Risk taking, remuneration and leverage

Mervyn King, Governor of the Bank of England, is correct in linking the reckless lending by banks and other financial institutions that, together with the matching reckless borrowing, lay at the roots of the current financial crisis, to remuneration structures that rewarded extreme risk taking on poorly designed financial products. The diagnosis is fine. What to do about it is less obvious. These remuneration packages did not fall to earth from the moon. They are the result of a distorted economic environment. The key distortions, unfortunately, cannot be remedied, because they have highly desirable consequences as well as the dysfunctional ones highlighted by the crisis. Let’s consider some of them:

(1) Limited liability. A great social invention for getting people to put up risk capital for ventures with uncertain returns. However, an enterprise with limited liability by definition introduces a serious asymmetry in the payoff function. Losses are limited to the capital provided to the company. Gains are unbounded from above.

(2) No more debtors’ prison. We have moved on quite far sinnce Mr. Micawber’s statement in Charles Dickens’ David Copperfield :” Annual income twenty pounds, annual expenditure nineteen nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.” A company that borrows and goes broke will not have its management team slung into the slammer until the debts have been paid off. With the growth of non-recourse loans for households and legal personalities, only the collateral is at stake in case of default. Non-recourse lending is, from the borrower’s point of view, a form of limited liability borrowing. The combination of limited liability and cheap default for corporates further accentuates the asymmetry of the pay-off function.

(3) Free labour. In most countries chattel slavery and indentured or bonded labour (including debt bondage) have been abolished de jure if not necessarily de facto. One consequence of this has been that human wealth (the present discounted value of the future expected stream of after-tax labour income) is lousy collateral for loans. Not only is it illegal to sell oneself or someone else into slavery, the free labour doctrine means in practice that labour contracts are binding (have legal consequences if breached) only on the part of the employer.

An employee therefore cannot credibly commit himself not to leave if a competitor makes him a better offer. The employee’s inability to sign a contract that is legally binding on himself means that opportunistic behaviour is constrained only by reputational considerations. In such a world there are likely to be at least two kinds of equilibria. One is where opportunistic behaviour is the exception, your reputation for ‘loyalty’ follows you around and people that renege on (non-legally binding) commitments are pariahs who don’t get hired by the best employers. The other equilibrium is where opportunistic behaviour is the rule, a reputation for loyalty means you are viewed as a ‘sucker’, employers ruthlessly raid their competitors to poach their best staff and employees are forever dropping handkerchiefs and have both eyes open for the main chance. The first equilibrium is based on Hirschman’s ‘voice’ and ‘loyalty’, the second on ‘exit’ or the outside option. There is no doubt that the world has moved comprehensively to the ‘exit’ equilibrium, where long-term commitment is the exception rather than the rule.

(4) No negative bonuses

The absence of negative bonuses is a form of limited liability for employees. It’s custom-based rather than legally based, as far as I know.

(5) Bonuses based on short-term performance

The combination of asymmetric pay-off functions for corporations, favouring risk taking, and the inability of employees to make a long-term commitment to stay with their employer means that contracts based on a long history of earnings, profits or some other measure of individual or company-wide performance are going to be few and far between. Should such a contract be signed, a competitor is likely to buy it out on generous terms, if the employee stuck with the contract has just the characteristics the competitor urgently thinks it needs.

(6) Excessive leverage

Finally, leverage permits the scaling of everything to incredible levels, including bonuses and other rewards. When irrational exuberance rules the roost, all promises become credible. Credit is based on the sale of promises. When promises are cheap, leverage explodes and bonuses with it.

What is to be done?

I don’t see an early return of chattel slavery and indentured labour in the financial sector. Nor are we likely any time soon to witness the abolition of limited liability and the re-introduction of debtors’ prisons. The fear of God, or of the devil, instilled by the current crisis will restrain risk taking and excessive and ill-considered remuneration in the financial sector for at most a couple of years (the half-life of memory in the City and on Wall Street). Another attempt at reforming corporate governance – across the board, not just in the financial sector – may help a bit, but I am not holding my breath.

I therefore only expect any real progress from limiting or penalising (through progressive capital and liquidity requirements), all highly leveraged institutions above a certain minimum size, regardless of what they call themselves, regardless of the sector they are formally located in and regardless of their ownership structure. Leverage amplifies the good, the bad and the ugly. Given the many asymmetries favouring excessive risk taking, restricting leverage and regulating it across the board, seems a promising way to tackle some of the worst excesses.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website