Comments on: Moral Hazard and Systemic Risk http://ozrisk.net/2008/01/25/moral-hazard-and-systemic-risk/ Risk Management in Australia Wed, 30 Nov 2011 12:41:58 +0000 hourly 1 http://wordpress.com/ By: Andrew http://ozrisk.net/2008/01/25/moral-hazard-and-systemic-risk/#comment-26036 Sat, 26 Jan 2008 02:52:44 +0000 http://ozrisk.wordpress.com/?p=284#comment-26036 Steve,
You are right, in that bonus structures provide a strong one way incentive towards risk taking – if the middle office and management are not doing their job. If a trader is spectacularly successful in one year he or she may earn a lot in bonuses – but if they lose money the worst that can happen is they lose their job. If most of their income is in bonuses then a big bonus is something worth shooting for. This is why most traders hate the middle office and risk management functions – they see them as getting in the way.
Traders, by their nature, will normally take on as much risk as they can, meaning the attitude to risk (provided appropriate controls are in place – see SocGen) will be set by upper management setting the risk limits of the firm. If they have in mind that the Greenspan put could be in play then they may well increase their risk limits to cover this. I tried to capture this in the last paragraph.
I do think it is overstated, though – they cannot know when or if it will occur so I just doubt it will be a major factor.

]]> By: Steve http://ozrisk.net/2008/01/25/moral-hazard-and-systemic-risk/#comment-26031 Fri, 25 Jan 2008 10:07:51 +0000 http://ozrisk.wordpress.com/?p=284#comment-26031 Probably a good point.

If there is an effect, I would imagine it would be a lot less than the salary and bonus incentives of the individual concerned. Let’s say I know I will make a million dollars if my bet goes up 10 million, but if it goes down 10 million, maybe I’ll lose my job or earn nothing… that would be a stronger consideration than the possibility of my bad bet being bailed out by a central bank or government.

However, it is up to the people further up the chain from the individual – the company bosses – to consider the cumulative effect of all these bets, and maybe they would be more likely to be affected by the perceived guarantees of large-scale bailouts, stimulus etc? Perhaps they are more likely to approve the individual decisions with this in mind? And then there is the psychological effect of there having been so few major downturns in recent history – perhaps some downturns that were cyclically “due” have never occurred due to actions that ignore moral hazard concerns?

I’m no banker, nor an economist, so I am probably missing something. I’ve been interested in following this blog, as well as the doom-and-gloom ones, but the issue of the bonus structures for traders has perplexed me since even before the current shenanigans.

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