Incentives and the Financial Crisis - 29 May 2009

Incentives and the Financial Crisis

Posted: May 29th, 2009, by Andy Spero  E-mail this post

There’s an excellent opinion column in yesterday’s (May 28) edition of The Wall Street Journal. It is Crazy Compensation and the Crisis by Alan S. Blinder.

Why do we write that it is “excellent” the dear reader may ask?

Well, for the obvious (and self-serving) reason that we have been
writing the same critiques on these pages for much of the past year
or so.

Mr. Blinder identifies several problems that created the potential for the crisis and its subsequent realization.¹ We will categorize the problems that he identifies as:

1. Wrong legal form/organization structure for some firms,


2. Incompetent boards, and


3. Lax controls and poorly-designed incentives.

He treats them in a different order than we list them; we’re going from top-to-bottom, which is consistent with Our Control Framework. Clearly, the three categories are related. For example, see our popular post, SOX’s Roles in the Financial Crisis of ‘08,
which hits on all three topics, and criticizes government regulation to
boot. In our mind, they all provide evidence of the fallen nature of
man. (We’re not complaining about that nature. We accept it in ourself
and, to a lesser extent, in others. We’re only trying to profit
from it.)

Wrong Legal Form/Organization Structure

We wrote about this on September 26, 2008, when we asked Will Investment Banks Go the Way of the Dinosaur? In
that post we speculated that partnerships may make a comeback because
“They provide control mechanisms and levels of oversight and scrutiny
that seem difficult to duplicate in public corporations.”

Mr. Blinder made explicit what was implicit in our post: the difference between one’s level of risk-taking when managing OPM (Other People’s Money) versus what he refers to as MOM (My Own Money), or one’s own money.² Those facing unlimited personal losses tend to be more conservative than those with limited losses.

In January, in a critique of The Wall Street Journal’s editorial board,  What Did They Expect?,
we wrote, “We also disagree with their [the editorial board’s]
assessment that “compensation levels are a business judgment made under
the pressure of competition.” That might be true if the firms were
partnerships or otherwise privately-owned, there was no agency costs,
and there was no self-dealing, i.e., the firms were run by independent
and knowledgeable boards.”

But with D & O (directors’ and
officers’) insurance, the limited downside of losses severely
decompresses that so-called “pressure of competition” for boards.
Moreover, shareholders of bank holding companies (and other
corporations, too) implicitly permitted managers to take greater risks.
In fact, Mr. Blinder seems unwilling to blame shareholders when almost
every stockholder was quite capable of selling their stakes. So, we
have no sympathy for folks who wanted the opportunity for large gains
without bearing potential liabilities if the firm.³

Incompetent Boards

While “Incompetent Boards,” may seem a bit harsh to some, we think
that it is milder than many alternative and equally fair
characterizations, and there is no shortage of evidence. See Directors Are Faulted at Home Loan Banks for example.

Regular readers will note that we often ask whether a party is
ignorant or cynical, and in this case we’d prefer to believe that many
directors were unqualified to understand the uncertainties and risks
associated with investing and trading, particularly with derivatives
and other structured products. In some way, that seems more “decent”
and ethical than the alternative: the cynical and devious behavior of
understanding the potential for loss but ignoring it due to one’s own
limited liability.⁴

For example, with the recent changes in the composition its board,
Citicorp has as much as admitted the lack of requisite expertise of its
past board. We’ve written about these topics in the past, particularly
in: The Failure of Boards to Direct, The Seventy-Year-Old Teenager, When the Going Gets Tough…Quit, and Idiosyncratic and Concentration Risk, Again. (Update: within hours of publishing this post, B of A announced that one of its directors was resigning: see BofA Says Sloan Quits Board Seat. There was much speculation that it was due to government pressure.)

Those (generally weak and) incompetent boards permitted senior
managers to maintain the lax controls and poorly-designed incentives
about which we have often written, and here is a summary.

Lax Controls and Poorly-designed Incentives

As Mr. Blinder notes, poorly-designed incentives—primarily via compensation schemes—led to ex post ”excessive” risk-taking. We write ex post
as in 20-20 hindsight as in “there are massive losses, so someone must
have done something wrong,” but, in fact, we’re note using that logic.
Instead, we note that there was no shortage of individuals warning
about the risk and uncertainties ex ante.

Unfortunately, many such folks were dismissed either figuratively or literally

http://speroconsulting.com/2009/05/29/incentives-and-the-financial-crisis/