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July 7, 2010

An Incentivized Anarchy

Are you conservative ...or a 'branded' pessimist? Are you ignored for being sceptical?

That's what you get, for being a wet blanket in bright times - Pretty much the status of risk managers in the times leading up to the crisis. You could argue that they were simply doing what they were paid for. Think again - So were the people who ushered them out.

Way before the Aug 2007 trading freeze, certain banks had started accumulating heavy mortgage loan losses and property prices were saturated. Did they go un-noticed?

I often catch myself convincing that the drawbacks of my latest impulse gadget purchase aren't significant - The business had strong "incentives" to paint a picture that the bad news was just a temporary blip and normalcy would be restored on sub-prime arena.

During the thick of events, banks had become simple "production houses", working over-time to 'produce' loans to meet the demand for securitized instruments; and with a purely revenue driven incentive structure, the lenders took the plunge.

In my last blog, I spoke about the organisational 'motivation', rather, the lack thereof, in ensuring an accurate capture of Oprisk events (owing to same capital charge irrespective of risk bucket). This time around, I thought of looking through of the individual 'motivation' elements viz. compensation and incentives and their role in fuelling the crisis.

Misaligned incentive structures are anything but new, and any sane individual exploits every such possible opportunity to reduce his / her financial or career impact. Despite yielding beneficial results in the short term, competitive edge and performance sustainability in the longer run are sabotaged due to the high degree of uncertainty.

The prime reason accountability cropped up, is to ensure an effective decentralisation. As pretty as it may sound, the current state clearly evinces the need for a mechanism to enforce accountability, which, in effect, is the incentive structure.

And decentralisation is one area where technology has proved counter-productive; but has the potential to do way more. If Basel can factor risk of assets, why not we factor the risk in an income stream? This would allow setting and tracking of risk tolerances at an individual level while also aligning it with changes in risk appetite at the org level, instead of leaving them to be some values on paper, as they are today - Technology can prevail as a differentiator and integrator, all at once. Besides, as a metric, risk adjusted incomes help in evolving a better incentive structure, one that is consistent with, and enforces the realization of the business objectives. (At Infosys, these transcend mere concepts whereby technology has been harnessed to integrate the chain from operational risk strategy to execution.)

At the firm level, a concept of risk adjusted profits can be introduced to indicate to the stakeholders, the extent of risk undertaken to achieve the said profits. This would eventually boil down to how the business compensates the employee and the inducement of the employee to undertake risks. There is a lot to debate here, which is better saved for later.

So, should you ask your boss, the pay hike you've always wanted?!