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Bloomberg: Are you a machine?


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    One of the many things that people blamed for the 2008 financial crisis was bank bonuses. The idea was that a lot of bankers and traders at investment banks got most of their pay in the form of variable year-end bonuses, so they would take a lot of risk in order to get a big bonus: If their risky bets worked out, they’d share in the gains (in the form of a bonus), but if they went bust they wouldn’t bear the losses. If they were instead paid mostly in salary, their risk-taking would have less upside (if they made a lot of money for the firm, they wouldn’t see much of it) and more downside (if they lost a lot of money for the firm, they’d be fired and lose their large recurring salary). I’m not sure this analysis was ever that compelling — even without a year-end bonus it seems like a good career move to make a lot of money for your firm, and also to lose a lot of money — but it was widely believed, and the European Union ultimately adopted rules limiting some bank employees’ bonuses to two times their salary.

    In theory this rule should make banks’ behavior less risky — all the bankers and traders will be less inclined to make big bets, etc. — but it also makes their finances more risky: One advantage of paying employees mostly in bonus is that you pay them a lot in good years and less in bad years. The EU bonus cap led to much higher banking salaries (and lower bonuses), which means that banks have to pay employees more in bad years than they would have under the old rules. In bad years, you want to have the flexibility to reduce your expenses.

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