Bank traders' bonuses:
perverse incentives?


Giving too high rewards for financial risk taking
can bring a boomerang effect.


Deserved reward or time bomb?
Proprietary trading by banks can end up putting in danger
customer deposits, and when getting widespread lead to
systemic financial crisis.

Fat bonuses to rewards traders might induce them to take
excessive risks in such activities, thus be highly dangerous
for the bank stockholders, their depositors and the whole
economy.

boite danger Deserved reward or time bomb?

What is a bank trader job?

Speed race with hot potatoes in the hands

What is trading?

Short term trading is an activity that implies
   * frequent buysell buying and selling on a financial market,
   * with usually a massive and
run  fast use of lever highly
       leveraged financial operations and derivative financial instruments.

This is done under a defensive or offensive strategy:
  • Defensive:
as a tool of risk management, an hedge against some
financial risks
  • Offensive:
for speculation with the objective to give a higher return
to capital
but here, by taking a higher risk  risk instead of
avoiding it

What parts banks play in this activity?

Many banks are highly active in such trading,
  • Either for their own account (proprietary trading)
  • Or for their clients 
as intermediaries, counterparties or money managers - ,

The professionals (traders) who perform this task in the bank can obtain
once a year
monetary bonuses, in addition to their salaries, that can reach
huge amounts (up to several million dollars), as rewards for the gains they
brought to their bank in the previous year, even if those gains are caused
first by the mass of money at play (and at risk).


Would "separation" be wise or worse ?

Some propose to separate into two (independent) corporate entities
the investment banking activities (arranging complex corporate
financial operations) and retail banking activities (credit / deposit
/ private banking).
The idea is that it would be safer for bank customers and for the
economy.

Under pretense of safety this separation could on the contrary go
against risk diversification. One activity would not any more help
another one and cushion, and in some cases, hedge the result of
the other.
 
Also there is some confusion here.
Market activities are a job in itself
,
They are used in those two other types of activities.

For example retail banks make long term loan with short term
resources,thus they  use derivatives that give them long term rate
guarantees.
Same thing for the use of exchange derivatives  for banks that make
loans in currencies that differ from those of their main resources.

If they would lose those possibilities, the credit activities would less
rely on classical banking techniques (intermediation) and would be
massively transferred to the financial markets (securitization,
currency pools...) thus much more speculative (see below "shadow
banking").


Those market activities could also be independent from both, depending
on the cases.
To put them only on one side of the profession is not a solution.
What is needed instead is to control them better, not only at the national
but also at the global level.

And maybe limit the overall size of big banks that represent a "systemic"
risk

The main issue might be that those operations are largely left
to
non-banks (hedge funds) and escape the bank norms, transparency
and discipline.
Thus the fog "shadow banking" appellation that is sometimes used.

The issue

Poisoned candies?

There is a vivid controversy, notably since the
subprime crisis, about how
justified are those huge salary bonuses, given as rewards to bank staff
active in trading.


* The rationale for those trader's bonuses is that trading gains contribute
   to bank profits. So why not share the champagne?
   And what is wrong to have
luck thriving banks to fund the economy?

* The pitfall is that this activity, however necessary for risk management,
    is often on the contrary devoted to massive speculative risk taking, a much
   
more dangerous game than traditional banking,
    When it is done on the bank's account, not only it commits its own funds,
    but above a certain volume of trading activity this so-called "proprietary
    trading" commits also its customer deposits.

Various events have shown this danger, notably the subprime crisis
(see
bubbles and crashes).

To give 
large bonuses for trading gains encourages, whatever precautions
are taken, to bank traders to take high risks that might send their
bank, and by contagion the banking system, to the ditch.


As the size of those gains comes more from the massive capital of the
bank
and the risks taken with it (and part of its other resources), than
from those people frenzies,
it is, above a small Chrismas gesture towards
the most responsible ones, practically a princely
boite present.

OK, but what is the problem for you and me?
To bet on the future is everybody's privilege, a distinctive trait that
makes human beings differ from lettuces, no?


The problem is that heavy risks taken by banks endanger

* bank customers deposits.

* sometimes the taxpayer who has to come to the rescue via
   government funds.


*
the economy itself, fragile banks restrict their loans to
   businesses and consumers.

   When banks cough, the economy gets the flu.

Should those traders play with my money and get the
rewards
...while leaving me the poor  risk?

What solutions?

If not separate businesses, at least a large piggy bank

Normally, speculative trading should be the job of dedicated funds
(hedge funds)in which people invest in perfect knowledge that risks
are involved.

At first sight (and maybe at second sight also), it does not seem
appropriate to make it a normal activity of institutions that
collect deposits and savings from the general public and
make loans that are needed to feed economic activities
.

Seems to be sending some of the client's money to the wrong pipe,
and even directly into the fire.


But banks insist that they would not be profitable, their services would
even be too costly
for their customers, without that juicy activity.
Also it would not be too easy to separate trading jobs for the bank and
the same
jobs for the clients.

Let us avoid a binary answer about letting banks do trading or not.
An intermediate solution; that would limit the perverse incentives /
moral
hazards, could be that banks that are active in trading:

* Transfer a part of the gains to a reserve account as a guarantee
   for deposits
(for example an amount at least equivalent to the
   bonuses
paid to traders.

* Or better, transfer it to a global bank deposit guarantee fund,
   It would be supervised for example by the International Monetary
   Fund or another
global monetary institution
   This is preferable to a tax that would be drowned into government
pockets.

* Have higher equity requirement so that the risk be largely backed
   by shareholders, (what is sought via the enforcement of the "Basel 3"
   international agreement)
   Shareholders are the normal risk-accepting investors, it is an ethical
   basis of
capitalism.
   On the other hand excessive bureaucratic and punitive rules incite to
   exploit poachloopholes (Basel 2 encouraged off balance sheet subprime
   vehicles) either by the bank themselves or by less secure competitors
   (shadow banking).

* Of course defer for several years some of the bonus payment
   and submit it to the condition there is no financial backlash (*) in the
   meantime.

* Maybe also, as mentioned in the last G20 discussions, set a maximum
  
ratio "Bonuses / Equity" or "Bonus / Banking Revenues".

But such "bureaucratic" regulations are no panacea, can give a false sense of
safety and hide loopholes that the smartest (or meanest) players would take
advantage of.

Those rules should not exclude a very active
supervision of bank risk-
taking
, at the global level, like some countries such as Canada knew
how to do it,  which avoided the excesses seen during the
subprime crisis.

What is done.

The CRD III Directive voted by the EuroParliament in Strasbourg on July 
2010 enforces  from January 1st 2011 drastic limits on such bonuses and
higher equity requirements for those activities.

Using a different approach, the US legislator
decided stricter rules on bank
activities (Volker's rule, it bans proprietary trading by banks that take  
customer's deposits)..

(*) Is it so risk risky?

Many traders would deny that they take huge risks, thanks to the
sophisticated quantitative martingales they use.
Overconfidence? Or true professional risk mastership?


They would add that their trades are made to manage (hedging) some
risks inherent to banking activities
But hedging gives only a small part of trading outcomes and creates its
own risks,

Also martingales collapse the day the external conditions
suddenly change
,
a not so rare situation in
dynamical systems (theories
of chaos, of extremes, of "black swan")

A typical example is that nice quantitative "stochastic" models (see

probability) get eaten alive the day illiquidity shows its horrible teeth.

Last but not least, even professionals are not immune to the recurrent
market pandemic called
herding.

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M.a.j. / updated : 25 Juil. 2015
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