In recent times, traders have been accused of taking excessive risks. Unfortunately, the structure of remuneration in financial markets tends to exacerbate animal spirits by creating incentives for risk-taking.
Traders benefit dramatically in prestige and bonuses when successful. Meanwhile, they don’t suffer when they do badly as society foots the bill. This agency problem in finance is described as the ‘Trader Option’.
Gambles that can seem rational from the perspective of an individual trader can have negative implications for society and the firm, if his incentives aren’t aligned with those of shareholders. The optimal attitude to risk will be the shareholder’s value judgement.
How can this reckless attitude to financial risk be tempered? This problem cannot unfortunately be adequately managed by CEOs. Because they are insulated from unemployment risk due to extremely high wages, they also enjoy the freedom to take risks – plausible deniability and generous severance package if they fail, and enormous rewards if they succeed.
There are several options available surrounding payment of traders. But no individual firm can adopt these practices, or they will become an industrial pariah. Any efforts to do so on an industry level is likely to arouse serious opposition from vested interests, as happened in 2008.
Note also that there is a link between the positive reinforcement effect from bonuses, and the temporal distance to the act being rewarded. This has been verified empirically in finance and firms are aware of it, which creates another barrier to pay reforms which might be effective. Thus, remuneration is unlikely to change.
Shareholders of companies, as the only people that can regulate the activities, will thus have to just keep an eye on risk management themselves. But they haven’t done so. Why is this?
Because shareholders have the same skewed compensation curve, although slightly different as it arises through limited liability. As far as they are concerned, they are indifferent to leaving the firm in debt or just destitute and insolvent.
As long as that exists, firms will always tend towards risks with large deviation rather than safe risk management. Large losses are automatically discounted, irrationally from the perspective of society but completely rationally in the mind of the firm.
This begs the question of whether limited liability is appropriate in the context of banking. Banishing it might be the only way of bringing the true cost of financial activity back to someone, and forcing them to take responsibility for it.
As long as traders, managers and shareholders don’t suffer the losses which result from their activities, the financial system will always be exposed to booms and busts. It would be nice to reform incentives everywhere. But it’s achievable in the case of limited liability.
© The Free Marketeer 2009