November 10, 2015    4 minute read

The Relationship Between Bonuses and the 2008 Crisis

   November 10, 2015    4 minute read

The Relationship Between Bonuses and the 2008 Crisis

The 2008 financial crisis has changed the world forever and has been declared the worst crisis since the Great Depression of 1930. The most important problem that rose in the last decade was the continuous creation of financial instruments that depended on weak underlying assets, e.g. the US subprime mortgages. With the increased fashion of securitize credits, the financial engineering became even more important. New types of securities, the Asset-Backed Securities (ABS), became very popular in the financial markets. The latter are not bad themselves, but they should be an exception rather than the standard for a financial institution.

However, even the biggest financial institutions granted credits to low solvency borrowers, based on the concept that then the credit would be transferred to another market player. The loop generated from this mechanism had to explode. Ultimately, the bursting of the US housing bubble, which reached its peak in 2004, has triggered the crisis.

In short, the pre-crisis years’ financial environment was characterized by:

  1. An unsuitable Regulation: Basel II has enhanced the crisis’ effects due to its procyclical measures rather than prevent them. Indeed, it requires that financial institutions increase their minimum capital requirements during weaknesses periods rather than on booming ones. Moreover, financial institutions were incentivised to adopt different ways to deceive minimum capital requirements.
  2. Individuals and companies were able to borrow money easily, because their creditworthiness’ assessment has become less restrictive: Financial Institutions put less efforts in the assessment of their clients’ solvency, because then they could transfer their credits (ex. mortgages) exploiting the securitization. Therefore, individual and companies were able to borrow money without difficulty due to the looser standards requirements. Last, but not the least, the risk management divisions were often moved to the background and had no much powers to avoid the disaster.

Financial Crisis and Bonuses

If there is a proved link between the financial crisis and the large bonuses that are paid at the financial institutions, then there should be placed some limits. We should ask ourselves if there were some causes that could be prevented.  An affirmative view is provided by the ex derivatives trader and professor Nassim Taleb. Author of “The Black Swan” (one of the most influential modern books about risk management and the uncertainty theory), Taleb has formulated theories concerning a rare and unexpected event that has significant consequences, i.e. the so-called “black swan”. According to Taleb, the bonuses at the major financial institutions should be ended. The reason is that the banking executives are incentivised to take on more risks. In case of good investments they earn a huge upside, on the contrary, in case of a bad bet, the downside is mainly borne by the firm and its shareholders.

“Inappropriate incentive structures played a role in encouraging behaviour which contributed to the financial crisis”

Moreover, there is another important thing that influence the managers’ behaviour: the possible intervention of the government. In order to avoid contagion and a systematic crisis, typically governments bail the banks out when needed. For instance, it has happened in 1998 with Long-Term Capital Management (a hedge fund managed by the two Nobel Prize winners Scholes and Merton). Therefore, this belief will increase the risk exposure of the banking executives’ investments, especially if there is the possibility to earn huge bonuses. However, an important counter case is the recent Lehman Brother bankruptcy, when the Fed has let it fail probably to give a strong signal to the other financial institutions. At the end of the day, following the Taleb’s suggestion could not solve the excessive risk-taking situation.

Furthermore, shareholders have a say in the financial institutions’ decisions, and if they are low risk averse then they would punish the managers that refuse to take on more risk. Therefore, the bonuses paid by financial institutions should be limited, but it would not totally solve the excessive risk-taking problem.

Current trends

Nowadays, the average of bankers’ bonuses is around $173,000 . According to “The Guardian”, even though the Wall Street’s profits are experiencing a moderate decline, the bonuses paid are increasing because they are paid out on revenues and not profits.

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Figure 1: Average Wall Street Bonuses (2015 dollars) (Source: NY Comptroller)

The bar chart depicts that the bonuses are reshaping the same of pre-crisis level.
We can conclude saying that financial markets and institutions seem to have a very short memory. The current high bonuses trend shows an alarming return to an excessive risk-taking environment.

 

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