http://www.csus.edu/indiv/s/sablynskic/documents/rewardingA.pdf

In a way this comes back to “the folly of rewarding A, and hoping for B”. In this case, we are rewarding executives for, excuse my French, screwing the tax payers/public, while hoping that they will act in the interest of the tax payers/public. The argument James Kwak is presenting is something like “instead of giving bank executives incentives to screw the public, then putting rules in place to stop them from doing it, why not remove the incentive to screw the public?”.

This seems like a very serious argument to me.

Just a small niggle- the appeal to Gödel is not quite accurate and is not, I think, necessary. The incompleteness theorems don’t say “no system can yield a proof of its own consistency”, they say “no complete formal system (with a certain laundry list of properties) can yield a proof of its own consistency.” Normal thinking, and even highly advanced academic thinking, is not a formal system, and so Gödel-type considerations don’t apply.

Trynig to apply Godel outside of the domain of mathematical logic is hard and not necessarily rewarding work.

That side, still a really nice post.

Then you don’t have to regulate anything related to pay. If banks have less avenues to make short-term fake profit (read: cause disaster in the long term), then they can’t pay generous salaries to traders.

Is there any reason that current regulators cannot simply declare that options are not consistent with safe and sound banking practices since they encourage excess risk relative to readily available close substitutes?

I found an essay on VOX to be very informative on how the compensation/bonus structure came about – you can find that essay here:

http://www.voxeu.org/index.php?q=node/3602

Essentially, the move away from private partnerships to limited liability corporations “substantially reduces the incentive of senior management to monitor risk taking.”

As a solution, the authors call for exposing the senior most members of the company to the risks inherent in this kind of business – rather than automatically rewarding them regardless of how the company performs.

Found the piece to provide a valuable piece of the puzzle that is Wall Street.

Also, heartland populist that I am, I want to share one of the most outstanding incentive programs I’ve heard about – a true fusion of American ingenuity, money, talent and ambition. You can read about that program here:

http://www.chicagotribune.com/entertainment/chi-kanye-concert-kidsjun12,0,1049036.story

To sum it up: Some students at an affluent school in the Chicago suburbs were appalled by an NPR story of how hard it is to finish HS in the inner city of Chicago – so they organized a free show by Kanye West as incentive for students to stay in school and improve their grades/attendance records. 3000 kids were entertained by a local boy who hit it big (whose mother happened to be an educator.)

We need to use our wealth and ingenuity to come up with more programs like this….

There is another question. Even if executive compensation is a problem, that does not mean that it should be addressed directly, nor, if it is addressed directly, that it should be done in terms of incentives. There is a downside to being too clever. Micro regulation leads to complexity, to the search for loopholes, and to lobbying for the creation of loopholes. Congressmen vote on measures that they do not understand, regulators attempt to enforce regulation that they do not understand, honest businessmen cross their fingers and hope.

“… leverage, combined with the bank holding company structure, combined with compensation in the form of stock options, combined with deposit insurance, combined with the implicit guarantee on uninsured liabilities, creates large incentives to take excessive risks – defined as actions that have a negative expected value for the bank’s assets, but a positive expected value for bank executives.”

The only other example the US economy has produced with such massive leverage is the public utility sector. There, a regulated and legally enforceable flow of cash — come hell or high water — from ratepayers to the utility was completely assured. The bond market understood the deal. For that reason, the utilities could run massively levered balance sheets, because, essentially, they were intermediating a stream of annuity payments from ratepayers to bondholders, who were financing the expansion of their asset base. What this led to was an incentive to expand the asset base, leading to often-necessary redundancy — think of the electric grid and generation infrastructure — and sometimes to overbuilding and waste. But overall, the slice of that cash stream the utility management could claim for its own enrichment was overseen by regulatory that fully understood what their role and responsibilities were — overseeing the buildout and maintenance of the utility infrastructure.

The banks, and now-former investment banks, bent the law and regulatory structure to create a full-faith-and-credit guarantee on total leverage — where once it was only an explicit guarantee to small savers leaving funds on deposit with them, so the banks could conduct the necessary intermediation of savings to investment. They transformed what was intended to be a utility-like backstop on a mundane process (intermediation of bank deposits) into a prop for massively levered risk-taking, which made them rich beyond their wildest imagining.

So, of course, they could minimize THEIR equity at risk, and convert that equity into a true call on total profitability. To be explicit, a convex payout (aka a call) on profits. At 30: to 40:1 leverage this was huge. They laid claim to all positive outcomes above zero $ of profit, in exchange for their minimal equity investment (aka “premium” in option-speak).

Year in and year out, they could up the ante and increase the bet and, since they were all doing it, asset values took off on a vertical trajectory. They were all doing the same thing, running the same no-arbitrage models, and bidding for the same assets. And, they had an extraordinarily accommodative Fed and regulatory edifice enabling all of this. It was delusional, and easily explained within the context of the models they all used — including the efficient-markets/minimalist-government theology economics had morphed into. But, as Kurt Godel demonstrated, a system is incapable of providing the proof of its own incompleteness, no matter how elegant. And, once again, we found the limits of a system of thought and belief that cannot step outside itself to prove its completeness.

Not to take anything away from the banks and former investment banks: Their behaviour was a brilliant and obvious outcome of banks’ ability to exploit advancements in financal theory that were every bit as significant as anything in bio-, micro-, nano-tech could produce. Options and derivatives theory has taken the mathematics of Brownian processes to levels never imagined in finance. Not unlike what physicists did for nuclear power. Physics got to the exploitation of the mathematics of randomness long before finance did, and gave us the whole suite of technologies we have routinized over the past 100 years or so — nuclear power, bio-physics, etc. Ultimately the banks were able to systematize this mathematics into new products and models of doing business.

What we’ve discovered, however, is that incompletely understood processes lead to uncontrolled reactions that are destructive beyond any experience anyone’s ever had. This is not some goofy metaphor: The banks and now-former investment banks are responsible for a level of destruction that would take multiple nuclear detonations around the planet to replicate (replication being a key aspect of the no-arbitrage world, not coincidently).

The thing that led the banks and us to this end was the fact that bankers were able to get so rich in the process of doing so. Every quarter, every year there wasn’t a totally destructive outcome, they were rewarded with more money than they could spend in 100 lifetimes. And, in the ultimate expression of not knowing what you don’t know, they all believed they were men (mostly) of genius, giants among us who had found a way to advance the evolution of perfect capital markets.

We’ve found one of many possible boundries of the financial universe. Our understanding is incomplete. Think about it.

One could envision banks colluding to take the same risks. Thus, when Banks falter and the FDIC reimburses individuals money would just be shifted back and forth between the Banks. However, I would feel that the most stable and profitable institutions would become the most attractive banks to do business with. Thoughts?

Executives Unruffled by Proposed Compensation Rules

By Tomoeh Murakami Tse
Washington Post Staff Writer
Friday, June 12, 2009

NEW YORK, June 11 — Corporate executives breathed a sigh of relief Thursday after examining the fine print on broad new executive compensation rules and proposals put forth by the Obama administration