Timelines, Risk, and Right: The ethical danger of short-term rewards

An editorial in yesterday’s New York Times addresses a deservedly sensitive issue in the world of business ethics: compensation. Of specific interest to me, this editorial homes in on most important question: the relationship between risk and reward with regard to pay. While the Times editorial focuses primarily on the legislative approach to this problem (which is some time in the future) the more basic ethical/decision-making issue is how well we judge risk in the short term vs. the long term and how we are likely to behave when we are rewarded for one kind of risk when the ethical thing to do is focus on the other. In short, are these traders going to make better or worse ethical decisions when they are rewarded for short-term risk taking?

First, the practical considerations. It’s been widely and accurately claimed that much of the market behaviour that led to the debt-based asset bubble was driven by short-term rewards. In fact, if you examine the mortgage value chain, each of the players received rewards and passed the longer-term risk on to the next player. The borrower passed it to the broker, the broker to the bank, the bank to the investment bankers, the investment bankers to the investors. Ultimately, when the risk aggregated with the investors in the longer-term, the system melted down and the effect has been, in large part, the global financial crises.

What the current bankers and traders are doing is much the same. They are paid quarterly or annually for returns on their investments from that period. The previous quarter or year’s transactions aren’t tracked from a compensation perspective. Since most people, lacking a compelling reason, practical, ethical, or otherwise, will act in a way that rewards them, the bankers and traders will continue to focus on short-term gains.

This wouldn’t be a problem if these short-term gains added up to long-terms gains but frequently they don’t. The bailout of the financial system, which has cost the taxpayers of the United States more than a trillion dollars, is the paradigm case of this. What ends up happening, therefore, is that the short-term rewards are expressed privately in the huge (by any measure) bonuses in the financial services industry while the long-term risks are socialized and/or passed on to the investors. Thus we, as an investor nation, end up paying twice: once for the bailout, and again as our 401ks bite the dust. The traders and bankers only get paid.

And herein lies the fundamental ethical question. Is it right to transfer risk from the people who stand to gain from it to people who can only lose? In other words, it’s a question of upside, downside, and time horizon. What the current system does is reward the long-term upside rewards to those who only have short-term risk, the traders and investment bankers. It also places this downside risk mostly with the long-term investors/tax-payers. So, contrary to the mythology of free-market fundamentalists, the risk-takers aren’t truly rewarded, and those who are rewarded aren’t truly taking on risk. I think this could be unpacked much further, but I think what I’m trying to say is clear: by transferring downside risk from those who get for it (Wall Street) to others (investors and taxpayers), the system encourages the traders to act unethically because it rewards them for doing so. Because people are so bad at estimating long-term risk, they end up acting unethically without even knowing it.

I know that there’s a lot more to be explored here. In fact, probably a book’s worth. For example, what about the upside rewards for investors? If the traders are acting in a way that they are supposed to (at least institutionally), how can they be said to be acting unethically. These questions can be answered but they’re out of scope here. The point I’m trying to make is that the system is currently broken, from the perspective of risk, reward, and ethics. The Times is therefore right in thinking it needs to be reformed, probably through legislation and regulation. But it’s also important to understand how it’s broken in order to fix it correctly and this is what I don’t see much discussed in the current debate. I hope my little blog post adds something positive to the discussion.