SciComp - Futures Volatility Surface Calibrator

Genius Led By Donkeys

I find that this quote from my paper on Risk Adjusted Bonuses had appeared on quite a few sites. So if you're tool azy to read the whole thing:

A clear factor in the recent calamities has been the lack of expertise at the very top levels of banks. Reviewing the publicly available lists of board members at many firms, I observe that most of them not only have never taken an active role in trading, analysis or risk management, but that today few would even be accepted as a trainee in a less prestigious organisation than they ran into the ground. In effect we had mediocre cavalry officers in charge of nuclear bombers. Fred Goodwin is the most egregious example of this, but he is far from unique.

If anything, a bit more research shows it to be worse than that. We find people better equipped to work in the leisure industry than banking to be quite common. I doubt if more than 5% of the boards of banks before, during and after the crash could have understood any of the risk issues at any useful level, even if they had been interested, which they were not.

Imagine if the people in charge of safety at an airline had never flown in a plane, or fixed one, or piloted, but instead were picked on their ability at golf and accountancy. Look at the set of ex-traders, risk managers or even quants on the boards of big banks. I almost failed to find them at all.

The mystery is not why the banks failed, but how they survived so long.

Bonus Arcitecture

Bonus Architecture We start from a position that in the large complex entities that the regulators most want to incentivise, do not have coherent or even centrally understood processes for determining how people are awarded bonuses.

This is not an intuitive position, but it does affect the effectiveness of any change to bonus allocation and gives insight into how to make these changes more efficient.

Nearly all such firms are composed from mergers and acquisitions, and have inherited bonus systems that are not only difficult to change, but in order to keep the assimilated management on board, remuneration is often delegated.

This also is transposed upon the standard “silo” structure for most large banks where bonuses are allocated on the basis of asset class or market. This is to simplify the task of setting bonuses, since in a large firm there are not only a large number of workers, but there work is far more diverse than in most (if not all) other businesses of equivalent headcount.

When large firms have substantial offices in multiple countries and this too adds to the complexity, and each firm has its list of idiosyncratic bonus factors, of which “risk” is conspicuously absent.

This leads to outcomes such as fixed income and commodities being in closely related bonus pools and management. Without getting drawn into the detail of either business it is clear that the risks in these areas do not correlate well, making risk based remuneration at this granularity difficult, and as we shall see later, possibly counter-productive.

Such aggregation is the norm, and although the exact form varies, the practice does not, and represents what is believed to be an efficient allocation of management resources and internal political concerns.

This intersects with the traditional organisation tree where each level of management delegates part of the bonus allocation to the level below. The patronage that this gives is earnestly sought by all managers, who pass as little information as possible to others. They must of course report exact allocations, but the process itself is more opaque the more levels one peers down through, and from a lower level is almost wholly impenetrable to see upward.

There exist policies, set from the top with the support from compliance, legal and HR staff, but in conversation with managers who set bonuses these are barely even given lip service, much less seen as useful guidance. At non bonus setting level, they will be dimly aware that “something political is happening” and money that is roughly related to their performance appears (or fails to appear) as a result of a process of which they are intentionally kept ignorant. For the avoidance of doubt, not only do some feel wronged, but others (confidentially) share with me that they have no idea why this bonus was so large.

Before this current regulatory initiative, this was seen as an inevitable but relatively benign aspect of the management of financial firms.

This is why I have adopted the term “Bonus Architecture” as opposed to “scheme” or “policy”. The FSA, in common with other regulators wishes risk management to have an effective input into bonus allocation, and the most important precondition for this is that they have an adequate understanding of the process in their firms, beyond “policy”. This is a daunting task given the extreme diversity of such firms, and it follows that to be effective this cannot be effected centrally. I recommend that and risk weighting that is applied to bonuses should involve risk managers specific to a given silo and asset class. This itself is not without risks, since risk managers are always in peril of being captured by their business units. This is not beyond solution as I shall suggest elsewhere.

I do however suggest that attempting to deliver this in 2009 is not only overly ambitious, but possibly counter productive, something that deserves its own section.

Everyone Should Suffer

The FSA has asked whether this risk adjusted bonuses (RABs) should be restricted to the top tier of management.

I am putting up my responses ahead of sending a document to the British regulators, the FSA.

A clear factor in the recent calamities has been the lack of expertise at the very top levels of banks. Reviewing the publicly available lists of board members at many firms, I observe that most of them not only have never taken an active role in trading, analysis or risk management, but that today few would even be accepted as a trainee in a less prestigious organisation than they ran into the ground. In effect we had mediocre cavalry officers in charge of nuclear bombers. Fred Goodwin is the most egregious example of this, but he is far from unique.

If RABs have a cut off anywhere near the top level of management then it will be difficult to engineer a bonus system to attract the right type and calibre of staff to lead firms. There will of course be no shortage of applications for roles that pay so well, but quantity is not our objective here. There is also the complex issue of promotion where a moderately senior executive may find a dramatic decrease in the quality of his earnings upon accepting greater responsibility.

This can of course be trivially fixed, by increasing top level remuneration to compensate, and it is quite possible that this is an unintended consequence of such measures.

There is thus an interesting trade off here.

To be effective, RABs must represent a substantial reduction in wealth for poor risk decisions, and so risk-taking executives will require greater compensation for this risk.

Few people currently support the notion that top executives should be paid more, and pushing up the staff costs of banks is not attractive, unless a very substantial benefit can be shown.

There will inevitably be grey areas on who should be covered by these proposals, and the simplest approach is to apply it to everyone in management.

Also a scheme by which everyone is to some extent being treated equally will tend to produce greater cohesion across complex firms, and in any complex financial entity the most important decisions with respect to risk taking are rarely taken at board level, and may be taken two or three levels lower.