A couple of months ago, I wrote a post about the Credit default swap market and whether it had to be reformed. Today, I want to talk about bonuses. Yes, the every liberal’s favourite topic: Wall Street bonuses. Media regularly feeds us with news on fat bonuses in the financial sector.

I’m a finance and economics student, aiming for a career in the financial sector. I figured I might be as good a person as any to deal with this subject, although some are probably going to claim that I’m biased; I have a personal interest in the big bonuses not going away, as I will certainly need them to pay back my study debt (and buy a porsche). However, I still feel I am a more objective observer than those who only read the headlines and nothing else.

There are certain facts about working in finance that everyone should be aware of. First of all, the base salaries and lack thereof. The base salaries in most areas of finance aren’t great, in particular not in the beginning. Traders sometimes don’t even have a base salary at all, but live fully on their commission (a % of the money they bring in to their firm).

Even if you’re a managing director at an investment bank, you’re unlikely to have a base salary of more than 200-300k. That’s big money for sure – but the bonus is the main part of the salary, unlike for other jobs where the bonus is only an “add-on” that you get in time for christmas. Also, anyone in the financial industry can be fired at the drop of the hat; what happens is the boss tells you to come to the conference room, and once there, he tells you your services are no longer needed and you got 20 minutes to leave the building.

Working hours are pretty tough too – anything from 70 to 100 hours a week is not unreasonable, depending on your role. You can’t really say no if your boss asks you to come to work, for whatever reason. And, as a matter of fact, the hourly salary for an average financier is not that great (here’s an article about that). Add the fact that only about 16 % of those who start at an investment bank will still be there 4 years later (because they get burned out, fired or just move somewhere else), and that the whole industry operates on an “up or out” basis – meaning after four years, if you work at an investment bank, you either get promoted or fired, and you can see why they have to offer decent bonuses to keep people around.

So, now that you hopefully have realized that working on Wall street is not what Hollywood has made it seem like…

Is there a problem with the big bonuses?

My answer is: Yes. The problem, however, is a tad more complicated than Obama and his buddies would have you believe.

The problem can be explained through microeconomics, which teaches us that consumers and investors in general are risk-averse: We won’t take risks just for the sake of it, but we want to be compensated for it. For example: If someone offered you a bet in which you’d toss a coin, and if it came up heads you’d win $1000, and if it came up tails you’d lose $1000, you probably wouldn’t take it. The pain of losing $1000 is greater than the joy of winning $1000.

Similarly, if you had a job where you had a 50 % chance of making 30k, and a 50 % chance of making 60k, and you got to choose between that and another job that would always pay you 45k, chances are you’d pick the job with the stable salary. It makes sense: You may have mortgage payments to make that are not going to become any lower just because your salary drops to 30k, which it will half of the time. It’s just simpler to have the same salary all the time, and not have to worry about it.

Traders (note: in this text, trader refers to anyone in asset management, not just those who technically speaking are traders), as I mentioned, sometimes don’t even have a base salary. They could potentially end up with no salary at all – which is why the expected, average salary that they will achieve must be so high. It’s all about compensating for the risk that it could become zero, under bad market conditions.

So what’s the problem? Just make a law that will guarantee everyone a base salary, right? Not really. While that MIGHT work in theory, the last thing we want right now is to take away the incentive from traders to do everything in their power to make a profit. After all, if traders can hardly make a profit even though not making a profit means not being able to pay rent, then lowering their incentive is probably not a good idea.

The problem is that while microeconomics teaches us that everyone is risk-averse, it also teaches us that not everyone is risk-averse with small amounts of money. Take a $1 lottery ticket for example, which gives you a 1/1 000 000 chance of winning $500,000. It makes no sense to buy this ticket, as the expected value of the lottery is only 50 cent. Yet, a lot of us would buy the ticket anyway, because we figure a dollar is not a whole lot of money anyway. We’re willing to gamble, as long as we don’t risk losing any significant amount of money. The chance of winning half a million, even if it’s so small it’s not objectively speaking worth one dollar, gives us so much utility (happiness) that we’re willing to spend one dollar for it. Plus, gambling can be fun in itself; I know plenty of people who play poker not to win, but because they like the game. They know the odds are against them, but they consider the activity to have a value in itself.

