Think for a moment about this recent statement by the Chairperson of the U.S. Federal Deposit Insurance Corporation, Sheila Bair:
“A broad consensus of academic studies agrees that poorly designed compensation structures can misalign incentives and induce risk-taking.”
There are two observations this brings to mind. The first is that this conclusion seems profoundly obvious. As any accomplished manager will tell you on the subject of incentive compensation, you get what you incentivize – which is why incentive compensation plans need to be designed very thoughtfully and are often modified. That is straight forward. It seems odd that it took a number of academic studies to establish this fairly obvious conclusion.
The second observation is that risk-taking is presented in this statement as a negative outcome. One more time with fervor; risk-taking is not the problem. Poor risk-taking is the problem.
In the midst of many well-intentioned efforts to reduce the chances of future turmoil in the U.S. financial system, we need to keep foremost in our mind that risk-taking is core of our economic system. We need to be very cautious in trying to regulate the risk instinct. It has served us all well much more often than it has worked against us.
Most of all, we need to always differentiate between intelligent risk-taking and excessive, ill-considered or poorly executed risk-taking. We need to allow the former to thrive or we will all pay the price
