Perverse incentives cause real harm

There is a lot of moral outrage about the big bonuses, but, as this world-class economist argues, the dysfunctional sides of people on ‘high-powered’ incentives (as they’re called in economics), betting with other people’s money, deserve more attention, much more..

Crazy Compensation and the Crisis
We’re all paying now because skewed financial incentives led to too many big bets.


Despite the vast outpouring of commentary and outrage over the financial crisis, one of its most fundamental causes has received surprisingly little attention. I refer to the perverse incentives built into the compensation plans of many financial firms, incentives that encourage excessive risk-taking with OPM — Other People’s Money.

What, you say, hasn’t huge attention been paid to executive compensation — especially those infamous AIG bonuses? Yes. But the ruckus has been over the generous levels of compensation, or the fact that bonuses were paid at all, not over the dysfunctional incentives that inhere in the way many compensation plans are structured.

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 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.

Amazingly, despite the devastating losses, these perverse pay incentives remain the rule on Wall Street today, though exceptions are growing. For now, excessive risk-taking is being held in check by rampant fear. But when fear once again gives way to greed, most traders and CEOs will have the bad old incentives they had before — unless we reform the system.

It was not always thus. Not so very long ago, banks shied away from big gambles on securities and investment banks were organized as partnerships, not corporations. In a partnership, the firm’s capital is the partners’ own capital, which they safeguard with the care you’d expect when using MOM — My Own Money. Back then, the upper echelons of Wall Street firms were not keen on giving a bunch of unruly 28-year-olds a lot of big coins to flip.

Hedge funds are a kind of halfway house between the stodgy old system and the brave new system. These funds do deploy oodles of OPM. But the senior partners — the bosses — almost always have significant shares of their own personal wealth tied up in the funds. So it’s no accident that hedge funds operated with far less leverage than investment banks and commercial banks. Thirty-to-one leverage is simply too risky for MOM. That said, they generally compensate their traders the same way.

These wacky compensation schemes have puzzled me for nearly 20 years. My worries were not assuaged when, in 1995, a smart and famous hedge-fund operator told me that the reason his firm paid its traders that way was “because everyone else does it,” which is always a terrible answer. But the issue could be considered an intellectual puzzle until the bottom fell out.

If the costs of foolish compensation schemes remained bottled up inside firms, they would not be a cause of public-policy concern, although shareholders should still worry. But that is plainly not the case. Most of the world’s financial system collapsed after an orgy of irresponsible risk taking, and the consequences for the real economy have been devastating. We are all now living through a world-wide recession of a magnitude that economists thought was only for the history books.

What to do? It is tempting to conclude that the U.S. (and other) governments should regulate compensation practices to eliminate, or at least greatly reduce, go-for-broke incentives. But the prospects for success in this domain are slim. (I was in the Clinton administration in 1993 when we tried — and failed miserably.) The executives, lawyers and accountants who design compensation systems are imaginative, skilled and definitely not disinterested. Congress and government bureaucrats won’t beat them at this game.

Rather, fixing compensation should be the responsibility of corporate boards of directors and, in particular, of their compensation committees. These boards, I’ll remind you (and please remind the board members), are supposed to represent the interests of stockholders, not those of managers. Quite plainly, many were asleep at the switch, with disastrous consequences. The unhappy (but common) combination of coziness and drowsiness in corporate boardrooms must end. As one concrete manifestation, boards should abolish go-for-broke incentives and change compensation practices to align the interests of shareholders and employees better. For example, top executives could be paid mainly in restricted stock that vests at a later date, and traders could have their winnings deposited into an account from which subsequent losses would be deducted.

Comprehensive reform of the financial system will probably take years. The problems are many and complex, and the government’s to-do list is not only long but also a political minefield. Yet fixing compensation incentives does not require any government action. It can be done by financial companies, tomorrow. Too bad they didn’t do it yesterday.

Mr. Blinder is a professor of economics and public affairs at Princeton University and a former vice chairman of the Federal Reserve Board.