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Did Wall St. Bonuses Cause the Financial Crisis?

This was not just true of Bear and Lehman. The financial crisis resulted in tens of billions of dollars in losses for those inside Wall Street firms. Even despite the bailouts, most of Merrill Lynch's brokers and investment bankers are still underwater on their stock. To propose that the incentives in the bonus system convinced them to lose far more than they could have ever made by taking risks is absurd.

The truth is that bankers don't face the kind of asystemetrical risk-reward incentives that the simple thesis proposes. Except at the most junior levels, Wall Street executives have tremendous downsides that tend to make them risk adverse.

As Friedman and Kraus forcefully argue in their book, it seems that ignorance of the actual riskiness of the positions taken on by Wall Street firms is far more responsible for the financial crisis than deliberately ignoring those risks in pursuit of higher bonuses.

Taleb is all too familiar with the idea that people are ignorant of the real risks they are taking, so he makes a far more nuanced case against Wall Street bonuses.

In Taleb's view, it was not just the perverse incentives of the bonus system that lead to too much risk-taking. Something else was necessary. In order for the bonus system to lead to a crisis, you needed something that would let bankers believe they could take on outsized risks that would potentially put their own firms at risk, but wouldn't personally result in the kind of losses experienced by Fuld and Cayne.

What was that extra ingredient that could transform the bonus system into a death trap for the financial system?

It was the government of the United States of America.

Or, more precisely, the belief of banking executives that their downside risk was limited by the ability of the government to bail them out in the event of catastrophic failure.

In other words, it was not the bonus system alone that led to the financial crisis. It was the bonus system, plus the belief in an implicit government backstop, that led to the financial crisis.

This idea matches up with the record fairly well. We know that a lot of top Wall Street executives subjectively believed that the Federal Reserve would support them if failure loomed. They had historical experiences, such at the 1998 bailout of Long-Term Capital Management, that confirmed this belief.
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