Incentives matter… A Lot

July 9, 2012 § 1 Comment

There has been a flurry of news about the Libor Scandle, JP Morgan trading losses and the whole banking industry once again starting to slide down the slippery slope of moral failure. I have worked for a bank and I feel I have seen the belly of the beast. I am also a student of economics and the first law of economics is that Incentives influence people’s behavior a lot. I was reading a very interesting article by the New Yorker Magazine with the title “The Money Empathy Gap“, this one statement resonated with me:

Putting someone in a role where they’re more privileged and have more power in a game makes them behave like people who actually do have more power, more money, and more status.

I have seen this behavior with employees within the bank, they suddenly inflate and act like they are superior to everyone else when they have to influence a decision to lend money or when the client needs to renegotiate terms of a loan. It has nothing to do with their ability to really assess the true risk of the situation, but just the fact they have the power to influence a decision the banking executives acted way superior to anyone. These are decent, honest, hardworking people who would not act that way in their homes or with their friends. Incentives matter and influences behavior. I also feel and know that the incentives i.e Salary, Bonuses, Stock Options, Perks and Benefits given to banking executives is disproportionately higher than other industries. It actually makes those working for the banks feel they somehow are superior to the rest of the community. I am not trying to say that we need to make the compensation for everyone the same on the contrary I think the financial services firms because they control flow of capital seem to be disproportionately rewarded for all the wrong reasons. The trading loss incurred by the JP Morgan trader occurred because he obviously has a bonus that is tied to this net return at the end of the day so he had an incentive to take disproportionate risk on the trading floor. This is easier for a trader working for the bank because he is not playing with his own money, it is a balance sheet actually already inflated because of the privilege that banks have i.e they can multiply their balance sheets 10 to 12 times the actual equity they have in the business. I think both of these things drive the risky behavior in banks. I think we need to rethink the incentives we give to traders, banking executives and the board of banks. In addition, banks should be barred from having the privilege to bet their balance sheet on the stock market. It provides for perverse incentives.

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