The Financial Industry Should Maximize Skin-In-The-Game To Discourage Bad Actors
By: Ajene Watson Llc
Tags: Skin In The Game, Nassim Taleb, Finance, Investing, Investors

Since humanity’s early days in Mesopotamia, managing risk has been a necessary part of life. As I wrote in this previous post, Hammurabi’s Code was the first set of comprehensive rules for finance, so the concept of skin-in-the-game is nothing new. Rather, this concept has been watered down, and the once-level equilibrium is off-kilter. Author of “The Black Swan,” Nassim Nicholas Taleb, has what may be the most egalitarian and pragmatic view on the often misunderstood concept. Taleb’s version of skin-in-the-game boils down to a simple equation: you own it if you break it. Achieving this means equal consequences whether you are wrong or right. This notion is exceedingly fair and should be widely implemented in finance, because it would vastly improve the industry by incentivizing the behavior we wish to see.

The seesaw of risk

Hammurabi understood strong incentives. Contractors were highly motivated to build a durable, quality home, because they knew they would be put to death should their construction fail. That may seem rather ruthless, but there’s no doubt that your home builder is motivated by skin-in-the-game. When risk is equally distributed, the entire system improves. Business networking is an example of managing risk with skin-in-the-game, because it’s structured to incentivize quality, since a bad referral reflects poorly on the referrer.

Reward favorable behavior

Pop culture has long depicted the reverence ancient societies like Greece and Rome had for stories of courageous feats and heroes. They exhibited courage and received accolades and respect in return. Seems like a fair deal if you’re going to fight a lion to the death, right? While we don’t need Russell Crowe to trade courage for clout in the Colosseum anymore, the need to prove merit prevails — especially in the financial industry. Are you not entertained!

If gladiators relied on courage to prove their merit, then shouldn’t investors in the venture capital space be required to as well? With their success rate barely cracking 5%, VC investors have consistently demonstrated that they rarely possess the courage to strike out and chase investments that are truly revolutionary. Groupthink is rampant in VC as investors flock to find the ‘next Uber or Facebook’, rather than blaze their own trail as mavericks. Nassim Nicholas Taleb might have said it best: “A foolish gambler is not committing an act of courage, especially if he is risking other people’s funds” and many of the issues in finance could be traced back to this sentiment. No solo investor made WeWork’s supreme grifter, Adam Neumann, a billionaire out of their own pocket, they were investing other people’s money. Bet they would have thought longer and performed more DD before investing in his “shaky” project (or other unicorns), had they been spending their own cash and had adequate skin-in-the-game. This is why I tend to invest my own money in projects I truly support before seeking capital from others.

Diversity Talk: Put your money where your mouth is, son!

On the flip side, while skin-in-the-game discourages unsavory behavior, it can be used to promote the actions we want to see. For example, companies that are serious about diversity in their workplace, would simply incentivize this outcome by linking executive compensation with long term retention of diverse hires. With executives shouldering more risk/responsibility, and their motivations properly aligned with the goal of actually hiring and retaining diverse staff, the needle would move forward very quickly. By placing this type of incentive on executives who expect to get paid, the deeply broken hiring structures in finance would magically be prioritized and fixed. That’s the transformative power of proper motivation through sufficient skin-in-the-game.

The social contract

For most of us, there are tangible consequences for sucking at our jobs, investing in a dud, or failing to save money for a rainy day. We get fired, lose our investment and deal with the real-world fallout. Over the past decade, however, airlines have spent 96% of their cash flow to buy back their own stock for the express purpose of dolling it out in the form of executive bonuses. Why’s that? Well, they have no incentive to save for a rainy day, because they have good reason to expect a never-ending supply of taxpayer funded bailouts. If we rewind to the 2008 crash, we’d remember that “Bankers who lost more money than ever earned in the history of banking, received the largest bonus pool in the history of banking less than two years later, in 2010.” Let Nassim Nicholas Taleb’s words sink in — “A foolish gambler is not committing an act of courage, especially if he is risking other people’s funds”.

Given this context, it seems reasonable to expect that financiers should prove themselves qualified before investing other people’s money and companies should be disincentivized from buying back stock for nefarious reasons and enriching shareholders with taxpayer money. Skin-in-the-game shouldn’t just apply to the 99%, because we certainly can’t count on consistent government support — even during a pandemic — like wealthy corporations can. It’s only fair that the real-world consequences of one’s actions apply to everyone, not just the average joe.

Own your consequences

“First do no harm” is a key principle of skin-in-the-game, but it is often the most overlooked concept. Facebook is a prime example of how dangerous it can be when that principle gets skipped. While Zuckerberg is the living embodiment of tech’s beloved ‘move fast and break things’ mantra, he’s not paying any consequences for what he’s broken; we are. Skin-in-the-game extends well into big tech, but it’s desperately needed in the American financial sphere. The scales have been unbalanced for far too long, and restructuring the financial systems to account for adequate skin-in-the-game is mandatory to fix the existing inequalities and injustices hurting the 99%. The entire system is better off when you risk losing in equal measure to what you win.

The real world consequences of bad investments should apply equally to everyone in the industry, not just the taxpayers and those investors who are habitually left holding the bag. It’s not too late to transform the financial industry for the better by further investigating and possibly adopting Nassim Nicholas Taleb’s version of skin-in-the-game as we struggle with the post-pandemic economy.