Against guaranteed bonuses

August 17, 2009
John Carney has a novel defense of guaranteed bonuses this morning: they're a good thing, because if they didn't exist, traders might take on less risk!

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John Carney has a novel defense of guaranteed bonuses this morning: they’re a good thing, because if they didn’t exist, traders might take on less risk!

The level of profits demanded by shareholders of financial firms increasingly require banks to raise their level of risk taking. Someone who knows that even if he loses everything he’ll still take home a million bucks can afford to be more daring than someone who is worried about paying his mortgage.

This argument doesn’t really stand up to scrutiny: if it were really true, then guaranteed bonuses would be most common among veteran senior traders whom the bank knows well. In fact, they’re overwhelmingly used to poach new traders to a desk, and expire after a year or two.

It’s also not true that shareholders are requiring banks to increase their level of risk taking — they’ve seen where that leads. Riskier banks always trade on lower p/e multiples than boring banks which take very little risk. Invariably, when banks take on lots of risk, their employees get most of the upside while their shareholders wind up with the first loss.

The fact is that guaranteed bonuses are a tool used by smaller, weaker banks who are desperately trying to beef up their trading desks to compete more effectively with the larger trading powerhouses. You don’t hear much about Goldman Sachs or Citadel paying their traders guaranteed bonuses. It’s also a fact that most of the time the smaller, weaker banks, after spending enormous amounts of money on guaranteed bonuses and the like, end up failing and dismantling those desks: the bonuses are simply a transfer of wealth from shareholders to opportunistic traders, and/or a way to persuade traders to join a weaker shop even though it’s more likely to fail. They do neither the shareholders nor the system as a whole any good at all.


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