Frontiers of Growth
The Great Bank Robbery
Nassim Nicholas Taleb and Mark Spitznagel
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NEW YORK – For the American economy – and for many other developed economies – the elephant in the room is the amount of money paid to bankers over the last five years. For banks that have filings with the US Securities and Exchange Commission, the sum stands at an astounding $2.2 trillion. Extrapolating over the coming decade, the numbers would approach $5 trillion, an amount vastly larger than what both President Barack Obama’s administration and his Republican opponents seem willing to cut from further government deficits.
That $5 trillion dollars is not money invested in building roads, schools, and other long-term projects, but is directly transferred from the American economy to the personal accounts of bank executives and employees. Such transfers represent as cunning a tax on everyone else as one can imagine. It feels quite iniquitous that bankers, having helped cause today’s financial and economic troubles, are the only class that is not suffering from them – and in many cases are actually benefiting.
Mainstream megabanks are puzzling in many respects. It is (now) no secret that they have operated so far as large sophisticated compensation schemes, masking probabilities of low-risk, high-impact “Black Swan” events and benefiting from the free backstop of implicit public guarantees. Excessive leverage, rather than skills, can be seen as the source of their resulting profits, which then flow disproportionately to employees, and of their sometimes-massive losses, which are borne by shareholders and taxpayers.
In other words, banks take risks, get paid for the upside, and then transfer the downside to shareholders, taxpayers, and even retirees. In order to rescue the banking system, the Federal Reserve, for example, put interest rates at artificially low levels; as was disclosed recently, it also has provided secret loans of $1.2 trillion to banks. The main effect so far has been to help bankers generate bonuses (rather than attract borrowers) by hiding exposures.
Taxpayers end up paying for these exposures, as do retirees and others who rely on returns from their savings. Moreover, low-interest-rate policies transfer inflation risk to all savers – and to future generations. Perhaps the greatest insult to taxpayers, then, is that bankers’ compensation last year was back at its pre-crisis level.
Of course, before being bailed out by governments, banks had never made any return in their history, assuming that their assets are properly marked to market. Nor should they produce any return in the long run, as their business model remains identical to what it was before, with only cosmetic modifications concerning trading risks.
So the facts are clear. But, as individual taxpayers, we are helpless, because we do not control outcomes, owing to the concerted efforts of lobbyists, or, worse, economic policymakers. Our subsidizing of bank managers and executives is completely involuntary.
But the puzzle represents an even bigger elephant. Why does any investment manager buy the stocks of banks that pay out very large portions of their earnings to their employees?
The promise of replicating past returns cannot be the reason, given the inadequacy of those returns. In fact, filtering out stocks in accordance with payouts would have lowered the draw-downs on investment in the financial sector by well over half over the past 20 years, with no loss in returns.
Why do portfolio and pension-fund managers hope to receive impunity from their investors? Isn’t it obvious to investors that they are voluntarily transferring their clients’ funds to the pockets of bankers? Aren’t fund managers violating both fiduciary responsibilities and moral rules? Are they missing the only opportunity we have to discipline the banks and force them to compete for responsible risk-taking?
It is hard to understand why the market mechanism does not eliminate such questions. A well-functioning market would produce outcomes that favor banks with the right exposures, the right compensation schemes, the right risk-sharing, and therefore the right corporate governance.
One may wonder: If investment managers and their clients don’t receive high returns on bank stocks, as they would if they were profiting from bankers’ externalization of risk onto taxpayers, why do they hold them at all? The answer is the so-called “beta”: banks represent a large share of the S&P 500, and managers need to be invested in them.
We don’t believe that regulation is a panacea for this state of affairs. The largest, most sophisticated banks have become expert at remaining one step ahead of regulators – constantly creating complex financial products and derivatives that skirt the letter of the rules. In these circumstances, more complicated regulations merely mean more billable hours for lawyers, more income for regulators switching sides, and more profits for derivatives traders.
Investment managers have a moral and professional responsibility to play their role in bringing some discipline into the banking system. Their first step should be to separate banks according to their compensation criteria.
