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The Best Risk-Management Rule Ever

Nassim Taleb proposes addressing the principle-agent problem in banking by removing banker’s bonuses.

He feels that bonuses are dangerous because they invite bankers to game the system by hiding risks. The most recent example of this is the subprime mortgage market meltdown, which triggered a broader financial crisis.

Consider that we trust military and homeland security personnel with our lives, yet we don’t give them lavish bonuses. They get promotions and the honor of a job well done if they succeed, and the severe disincentive of shame if they fail. For bankers, it is the opposite: a bonus if they make short-term profits and a bailout if they go bust. The question of talent is a red herring: Having worked with both groups, I can tell you that military and security people are not only more careful about safety, but also have far greater technical skill, than bankers.

The ancients were fully aware of incentive without disincentive. So they built simple rules, or heuristics, to guide them.

Nearly 4,000 years ago, Hammurabi’s code specified this: “If a builder builds a house for a man and does not make its construction firm, and the house which he has built collapses and causes the death of the owner of the house, that builder shall be put to death.

I’m hard pressed to think of a better risk-management rule.

The Babylonians understood that the builder will always know more about the risks than the client, and can hide fragilities and improve his profitability by cutting corners — in, say, the foundation. The builder can also fool the inspector; the person hiding risk has a large informational advantage over the one who has to find it.

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Nassim Taleb is the best-selling author of AntifragileThe Black SwanFooled By Randomness, and The Bed of Procrustes.