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The Power of the People

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2 Responses

  1. Ken says:

    Michelle–This subject is vastly more complex than it seems to the “populists” who like to vent their rage. I am glad you posted this item, because it gives a view into a problem that seems to engender oversimplification, and the Cardiff Business School paper you cited is a perfect example.

    >>Abstract: …In this paper we argue that the cushioning of banks downside risks provide the incentive for banks to take excessive risk and design compensation packages to deliver high returns. Macro-prudential regulation will have a better chance of curbing excess risk taking than controlling banker’s compensation.>>[FALSE DICHOTOMY]

    Diet and exercise are the most important factors in controlling Type II Diabetes. This does NOT mean, however, that I ought to ignore my Metformin and simply exercise more.

    I think that, instead of the author’s simplistic “either-or” view, what has a better chance is a more complex program in response to a very complex problem.

    >>1. Introduction: …The popular view is that bonuses have encouraged bankers to take risky positions with the aim of making short-term profits. …

    This paper argues that banker’s bonuses are an effect and not a cause of excessive risk taking by the banks.>> [FALSE DICHOTOMY]

    Here the author inserts a dichotomy that NOBODY claims. Everybody from Pavlov to the present time knows that there are two diametrically opposite “cause-effect” relationships in human behavior. When Action A produces Positive Reinforcement R, then the subject will do A. “A causes R” in the physical sense, and “R causes A” in the motivational sense.

    >>In the parlance of economic modelling, both compensation and risk taking are endogenous variables.>>

    Oh c’mon, don’t try to snow me with vocabulary, try to convince me with logic. First of all, that term “endogenous” doesn’t mean “it doesn’t count.” Far from it, endogenous variables are often the independent and dependent variables of significance in meaningful models. Rather, in many cases it means that those two variables exhibit a relationship that may be dependent, as well, on some other omitted variable. Secondly, that omitted variable may not be invisible, or even difficult to account for, but simply doesn’t appear in the function(s) of the model.

    In such a case, the appropriate approach to improving the model is not to ignore the “endogenous” variables and simply focus on the omitted variable. Rather, it is to include the omitted variable in a more complex formulation of the model. There is a clear and concise article on this subject in Wikipedia: http://en.wikipedia.org/wiki/Endogeneity_(economics)

    In this case, I posit that the omitted variable (in the simplistic formulation of the problem) is the set of computation factors in the compensation arithmetic. Since the compensation function has multiple variables, there are many opportunities to vary the factors to emphasize certain “desirable objectives.” But first the Board of Directors has to come to grips with the desirability of multiple objectives, which are sometimes at odds with one another, like this year’s profits and next year’s security.

    …which is why I keep coming back to “this is a complex problem.”

    >>The driving factor is the widespread expectation that banks in the UK are ‘too-big-to-fail’ (TBTF).>>

    “The driving factor???” Gimme a break! I set up a physical Activity-Reward experiment. I put the squirrel in a cage with a big red pedal. When the squirrel presses the pedal, a reward pellet drops from the pellet supply (outside the cage) into the reward tray (inside the box). The squirrel pounds away at the pedal, getting his rewards in proportion to his frenetic activity.

    And you think the driving factor is how many pellets are available in the supply cannister?

    That’s an “enabling factor.”
    —————————————————-
    >>Controlling Banker’s Bonuses: Efficient Regulation or Politics of Envy?>>

    I think the title of the paper, the first false dichotomy presented by the authors, paves the way for the rest of the paper.

    No, I say, neither efficient regulation nor envy. Rather, one of the many components needed for a comprehensive, and very complex, overhaul of an industry run amok.

  2. Michelle Harner says:

    Ken:

    A wonderful comment; thank you. In posting items, I try to pick topics that will generate a discussion and help flesh out complex issues. I also frequently try to mute my voice so that I can clearly hear others. And this is a great example.

    I completely agree with you that the issue of bonus and compensation structures is far more complex than many will acknowledge. And although simplification often can help you understand the origin of a problem, it also can cause you to miss critical contributing factors. I think the issues we face in the bonus/compensation context require an indepth analysis from multiple vantage points, including a pure economic and a behavioral perspective. It is similar to the issues I raised in a prior post in the context of risk management; only by understanding the whole can you start to fix the parts so to speak.

    For additional, thoughtful discussion of these and related issues, see, e.g., Lucian Bebchuk, et al., The Wages of Failure: Executive Compensation at Bear Stearns and Lehman, Yale Journal on Regulation (forthcoming 2010), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1513522; Karl Okamoto, After the Bailout: Regulating Systemic Moral Hazard, UCLA Law Review (2009), available at http://works.bepress.com/karl_okamoto/8/.

    Best regards, Michelle.

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