it is clear that a lot of tension is building up in the system. If the Chinese government stops buying Treasuries, the Renminbi will appreciate against the dollar, which devalues all the bonds the Chinese government already holds. Furthermore, Chinese exports would become less competitive in the global marketplace, potentially damaging its economic growth. And the US will find it harder to finance its budget deficit, likely to cause serious problems for its domestic economy.
The only thing that will sustain China’s growth is a rebalancing of China’s economy toward domestic consumption. This will cause a large shift in the nature of the goods and services most in demand. It presents both local and foreign companies with a great opportunity for growth. Capitalising on this shift in consumption from developed to developing countries should be high on the list of strategic priorities of any multinational corporation.
During its period of growth, China has benefitted from being a low cost economy by exporting manufactured products to the rest of the world. Now, its low levels of domestic consumption have been brought into the spotlight by the sovereign debt crisis. “How can developed countries deal with their trade deficits while China runs such a large surplus?” is the question Western politicians and economists are asking. China’s ability to export is propped up by its cheap currency, which results from the Chinese government selling Yuan and buying US-dollar denominated Treasury Bonds.
Some American economists decry this as manipulation of the Chinese currency, at odds with a free-market philosophy of world trade (this is a view I see as rather hypocritical: as long as the Chinese government is buying Treasury bonds on the free market it is up to them how to spend their Yuan). However it is clear that a lot of tension is building up in the system. If the Chinese government stops buying Treasuries, the Renminbi will appreciate against the dollar, which devalues all the bonds the Chinese government already holds. Furthermore, Chinese exports would become less competitive in the global marketplace, potentially damaging its economic growth. And the US will find it harder to finance its budget deficit, likely to cause serious problems for its domestic economy.
The only thing that will sustain China’s growth is a rebalancing of China’s economy toward domestic consumption. This will cause a large shift in the nature of the goods and services most in demand. It presents both local and foreign companies with a great opportunity for growth. Capitalising on this shift in consumption from developed to developing countries should be high on the list of strategic priorities of any multinational corporation.
Thursday, 9 December 2010
A few more words on Tuition Fees before I get back to writing about the rest of the World
The passing of the motion to raise the cap on tuition fees came as a massive disappointment today. I was impressed by Labour MP Sharon Hodgson, who made the best speech in the commons on the actual sums involved. She emphasised the fact that graduates on typical salaries will not even be paying the interest on their loans, which will lead to a large proportion of the debt being written off. (as I have discussed here).
I also admire the students who came to London to peacefully engage in a protest on this important issue, and I wished I could have joined them. I heard a number of comments today critical of the protesters, grouping them all together as violent aggressors, but really this label only applies to a small minority of them. The vast majority were only interested in peacefully expressing their discontent at the cuts to education funding. The tactics of the police, in particular the thuggish ‘Territorial Support Group’ were heavy handed, and were responsible for inciting and perpetuating violence rather than stemming it. The latest figures – 9 police officers* injured compared to 15 protesters – underlines which group was the more violent.
I am sure we have not heard the last word on the tuition fees debate, and as the details are ironed out in a white paper next year I am hopeful that more politicians will see sense and will make amendments to the current proposals. I expect that I will have more to write on the matter later. But the tuition fees debate has distracted me from my intention to write more about China, following my visit there in October. The aim of this blog is to take a ‘worldview’ and I have become wrapped up in the problems of the UK, which significant though they are, pale in comparison to the challenges faced by most countries in the developing world.
As an example, one of the most memorable features of my trip to China was living with the air pollution. I am not especially prone to respiratory problems, but even so my lungs felt weak and I had frequent bouts of coughing due to the air pollution, and I was only there for two weeks. The pollution in China is something that hundreds of millions of people have to live with daily. In time it is bound to cause serious chronic health problems.
The pollution is directly related to China’s rapid economic growth, which has spurred the building of a large number of coal-fired power plants. It is an example of the ‘tragedy of the commons’ where a common resource – in this case clean air – is depleted through over-use. The only solution to this kind of market failure is government intervention, which has been slow as the government prizes economic growth so highly.
Reminding myself of the scale of problems like this helps me to feel a little less angry about the UK’s University funding debate.
*At least one police officer was injured when he was ‘forced off his horse.’ Perhaps the use of horses in crowd control is a little outdated nowadays?