But what, really, is a significant amount of money, large enough that we would not be willing to gamble with it? I might buy that lottery ticket for $1, but if it had cost me $100 (with an expected value of $50), I may have thought it was too much money to gamble with. Same odds, same expected value, but now I’m suddenly risk-averse.

However, if you’re a trader or an investment banker with $1 million in the bank, you might be willing to gamble with $100 or even $1000. It’s not a lot of money to you anyway, so who cares?

Now, here we come to the real problem with bonuses: They’re not usually spent. Plenty of bankers and traders take it as a habit to live on their base salaries (if they have one – bankers nearly always do) and just put the bonus in a bank account. After a decade or so in the industry, if they’ve been good, they may very well have saved up enough that they could retire if they wanted to.

Let’s say that by taking on another 10 % extra risk, a trader might risk losing $10 000 (ie his bonus will be $10 000 smaller) if the bet goes bad, and win $10 000 if it goes well. He might very well consider this a good deal – $10 000 isn’t a whole lot of money to him anyway, he doesn’t really need any more money, so even if he were to not get another bonus in his entire life, he’d still be able to live comfortably until he met his creator (not necessarily after that, though…).

Now, look at it from the saver’s perspective: He trusts the trader to make the right decisions and to try and maximize his, the saver’s, utility. 10 % extra risk might mean an individual saver will risk losing $1000 more than he otherwise would have, and win $1000 if the bets go well. Is the saver willing to take on this extra risk? Supposing he’s risk averse (and that the probabilities of a good and a bad outcome are the same), the answer is no. The trader don’t see what the big deal is; $1000 dollars is just spare change to him anyway. The saver would like the trader to be careful with the saver’s money, but the trader has no great incentive for that. Worst case scenario for him, he gets fired and retires.

Of course, far from all traders could actually retire on their savings. The point however remains: As you get richer, you care less about each additional unit of money, and you take higher risks.

In essence, this is a version of the age-old principal-agent problem: How do you get a worker to do his best, when you can’t supervise him all the time? As a saver, I’ve invested money in plenty of mutual funds, and I just don’t have the time to go over to the respective fund managing companies and watch over the traders’ backs every minute of the day to make sure they don’t take any risk that I don’t want them to take.

Now, the classical solution to the principal-agent problem is very theoretical: Essentially, the worker should pay the employee to work, and then he gets to keep all the proceedings from his work. For example, you’d pay a fee to have the right to work in a mine, but then all the gold you manage to dig out belongs to you and you can sell it to whoever you want. Then, you’ll obviously do your best as you want to recover the cost of the fee.

This is actually a part of a well-known concept: Franchising. You pay a fee to McDonald’s (or Subway, or Burger king – you get the deal) and in return you get to start a restaurant with their name and logo. You can keep the returns from the restaurant, you just pay a fixed fee for the right to use the brand (though the model varies slightly and in some cases you pay a % of your revenue).

How would this work in asset management? Essentially, the trader would “buy” your money from you, trade with it and then get to keep the return. This is not a very realistic concept, but it is certainly a funny thought.

Some suggest that the problem is the size of the bonuses, that allows traders to get so rich that they no longer have to care about getting richer (or worry about a salary reduction). I don’t think the size of the bonuses can be regulated (it’s not like no-one’s ever tried it), and I believe bonuses are a necessary part of the financial industry. Having said that, while bonuses are necessary, gamblers need not apply. What we need to work on is getting the right people into finance.

