Risk Taking

Karl S Okamoto

First, kill all the bankers. -Marcus Walker & Emma Moody With this phrase, the Wall Street Journal recently captured the sentiment driving the movement to regulate bankers' pay. While we agree that financial industry executives made poor decisions, we take issue with the recent suggestion that, to prevent the excessive risk taking that led to the recent financial crisis, we must only correct certain "perverse" compensation-related incentives. This logic, unfortunately, underpins a worldwide call to reform executive compensation in the finance industry. The precise prescriptions differ, but a common view has prevailed: If the government can dampen the incentives to take risk, it can achieve greater financial stability. Prudent risk taking is a necessary component of financial stability, but we reject, on two levels, the prevailing view's myopic focus on compensation. On one level, we argue that compensation-related reforms simply miss their mark. In what we term the functional critique, even assuming excessive risk taking is an appropriate regulatory target, the proposed reforms fail to speak to excessive risk taking. Indeed, we find that attempts to deleverage executive compensation may actually exacerbate risk taking. Beyond this, however, we have an even greater concern. In what we term the completeness critique, we point out that any regulatory attempt to curb excessive risk taking would need to offer an account of optimal risk taking. Without defining when risk taking becomes excessive, schemes to prevent executives from taking "too much" risk remain fatally incoherent. Because the science for such a determination does not exist, proponents of this approach can only hope that government will get right what industry has failed to achieve. Therefore, even if the prevailing view's proposals could work to curb risk taking, we fail to see how regulators could intelligently design such a program. Rather than paint risk taking as an evil to be avoided, we advocate a regulatory response that is aimed at a particular failure in the private construction of incentives. We provide a description of the risk-taking process that depicts investment decisions as a hypothetical conversation between risk seekers and risk managers. Our purpose is to isolate when regulators can expect that conversation to produce imprudent risk taking and how they can act to correct that failure. In doing so, we ask regulators to do what regulators can do well-facilitate the establishment of industry standards, examine past incidences of loss, and assess compliance with established standards of conduct. We find this approach superior to those that require government to micro-manage bankers' pay.

Risk Taking

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Risk Taking

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