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Did Wall St. Bonuses Cause the Financial Crisis?




By John Carney, Senior Editor at CNBC.com

NEW YORK ( CNBC) -- Did the bonus system on Wall Street cause the financial crisis? Are bonuses still putting our financial system at risk?

An affirmative answer to those questions is the underlying thesis of Nassim Taleb's op-ed in the New York Times today. Taleb, the financier famous for authoring "The Black Swan," proposes ending bonuses for all systemically important financial institutions: the Wall Street banks, some insurance companies, the biggest hedge funds.

Taleb is probably one of the smartest people I've ever encountered.

I've learned more from Taleb and his books than almost any other living thinker. Most people misunderstand the lessons of The Black Swan which is a great frustration to him. He wrote a book that tried to explain that we need to make ourselves less vulnerable to unpredictable shocks -- and people instead went around trying to predict the next shock to the system. They missed the point about unpredictability, about the limits of our knowledge of future events, altogether.
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A single walk with Taleb through the streets of Brooklyn changed my life in very profound ways. I eat, walk, and see differently. Eat more but simpler foods, walk more slowly, never rush to catch a subway, look at the street scenes I pass rather than just pass by on the way to my destination.

Taleb avoids the simple thesis on bonuses. The simple thesis is that bankers have an asymetric exposure to the risks they take that encourages them to take on so much risk that they put their firms at risk. If they take risky bets that pay off, they get big bonuses. If the bets destroy the firm, they are none the worse for it.

The problem with this simple thesis is that it runs contrary to the behavior of actual banking executives at the firms that failed in the financial crisis. The CEOs of Bear Stearns and Lehman Brothers, for example, each lost more than $1 billion when their firms collapsed. This was far in excess than what they made selling stock of their firms in the years preceding the crisis, as scholars Jeffrey Friedman and Wladmir Kraus point out in their book, Engineering the Financial Crisis.

If Dick Fuld and Jimmy Cayne knew they were risking their firms, they surely would have taken much more money off the table by selling nearly all stock they owned in their firms. It makes no sense to say that they risked over a billion dollars in downside risk for tens of millions of dollars in upside gains.
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