How could this be done? What I would suggest is a license. Think about it: If you want to become a doctor, you need a license. Why? Because as a society, we believe the practice of medicine to be a very serious issue and we believe that since a bad doctor can cost a patient his or her life, we need to do everything to make sure that the people with trust as doctors are the type of people who can handle this responsibility. The same goes for lawyers, judges and many other professions.

When a mistake is very serious, we require a license: A mistake by a doctor can cost a human life, a mistake by a judge can lead to an innocent being thrown in jail. A mistake by a fast food worker on the other hand will lead to someone getting a regular hamburger instead of a cheeseburger, or vice versa. This isn’t very serious and is easily corrected, hence we don’t require a license to practice preparation and serving of fast food.

A mistake by a financial sector worker is potentially very serious. It can lead to anything from a bubble (yes, I know those aren’t caused by single individuals) to bankruptcies and layoffs. Hence, it would make perfect sense to have everyone who wants to work in the financial sector pass an exam to get a license to practice finance. Right now, the financial sector is hiring people from all kinds of backgrounds with degrees that don’t have a thing to do with finance: Engineers, software developers, mathematicians, even those with degrees in theoretical physics! These people may be really good at mathematics, but when the formulas break down (as happens during times of financial crisis), they find themselves clueless, unable to fly with the autopilot turned off. Far from all of them  understand behavioral finance, and they’ve never even heard of microeconomics (much less macro). These things are essential to understand to be successful in finance, but this is forgotten during booms and only rediscovered during recessions.

To work as a lawyer, you study law. To work as a doctor, you study medicine. And in order to work in finance, you should have studied… finance. Not software development. If you have a degree in software development, feel free to get a job at Microsoft.

Of course, if you have a degree in a field unrelated to finance, but has studied finance (and the other necessary areas like economics) in your free time, then you should be able to sit an exam, and if you pass it, you’ll have a license which gives you the right to work in finance. Everyone, no matter their background, should have to pass the very same exam. That will weed out the losers who have no interest in finance and who are only there for the money, as well as the gamblers (a personality test/risk aversion assessment should be included as part of the exam).

It may seem that I’m being harsch against engineers and mathematicians. Let me assure you that I got absolutely nothing against them. I just don’t want them to wreck the world, which is what they do when they work in a field which they are not qualified to work in. I, who am studying for a degree in finance and economics, would never even think of working as an engineer or a software developer. If that was my goal, I would have gotten a degree in any of those subjects instead.

I realize I’ve gone off topic, but I really wanted to take the time and explain what I think the real problem is: The people who work in finance. Not the level of compensation as such.

This will do for now. Thank you for reading.

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  1. I would like to start with stating this is a very well written sector analysis of finance. Quick, flows well, easy to digest. My one sticking point however (there’s always one), is from the corner of the token liberal. Speaking for most liberals I know (including myself), there is NO problem with well run businesses handing out as much money as they want in bonus money. Good for you, you earned it. The issue is in when, such as these recent bailouts, men who poorly managed, or at least PERCEIVABLY so, such a business. When Freddie/Fanny were “bailed out”, the CEOs were fired/let go/quit and got millions in bonuses, as these companies were receiving federal aid. It is perceived as rewarding failure. These men/women I’m sure were receiving healthy bonuses in the past, and the feeling is they should have been quickly and quietly taken to the door and let into the wild. $0.02. 

    PS, I miss the cents key on the typewriter. 

    1. Thanks for your comment! First, the reason why I didn’t deal with the bonuses that has been paid out now during the recession is because the post was already 2300 words long and if I had dealt with that subject¨as well it might have ended up being 3000 by the time I was finished. Secondly, we should be aware of the fact that compensation levels have fallen during the recession, and that there has been massive layoffs in the financial sector. There has been a few cases of really high bonus payouts, but that’s the exception, not the rule. If a company is bankrupt, then a bankruptcy court should decide what should happen to any bonuses and wages that may have been promised before the default. The CEO’s should be treated as any other creditor, and just like any other creditor, the CEO should be forced to take a haircut.

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