How to Reform Risk Management

MoneyIn 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

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8 Responses to How to Reform Risk Management

  1. David Wilkins says:

    Suppose some investment is very profitable in the short term, but locks the business into commitments that could prove extremely risky in the long term. Such an investment is surely to the advantage of a canny well-informed shareholder, who will purchase the shares only to sell them a short time later in order to realise the profits and move on. Of course the sids will suffer. They can hardly be expected to know what is going on, and when best to get out. But who cares about them?

  2. thefreemarketeers says:

    Surely that could happen under the status quo just as easily? The ignorant investor is only protected now from being punished beyond his initial investment. If he doesn’t suffer the loss, someone else does.. But you only want him to TAKE the risk if he’s balancing up all the costs and benefits – including all potential losses.

    Although, I’m not sure what exactly the problem is that you’re describing.. Exploiting information sounds like business as usual in the efficient market.

  3. Dante says:

    “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.” What do you mean by this? The awareness of firms have of “temporal distance” (or delay) between when CEOs receive bonuses and when they engage in the risky behavior does not seem to me to pose a barrier to reform. Nor is this the case with the delay itself. Any reform introduced would not deprive CEOs of bonuses for acts which they have already carried out- this would be an unlawful infringement on a contractual entitlement.

  4. thefreemarketeers says:

    Delay was indeed the word that I was searching for.. Thanks. First of all though, I was talking about traders at that particular point in the argument – although admittedly it was unclear.

    I was actually referring to the practice of tying up bonuses in long-term performance of assets rather than immediate gains. If alternative means of paying bonuses reduce the effectiveness of a given financial incentive, then it could be too expensive to reform.

    Considering how competitive financial markets are, I don’t think any firm will sacrifice how well their traders perform in the short-term, in order to make sure their decision mechanism is correct (especially when the degree to which interests are misaligned is so questionable). That was basically what I was saying.

    Obviously any reform would have to written into new contracts. Again, high wages of CEOs/top traders make it quite clear who has bargaining power there – which is why it would be surprising for reform to take place there. Traders would be worse off under any system which eliminated moral hazard on their part, I suspect.

  5. […] World Without Limited Liability It was suggested recently here that limited liability had proven inappropriate for the banking system. Gambles which are rational […]

  6. Dante says:

    So perhaps, and I have yet to go on to read your most recent article so apologies if this issue has already been addressed, the best method for achieving the equilibrium between attractive financial incentives for CEOs/ top traders and responsible risk management would be to increase wages in a renegotiated contract which de-emphasises the role of bonuses and increases the flat wages which the relevant parties receive. This creates an incentive for responsible risk management as the CEOs then have an incentive to keep their job which stands out as particularly attractive in the market rather than risking it for an non exorbitant bonus. The equilibrium would have to be struck through empirical trial and error and would be the quantum would need to be relative to the particular trader/CEO’s fiscal situation. This sort of ordering of incentives is already common practice in the many companies anyway. This obviously might be a bit byzantine, but the current bonus schemes already are pretty much just as bad.

    The share holders limited liability, whilst potentially creating incentives for more au fait risk-management, also chills people from investing in the first place. Outside of any theoretical-speak, people nowadays would be too scared to invest if they thought it could seriously damage their financial situation. I think this may have already been mentioned.

  7. Dante says:

    The second paragraph should start with “abolishing share holders limited….”

  8. thefreemarketeers says:

    I don’t think that any firm could formulate contracts that emphasised basic wages rather than bonuses would be able to survive in the market. That would alienate the top traders and drive them elsewhere, while it would be most attractive to pretty average or below average traders. Either your wage costs spiral, or you have serious adverse selection.

    I agree that insulation from unemployment risk is a major factor that allows CEOs to take crazy risks. But anything which tampers with that market remuneration scheme threatens to leave the firm with the best people not interested in the job.

    As regards limited liability, I just wrote another post on that. Any increased risk to share-holders is a decreased risk to bond-holders. So the aggregated effect, I suspect, would leave the firm with the same weighted cost of capital. At least that is my suspicion?

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