Misaligned Incentives and the Economic Crisis

Compensation problems have been highlighted in much of the coverage of the financial crisis, including a number of reports from the Institution of International Finance. (See, for example, Report of the IIF Committee on the Market Best Practices: Principles of Conduct & Best Practice Recommendations, Financial Services Industry Response to the Market Turmoil of 2007-2008.) These reports have made some sensible recommendations relating to executive compensation practices, mostly aimed at aligning compensation incentives with risk-adjusted performance and providing for recourse when the rewarded performance later results in undesirable outcomes.

However, the news about the billions of dollars in bonuses paid out on Wall Street in January and, more recently, the controversy surrounding the AIG "retention" bonuses have taken the compensation thinking off course. Everyone has a right to be angry about ill-gotten gains, especially if at the taxpayer's expense, but the alarm about the amount of compensation is taking the focus away from the more important issue of the misalignment of incentive schemes with safety and soundness.

To find sustainable solutions to the compensation issues, the thinking needs to refocus on how incentives contribute to risk origination and transfer.

Staving Off Collapse

Consider first an analogy: Many years ago, mining engineers determined that mine collapse could be prevented by forcing bolts into the walls and ceiling of the mine cavity to essentially replace the pressure of the rock that had been removed. The mining engineers learned to calculate the number of bolts and the length of bolts needed for the mine to remain safe. The drilling and installation of the bolts was a labor-intensive process, but doing so well worthwhile as it substantially reduced the risk of mine collapse.

Management then discovered that if the laborers were given an incentive based on the number of bolts they installed, they tended to work a little harder, resulting in improved productivity. However, some laborers soon determined that a little compromise on the length of the bolts would increase take-home pay and go unnoticed by management. Of course, those laborers did not, or chose not to believe such compromise would affect safety.

Amid a false sense of security, this practice of "short-bolting" ultimately led to mine collapse, revealing that financial incentives could encourage unsafe practices and compromises by otherwise good and caring people. Bear in mind that these miners were not taking home million-dollar bonuses. The issue is not the amount of the incentive, but rather what practices or compromises will earn the most.

In this life-and-death example it is easy to see how misaligned incentives produced unacceptable risks. The parallels to the financial services industry are painful to consider. Beginning with subprime mortgages, brokers and lending officers inch by inch compromised the quality of the loans. Given an incentive to expand the book, they were tempted to bend standards or compromise on compliance, not intending to put their institutions at risk. These loan portfolios were then packaged and sold and repackaged and resold, each time with the apparent security of being "asset-backed." The true quality of the assets was hidden (as was the case with short bolts) resulting in the infection of institutions across the industry and around the globe. At each hand-off, someone earned a volume or spread-based incentive, and no one had an interest in looking carefully at the bolts.

Take Away the Carrot

The mining industry had two options to deal with the practice of short-bolting. It could either increase inspections and penalties to ensure that the bolts were meeting the specifications or they could remove the incentive to compromise. They chose the latter, and it proved to be a simple, safe, sound, economical, and sustainable solution.

In light of the economic disaster to which these dangerous incentives contributed, it is clear that they must be curbed. Regulators may have a role to play, in addition to directors and executives, to eliminate unsafe compensation practices without eliminating the entrepreneurial spirit of the industry.

While an industry-led solution is preferred, it is difficult for any single company to act, because competitive (which often means comparable) compensation is critical to attracting and retaining talent. If the regulators can establish principles for safe practices in incentive compensation, then individual institutions can restructure compensation incentives knowing competitors will do likewise.

Directors, like most market observers, were aware of the subprime bubble but failed to spot the risks in related derivative securities. It may, in fact, be unreasonable to expect the average board director to understand the risk inherent in all of today's complex financial instruments. However, every director understands human behavior and should be asking tough questions about incentive schemes that may be undermining safety and soundness. For example, are front-line incentive systems creating systemic risk? Do management incentives systems add to risk (by paying for team performance), rather than balance it (by paying for team compliance or long term profitability)? The systemic risk issues and, therefore, the directors' responsibilities go beyond the board's traditional role of CEO and executive compensation oversight.

Deeply Flawed Compensation

Executives must continue to compete for the best talent and motivate top performance. However, the dominant practice of compensation benchmarking is deeply flawed. The mindless matching of competitive compensation has resulted in escalation and the spread of misaligned incentive systems across the industry, creating industry-wide systemic risk. Surely the measure of a winning compensation system should not be equally dumb. Executives can compete more effectively by aligning incentive compensation with product/market strategy, within guidelines for safety and soundness, and modeling the outcomes for a range of possible market conditions.

The failure of the financial system has done great harm and, further, has undermined confidence in the way business has been conducted in the past. As a result, more regulation is coming for sure and institutions will be shoring up risk management functions.

Fixing dangerously misaligned incentives may be one of the most important changes coming. In fact, given our understanding of human behavior and the fresh wounds of the current crisis, it is now irresponsible to tolerate incentive systems so misaligned with safety and soundness, just as it was in the mine.

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