Misaligned Incentives and the Economic Crisis

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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.

Ken Smith is the chair of SECOR Consulting, an international strategic management consulting firm .

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