Investors have used ethical grounds in the past – excluding, say, tobacco companies or corporations abetting apartheid in South Africa – and have been successful in generating pressure on the underlying stocks. Investing in banks constitutes a double breach – ethical and professional. Investors, and the rest of us, would be much better off if these funds flowed to more productive companies, perhaps with an amount equivalent to what would be transferred to bankers’ bonuses redirected to well-managed charities.
Nassim Nicholas Taleb is Professor of Risk Engineering at New York University and the author of The Black Swan. Mark Spitznagel is a hedge-fund manager. The authors own positions that profit if bank stocks decline in value.
Copyright: Project Syndicate, 2011.
www.project-syndicate.org
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ravikunjurs 07:54 02 Sep 11
Nassim, I'm your fan, and I see the point your trying to drive home. Question is, who is gonna bell the cat?
Haz0 09:10 02 Sep 11
Gracias por decir verdades, que los bancos tiemblen! : Thank you for your honesty, may the banks quiver!
Factified 11:18 02 Sep 11
Well said. Which part of "too big to fail is too big to exist" don't we get? Why do we allow financial institutions with more than say $250 billion in assets to exist? Why not just break them up? What is our Department of Justice doing? Oh yes, getting involved in the endless cycle of breaking up and reforming the Telephone monopoly.
This reminds me of the late-great comedian Richard Jeni's line. To paraphrase: "What did the government do after Enron and WorldCom? They nailed Martha Stewarts hindquarters right to the wall!"
Yurifal 04:59 03 Sep 11
Уважаемый Николай Жданович (автор русского перевода статьи)! Смысл самого последнего предложения ("The authors own positions that profit if bank stocks decline in value.") немного иной, чем в Вашем переводе. Эта фраза является стандартным дисклаймером (то есть раскрытием информации), и означает она, что авторы статьи имеют финансовый интерес в виде открытых позиций (финансовых инструментов), которые могут принести им доход в том случае, если стоимость акций тех банков, о которых упоминается в статье, понизится.
arm50 10:32 03 Sep 11
Good article. I agree with the iniquity, but really think it is a function of the regulations or "governmental arbs" presented. A blanket FDIC guarantee across all banks clearly doesn't account for risks. Also, I'd just point out a bit of survivorship bias. let's not forget that WM,LEH,BS,CFC,etc don't trade anymore.
marrette 04:26 04 Sep 11
Any bets on the date when the deterioration will bring Americans into the streets as it has in the Middle East?
isaiahb3rlin 05:20 04 Sep 11
Your analysis is alright, although you miss the political part of the problem, and thus the solution. The solution doesn't lay in investors abandoning bank stocks or labeling them differently, it lays in a political force able to override the lobby of the banks and the big corporations. The price of the stocks is altered in many many ways in this "free market" of ours, from the reduction of the risk caused by moral hazard to the dirrect interventions of the central bank or preferential contracts. Political leverage on external markets counts as well, leverage on the media reports, countless others. Don't you agree Dr. Taleb?
ravindrajain 06:46 05 Sep 11
Very nice article with an indepth analysis.
phermarquez 02:10 05 Sep 11
You're right professor. As public opinion claims for more regulation, it might not be the panacea. The banking system has grown institutionally far over the State. Our modern social contract can't deny the Bank as a ruler of the common life.
llisa2u2 07:17 05 Sep 11
Good article. Clear and to the point with concise explanations.
Marquez on 09/05 mentions an interesting aspect of institutional imbalance.
It still is a well-functioning market. It's just that the present market isn't what a lot of people think, expect, presume or assume it is.
KevinK 10:53 06 Sep 11
Remove GSEs and Government Backing and risk aversion increases and moral hazard is addressed. With backing of taxpayers, Bankers will always (and in all ways) have the upper hand.
JerryLapell 06:33 07 Sep 11
All "serious economists" demand that interest rates be zero, or at least targeted to zero.
Given that, there's no way to penalize banks.
ddesimone 11:40 07 Sep 11
Thank you for the article.
The Government Pension Fund of Norway is an interesting example as it produces a public list of banned companies whose business practises it considers unacceptable. The current list contains companies from the extractive industries and the arms trade, but it would be great to see some banks on there too.
