Crazy Compensation and the Crisis

grimace“TAKE A TYPICAL TRADER at a bank, investment bank, hedge fund or whatever. Darwinian selection ensures us that these folks are generally smart young people with more than the usual appetite for both money and risk-taking. Unfortunately, their compensation schemes exacerbate these natural tendencies by offering them the following sort of go-for-broke incentives when they place financial bets: Heads, you become richer than Croesus; tails, you get no bonus, receive instead about four times the national average salary, and may (or may not) have to look for a new job. These bright young people are no dummies. Faced with such skewed incentives, they place lots of big bets. If tails come up, OPM (Other People’s Money) will absorb almost all of the losses anyway.

Whoever dreamed up this crazy compensation system? That’s a good question, and the answer leads straight to the doors of the top executives of the companies. So let’s consider the incentives facing the CEO and other top executives of a large bank or investment bank (but, as I’ll explain, not a hedge fund). For them, it’s often: Heads, you become richer than Croesus ever imagined; tails, you receive a golden parachute that still leaves you richer than Croesus. So they want to flip those big coins, too.

From the point of view of the companies’ shareholders — the people who provide the OPM — this is madness. To them, the gamble looks like: Heads, we get a share of the winnings; tails, we absorb almost all of the losses. The conclusion is clear: Traders and managers both want to flip more coins — and at higher stakes — than shareholders would if they had any control, which they don’t.

The source of the problem is really quite simple: Give smart people go-for-broke incentives and they will go for broke. Duh.”

Alan S. Blinder at the Wall Street Journal gives us the heads-up on the lowdown about investment banking and Other People’s Money.

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