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Sunday, March 7, 2010

Okamoto & Edwards on Risk-Taking

Risk-Taking, by Karl S. Okamoto, Drexel University - Earle Mack School of Law, and Douglas O. Edwards, University of Colorado Law School, was recently posted on SSRN.  Here is the abstract:

“First, kill all the bankers.”

With this phrase, the Wall Street Journal recently captured the sentiment driving the movement to regulate bankers’ pay. While we agree that financial industry executives made poor decisions, we take issue with the recent suggestion that, to prevent the excessive risk-taking that led to the recent financial crisis, we must only correct certain “perverse” compensation-related incentives. This logic, unfortunately, underpins a worldwide call to reform executive compensation in the finance industry. The precise prescriptions differ, but a common view has prevailed - if we can dampen the incentives to take risk, we can achieve greater financial stability.

We agree that prudent risk-taking is a necessary component of financial stability, but we reject, on two levels, the prevailing view’s myopic focus on compensation.On one level, we argue that compensation-related reforms simply miss their mark. In what we term the functional critique, even if excessive risk-taking is an appropriate regulatory target, we show that the proposed compensation-related reforms fail to speak to excessive risk-taking. Indeed, we find that attempts to de-leverage executive compensation may actually exacerbate risk-taking. Beyond this, however, we have an even greater concern. In what we term the completeness critique, we note that any regulatory attempt to curb excessive risk-taking would need to offer an account of optimal risk-taking. Without defining when risk-taking becomes excessive, schemes to prevent executives from taking “too much” risk remain fatally incoherent. Because the science for such a determination does not exist, proponents of this approach can only hope that government will get right what industry has failed to achieve.

Rather than paint risk-taking as an evil to be avoided, we advocate a regulatory response that is aimed at a particular failure in the private construction of incentives. We provide a description of the risk-taking process that depicts investment decisions as a hypothetical conversation between risk-seekers and risk-managers. Our purpose is to isolate when regulators can expect that conversation to produce imprudent risk-taking and how they can act to correct that failure. In doing so, we ask regulators to do what regulators can do well - facilitate the establishment of industry standards, examine past incidences of loss, and assess compliance with established standards of conduct. We find this approach superior to those that require government to micro-manage bankers’ pay.

http://lawprofessors.typepad.com/securities/2010/03/okamoto-edwards-on-risktaking.html

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