Thursday, November 8, 2007

Why pay executives to take risk?

Nice description of the moral hazard problem created by Citigroup and Merrill Lynch by letting their CEO's resign and collect huge bonuses:

The moral hazard ... is caused by a phenomenon called the "trader's option" - the problem that a financial trader has an incentive to take careless risks with his bank's capital because he gains a multi-million dollar bonus if he makes money but loses nothing (apart from, perhaps, his job) if he is wrong. Any trading loss is borne by his employer and its shareholders.

In recent years, banks have done their best to counter the trader's option by paying bonuses largely in shares that vest gradually over three or four years. This provides two safety mechanisms.

The first is that, since traders are paid in shares, they have an equity incentive to do their best for the bank as a whole. The second is that, since their bonuses vest only gradually, banks have the time to find out whether trades that make big profits in one year blow up the following year. They can fire a dodgy trader before he gets all of his bonus. ...

This is why Merrill's board should not have caved in to Mr O'Neal and allowed him to claim his unvested stock. He punted with Merrill's capital and made a terrible error. He should have been dispatched without his unvested shares as a lesson to him and his successors.

Hat tip to Stephen.

1 comment:

  1. Since Merrill's BOD caved to O'Neal's golden parachute demands are they the real culprits in this instance? Would a CEO be more "cautious" in his risk taking decision making approach if he had a healthy fear of the BOD? Are BOD's ineffective checks because they only bare their fangs in the most dire of circumstances? Additionally, it seems as if the BOD is usually, but not universally, an extension of the CEO's social network, making being an effective counterweight more of a challenge.