Heads I Win, Tails You Lose: Perverse Incentives on Wall Street

Just as we thought we had heard or read all the different ways people from Lehman Brothers to AIG could violate our trust, a new scandal emerged in connection with the bankruptcy of MF Global, a hedge fund that placed huge bets of other peoples’ money on sovereign debt in Europe. You may have read that this scandal adds a new twist to the list: someone at MF Global managed to steal–uh, excuse me, misplace–over $1 billion of cash belonging to clients of the fund.

I’m not talking about losing an investment. Rather, in this case it’s money in a client trust account that someone (we don’t know who) “borrowed” for as-yet undisclosed purposes. The money is gone.

There are laws against this sort of thing. It is a strict no-no in any profession that deals with client funds. Lawyers get disbarred for co-mingling client funds with their own even if they never take or use a penny of client money. (If they happen to spend money belonging to clients and get caught, they go to jail.) Similar laws apply to the financial industry.

Jon Corzine, the CEO of MF global, when testifying before Congress recently, was unable to explain what happened to the money. And he was somewhat evasive when talking about it. (Click on the picture of Corzine to the right to watch the testimony.)

William Black, a law-school professor, former prosecutor of malefactors in the Savings and Loan scandal of the 80′s, and author of The Best Way to Rob a Bank is to Own One, recently appeared on the public radio program, On Point with Tom Ashbrook, and explained that we have set up a system in which people receive giant bonuses for taking huge risks with other peoples’ money when these bets pay off but pay little or no price when their casino-like gambling comes a cropper. (You can hear the On Point interview online at The Lessons of MF Global.)

No doubt, there are people who nevertheless act responsibly, making sure that they do not put the company at risk. But others do not exercise such restraint. From their perspective, they would be fools to do so. In their minds, it would be like turning a possibly lost suitcase containing $100,000 into the police. It might be wrong to keep the money, perhaps, but since it’s easy to get away with, let’s go for it.

As Black explains in a short video interview, if top-level leadership (in this case Jon Corzine) allows or encourages such behavior, those who do not play along–the good guys–get ostracized or fired. A culture of gambling and fraud develops.

We will not stop this kind of system-threatening behavior until we increase the costs of such bets high enough to focus the minds of top executives. (In a recent post, Getting Away with Grand Theft Economy, I discussed the failure of the Justice Department to use the Sarbanes-Oxley Act as a basis for prosecuting CEO’s and CFO’s from Countrywide and other companies that appear to have filed misleading financial statements. Rules are not enough. They must also be enforced.)

Or, perhaps we should try Jayne Barnard’s suggestion to reintegrate shaming in response to corporate misdeeds.

As William Black says, we must eliminate the perverse incentives that encourage bad behavior.

Neuroscience and psychology have made great contributions to the science of ethics in recent years, helping us better understand why good people do bad things. But we don’t need state-of-the-art science to tell us that perverse incentives will attract enough people willing to do stupid or venal things that seriously damage the rest of us. We’ve known that since Socrates and Plato and before.

Those responsible for the development and operation of organizations would do well to apply this lesson at the micro-economic level as well.

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