Tuesday, May 19, 2009

Do current incentive structures make sense?

On the weekend my family went to the new Star Trek movie. As I watched the film, I reflected on the effects that popular culture has on the incentive pay system, which has been a hot topic lately.

Should we looking for heroes?
The archetype of the hero in the movie is Kirk, the rebel and maverick who flouted the rules to get things done against the odds. He succeeded and became the captain of the ship. Playing against Kirk, we have the character of Spock, the logical and reasoned thinker (who will never become the captain of a starship). The Kirk hero archetype is a common feature in many Hollywood films and a common characteristic of heroes in American popular culture.

When we extrapolate those popular culture notions to how investment banks pay bonuses, does Kirk sound like the star producer and Spock is the risk manager?

This kind of thinking that as permeated not only American culture, which migrated across the Atlantic, has created a winner-take-all mentality. As a former colleague of mine once remarked, “It’s like an Olympics out there, if you’re not in the top three you are nothing.”

In support of this philosophy, Paul Kedrosky noted:

Well-timed conservatism is a fine thing, but there is something to be said for taking risks. Among the reasons why Bill Gates dropped out of university and started Microsoft and made billions when you know you're the same age as he is and you know he's not really that smart and Windows sucks and you can't stand the guy, is that he took a risk and you didn't. Elevating uber-conservatism into the highest virtue is no path to growth and wealth and all good things capitalism.
But do we really want to elevate the hero archetype that way? Is this the best way to incentivize everyone?

Sauce for the goose
Take the issue of compensation for government workers. Would Dwight Eisenhower have done a better job in World War II had he been given incentive bonuses to win the war? What about Norman Schwarzkopf during the Gulf War?

Do you get what you pay for?

Aldrich Ames turned over the CIA’s network of spies to the Soviets in exchange for a total of about $2 million. The initial payment that he received in 1985 was $50,000. Should the U.S. government be paying their people better? Had the CIA been giving people substantial incentive bonuses, could they have forestalled this intelligence disaster for roughly twice of what the CEO of Credit Suisse paid his ex-wife in interest in a divorce settlement?

Mediocre cavalry officers in charge of nuclear bombers
Dominic Connor, a headhunter, recently commented on the culture within banks [emphasis mine]:

A clear factor in the recent calamities has been the lack of expertise at the very top levels of banks. Reviewing the publicly available lists of board members at many firms, I observe that most of them not only have never taken an active role in trading, analysis or risk management, but that today few would even be accepted as a trainee in a less prestigious organisation than they ran into the ground. In effect we had mediocre cavalry officers in charge of nuclear bombers.

While it is important to create compensation and incentive structures so that originality and innovation are not stifled, we should not forget Paul Volcker’s comment that the most important financial innovation for most people years has been the automated teller machine.

1 comment:

Unknown said...

I'm Dominic, the headhunter who wrote the response paper, and I'm glad you saw one of the most important points.

I reject the idea that this mess was driven by greed as an important factor. Even personal incompetence is a hard charge to make stick, my model is simply that no one seemed to think it was their job to manage large scale systemic risk.
Now, of course everyone seems to want in on that game.

To me a good analogy is a crowd crush, where tragically people die.

Rarely is this caused by individuals behaving very badly, perhaps impatience, or sudden fear from some loud noise, but no real malicious intent.

However, most times you can see (afterwards) that if the design of the location had been better, or the people responsible for keeping order had done their job better it would not have happened.

If I bump into you, that damage varies from zero to light bruising. If 1,000 people bump into you, you die.

Same with banks.