A campaign that resulted in investors forcing the banks into adopting some ethical practises would be wonderful. I hope that your excellent article helps to create one.
pmcgratty 08:40 08 Sep 11
The key to investing in banks has always been to understand how bankers are compensated for managing risk. Most banks are obssessed with growth and getting bigger. Compensation schemes reflect that. They eventually get into trouble.
Banks where credit reports directly to executive management and where executive management is compensated based on return on capital ... and where their lenders are compensated for profitability and credit performance avoid the potholes. But because they tend to grow more slowly, more prudently, they tend to underperform in economic upcycles. Since most managers are paid with stock which is predicated on growth in profits, and since we are in upcycles mor than downcycles, managers always prefer growth. They also like to talk about how big they are.
See an op-ed I wrote on this subject a couple years ago at
http://www.thefinancialstrategist.com/index.php?option=com_content&view=article&id=55:sf-chronicle-compensation-must-be-balanced&catid=38:articles&Itemid=56
mgheller 11:59 08 Sep 11
The real elephant in the room is Schumpeter. He would fall over laughing if he could read your pathetic solution. Charity! Ethics! Next you’ll be saying God!
Come on guys. Let’s not beat about the bush please. It is very easy to understand why the market mechanism does not eliminate the many questions you raise but avoid answering.
The market does not succeed because government does not allow it to. It’s a systemic problem that only government can solve, by regulation, yes regulation, a different kind of regulation, a merciless kind of extraordinarily simple even-handed impersonal regulation that has no friends and favors no one in particular but only everyone in general, which Schumpeter dubbed ‘creative destruction’.
Schumpeter's form of regulation could work only if voters were persuaded to abandon the welfare state and join the risk game, the game of making life decisions with awareness of risk. Risk is inherent in a natural society. Taleb, society must learn to be robust to risk, right? I’m sure I’ve heard you say so. It’s not ethics. It’s expectations.
For heaven’s sake, what are a couple of whizz kid investors like you doing when you don your intellectual sun hats but hide your half-read Hayek under the poolside chair and join the stupid populist clamor of banker bashers. Bankers are simply following the incentive structure for profit provided for them by governments that articulate voter preferences for artificial security and shelter from risk.
You too are following the incentives available to you in the hope of profit. Difference is, and I think you would appear more creditable if you had drawn attention to it, is that you are exposed to failure. You can fail. The banks can’t, yet.
Michael G. Heller
http://tandf.net/books/details/9780415694452/
phermarquez 01:38 09 Sep 11
mgheller;
Perfect.
marrette 03:58 09 Sep 11
What would Darwin say?
Alvar 02:04 11 Sep 11
I simply do not understand why intelligent people such as you, are always letting the government off the hook.
The government more than doubled the money supply during the Greenspan years, while simultaneously providing government backed securities; add to the mix the fact that the government doesn’t allow me to drive to the corner without a seat-belt, for my own protection, yet allows financial institutions to exist, that their collapse would be catastrophic to the whole economy, and you don't think this is the bigger problem?
It is government that allows risk to be transferred to the taxpayers not the banks.
stxxnet 12:33 12 Sep 11
Another superficial white noise Taleb heating up yesterday's topics distoring facts and presenting a populist "hate-the-banker" framework. All just to push his book that contains no original ideas.
Texasred 12:30 15 Sep 11
It is a shame that the article finishes with the market autoregulatory fairy, and I event do not believe that the authors believe in their own words in that respect.
polaris007us 09:47 18 Sep 11
Excellent reasoning and anyone with rational thinking would agree. Nothing radical in my opinion. However, the american people are conditioned to an extreme conformist mindset by the media-industrial-financial-complex to be scared of any criticism of wall street. Sometimes I wonder whatever happened to all the worshippers of Alan Greenspan and his own admission of ignorance of how markets function and that his beliefs were shattered. This coming from man who supposedly sat on top of the financial world for decades. A day of reckoning must come and will come!! A matter of time !!
