iCubed

It was similar to the Six Nation’s this year (not the quality of the game but the circumstance of my lack of objectivity!) My abiding memory of the campaign was the Ireland/Wales match, a game in which the referee made some appalling decisions and ultimately had a greater than normal influence on the final result. I was apoplectic.

It’s very difficult to separate yourself and view something objectively if you are involved, either emotionally or financially (I did have a bet on Ireland, though Paddy Power is not yet accepting bets on St. Brigid’s matches!) If the incentives are in place for you to see reality a certain way you will convince yourself that decisions that go against you are unfair. 

According to Dan Ariely, we can extend that analogy to a business context. If you are paid a lot of money to see reality in a certain way, you will construct a view of reality that helps your intuition deal with any internal dissonance. 

Bankers have been treated as pariahs since the financial crisis, many would argue with good reason. Are they really bad people or just people with a really bad incentive structure? The relationship between incentives and behavior is vastly more complex than I’m portraying it here, but the answer to this question has profound implications for capital markets.

Imagine the following business; A lottery company with very generous odds of success. It sets a prize pool of €1m, offering a 1 in a million chance of winning. It only charges 50c for the tickets (fair price is €1 each). It limits sales to 100,000 tickets to reduce the chances of the prize being won. All going well it will run the company for long enough to make a serious profit.  Eventually when the prize is won, the company goes bust and it then becomes a problem for creditors. 

The dodgy lottery company is an analogy for the real world banking model. Bank lending followed a similar path to that described by the Lottery. Many lenders assessed applications not based on ability to repay, but on the profits available. This resulted in loans being issued with a probability of default significantly higher than implied by the price (interest rate) charged. The banks made extraordinary profits for a long time. Eventually it was a problem for the creditors (taxpayer).  

It is a truism that people respond to incentives. If pay and incentives are inappropriately structured, we are exposed to future blowups. At the micro level this has implications for the types of investment funds we invest in. At the macro level it has implications for the financial system.

This was amongst many of the issues discussed at a talk I attended at the recent Kilkenomics festival by the best-selling author, Nassim Nicholas Taleb.  He has written extensively on the topic of incentives. Receiving bonuses for “performance,” but not reverse bonuses for negative performance, provides an incentive to bury risks and delay blowups. And not much has changed since the crisis in Taleb’s view.

He is very skeptical about predictions in socioeconomic domains. Those making predictions are rarely harmed by their forecasts. Taleb advises people to only take into account what the predictor does with their own money. 

I think we need something a little more workable than this as a solution. The starting point should be for the correct incentives to be in place, rewarding the outcomes we desire. As Taleb observes, I’d prefer a nuclear plant manager to be incentivised by measures of safety and accident prevention than to be remunerated for maximizing output.  

We shouldn’t be surprised by poor outcomes in markets with misaligned incentives. As Dan Ariely observes, incentives will foster the illusion that you are doing good, so the charlatan’s actually think they are on the side of progress.  To rephrase de Tocqueville, in a free market, you get the outcomes you deserve. Maybe those that we frequently like to blame for the crisis both at home and internationally (bankers, developers etc), are not the pariahs we make them out to be. 

I am all for rewarding risks. In a properly functioning market risk and reward are desirable, but only to the extent that there is symmetry; that if there is a downside to your actions, you must pay a price. Entrepreneurs are rewarded for their gains; they are also penalised for their losses. People to whom we entrust the management of our hard earned cash should be held to the same standard. 

As I continue to grapple with my own lack of objectivity in domains where I have an involvement, I have at least learned (mostly) to keep my counsel on the sidelines at St. Brigid’s under 9’s matches.