The Persistence of Perverse Incentives
posted by Frank Pasquale
There is news today that “regulators are considering whether to require large financial firms to hold onto a chunk of executive pay to discourage the excessive risk-taking that contributed to the financial crisis.” Europe is way out ahead on the issue; “Starting next year, [its] rules limit the amount of certain bonuses that can be paid immediately in cash to 20% of the overall payout, meaning the rest must be a mix of upfront shares and deferred pay.” I would like to be encouraged by the news that the US is seeking to crack down on what can amount to a form of looting. But after reading Richard Freeman’s reflections on the financial crisis, recently published as the Kenneth M. Piper Lecture, it is daunting to consider just how much of an uphill battle pay reformers face:
For the most part, as Harvard’s Rakesh Kurana and Andy Zelleke have stated, during the 1990s–2000s management seemed to operate corporations “for the purpose of creating vast wealth for senior executives.” Just as Bernard Madoff knew he was running a Ponzi scheme, the big Wall Street firms knew what they were doing when they packaged sub-prime mortgages and earned their fees by selling them quickly to others; as one portfolio manager put it, “a lot of people knew this was bogus, but the money was too good.” . . .
As criminal investigators, business reporters, and economic historians probe the behavior behind the financial implosion, I anticipate that they will find less incompetence or ignorance of what banks were doing with their shadow operations and more conscious venality, chicanery, and financial crime motivated by the chance to make huge sums of money.
Freeman is the Herbert Ascherman Chair in Economics at Harvard University and the Faculty Director of the Labor and Worklife Program at the Harvard Law School. He goes on in the piece to discuss how expertise in employment law could help those drafting new incentive schemes for financial institutions.
I would like to see the degree to which Lynn Stout’s recommendations for “prosocial behavior” and business ethics could inform Freeman’s framework. Stout acknowledges that “corporate bad behavior often pays,” but also believes that “trust, ethics, and other forms of prosocial behavior in business are statistically correlated with higher investment levels and greater economic growth.” But it strikes me that high level employees at financial institutions are not motivated to preserve the long-term health of their employers. Perhaps new deferred pay rules could help, but getting 20% of, say, $100 million now via ultra-high risk may be more desirable for an already rich trader than a middlingly risky strategy that generates a three or four million dollar payday. Karen Ho’s book Liquidated suggests that nearly everyone she met on Wall Street worked on an extremely short time horizon. Freeman notes the persistence of the “I’ll be gone—you’ll be gone” mentality in the industry:
In 2008, even the banks that received TARP government aid gave out huge bonuses. Given the precarious state of the financial markets and the public outrage at the banking sector, this behavior has the flavor of “endgame bargaining” in which agents grab what they can as they go out of the door, fearful that there is no tomorrow.
I would like to believe that Freeman’s and Stout’s ideas for reform could be implemented and change the environment. But as conscientious regulators increasingly get ignored, punished, or defunded, I have little faith that matters will improve in 2011.
December 21, 2010 at 3:31 pm
Posted in: Financial Institutions, Uncategorized
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Responses (2)
A.J. Sutter - December 21, 2010 at 10:10 pm
I find Lynn Stout’s argument very confusing, especially this part:
“Put simply, the unfortunate truth is that corporate bad behavior often pays. Thus, if accountants always behave like homo economicus — the hyper-rational, purely opportunistic hero of economic theory — rampant frauds are only to be expected. [¶] Luckily, most people — including most accountants — don’t always behave this way, and may even act ‘prosocially’ by following ethical rules. … [¶] In my research, I have found that trust, ethics, and other forms of prosocial behavior in business are statistically correlated with higher investment levels and greater economic growth. In other words, while self-interest has its place in the business world, so do ethics and personal integrity.”
First of all, what does she mean by “economic growth”? Is that with respect to national GDP, or with respect to a firm? Given that the national economy includes both ethical and unethical players at any given time, it’s hard to imagine that she could come up with reliable findings relating to GDP. And indeed, the Enron, WorldCom & al. fraudsters were active during a period of high GDP growth. So I take it she means growth on a firm basis.
Then, second, what’s the direction of causation, if any, in the correlation she mentions? Couldn’t it be that when a firm is feeling flush, people behave better? I.e., that the causation runs from financial condition to behavior, rather than the other way around? (The Enron and WorldCom cases don’t contradict this, since the purpose of the frauds was to create the illusion of growth when the reality was different. In fact, one might wonder whether the perceived need for growth might encourage fraud; see also Madoff. But that’s too far afield from this post …)
Finally, assuming she means to suggest the opposite — that the causation runs from good behavior to financial results — this is problematic too, beyond the evidentiary issue of correlation/causation. For one thing, it’s hard to square with her comment that “corporate bad behavior often pays.” For another, it’s a mixed message to argue against being self-interested when your argument in favor of “prosocial” behavior is based on an appeal to self-interest, à la “focus on being good instead of making more money — that way you’ll make more money!” Such arguments are very common in the business ethics and CSR fields, often because of the patronizing assumption that the best way to “get through” to businesspeople is to appeal to the “bottom line.” Arguments that ethical behavior by companies is good in its own right or because it is “prosocial” (i.e., beneficial to society as a whole) would be stronger.
Ken Rhodes - December 22, 2010 at 11:12 am
I have to agree with the points that A.J.Sutter makes here, and point out that in the main, he reinforces the truth that in most things of importance, there is a lot of anecdotal evidence pointing to anything you want to prove … but it ain’t proof.
In order to draw a valuable conclusion, you first have to clarify several points that AJ has raised:
(a) You need to be more precise in your terminology.
(b) You need to design a statistical test that isolates the factor(s) you are testing for.
(c) You need to propose a non-ambiguous hypothesis.
(d) You need to ensure that your test does, in fact, measure what it purports to measure, and that it is repeatable. In other words, demonstrate the validity and reliability of your results.
Economists have addressed the issue of “ethical performance” with only moderate success. It doesn’t take a scientific study to guess that many (most?) people will take the opportunity to make huge sums of money if they can do it within the law. The question of how to arrange for rewards to accrue to “prosocial behavior” presupposes some agreement on what is prosocial, and then an agreement on how much control of the rewards is appropriate outside the “free marketplace.”
In my lifetime there has been no general agreement on these questions. The solution after the Pecora hearings was Glass-Steagall, which seemed to work pretty well for a long time. Instead of focusing on “regulation” per se, that legislation sought to minimize problems in the banking sector by making banking a rather simplistic, boring, and moderately rewarding endeavor. Retail banks, separated from the riches of brokerage, insurance, and private investment, were what we (Mr. and Mrs. Everyman) always thought of banks to be–guardians of our money, who looked at loans as relatively secure transactions between depositors and borrowers, with the bank as middle-man taking a small commission (the spread).
Yes, of course I know that’s oversimplified. But it reflects, I think, the fundamental ethics of retail banking for fifty years or more. And I still think it’s OK that way.
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