How can you limit excessive risk-taking at the institutional level?

Question

Some firms have a compensation structure that encourages risk-taking while insulating employees from the bad consequences of their decisions. This creates the potential for moral hazard.

I started thinking about this because of what happened at AIG. For those unfamiliar with the situation, a small division (AIG Financial Products) in a huge insurance company was able to bankrupt the entire company. Incentives were very lop-sided for division management relative to the risks they were taking. Even though management was making millions, they were taking risks an order of magnitude larger than that. If they lost billions, they would only lose their future income (assuming they would be fired).

My question is, how do you align management/employee incentives at the institutional level in order to prevent this types of moral hazard?

Two things to note:

1. The situation at AIG is just an example. I'm not asking for solutions specific to AIG (e.g. limiting leverage) or financial firms in general. Many firms face this type of moral hazard with the CEO (i.e. a "golden parachute").

2. Aside from not being "at the institutional level", I doubt regulation is the answer. While there's a place for regulation, regulators seem to — at least initially — react to crises instead of prevent them (though there's no counter-factual for crises regulators may have prevented).

Answer 1

Optimal contracting under moral hazard is an incredibly rich field. Any answer to your question would rely more on the assumptions being made about risk preferences, effort sets, etc. than any "universal solution" to moral hazard.

That being said, there are a couple of interesting pieces of the literature to note:

1. Optimal contracts often have a fixed component (the opposite of your "alignment" premise), with the variable component offered only insofar as it is required to induce more effort from the agent.
2. Optimal contracts use any information relevant to determining the effort expended by the agent, not just the result.

So I would think an answer would be to reduce (not increase) the amount of compensation variable upon the result and to condition compensation relative to other benchmarks that would indicate whether someone is just benefiting from tailwind.

Answer 2

I assume you meant to ask "can you align management/employee incentives to prevent these types of events from the institutional level?" Well in the simplest possible model which you seem to be familiar with, of course you can. But things are not so simple as they may seem at first, because incentivising exactly the right behaviour is hard.

For example, suppose that an employee has two tasks, A and B. A is observable but B is not. If you provide incentives to do job A well, the optimal response for the employee is to do as little of B as he can get away with. The moral is that unless all the contributions of an employee can be monitored, incentives can induce lopsided priorities for employees. If the aspect they are ignoring is crucial to the functioning of the organisation, the incentives will end up being counterproductive.

Answer 3

Investing is all about returns. Increasing returns in the short term is easy to do through taking on risk. Many institutions reward short term profits without considering any risks taken. This encourages irresponsible risk taking since the risk takers have nothing to loose.

One solution is to provide risk adjusted compensation instead of purely (short term) profit based compensation.

Another safeguard (that was put in place after the Great Depression in the USA) is to limit the size of financial institutions. Smaller institutions cannot take as large risks as larger ones. Unfortunately that legislated safeguard was removed back in 1997.