The 3 reasons Wall Street lurches from one crisis to another

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20th Century Fox/IMDB

Why is it that Wall Street keeps lurching from one crisis to another?

The reputation of Wall Street professionals is nothing to write home about, and many have made a career out of writing on Wall Street follies.

Karen Ho, a professor at the University of Minnesota who studies Wall Street anthropology, recently sat down with Alan Li, who puts together The Vampire Squid podcast. The two talked about the “Wall Street culture-cocktail” that, Ho thinks, contributes to frequent crises.

Karen conducted three years of field-research with Wall Street financial institutions in the late-1990s until 2000 and found that “smartness, short-termism, and bonus structure” are the three toxic ingredients that create trouble on Wall Street.

Smartness doesn’t help

“What most people who are not in the industry don’t realize is that bulge-bracket Wall Street investment banks really recruited only from a handful of elite, mainly private universities,” Ho said. She pointed to the Wall Street practice of hiring exclusively from institutions branded as “the best and the brightest”.

Students from Harvard and Princeton are the most sought-after. “Nothing wrong with that,” she said. It becomes a problem only when elite education is mistaken for actual possession of knowledge.

For instance, during her studies Karen found that professionals with elite education “began to justify their legitimacy as global advisors to corporations even when they actually didn’t have that much experience [required to advise corporations].”

In other words, arrogance and inexperience leads to bad decisions.

Just a short-term stint

While a career on Wall Street may sound extremely attractive to outsiders, many investment bankers on Wall Street don’t, in fact, desire a long-term career in the financial industry for various reasons.

“Many of the bankers really thought of their jobs as having an expiration date, they really didn’t think of themselves as really being there for the long-term,” Ho said.

For instance, the host points out, a stint on Wall Street, as an analyst for instance, is often seen just as a stepping stone to a different career, either on the buy-side or in a startup.

The incentive to look beyond just the short-term is usually absent in these professionals.

Bonuses distort incentives

Then there is the problem of Wall Street professionals offering bad advice fully aware of how it could blow up, or even selling toxic assets to clients without having to worry about the long-term repercussions.

The likely culprit, it seems, is the bonus-system that encourages short-termism.

“Investment bankers are not paid by the quality of their advice but in many cases the quantity of deals and transactions they can execute,” Ho said. “Even when they knew that a particular transaction or advice was not necessarily the best, they legitimate it by saying ‘In a few months I’m going to be compensated based on the fact that this deal went through’.”

While Ho thinks these qualities may be ingrained in human nature, she proposes Wall Street professionals be paid based on long-term performance as a possible antidote to the deadly “culture-cocktail.”