Misaligned Incentives and the Economic Crisis

The problem isn't the amount of the bonuses Wall Streeters received. It was a system that rewarded unacceptable risk

By Ken Smith

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.

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