I also admire the students who came to London to peacefully engage in a protest on this important issue, and I wished I could have joined them. I heard a number of comments today critical of the protesters, grouping them all together as violent aggressors, but really this label only applies to a small minority of them. The vast majority were only interested in peacefully expressing their discontent at the cuts to education funding. The tactics of the police, in particular the thuggish ‘Territorial Support Group’ were heavy handed, and were responsible for inciting and perpetuating violence rather than stemming it. The latest figures – 9 police officers* injured compared to 15 protesters – underlines which group was the more violent.
I am sure we have not heard the last word on the tuition fees debate, and as the details are ironed out in a white paper next year I am hopeful that more politicians will see sense and will make amendments to the current proposals. I expect that I will have more to write on the matter later. But the tuition fees debate has distracted me from my intention to write more about China, following my visit there in October. The aim of this blog is to take a ‘worldview’ and I have become wrapped up in the problems of the UK, which significant though they are, pale in comparison to the challenges faced by most countries in the developing world.
As an example, one of the most memorable features of my trip to China was living with the air pollution. I am not especially prone to respiratory problems, but even so my lungs felt weak and I had frequent bouts of coughing due to the air pollution, and I was only there for two weeks. The pollution in China is something that hundreds of millions of people have to live with daily. In time it is bound to cause serious chronic health problems.
The pollution is directly related to China’s rapid economic growth, which has spurred the building of a large number of coal-fired power plants. It is an example of the ‘tragedy of the commons’ where a common resource – in this case clean air – is depleted through over-use. The only solution to this kind of market failure is government intervention, which has been slow as the government prizes economic growth so highly.
Reminding myself of the scale of problems like this helps me to feel a little less angry about the UK’s University funding debate.
*At least one police officer was injured when he was ‘forced off his horse.’ Perhaps the use of horses in crowd control is a little outdated nowadays?
Wednesday, 1 December 2010
J.K Rowling, JJ Abrams and Claudio Sanchez: Epic visions, brilliantly realised
I caught Harry Potter and the Deathly Hallows Part One this weekend, which brought back to me how much I enjoyed reading J.K.Rowling’s novels.
J.K Rowling clearly has a fantastic imagination, and a gift with words. This was clear from the first novel, The Philosopher’s Stone, which was enough by itself to get many people (adults and children alike) hooked on the Harry Potter series. However I think it was only when the whole series was released that her greatest achievement became clear: the creation of a narrative that spans seven books, while each book is in itself a compelling self-contained story. Few authors, even the amongst world’s most celebrated, have attempted such a feat.
The process of producing an uber-narrative that is told in multiple parts has many challenges, but has in recent years lead to some brilliant creations. In television, the first series of 24 was ground-breaking not just in its real-time photography, but in the way the 24 consecutive episodes fitted together to tell a seamless story. JJ Abrams’ Lost has taken the epic-television-series even further, with six series (121 episodes) interweaving one major story arc with emotive details from each character’s back-story. The blend of genres - fantasy / sci-fi in the major arc and drama / tragedy in the back-stories - creates a powerful and suspenseful masterpiece.
In music, one of my favourite bands, Coheed and Cambria, have used the multi-part narrative to great effect. The multi-talented Claudio Sanchez used Coheed and Cambria the band to tell the story of “The Amory Wars” a science-fiction story that he originally conceived as a comic book. Each chapter of the Amory Wars corresponds to a Coheed and Cambria album, creating a five-album rock epic. Furthermore, after four albums were released the band famously played a four-day concert series, performing one album each day, an event called The Neverender.
I have gained much enjoyment from these works, but by their nature they have all come to an end. I look forward to discovering new epic sagas in the future, ones that are perhaps being written as I write these words now...
J.K Rowling clearly has a fantastic imagination, and a gift with words. This was clear from the first novel, The Philosopher’s Stone, which was enough by itself to get many people (adults and children alike) hooked on the Harry Potter series. However I think it was only when the whole series was released that her greatest achievement became clear: the creation of a narrative that spans seven books, while each book is in itself a compelling self-contained story. Few authors, even the amongst world’s most celebrated, have attempted such a feat.
