In some ways, this chapter is the “easiest” in the ongoing series of postings on incentives.the research puzzle | The previous effort, “draw your return,” focused on hedge funds. It is, after all, the most explored:  Whither the investment banks and the investment bankers?

If ever a group deserved extinction, this is it.  (I am talking here of the large firms that specialized in taking but not managing risk in proprietary trading and other principal-taking activities, not those that stuck to the basic advisory and trading businesses as they had been run for most of modern times.)  The question is whether they can and should be allowed to fail.  In a word, yes, but let’s do it slowly.

The incentive structure in place attracted large numbers of the “best and brightest” (who knew we had that many?) and encouraged them to build with disregard edifices that looked good but weren’t in fact real, like the façades of a Hollywood backlot town.Washington Post | Toles used an apt metaphor to depict the behavioral antecedents for the activities. If a disincentive structure, specifically the caps on pay instituted at firms that have received government money, drives those bankers away, so be it.  If the firms die a slow competitive death as a result, that’s fine too.

There will be those employees who will stay to slug it out, perhaps to help preserve what equity value they retain, but many will be forced to leave and others will decide that the more limited lucre now available at the big firms just doesn’t cut it.  Good enough.  The industry needs new firms and new thinking.  That’s the real benefit of the compensation limits.  Many people will be scattered and some of them will build the dominant organizations of tomorrow.  Those with ideas and the willingness to risk the capital that the old business model put in their bank accounts will bring life to the financial system.  Hopefully, having been witness to the witless compensation practices of the past, they will fashion incentive approaches that reinforce the organizations they build rather than imperil them.

It is no great insight that the incentives must match the needs of the organization, and therefore should be longer-term in nature, have features like clawbacks, be based on profits that are calculated after a risk-based capital charge, and be integrated more completely with the results of the organization.  If individuals don’t like that approach, they can make do on their own.  It is time to recognize that the ability to generate profits depends to a significant degree on the attributes of the organization; employees are not independent actors and shouldn’t be paid as such.  And, although it will rise from the dead in some future cycle, it is time to bury the canard that “stars” are irreplacable.  They are not, and the distortions that have entered the compensation arena can be corrected now that there are plenty of out of work bankers.  You can find well-qualified people that are willing to do work they love in a way that lasts.

Some of the big investment banks also have large numbers of financial advisors in their employ.  We will next turn our gaze on them and an industry repast that provides little nourishment for their clients.