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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?!


Vikram, I see your point. As a matter of fact, I even recollect reading about an incident on the tabloids where a key audit person was deliberately kept out of meetings in which the business (a top US insurance co) made decisions on how to account for their CDS transactions. Any person so much as hinting at the possibility of a risk, was ignored, bringing things to where they stand today.

Generally, there are 2 assumptions about risk - they can be held until maturity or they can be traded. The latter was the one that was held during the crisis and rather the one that propogated the crisis making it spread like plague. Instead of tracking the amount of risk the decision maker took, the banks were merrying in the fact that they no longer held the risk! To trap the risk at its root, definitely accountability needs to be established and enforced through a mechanism that hurts when hit; and nothing better than compensation structures for the same. Totally, concur with your thougts.

Very well stated, Vikram. Let me elevate your concept of motivation from individual level to a higher organisational standpoint - The limited liability concept. This allowed firms setup as such, to get away with losses even exceeding their capital. And since, the impact of a a failure event is only partially on the firm (with the remaining being on the society), the firms utilised risk models that only factored the impact on them. Needless to say, the precedent in such lenient insolvency laws is the US, dating back to early 1800s. What do you think?

The last part about risk adjusted incomes and profits is very relevant - Particularly in insurance and banking business, simply underpricing the risk, manipulates volume and profit, at least for that reporting period and works to the business manager's interest. And these are not subject to being detected right away, which results in higher losses later on. So, definitely accounting standards need revamp, but in the current state they are in, the only option to handle these scenarios is to really change risk from a 'variable' (which is being subjected to manipulation) to the basis by which outcomes are measured, making profits only a part indicator in this process. I am for anything, that bring a positively impacting risk - my vote would be a yes

This is an important but often very overlooked area in examining the crisis. A survey conducted, soon after the crisis affirmed this, with close to 45percent blaming the financial sector's compensation structures for the same. In the endeavor to exploit this, the financial executives brought in teaser rates, no doc & less doc loans and even excessive loans. They capitalized on the air of optimism from long period of low inflation and stability of the economy. When thing came crashing down, it left every one hurt, from the borrowers, to the bank and the investing public.

Yes, I would definitely tend to agree with the notion on risk adjusted profits - Over a period of time they have become 2 separate metrics of relevance to two different sets of people - the investors (are concerned about profits) and regulators (about the risk and exposures). Clearly, a composite measure is required to provide an accurate and unified view of the exact 'state' of the organisation.

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