Intellectual breakdown?

carrot-incentiveI have repeatedly asked me this one question when it comes to the financial crisis: Was it a lack of intellectual capabilities that made people invest into structured subprime assets believing the AAA ratings? What about leveraging 40-1? Does that sound smart?

An interesting article by Joe Nocera in the NY Times Magazine this weekend about the VAR (value at risk) risk models used on Wall Street made a point. The article is primarily about the VAR model and the problem of applying a statistical model that covers 99% of probable outcomes and leaves out the 1% outliers – good reading about the misuse that results from the yearning for simplification (only if you can stand reading more of Nassim Nicholas Taleb’s comments on ‘imbeciles’).

Without going into the article in too much detail, I noted one aspect:

Traders were not only incentivised by trading performance but as well to fool the VAR model – meaning to minimize the effect that the trade would have on the VAR model. This made them structure trades that would be of low risk in 99% of all cases, but that yielded at the same time devastatingly punishing risks outside the scope of the model, in the remaining 1% – the outlier event.

The point is: Professionals on Wall Street are not stupid – probably quite the opposite: They are smart, utility maximizing agents that play by the rules/incentives that were set. Only that these incentives have been wrong since the first investment bank, Salomon Brothers, transformed from a partnership into a public company in 1981. That shifted the balance: Upside lies with the executives, downside with the shareholders. Who can blame them. After all nobody was forced to buy shares of investment banks.

The incentives for Wall Street professionals were structured to take on maximum risk (VAR optimizing, overleveraging) to generate short term results (Yearly bonus). Everybody inside the industry knew, but ‘as long as the music is playing, you’ve got to get up and dance’ as Charles Prince famously put it. At some point the party would end – that was obvious – only when was the question. Until then you carry on.

The financial crisis is a result of smart inviduals playing by the rules (forget Madoff for a while) – but the rules created the wrong incentives. That is not a new discovery. People have been writing about that for the last couple of years (see for example here). Setting the right incentives will be key to repair this industry.

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1 Comment »

  1. Nice writing. You are on my RSS reader now so I can read more from you down the road.

    Allen Taylor

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