The importance of incentive

A quant squint explains why bank traders tend to behave so irresponsibly when analyzing risk/reward probabilities:

Suppose that instead of betting on the biased coin you join in with all your colleagues and bet on the same toss of the first coin. Now you all win or lose together, the odds are even and the probability of getting your bonus is 50 percent. This is significantly higher than if you’d done the “responsible” thing of helping your bank to increase its expected return and decrease its risk.

This example makes it clear that your interests and those of the shareholders and depositors can be complete opposites. They probably didn’t teach you that at business school.

The fact that the federal government will then step in and bail out the bank – ensuring that bonuses are paid even in the event of failure that would normally result in bankruptcy – can’t help but exacerbate the undesirable appetite for foolish and unprofitable risk-taking.