Monday, June 1, 2009

Incentive Compensation Did Not Induce Excessive Risk Taking

The individuals who are opposed to incentive compensation at financial firms are probably risk adverse individuals who have not experienced the thrill of working on large trades or deals in a financial firm. For example, see comments by James Kwak and Alan Blinder.

Some people are greater risk takers than others. Just as some people drive faster or ski down the expert slopes, people with a greater risk taking profile, take jobs where they can engage in greater risk taking. Trading ranks as one of the most stressful jobs with a high degree of risk.

Lowering the compensation will not change that part of the job profile. Risk seeking individuals will still take these jobs.

Lowering the compensation and incentive pay structure will change the types of people who take these jobs along other measures but it will not stop their risk taking.

People self select for jobs using many attributes of the job as their criteria. Compensation is just one of a job's characteristics. People who enjoy jobs where there is stress and thrills will always seek to be traders and deal makers. They will always push the envelope.

Just as incentive pay is not the defining difference between test pilots and regular pilots, lowering the compensation and incentives will remove those applicants who self-select based on total compensation, but it will not remove thrill seekers as applicants.

Yes, a lower compensation without bonus incentives will change the types of individuals in financial firms, but not along the qualities that you want to eliminate. It will not prevent a recurrence of excessive risk taking, just as it was not the cause of the excessive risk.

Blaming incentive compensation is equivalent to blaming a high performance sports car for a driver's speeding instead of blaming the driver. Drivers who speed choose fast cars and not vice versa.

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