A V Rajwade: Fixing risk-reward ratios

Did hedge funds do better because managers invest most of their savings in the funds they manage?

The spate of losses recently suffered by most major global banks through their exposure to complex investment instruments backed by sub-prime mortgages, have once again brought to the fore the question of compensations in financial services, and to what extent they encourage excessive risk taking. We in India are also not very far from following the same path. Recent news reports indicate that a financial services firm paid sign-on bonuses of more than Rs 30 crore to attract a small team from a commercial bank, to head its subsidiary in wealth management. (Earlier, the same company had 'bought' an institutional equity marketing team from a foreign brokerage house, for an even larger sign-on bonus.) One also does not know to what extent the reported marketing of complex derivatives to relatively unsophisticated companies in the SME sector in India, and the huge margins structured in the pricing, were driven by "performance related" bonuses for the structurers and dealers.

On earlier occasions (June 8, 2007; Dec 14, 2007; and others), I had commented on the huge bonuses in the financial sector and how these may be distorting the risk-reward relationships and the dubious benefits of the financial economy becoming the master of the real economy, instead of being its servant.

The key issue is the distorted risk-reward relationship between the traders on the one hand, and their employers, namely the banks, on the other. If the risk taking results into a gain, the trader gets his bonus upfront, while his employer needs to carry the risk on its books for a much longer time; should it result into losses, as in the credit derivatives market recently, the entire loss is borne by the shareholders of the employing bank. The worst that can happen to the dealer is a sack.

To quote a recent incident, the SocGen trader, who lost 5 bn euros recently (see "World Money", February 4, 2008), seems to have been motivated to take excessive risk in the hope of joining the ranks of the "masters of the universe", an expression coined in the classic novel, Bonfire of the Vanities, by Tom Wolfe. Despite the huge losses suffered by shareholders, and a 60 per cent drop in profits of the Big Five investment banks, Wall Street bonuses in 2007 actually total more than in the previous year, at $40 bn. Chief Executives of Citi and Merrill Lynch were forced to retire in disgrace after the huge sub-prime losses. They went pocketing severance compensation totaling $200 mn, and were questioned last Thursday by a US Congressional Committee about the benefits this gave shareholders!

If the compensation of investment bankers and traders are in seven-eight figure dollars, those of their counterparts in the hedge fund or private equity business are sometimes in nine or even ten figure dollars ($1 bn); to be sure, they do not get as much publicity as the listed banks. In a somewhat different perspective, as a student of risk management, I find it interesting that the hedge fund industry seems to have suffered far less in the credit market turmoil, than the commercial and investment banks. Could it be because the risk-to-reward relationship between hedge fund managers and investors is more closely aligned as, typically, it is expected that hedge fund managers put the bulk of their savings into the funds they manage?

But this apart, is it inevitable that capitalism, the economic system which is much more successful in creating growth, should reward speculators far, far more than those who create jobs, who make 'two blades of grass grow where only one grew before', who father genuine technological or scientific breakthroughs?

Closer home, I found the recent 'auction' of cricketers an equally bizarre manifestation of what one had thought sports are about. I am aware that this is no different from what happens in soccer in Europe and Latin America, or baseball and basketball in the US; nor is this, in principle, very different from employees changing jobs for higher compensations. Still, I find the whole spectacle difficult to digest or accept when cricketers are attracting more headlines for reasons other than their performances, and in a country where 20 per cent live below $1 per day (Rs13 at PPP)!

But coming back, the huge compensations to bankers are justified as being rewards for financial innovation which benefits the society at large "" but more on this in a later article.

avrajwade@gmail.com