Bankers Bonuses

The conventional wisdom is that a major cause of the GFC was the large bonuses paid to bankers that created incentives for short-term profit taking. Many economists and politicians argue that bonuses need to be brought under control to reduce the risks to the banking system.

Jeffery Friedman and Wladimir Kraus argue against this view in their book called Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation. They argue that most incentive compensation was paid in equity-based bonuses. These bonuses generally had a vesting period of three to five years, meaning the time horizon of the recipient was constantly moving out as they accumulated equity. By the end of the boom, few individuals had a larger stake in the banks than their own employees. In the aftermath, many bankers lost more than they had earned during the boom. This casts doubt on the idea that bankers knowingly took short-term risk to boost their bonuses.

This confirms the understanding I have gleaned from the biographies of several leading bankers. My impression is that they totally misjudged the risks they were taking on. They did not knowingly take on short-term risk to boost their bonuses. They thought that they had their risks under control. They unwisely went into profit opportunities that they mistakenly assumed were risk free.

The problem was banker foolishness, not deliberate risk taking.