Finance Compensation

The current compensation structure of finance employees is equivalent to what is called an option in finance. An option is a instrument where the downside risk is limited, but the upside potential is unlimited. In the US, where banks only recourse to foreclosure is seizure of the property, a mortgage is an option, because the property can increase in value infinitely, but the owner can only lose the house. An interest only, no money down mortgage allows a person to bet that the real estate market will go up without being able to lose any of their own money.


Finance compensation is an even sweeter deal than a no interest, no money down mortgage. They are always paid their salary, and the potential bonus is unlimited. This encourages risk taking, to make the biggest possible bonus because the possible loss is exactly zero. This is just pure economics. If I can make a bet where I can't lose, I'll make as big a bet as possible, and bankers and mortgage brokers did this. Before investment banks started going public, they were partnerships, and any money being bet for the firm was the partners money. Consequently, risk taking was limited because the partners were afraid of losing their hard earned money. Similarly, public owners should exert the same control over firms with the shares they own, but common shareholders have very limited control over companies they own.


The solution to the problem of risk taking on Wall Street is not to compensate with stock, or to limit compensation, but to force the employees themselves to invest a portion of their own personal money in every deal they make. Possible losses must be real to the employee too, or to the mortgage broker. This is how hedge funds work. Hedge fund managers are not considered credible unless they are willing to put their own money at risk in their fund. Why should it be any different for financiers?