The Financial Meltdown Was the Result of Too Little Risk

March 7, 2011

Excessive risk-taking has been the whipping boy for the financial meltdown over the last 3 years. On the surface I get it – executives at many financial institutions took on irresponsible amounts of leverage and got burned. However, something about this concept of these people being excessive risk-takers never made sense to me. Having worked with successful executives for many years, something I know about them is that they’re generally not stupid risk-takers. They know how to balance the possibilities of loss and gain and make smart decisions. That’s how they’ve succeeded.

Then, in reading Simon Johnson’s NYT article on executive pay, it started to make sense. In it he quotes a new study by Professors Bhagat and Bolton regarding executive pay which finds very little connection between executive compensation and long term shareholder value. The upshot: while these executives were taking excessive risks with long term shareholder value, it presented close to NO RISK for them personally. They could turn the illusion of strong performance into cash for themselves. If they blew up, it didn’t matter. They already had cash and a government would probably help bail them out.  Johnson writes:

“The key finding [of Bhagat and Bolton’s study] is that chief executives were “30 times more likely to be involved in a sell trade compared with an open-market buy trade” of their own bank’s stock and “the dollar value of sales of stock by bank C.E.O.’s of their own bank’s stock is about 100 times the dollar value of open market buys.” (See page 4 of the report.)

If the chief executives had really believed in what their banks were doing, they would have wanted to hold this stock — or even buy more. Disproportionately, more sales than purchases strongly suggests that the chief executives felt their stock was more likely overvalued than undervalued.

The problem runs deeper, as Professors Bhagat and Bolton explain. Given the compensation structure of chief executives — particularly the fact that they can sell stock with very little restriction — they have an incentive to take on excessive levels of risk. When the outcomes are good, as they may be for a while in an up market, the chief executive can turn his or her stock into cash.

When the outcomes are bad, the chief executive doesn’t care so much because he or she already has cash — and some form of government bailout or other support may be forthcoming.”

So there we have it. These executives were sending their organizations careening towards an abyss, benefiting from it financially with very little risk to themselves. This points to the fact that the real, underlying problem has never been excessive risk-taking. It’s been poor risk alignment between the executives and their shareholders. You get that in line and the excessive risk-taking goes away.

Of course that’s easier said than done. I’m quite certain several board members at these financial services firms took one look at these poorly-structured compensation schemes and thought they were ludicrous. But then they were told “everyone else is doing it” and “that’s the only way we can attract these big names” – they got on board against their better judgment.

That’s why government intervention and the SEC’s proposal on incentive-based compensation makes sense to me. They’re not trying to take away the possibility of big payouts – they’re just trying to get them in line with shareholders’ and the public’s interest.  This is something boards have been unable or unwilling to do for a variety of reasons. They’re trying to get executives to feel the same level of risk that they subject their organizations and shareholders to. In the end, if the shareholders win, then you can too Mr. or Mrs. Executive.

Seems like a fair deal to me.

Reprinted from Doug Sundheim’s blog on Fast Company
First published March 4, 2011

— Doug Sundheim is a leadership consultant, author, and speaker. His book on Smart Risk-Taking is due out in 2012.

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