Lagaffe 12:45 21 Sep 11
"The largest, most sophisticated banks have become expert at remaining one step ahead of regulators – constantly creating complex financial products and derivatives that skirt the letter of the rules". How true! Between 2003 and 2006, I worked at UBS Investment Bank in London where investment advisors specialising in circumventing Sharia law were recruited to come up with creative solutions for new investment opportunities opening up in the Middle East (the US was then at war with Iraq).
penguin 11:09 22 Sep 11
yep, if you discuss this in the language of finance then you do indeed reach an aporia where banks are both the regulated and regulators of the economy. Of course there are other language games available for us to use - class for instance. However I'm assured you are not keen on the Wittgensteinian approach to logic, so I'll simply leave you staring your brick wall.
Mmcmillan 04:23 24 Sep 11
Great article, thank you. Having worked around Wall Street for over 20 years, I always wondered when the free lunch is going to end. Wall Street is the biggest ponzi scheme ever invented and it will sooner or later collapse.
One other reason this has been going on is that Washington, in particular the Congress is very active in protecting this ponzi scheme because of special interest funneling significant amounts of what I would call bribery money to DC. Most is under the disgusie of campaign contributions but anywhere else in the civilized world this would be bribery.
AIPAC for instance receives great majority of its funding from Wall Street. This is not direct funding. It is the campaign contributions AIPAC members on Wall STreet direct towards "approved" candidates in the House. AIPAC, in turn, uses the ability to direct this funds to blackmail or direct the House members to not only deal with foreign policy issues but also makes sure that Washington does its best to keep the Wall Street working to ensure the flow of money.
I have seen this work from the fund raisings at Ciprianis in New York to the interactions of Senators/Congress men with AIPAC member bankers.
Charlesst 06:14 25 Sep 11
Perhaps if some of the social consequences were rendered more concrete to the public, they might react more coherently. For instance, the outrageous compensation of bankers, and the rest of the corporate CEO’s, is one of the main factors responsible for the high unemployment rates in the US.
http://anamecon.blogspot.com/2011/09/unemployment-average-wage-and.html
MyFinancialIndependence 12:33 17 Oct 11
This would be the only additional argument not to invest in the stock market, particularly in the financial stocks. The overheads are not performance related and on the rise. Almost like college tuition fees...
Financial sector is the self-consuming machine. The bankers themselves fairly frequent do not invest in the fiancial sector. On the other hand - it is a free economy and so far there has been no evidence of any competetion...
I do not think eithical grounds could be an excuse. We have no problem dealing wuth China or any other countries politicians denouncing. I guess it is time to nmove on and not being so sentimanteal...
BetterFailling 10:54 07 Nov 11
So the real problem is not the mere existence of the elephant but its addiction to easy money – the real problem being not the amount of compensation paid but the fact that too much of it goes to people who distort economic mechanisms instead of directing capital to the deserving economic actors.
I agree that no amount of regulation can match greediness – “more complicated regulations merely mean more billable hours for lawyers, more income for regulators switching sides, and more profits for derivatives traders” – but I don’t think “investment managers” can bring much relief.
At least not the ‘institutional’ “investment managers”.
There is hope though. In reality every one of us is an investment manager. When opening a savings account or even when deciding that ‘no, I won’t buy that on credit, I can wait until I have saved the money’ we are making investment decisions. We are our own investment managers only we don’t take it seriously enough.
Even more so when deciding where to invest our time: ‘what should I do, take a second job so we can have that second car and the fancier house or ‘save’ some time and enjoy it driving the kids to that marvelous place I found twenty five years ago, promised myself to visit every year and never returned to?’
JimL 10:19 10 Dec 11
What is the price of TARP again? We ask Mr. Taleb with his command of mathematics to give us his estimate. Because it sure was not the cost of the loans.
How long would it have taken for the market to clear all those assets, if the banks were nationalized, and their assets sold to profitable organizations, so the economy could once again reboot?
I submit the difference in GDP between market clearing dates and today's stagnation is a good place to begin in estimating TARP cost.
mholzman 03:51 02 Sep 11
Thank you Dr. Taleb. The theft you reference and its consequences on future growth seem to be ignored by even well-respected economists. Please keep writing about it.