Perverse Incentives Encourage Excessive Risk-Taking

In an article in Thursday’s WSJ, Alan S. Blinder says that the perverse incentives that encouraged excessive risk-taking with other people’s money bear a large portion of the blame for the crisis.

From WSJ: Amazingly, despite the devastating losses, these perverse pay incentives remain the rule on Wall Street today…

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.”

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