The process of producing an uber-narrative that is told in multiple parts has many challenges, but has in recent years lead to some brilliant creations. In television, the first series of 24 was ground-breaking not just in its real-time photography, but in the way the 24 consecutive episodes fitted together to tell a seamless story. JJ Abrams’ Lost has taken the epic-television-series even further, with six series (121 episodes) interweaving one major story arc with emotive details from each character’s back-story. The blend of genres - fantasy / sci-fi in the major arc and drama / tragedy in the back-stories - creates a powerful and suspenseful masterpiece.
In music, one of my favourite bands, Coheed and Cambria, have used the multi-part narrative to great effect. The multi-talented Claudio Sanchez used Coheed and Cambria the band to tell the story of “The Amory Wars” a science-fiction story that he originally conceived as a comic book. Each chapter of the Amory Wars corresponds to a Coheed and Cambria album, creating a five-album rock epic. Furthermore, after four albums were released the band famously played a four-day concert series, performing one album each day, an event called The Neverender.
I have gained much enjoyment from these works, but by their nature they have all come to an end. I look forward to discovering new epic sagas in the future, ones that are perhaps being written as I write these words now...
Tuesday, 23 November 2010
Follow-up on tuition fees: What politicians need is a new frame of reference
Over the past few weeks I have had a number of conversations with people coming from various viewpoints on the issue of HE financing. When I have criticised the proposed system I have been challenged in two key areas: How would I propose universities be funded, and Why should taxpayers subsidise universities anyway?
On the question of how to fund higher education, I believe it is a matter of priorities. The government undoubtedly needs to cut expenditure, but has a number of options for doing so. For example, we should prioritise funding universities ahead of replacing the Trident missile system. I would favour full funding for a smaller number of University places, awarded on the basis of merit, over arbitrary targets for the percentage of people starting degrees. Many school-leavers may be better off getting vocational work experience than learning an abstract academic discipline.
There is a broader, more philosophical, question about whether it is fair that taxpayers support a student’s education. One strong argument in response to this is that graduates who benefit financially from their degree (e.g. going into banking, law or medicine) pay higher tax through the existing income tax regime, thereby giving back to the Treasury. This does not apply, however, to graduates whose earnings are in line with or less than non-graduates. In this case, they may be seen to have enjoyed a few years of relative leisure being subsidised by hard-working taxpayers. When described in this way, I realise that this scenario looks unfair. But only with the benefit of hindsight can we know which graduates go on to be financially successful (and pay loads of tax) and which go on to earn relatively little.
The fundamental problem with an increase in tuition fees is that it will affect people’s decisions in a negative way. The tuition fees question is being approached purely from the perspective of economics, when what policy makers need to consider is the psychological effects tuition fees will have. People who ought to go to university won’t. Graduates who ought to explore career paths based on their passions will instead go into low-paying but safe jobs. I sincerely hope that politicians realise this before voting on the issue.
On the question of how to fund higher education, I believe it is a matter of priorities. The government undoubtedly needs to cut expenditure, but has a number of options for doing so. For example, we should prioritise funding universities ahead of replacing the Trident missile system. I would favour full funding for a smaller number of University places, awarded on the basis of merit, over arbitrary targets for the percentage of people starting degrees. Many school-leavers may be better off getting vocational work experience than learning an abstract academic discipline.
There is a broader, more philosophical, question about whether it is fair that taxpayers support a student’s education. One strong argument in response to this is that graduates who benefit financially from their degree (e.g. going into banking, law or medicine) pay higher tax through the existing income tax regime, thereby giving back to the Treasury. This does not apply, however, to graduates whose earnings are in line with or less than non-graduates. In this case, they may be seen to have enjoyed a few years of relative leisure being subsidised by hard-working taxpayers. When described in this way, I realise that this scenario looks unfair. But only with the benefit of hindsight can we know which graduates go on to be financially successful (and pay loads of tax) and which go on to earn relatively little.
The fundamental problem with an increase in tuition fees is that it will affect people’s decisions in a negative way. The tuition fees question is being approached purely from the perspective of economics, when what policy makers need to consider is the psychological effects tuition fees will have. People who ought to go to university won’t. Graduates who ought to explore career paths based on their passions will instead go into low-paying but safe jobs. I sincerely hope that politicians realise this before voting on the issue.
Subscribe to:
Posts (Atom)
Posts
