We need to understand this

I am necessarily consumed by financial/political news, so can easily understand why this economic crisis seems so opaque and overwhelming. The system is clearly collapsing, but why? What drove such a complete collapse? I am not going to pretend to have some witty answer to that question, but there is a component of the wall street incentive structure that should be understood by every citizen on this earth and then we should all get really really fucking pissed at what they did.

One of the arguments one hears in the compensation debate is that the bonus system used by Wall Street ....is there to “reward talent”. While I find this notion of “talent” debatable, I fully agree that incentives are the heart of capitalism and free markets – but certainly not that incentive scheme.

In fact, the incentive scheme commonly in place does the exact opposite of what an “incentive” system should be about: it encourages a certain class of risk-hiding and deferred blow-up. It is the reason banks have never made money in the history of banking, losing the equivalent of all their past profits periodically – while bankers strike it rich....

Take two bankers. The first is conservative. He produces one annual dollar of sound returns, with no risk of blow-up. The second looks no less conservative, but makes $2 by making complicated transactions that make a steady income, but are bound to blow up on occasion, losing everything made and more. So while the first banker might end up out of business, under competitive strains, the second is going to do a lot better for himself. Why? Because banking is not about true risks but perceived volatility of returns: you earn a stream of steady bonuses for seven or eight years, then when the losses take place, you are not asked to disburse anything. You might even start again, after blaming a “systemic crisis” or a “black swan” for your losses. As you do not disgorge previous compensation, the incentive is to engage in trades that explode rarely, after a period of steady gains.

Here you can see that this mismatch between the bonus payment frequency (typically, one year) and the time to blow up (about five to 20 years) is the cause of the accumulation of positions that hide risk by betting massively against small odds....

If capitalism is about incentives, it should be about true incentives, those resistant to blow-ups. And there should be disincentives to remove the asymmetry of the free option. Entrepreneurs are rewarded for their gains; they are also penalised for their losses. Now, by comparison, consider that Robert Rubin, the former US Treasury secretary, earned close to $115m (€90m, £80m) from Citigroup for taking risks that we are paying for. So far no attempt has been made to claw it back from him – only UBS, the Swiss bank, has managed to reclaim some past bonuses from its former executives....

[W[hen it comes to banks and other “too big to fail” entities, the problem is severe: we taxpayers in our respective countries are funding these global monsters and are coughing up money for mistakes made by bankers who retain their bonuses and are hijacking us because, as we are discovering (a little late), banking is a utility and we need them to clean up their mess....