Are Managers Really Rational About Pay Incentives and Risk Taking?

I am officially confused.

Much has been written about how managers respond rationally to pay incentives, and how their supposedly “rational” behavior manifests as excessive risk taking with other people’s money. Many have even detailed how excessive risk taking brought about by distorted pay incentives was central to the financial crisis.

I agree that excessive risk taking played a role in the financial crisis. This has been well documented. Moreover, I am willing to concede that in some cases the behavior observed may have seemed rational. At the very least, the managerial behavior was a response to some form of incentive. After all, we know incentives work.

Indeed, I have even written a bit about executive compensation and managerial excess on this blog (see Op Ed on Executive Pay, The Credit Crunch and Executive Pay, New Approach to Executive Compensation, and Revisiting Executive Pay). But for me, the issue of executive pay is a systemic, economy-wide problem, not simply limited to the financial sector.

That said, there is one thing that has always bothered me about the explanation that somehow managers acted rationally, and that this “rational” behavior to an existing incentive structure caused the financial crisis. That is, it implies that someone else, somewhere, acted irrationally.

For example, Calculated Risk, discussing Martin Wolf’s column (see Financial Reform and Incentives or Reform of Regulation), writes:

[Martin] Wolf discusses how it is rational for management…to gamble when the risks are asymmetrical (huge potential winnings, limited losses).

But this begs the question: Why was a system that provides managers the incentive to make stupid bets like that constructed in the first place? That seems pretty irrational to me.

If the person/people who built such a system were rational, they would have anticipated the deleterious consequences of the system that they were about to enact, and they would have refrained from so doing.

So then who are all these irrational people running around building silly executive compensation systems? Aren’t they, after all, current and former managers – boards of directors, compensation consultants, and the like?

So then remind me again, how can managers be the rational ones??

Disclosure: No positions

Comments

[Davewmart:]

The rational market hypothesis only had firm existence in someone's imagination.
As Bill Gates remarked, profits are unnatural, and maintaining a productive profitable business is difficult.
So in real life people look for the angles, hence the asset bubble, where by the miracles of leverage and risk which had been passed off elsewhere huge money gains could be shown when in terms of actual productive capacity nothing was being added.
What happened was that the people who had their hands on the actual levers of power, the directors, had huge incentives to 'play the game' and shoo in huge bonuses, in the firm expectation that they would in turn be given plum appointments.
The prime example is, of course, Paulson, who moved from gaming the system for Goldman Sachs, to a position in Government where he could destroy his competitors, and back out to banking and choice 'speaking engagements' etc quite seamlessly.
The practicalities are quite simple, with all those in a position to influence the system being also in a position to profit from it, from politicians to bankers and the heads of the pension funds etc.
Does anyone seriously believe that the interests of the head of a pension fund who makes the decisions and can approve executive pay are in any respect aligned with the interests of his average member, instead of those of his fellow members of the elite in the banks and boardrooms?
In the UK, as the final pension scheme has degraded in frequency, what has substituted have been 'managed funds', where large management fees are taken on the dubious premise that they will outperform a tracker.
No money directly changed hands for the placement of these funds there, instead of where they would do the fundholders much more good, but you can bet that those responsible for choosing the management funds get everything from lavish corporate hospitality down the years, to plum 'non-executive directorships' on retirement.
The US and UK are both banana republics, and rational expectations have as much to do with the running of the economy as has the fact that the moon is made of green cheese.

Jun 24 06:13 AM

[Leftfield:]

It's only necessary to be rational within one's own limited vision for the theory to be valid. Even then, wrong choices are constantly made by errant humans. The big picture is not much in the daily calculus. That's even more subject to error. The founders hoped a balance could be struck amongst competing interests that would rein any one or several that threatened the wellbeing of the rest on any issue. Balance of powers.
Our country is at a breaking point where too many self-interested parties without functional principle have driven us towards the culmination of too many wrong decisions. Outside of Constitutional bounds, using the force of government power, many interests have metastasized far beyond what a rational market would allow. People with power in boardrooms have grabbed anything and everything possible, wrecking the world economy in the process.
Founders like Jefferson knew that a democratic republic needed principled, educated and engaged citizens to last and prosper. Seems to be a shortage at present.

Jun 24 08:28 AM

[Teedeebee:]

Wanting to have enough to be comfortable and, insofar as it is possible, safe, is understandable. Wanting to compete on the level of "my 12 seater jet has more amenities than yours" should be classified in the DSM VI which lists and catagorizes mental illness. The unbridled lust for having that much is a thin veneer over a much deeper emotional/developmental problem. I know that I sound like a curmedgeon, but I'm really not. It's just that the acceptance of this behavior as reasonable and rational is the root of the problem. We don't consider it ok to use children as sex objects. We don't think it's "good for capitalism" for people to rob the local convenience store. Yet we expect and encourage unbridled greed. How can a rational person engage in such conspicuous consumption and enjoy it when so many are just trying to exist. Refilling your plate for the third time at the dinner table wouldn't be so much fun if you had to look across at someone that was starving. Now Bernie Madoff's lawyer is looking for "justice"? How many people can't care for an ailing parent or child, or even for themselves because of him? How many lives will be irrevocably made worse because someone didn't have the money to go to school? Don't the ultimate consequences of the crime determine how terrible it is? Were that the case, Bernie would be up there with people at Nuremburg.

Jun 24 09:26 AM