February 29, 2008
Chapter 31 - Aligning Compensation Systems with Risk Management Objectives
This week, Fed Governor Randall Kroszner called on the financial sector to develop industry-wide guidelines for compensation that would better align individual incentives with the long-term interests of the firms they work for (see article).
"Aligning Compensation Systems with Risk Management Objectives" is a chapter that I wrote in 2006 for Michael Ong's book Risk Management: A Modern Perspective. Click on the link to download the chapter in PDF format.
I also have a brief article on "Generalized Problems with Metric-Based Incentive Plans" which you can download by clicking on the link as well.
Design and review of compensation schemes does not typically fall under the oversight of risk management areas. But, given the numerous case studies of how miscommunication and mis-alignment of incentives have led to loss, it is clear that they should.
I hope that the risk profession will take up the challenge from the Fed and lead the movement towards better designed programs. Feel free to contact me if you'd like to discuss further.
Posted by dkoenig at 04:31 AM
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February 21, 2008
Blame the Pension Fund "Animals" for Excessive Risk-Taking Behavior?
At the recent PRMIA Credit Forum in New York, one slide from an early morning presentation leaped off of the screen. The slide depicted the number of issuers coming to the marketplace at below investment grade. In 2000, less than 100 Single-B issuers came to market. In 2007, that number had grown to nearly 250. In 2000, slightly more than half of the issuers were below investment grade. By 2007, the figure was 82%. At the same time, the number of issuers who were able to come to market increased by 56 percent. Said another presenter, "10 years ago, most of these firms could never have issued". So, what gives today that allows firms of sub-investment grade credit the ability to come to market? The answer may come from "animalistic behavior" in pension funds.
Ron Ryan, also a past presenter at PRMIA New York meetings (Pension Crisis) in his Ryan Letter, emphasizes with alarm that pension assets across the board are lagging pension liabilities by substantial amounts. He notes that that was not the case, though, prior to the 2000-2002 stock market retreat. In the most recent issue of the Ryan Letter, he says that the performance on pension assets has trailed the growth of liabilites by 87% since the start of 2000 ("Most pension funds enjoyed a funded ratio surplus in 1999. However, assets have underperformed liabilities by about -87% since 1999 on a compounded index basis starting at 100 on 12/31/99!"). Of course these pensions must regain their surplus at some point or they will default. In other words, they are hungry for yield, hungry for return and implicitly hungry for risk.
I use the term 'hungry' purposefully. In the study of risk-sensitive behavior psychologists have developed something called risk-foraging theory. Within this field, we find the "energy budget rule". The energy budget rule predicts that animals will be risk-averse when they're not in danger of starving. But,the same animals will be risk-seeking when there is a risk of starvation. Consider for example, an animal that must yield 2000 calories a day to sustain itself on any given day. If it knows that it can go to one field and consistently locate a 2000 calorie diet, while at the same time another field yields returns of 1800 calories one day or 2200 calories on another day, it must go to the 2000 calorie field or face starvation. In other words, it becomes risk-averse, knowing that if it goes to the other field, there's a one in two chance of starvation.
Now, change the animal's requirements. Suppose, for example, that the animal now requires 2100 calories a day to avoid starvation. It is now forced to make the choice to go to the risky field, for if it goes to the field with certain return of 2000 calories, it is certain to die. The animal has now become a risk-seeking animal. We see the same kind of behavior human beings as relates to sales objectives where a salesperson must reach a minimum quota or be fired. Salespeople are motivated to take on risk that they would not ordinarily take in order to ensure that they reach the required minimum level of return.
If Mr. Ryan's data is correct, then the pension fund animals must be quite hungry and must be recognizing that their minimum need for caloric intake is not being sufficiently met by "normal" foraging and its associated assumption of risk. In other words, these animals must now be risk-seeking if they have any hope of survival. It's not just in the field of new, low-quality debt issuances that funds are foraging. But, the pension fund's foraging into the fields of alternative investments, equities and other risky fields in order to possibly achieve returns that could bring them back to solvency.
So, what's new? Pensions are chasing yield. We know that. But, what we are not necessarily incorporating are the add-on, or amplification effects of the pension fund's risk-seeking foraging.
If pensions are seeking risk in excess of the returns those risks warrant, then we should expect substantially more volatility in the return of all risk-sensitive assets as the pension crisis mounts. If liquidity is going to be as skittish as it has been during the subprime crisis, then we should expect liquidity crises to be growing in frequency and perhaps severity. To what extent pension underfunding contributes to this in total is yet unknown. But given the size of underfunding in this country and others, one has to imagine that the impact is potentially immense.
Is there an answer? Is there some way to make the safer fields more caloric? Is there some way to reduce the risk of the fields that are peceived to be potentially higher in return?
Perhaps the answer is that the pension plans believe that the improvements in ERM and other risk management techniques have made "risky" firms less risky than before. This would suggest that the required return from those assets would be overstated using historical measures and that they would represent value. There is a strong argument to make that the risk of systemic loss has been greatly reduced by the speed with which capital (human and financial) can redeploy, by the distribution of risk made possible by derivatives and through other "modern economy" developments. Partially, this is the value that risk management brings to society.
Or, maybe the pension plans are relying on past experience and descriptive measures, e.g. rating agency grades, to convince themselves that the risk is not so great. Anyone else care to eat from that field?
UPDATE (April 2, 2008): Institutional Investor story "Pension Funds Leap Into Hedge Funds"
Posted by dkoenig at 02:26 PM
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February 05, 2008
Pro-cyclicality (the flip side)
While Basel II is generally seen by industry practitioners as having been a positive contributor to the risk management of banks and the stabilty of financial systems (see PRMIA Survey), the nagging worry that most have had is that the use of market-sensitive credit models would lead to an exacerbation of credit cycles. This may be coming to fruition in terms of credit restrictions and some would argue that this is just the flip-side of the easy credit terms the same models allowed when volatility was low and stock prices were increasing.
As the Bloomberg headlines says today MBIA, Ambac Downgrades May Lead to Bank Rating Cuts, S&P Says. Changes in credit ratings or market prices that drive Merton-type credit models will no doubt be affecting factors like collateral and lines of credit and general liquidity to banks and other affected financial service firms.
See my previous posting on the Social Amplification of Risk to see how the human response to risk events can cause the same kind of impact.
Is this just the beginning of the regulation-based contribution? Could the economic downturn be exacerbated even further by the pro-cyclicality of Basel II? Does this kind of approach prohibit banks from making opportunistic lending when other credit providers do not face the same restrictions?
Please share your comments.
Posted by dkoenig at 11:25 AM
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