Tuesday, September 22, 2009

Incentive Compensation Restrictions Will Not Accomplish Their Goals: Incentive Bonuses Only Identify Risk Taking Employees

Limiting incentive compensation will hinder employers from finding risk takers to hire or weed out.

One of the common myths of the causes of the past financial crisis in mortgage derivatives is that incentive bonus compensation contributed to undue risk by an excessive amount of improper mortgage lending to borrowers who could not afford their mortgage payments. Additionally, many argue that the incentive pay led to easy credit and an unsustainable housing bubble.

There is not any decisive research to show that incentive compensation caused excessive risk taking at financial institutions. Most research has been unable to substantiate this common narrative. (See Jeffrey Friedman article mentioned in my ealier post, "Debunking Bonuses, Irrationality And Capitalism As Causes Of The Economic Crisis.")

Fist of all, the issue is not the risk taking of the employees but the change in their risk behavior due to the compensation structure. Research to substantiate incentive compensation as a cause of excessive risk taking would need a measure of the employee's risk profile before and after exposure to incentive bonus compensation to measure a change due to incentive bonus compensation.

There is the obvious signaling/selection problem. Companies make their compensation structure known during the pre-hiring and hiring process. Anyone applying to the job is attracted to the idea of uncertain compensation based on performance and is already an above average risk taker. The bonus does not entice them to take on excessive risk. It identifies them. The payment structure is a signal to applicants that above average risk takers have a higher probability of hire.

If it is true, that incentive compensation is a signal to identify above average risk takers, then eliminating incentive bonus compensation removes the identification and filtering process. Excessive risk takers will remain in the applicant pool for all related finance and banking jobs. They will apply and find jobs where risk takers are unwanted. We have asymmetric information. Some applicants know they take excessive risk, but employers will not be able to identify them and will hire some of them. Employers who seek risk-taking employees might adopt some other signal or means to attract and find above average risk taking employees. If desired, they will still staff certain positions with personnel prone to excessive risk. Behavior in these risky areas of a financial institution will behave as if there were incentive compensation in place and take a lot of institutional risk.

Additionally, some of the personnel employed in non-risky positions will have an excessive risk profile because they will have applied to jobs believing the openings were for high risk taking individuals. Compensation structure without incentive bonuses will not distinguish employers seeking risk-taking employees from those seeking non-risk taking employees. Employees will lack job risk characteristics and information. Once employed, these employees will promote excessive risk taking in average and below average risk taking organizations. These companies might not be prepared for these excessive risk takers. Eliminating incentive compensation may only cause problems for a slew of companies and jobs that are unprepared for and unused to risk taking employees.

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