I believe the main problem is not the bonus and the risk taking that it causes, the problem is the structure of the bonus and the type of risk taking we see as a result. It should rather resemble long term share option or recurring commission schemes. There are many other good long term risk reward schemes in mature industries that work, and these could apply to investment banks. Just because the item being traded has a short life doesn't mean the incentive should be short term. This is because long term products in the system rely on it, as we've been seeing.
This is essentially a structure the banks has to solve themselves to remain in business, and if they actually went bust and weren't bailed out it would have been solved already. Instead they were bailed out because of the potential effects on the rest of the economy, but that has delayed reform within the banks themselves.
The problem is the governments work on a similar incentive structure, where their reward is winning the next election. They bailed out the banks because of the short term reward of avoiding short term pain. Now sovereign debt is being traded by the same banks in the same way through the same type of complex derivatives with the same type of guarantees from the governments as we had with bad CDOs before.
In Europe they're creating a bailout mechanism that resembles a super CDO. This is creating bonuses for bankers in the short term. The best I can hope for is that this will cause a gradual devaluation of the Euro and not another shock like we had in 2008.
In finance, you can construct a highly leveraged investment vehicle that earns fantastic returns for nine years in a row and then blows up in your face in the tenth year. It’s a lot harder to do this in other industries: next year’s iPhone may not be as successful as this year’s, but it’s highly unlikely to be a dud, and even if it is, low iPhone sales are not going to bankrupt Apple in a year.
So I’m not sure that compensation plans that work for most other industries will work for finance.
"So I’m not sure that compensation plans that work for most other industries will work for finance."
Conclusion B doesn't really follow from point A in your post. Sure, finance is different in many fundamental ways from other industries. But it doesn't have to be as risk-seeking as it is. It wasn't always that way, and in fact, it worked much better when it wasn't.
If a banker had personal "skin in the game," as it were, he'd work much more rigorously on ensuring that his vehicle doesn't blow up in year 10. He'd also have no incentive to hide any leaks in his model, and cross his fingers that they never bust open.
Furthermore, and far worse, we've seen instruments that were so amazingly outlandish as to seem specifically designed to fail, i.e., CDOs on subprime mortgages. In your Apple analogy, this would be the equivalent of Apple's intentionally designing a dud iPhone with a critical safety flaw.
As I understand it, CDOs on subprime mortgages would have been a reasonable investment vehicle if the odds of mortgage defaults and the correlation among default rates in different regions had stayed at historically low levels.
The problem was that because investors were pumping money into these CDOs, real-estate bubbles inflated simultaneously in a bunch of markets across the country, and then popped simultaneously.
The problem was that there was an entire feedback cycle of fraud going on:
* Lenders were making outrageous loans (no money down, no payments -- just accrue more debt!) and coaxing people to sign up for them. These lenders collected transaction fees, then sold these loans to investment banks.
* Investment banks carved up these B-rated loans into fractional amounts, then repackaged them into bonds. The ratings agencies -- due to either fraud or stupidity -- would rate these bonds AAA, because their contents, despite being low rated, were diversified. The thinking was that they wouldn't all fail at once. Ratings agencies then collect a big fee for rating the bond well.
* Still more investment banks would take these bonds carve them up, and create CDOs, just another layer of abstraction using the same basic template. Whatever bad ratings couldn't be laundered away in the previous step were laundered away in this step.
* Banks would then trade these instruments.
It appears to have been a "don't ask, don't tell" atmosphere between everyone in on the game.
"The Big Short" is a great read on the whole situation.
This is essentially a structure the banks has to solve themselves to remain in business, and if they actually went bust and weren't bailed out it would have been solved already. Instead they were bailed out because of the potential effects on the rest of the economy, but that has delayed reform within the banks themselves.
The problem is the governments work on a similar incentive structure, where their reward is winning the next election. They bailed out the banks because of the short term reward of avoiding short term pain. Now sovereign debt is being traded by the same banks in the same way through the same type of complex derivatives with the same type of guarantees from the governments as we had with bad CDOs before.
In Europe they're creating a bailout mechanism that resembles a super CDO. This is creating bonuses for bankers in the short term. The best I can hope for is that this will cause a gradual devaluation of the Euro and not another shock like we had in 2008.