Changes to Risk Compensation and “Best Practices” Are They Barn Door Closers?

Many in the popular press and a few politicians believe that current compensation practices do not sufficiently penalize risk taking. Thus, they rail against incentive compensation both for “Wall Street,” (read financial institutions), and for industry in general. As we all have suffered from the collapse of the financial markets in 2008, there is a deep psychological need to assess blame and punish those that created this pain. We need to accept the reality that everyone of us bears some responsibility for over-extending ourselves and our society beyond a level of wise prudence. To come to grips with this issue there are two realizations which with we need to fathom. The first is that risk is not usefully measured as a number, but rather its impact. For me, risk is the penalty for being wrong to such a degree that it forces changes in one’s life’s plans. If one’s financial assets are ten thousand dollars or less, a loss of one thousand dollars may cause a change of plans for college, rent or purchase of a car. The same loss by a millionaire is an annoyance, but not a life changer. The second realization is that while in truth we are at risk every single day from some catastrophe, we don’t feel at risk. We believe almost everything we purchase was bought at an appropriate price, without fear that some subsequent event will cause our purchase to be worth much less. Both the mortgagee and the mortgagor believed at the time the sub-prime mortgage was struck, that neither the buyer nor the seller was at substantial risk. The same could be said of the domestic or foreign institution that bought a tranche in a structured financial package of subprime mortgages as well as those who sold the paper to them. There was little in the way of history which would alert all those who, in actual fact, were taking substantial risks. The size of the extra incentive compensation would not have been worth the large losses which were sustained. In many cases the participants’ jobs, careers, and their own capital in their firms were sacrificed by being wrong. I seriously doubt that any change to the risk/reward matrix would have changed many people’s behavior.

We are not blameless for the mistakes that caused us, our clients and our society to pay the risk penalty. We are guilty of not looking for the unexpected, or if you will the “Black Swan.” Under the pressure to meet human needs for housing on the one side and income generation on the other side, we failed. I am not suggesting that there weren’t liars and others driven by greed, but for the most part the mistakes that were made were made by relatively honest, upstanding people who had no knowledge or experience to guide them through their next set of troubles. Even many of the traders, with their own and their firms’ capital, were unaware of the risks about to fall on them. At the end of the day, the fault was poor, one-sided research, not the compensation arrangement.

In our natural desire to avoid future penalties, we look at what went wrong in a mechanical sense and wish to institute changes to prevent what happened from happening again. I guess this comes under the headline of avoiding a second lightening strike. The theory holds that if one attacks the motivation of the guilty, (compensation), they will become reformed and won’t stray again. I believe that this type of change is unlikely.

To avoid future problems there is a tendency of the great and the good, (to use a British expression), to codify a new and more stringent Code of Conduct. Some of the popular headlines would require more transparency, more capital, and less leverage. These lists of “Best Practices” attempt to correct the past in a systemic approach. Perhaps, they should look at the lack of complete success at past lists of Best Practices. I believe they will find two obstacles in designing effective risk penalties. First, we live in a dynamic world that is always re-inventing or perhaps more accurately, re-packaging financial instruments. In this most creative community, good and bad people will find ways around the current rules. The second drawback to believing that Best Practices or regulations will prevent future problems, is that problems are caused by people, not procedures.

People are human, so they can and will make some mistakes. People have friends and family that they will treat differently than total strangers at times (and in some cases, very subtly different ways). People also have unfulfilled desires which can override their natural caution. I suggest that most problems will be avoided by those groups or families where the supervision knows their fellow workers/members, and can anticipate many of the human problems that drive people to take risks.

Changing financial compensation procedures without changing the psychic benefits gained from various forms of risk taking is like closing the barn door after the animals have fled. Better results will be had by leading people to the benefits of avoiding unwarranted risks rather than by promulgating Best Practices or by additional regulation.

We look for fund managers who lead their organizations effectively, they manage risk well.