The Wall Street money ratchet

If you ever read one of those quaint old books on banking - you know, the ones written maybe 10 years ago - you will see them mentioning a curious concept. Managing risk.

Banking has at its heart a behavior which is very risky. Banks borrow short, and lend long. This is risky because a short term loan (like your savings balance or your 3 month CD) may be withdrawn, while the bank's long term obligations (like your neighbor's mortgage) can remain on the books for 25 years. Now, since the bank's source of funds is primarily short deposits like yours there is obviously some alchemy going on to generate 25 year loans.

It used to be that the alchemy was done with a trifecta of advantages the bank had:
- it has lots of deposits, with average behavior that can be trusted
- it has a core of long term capital to smooth over the slight variations
- it is very careful to minimize other sources of risk

And there you have it, the banking system that can be recognized from "It's a wonderful life", a nice little earner which fueled our economy steadily for about 70 years.

Two things changed recently. The first is that securitizing the long term loans replaced bank depositors with a new class of investor, who previously would have invested in bonds. These investors lend long too, and are expected to manage their own risks. Sort of. Anyway, the bank was relieved of the alchemy of turning short loans into long ones, and in making this change banks felt themselves become free to take risks.

The more insidious and troubling change is the conversion of banking culture to a system of bonus rewards. The problem is, bonuses reward risky behavior. Modern banking is an exercise in statistics, well understood by the bankers. So if you are managing some money and fail to hit your targets, well everyone knows it is not your fault. You still get your salary. Not everyone can be above average. Maybe if you are consistently under the average you will move into a nice quiet job in the bank - hey, they still have those. But, if you are lucky the funds you manage will beat the average. Now you are eligable for a bonus. And as we have seen these can be very big.

But, fundamentally all the bonus is rewarding is risky behavior. Suppose you did like banks used to do and managed a portfolio for steady gains and low risk. If you do that then you will have no chance of a big bonus. It is much more interesting to play a high risk strategy which could have a higher gain. Now, maybe you will just collect your salary. Or maybe, just maybe you will be in the 10% lucky sods who have the luck to seriously outperform and collect the big $ bonus.

Since the baseline is "collect a salary" and there is minimal penalty on failure, while the bonus for luck will be enough to retire on (well if you were not Wall Street greedy), the clear best strategy is to create investments with high likely gain and who cares if they have, inevitably, high risk.

So the fundamental problem with bonusses on Wall Street is that mostly they are not rewarding the best. They are rewarding the riskiest. And if we want to trust our banks that culture has to be eliminated. And the fear that the "best and brightest" will be driven away? Nah, they'll fly away. Vegas is too far for them to want to drive.