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Incentives + Opportunities = Cheating

The article is edited below:

“In other words, by using financial incentives to encourage better performance by managers, investors unwittingly expose themselves to being cheated by people who can appear to deliver the goods, but only by exposing the investor to huge risks.”

newscientist.com  Banking cheats will always prosper 

by MARK BUCHANAN  •  MARCH 23, 2011

Clever schemes to make bankers earn their bonuses look good on paper, but economics proves they won’t work

Economists are well aware of these problems. For decades they have been trying to design incentives to make managers work in the interests of their employers, without obvious success…there’s also scientific evidence that it’s simply insolvable – it will always be possible to beat the system, whatever provisions are put in place to keep managers in line.

As finance theorist Andrew Lo of the Massachusetts Institute of Technology first said 10 years ago, there’s a fundamental problem with finance.

  • Imagine an investor hires a company to manage their money and rewards them based on performance – a percentage of profits, for example. 
  • If the investor doesn’t monitor the manager’s activity in detail, the manager can manufacture the appearance of superior performance without actually delivering it.

Here’s how.

  • Suppose that hedge funds, using fairly safe strategies, can earn a return of about 10 per cent per year. 
  • An unscrupulous manager can easily do better, at least in the short run. 
  • All the manager has to do is sell insurance policies to people who are worried that the market may suffer a major crash, protecting them against losses if the market ever drops by, say, 40 per cent in one year. 
  • There are always people seeking to protect themselves against rare disasters, and willing to pay for it.
  • The big crash probably won’t hit for a few years or even 10 years, and during this time this manager’s Miracle Fund will earn more than the standard 10 per cent per year. 
  • They will be hailed as a genius and earn enormous profits. 
  • And then, one day, that 40 per cent drop will actually happen, and investors will lose all their money. 
  • Even then, however, the manager doesn’t get burned, walking away with the profits while burdening investors with the losses (Financial Analysts’ Journal, vol 57, p 16).

This was the apparent modus operandi of AIG, the international insurance giant whose executives made a killing before the crisis by selling insurance contracts – those now infamous credit default swaps – on mortgage bonds. Other firms, including many of the world’s biggest banks, paid AIG fees to protect themselves against a potential market collapse, and AIG’s executives and traders were cashing in even as they positioned the firm at the eventual epicentre of the meltdown.

You might think that smarter rules could get around the problem. …. Economists Dean Foster of the University of Pennsylvania in Philadelphia and Peyton Young of the University of Oxford have now extended Lo’s argument, showing that the problem is simply unsolvable as long as investors cannot see the strategies used by managers (Quarterly Journal of Economics, vol 125, p 1435).

As they point out, delaying bonuses for a few years may deter some people as the risky strategies could explode before the period is up. But a manager willing to live with the uncertainty can still profit enormously if they don’t. On average, managers playing the game still profit from excess risk while sticking the firm with the losses.

So-called claw back provisions, in the news as politicians ponder how to fix the system, will also fail.

  • While sufficiently strong provisions would make it unprofitable for managers to game the system, 
  • Young and Foster show that such provisions would also deter honest managers who actually do possess superior management skills. 
  • Claw back provisions simply end up driving out the better managers that incentives were meant to attract in the first place.
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Written by Rich and Co.

March 24, 2011 at 2:25 pm

Posted in Uncategorized

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