Wednesday, November 9, 2011

Ultimate Bonuses

Just when you think there is a lack of humor in the exposition of dry, but critical issues, such as risk management, our old friend Nicholas Taleb comes to the rescue.*  His op-ed piece in the New York Times** earlier this week has a subdued title, “End Bonuses for Bankers”, but includes some real eye-openers.  For example Taleb cites (with hardly concealed admiration) the ancient Hammurabi code which protected home owners by calling for the death of the home builder if the home collapsed and killed the owner.  Wait, I thought we were talking about bonuses, not capital punishment.

What Taleb is concerned about is that bonus systems in entities that pose systemic risks almost universally encourage behaviors that may not be consistent with the public good much less the long term health of the business entity.  In short he believes that bonuses provide an incentive to take risks.***  He states, “The asymmetric nature of the bonus (an incentive for success without a corresponding disincentive for failure) causes hidden risks to accumulate in the financial system and become a catalyst for disaster.”  Now just substitute “nuclear operations” for “the financial system”. 

Central to Taleb’s thesis is his belief that management has a large informational advantage over outside regulators and will always know more about risks being taken within their operation.  It affords management the opportunity to both take on additional risk (say to meet an incentive plan goal) and to camouflage the latent risk from regulators.

In our prior posts [here, here and here] on management incentives within the nuclear industry, we also pointed to the asymmetry of bonus metrics - the focus on operating availability and costs, the lack of metrics for safety performance, and the lack of downside incentive for failure to meet safety goals.  The concern was amplified due to the increasing magnitude of nuclear executive bonuses, both in real terms and as a percentage of total compensation. 

So what to do?  Taleb’s answer for financial institutions too big to fail is “bonuses and bailouts should never mix”; in other words, “end bonuses for bankers”.  Our answer is, “bonuses and nuclear safety culture should never mix”; “end bonuses for nuclear executives”.  Instead, gross up the compensation of nuclear executives to include the nominal level of expected bonuses.  Then let them manage nuclear operations using their best judgment to assure safety, unencumbered by conflicting incentives.

*  Taleb is best known for The Black Swan, a book focusing on the need to develop strategies, esp. financial strategies, that are robust in the face of rare and hard-to-predict events.

**  N. Taleb, “End Bonuses for Bankers,” New York Times website (Nov. 7, 2011).

*** It is widely held that the 2008 financial crisis was exacerbated, if not caused, by executives making more risky decisions than shareholders would have thought appropriate. Alan Greenspan commented: “I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders” (Testimony to Congress, quoted in A. Clark and J. Treanor, “Greenspan - I was wrong about the economy. Sort of,” The Guardian, Oct. 23, 2008). The cause is widely thought to be the use of bonuses for performance combined with limited liability.  See also J.M. Malcomson, “Do Managers with Limited Liability Take More Risky Decisions? An Information Acquisition Model”, Journal of Economics & Management Strategy, Vol. 20, Issue 1 (Spring 2011), pp. 83–120.

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