On Bankers and Entrepreneurship

So I had a thought about entrepreneurship. Actually, two: the first was, "isn't it funny that entrepreneur - the very watchword of free market capitalism (and, indeed, the very word for free market capitalism - laissez faire) is, of all things, French?". But that was a parochial and borderline xenophobic thought, and I resile from it (whilst secretly finding it pleasing and quite funny).

But my other thought about entrepreneurship was more interesting. It was Bankers what made me think it. Currently, the furore is about overpaid bankers.

I have an interest in this furore because - after a fashion - I'm a banker. Not just any old banker, but the worst kind. An investment banker. Who is into derivatives and that stuff. I say "after a fashion", because I don't actually do derivatives: I just help other people do them. I used to be a banker proper, for a short while, but I decided it was less stressful and more rewarding just helping bankers, rather than actually, properly being one. That's because I'm not especially entrepreneurial - when push comes to shove, I would prefer regular, safe, income to putting that on the line in the gamble for success and a lot of money.

So I'm actually a lawyer, and I just work for a bank. But even though in my mind I'm not really banker, in most people's minds, I totally am. Being a banker, I go to quite a few dinner parties. And it's a bit uncomfortable having to admit I work in a bank. Often, I just lie.

I digress. Real investment bankers, so the theory goes, are entrepreneurs: risk takers: that's why they get paid so well. "You civil servants and teachers aren't putting everything on the line every day: you don't take huge economic risks: people's livelihoods don't depend on you," (I imagine teachers might disagree; but let's park that.) "You don't take as much risk as I do, so therefore your potential reward is commensurately lower."

Which is all fine, if you accept that Investment Bankers are huge risk takers. But the thing is, they're not.

Now I like bankers (well, some of them, as individuals: of course I don't like them unhesitatingly as a class): I work for them, I have done for more than a decade, and I expect to do so for a decade more.

But investment bankers only necessarily take risks with other people's money. That, to me, doesn't count as risk taking. It's not particularly entrepreneurial. Really, that's being rather safe, relying on steady income. It is true that many bankers do put their own capital on the line (in the form of share ownership in their own companies) but generally this will be limited to a small portion of their annual income (between 5 and 30%), and even the most sage investment banker won't put any more than he is contractually obliged to into his own company ("I am already very long on exposure to this bank," he will say, "for I rely on it to pay may wage, and I already have 15% of my income in its stock. It is not wise, economically, to concentrate my investment portfolio by increasing my exposure to this bank. And if there's one person I know who's economically wise, it's me. I'm an investment banker (did I mention that?)".

So investment bankers tend to invest their savings in enterprises other than their own employer.

So when an investment goes horribly wrong for an investment banker, what happens? Does he lose his house and all his possessions?

I hope you won't be disappointed to hear that the answer is "no". Even if things go so disastrously wrong for the Banker that, Nick Leeson style, he manages to bankrupt his entire company, his loss is limited to his future earnings. Stuff that's already in the bank stays there. No one has a claim over his house or his Maserati Quattroporte. (Even if they otherwise would, do you think he wouldn't have had his financial adviser put his assets somewhere they can't be reached?).

This is known in the game as being long a call. Owning a call means that, if the value of the asset you have a call on goes above a pre agreed price, you get the right to "call" it - meaning buy it for that agreed price. Since, by definition, it's worth more than the price you buy if for, you make an instant profit, because you can immediately sell if for more money than you bought it for. If it goes down, you just don't exercise the option to call it. No loss. Except for the price you paid for the right to call in the first place.

A call, in legal parlance, is a right with no accompanying obligation. Note that employees don't pay (as such) for their calls: indeed they are paid for them. The "consideration" an employee gives for the call is his or her time: he or she has to show up, and do the employer's bidding to the exclusion of all else.

A call, by the way, is a sort of derivative.

Entrepreneurs, on the other hand don't just buy calls. Because they own the equity in their company, they take full exposure to gains and the losses of the business. If it goes up, they take the profits. If it goes down, they suffer the losses (because the equity capital, which they own, has decreased in value).

Entrepreneurs,therefore, buy a call and sell a put. (Selling a put is the opposite of buying a call - it means giving someone else the right to sell an asset to you at a pre-determined price. If the asset drops below that price the put holder will always exercise his or her put, and so this is an obligation without an accompanying right.

Bankers don't have that. So should they be paid as if they do?