A number of commentators are going to great lengths to explain how misalignment of incentives on Wall Street and in global finance helped inflame the current economic crisis. I have a much simpler explanation that can be summed up in five simple words that every banker and analyst has heard at least one in his or her life:
“Don’t dilute the bonus pool.”
Former clarion of the dot-com era Henry Blodget  makes the latest attempt to explain the misaligned incentives in Why Wall Street Always Blows It . Blodget spends a large amount of text citing lack of experience and knowledge of history as reasons for analysts’ misjudgments about the market. This may be true (and is fixable), however, buried at the end of the article, Blodget hits the nail on the head:
Professional fund managers are paid to manage money for their clients. Most managers succeed or fail based not on how much money they make or lose but on how much they make or lose relative to the market and other fund managers.
If the market goes up 20 percent and your Fidelity fund goes up only 10 percent, for example, you probably won’t call Fidelity and say, “Thank you.” Instead, you’ll probably call and say, “What am I paying you people for, anyway?” (Or at least that’s what a lot of investors do.) And if this performance continues for a while, you might eventually fire Fidelity and hire a new fund manager.
On the other hand, if your Fidelity fund declines in value but the market drops even more, you’ll probably stick with the fund for a while (“Hey, at least I didn’t lose as much as all those suckers in index funds”). That is, until the market drops so much that you can’t take it anymore and you sell everything, which is what a lot of people did in October, when the Dow plunged below 9,000.
I. Wall Street in 5 simple words
“Don’t dilute the bonus pool”
These five words are prime directive number one in the business of OPM management (Other People’s Money). Let me explain briefly how this works.
Markets go up: The goal of OPM is to earn as much as possible on the upside. Period. Let’s say you do excellent research, prudent investing, appropriate risk management and earn a 10% return with little provable downside. At the same time, the other guy in the pool employs a shoot-the-moon risky strategy but earns a 25% return. You have just diluted the bonus pool.
Markets go down: There is no bonus pool, so if you break even and the other guy loses 50% it doesn’t matter since it isn’t your money!
II. Existing solutions, partnerships and UBS
Bonus calculation where management of OPM is involved will always invite risky behavior for the simple reason that bonuses are not directly attributable to an individual. The only exception to this is in trading.
Two solutions have been proposed for the bonus hazard that contributes to financial system risk:
- Force banks and brokerages that deal in risk to reform as limited partnerships and trade with their own capital. Many Wall Street banks were historically partnerships and behaved more conservatively when they had partner capital at risk in addition to OPM. The flaw here is that a partnership which is out of the money may still have incentive to gamble, perhaps even use OPM to cover its tracks.
- The Swiss solution proposed by UBS  of bonuses and maluses for underperformance. This attempts to attribute performance more on an individual level and punish incompetent or risky behavior. While this is a better solution than #1, there is still the possibility that a malused employee, with no more incentive, could just quit and make things worse.
III. A better way, make risk a profession
The best solution to the problem, at least within the U.S. structure, is to start treating financial professionals with the same level of responsibility that we treat doctors or lawyers. This supposes a greater level of trust in finance, but it also imposes burdens of qualification and assumption of liability on financial professionals:
- Require a specific level of education and examination for financial professionals. Lawyers take the Bar Exam, doctors must pass a gamut of medical boards before being allowed to practice. Both attend at least 3-4 years of postgraduate education. Finance has the groundwork for this in MBA programs as well as CPA and CFA exams. It is apparent that the Series 7, 63, 65 exams do not do the job.
- Do not allow financial professionals to disclaim professional liability. On a legal level, this means firms cannot take advantage of the limited liability protections of incorporation for professional decisions (they can for incidental issues like workplace hazards). Lawyers, doctors, accountants and most other professionals have this restriction. In other words, if your broker commits malpractice, he pays for it – there is no optional corporate remedy like maluses.
We’ve seen the last gasp of bonus pool culture with AIG  and the Wall Street banks’ attempt to use U.S. Government funds to pay bonuses  in spite of losses. UBS was very brave in taking a bold step at reform, but the Swiss cannot fully reform the system by themselves. We, as investors, must call for wholesale alignment of incentives with financial professionals. Time is short.
. . . And that’s how it goes