Individual - Risk Article

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Risk Anatomy


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In the benign market model, the basic unit of commercial replication is the individual. The analogy to the ecosystem is close but not perfect:

  • The crabs can pole-vault: Individuals can move from firm to firm; genes cannot leave one host and join another (except via reproduction)
  • Firms don’t “evolve: However transfixed their executives might be with evolutionary metaphors, corporations do not evolve like organisms. Just as well; that would involve dying. Firms adapt during life. If there is any heritability it is by way of heretical Lamarckian evolution[1] at best. But, since the crabs can pole-vault, a Lamarckian approach might make sense: The firm is a vessel for replicating individuals. It is not a replicator itself.
  • The firm has NO conscience: No matter how often we tell ourselves it has a corporate personality, responsibility and “conscience”, these are fictions. A firm has no personality other than the one that emerges from the individuals comprising it, Ouija board style. Indeed this is one of the great sources of the agency problem: at the end of the day no-one speaks, without conflict, for the corporate entity itself,

Just as the evolutionary fitness of an organism can only be explained by the reproductive capacity of its genes, so the fitness of an firm is a function of the survival instincts of its employees.

Risk controllers

For employees who are part of the infrastructure rather than revenue generation – that is, most of them – there is a sharp asymmetry. They are not rewarded for ambition or risk taking – that is not your job, and to be incentivised that way would be a significant conflict of interest. But nor are they rewarded for actually avoiding risks – a bad outcome that did not eventuate is not just the dog that did not bark in the night-time, it is part of the infinite set of possible but non-existent events.

Motivations

(c) Behaviour which reduces fear
(i) Repeated tasks
(ii) Familiar tasks
(iii) Pre-established modes of operation
(iv) Behaviour which is characteristic of most people in the organisation (homogeneity)
(v) Decisions for which somebody further up for line or across the organisation has accepted responsibility
(vi) Encouraging others to underwrite risk or collectivise /diffuse risk
(d) Behaviour which accentuates fear
(i) New situations
(ii) Unhedged risks
(2) REWARD. Compensation for what you do.
(a) Generally an employee does not have an equity stake in the business (OK, OK bonuses – we’ll get on to that)
(b) Employee reward is pre-defined: there may be incentive structures but employees for the most part get fixed compensation. They are creditors of the firm for that compensation. Unless the firm is bankrupt, they are paid regardless of performance. The sanction for poor performance is termination. It is very hard to reduce fixed compensation.
(c) The larger the firm the more specialised the staff, the fewer are specifically revenue generating roles. Most of a multinational Bank is infrastructure: operations, risk management, IT and increasingly middle management : infrastructure to manage the infrastructure.
(d) Therefore only a small portion of the staff have any grounds for incentive based compensation. Some could be incentivised by cost management, but for many – risk, legal, compliance – performance related pay is largely antithetical.
(i) This will not stop enthusiastic general counsel arguing, in times of feast, that his legal team are skilled enablers of revenue generation, and should be compensated for the profits they help to bring in.
(ii) The stock reply: turning a control function into a profit and loss centre has bee tried before. It didn’t work out so well.
(e) The bonus culture. No doubt to redress the fear / reward balance, investment banks shifted towards a bonus culture throughout the eighties.
(i) Many of these firms started out life as partnerships, where those bringing in the profits were personally liable for losses, and the compensation they shared was specifically the equity. These firms took advantage of regulatory change to incorporate. The partners changed their formal status (if not their titles) from partner to employee, but the compensation structure remained. While these firms encouraged equity participation (to the point of paying compensation in shares) employees main source of income was celery and not share performance. Indeed the manual dilution of equity capital in the bonus round had the typical effect of depressing share performance. In this way and in many others comma employees in these Incorporated partnerships were and continue to be systematically preferred over equity holders. The same pay structure has been adopted by competing banks which have always had a corporate structure full stop the lesson of the last 30 years has been only a mug is long banking stock.


References

  1. Being a great biological heresy.