Why Using OPM (Other People’s Money) Can Be Disastrous

The recent Global Financial Crisis has been a wakeup call for some financial institutions, and a death knell for others. There has been no end to the finger pointing and blame laying from government regulations (or lack thereof) to executive compensation.

As has been clear from the beginning, there are no easy answers yet reformers of every stripe have been eager to use the crisis to point out why drastic changes are necessary. The clamor for attention has been deafening; with each person trying to be heard above the other while the cacophony of shouting voices in the midst of a storm are drowning each other out.

Perhaps what we ought to realize is our entire economic system is built on an evolutionary model of continuous adaptation and mutation which leads to both phenomenal successes and catastrophic failures. If we try to prevent the possibility of failures we have to restrict at the same time the opportunities for successes.

In a previous post I talked about the evolution of economic advancement in terms of a landscape of all possible ideas. In this land idea explorers set out to locate the ideas which will be most advantageous for society. The more explorers there are the more likely it is they will find the best ideas. At the same time the chances of stumbling across really bad ideas increase as well.

We want many explorers. But we want them to be intrepid, not foolhardy. One of the ways of mitigating the harm done by explorers inclined to be foolhardy is by encouraging them to be cautious in their exploration. We can do this by causing them to experience some of the pain of failure. Explorers must have a measure of their own welfare at risk.

Creating this balance between risk taking and caution is tricky business. It’s not surprising, nor necessarily a bad thing, we got it wrong. But clearly we did get it wrong and it’s time to correct in the other direction.

William Cohan, author of House of Cards: A Tale of Hubris and Wretched Excess on Wall Street, illustrates how bankers have been conditioned to take too much risk by insulating them from the effects of their poor choices.

In an interview with EconTalk host Russ Roberts on September 22, 2009, Cohan talks about compensation on Wall Street and the equity participation of WS executives. These executive often point to their stock options as evidence they are “in it with us [investors]”. This is reality only on paper. Their compensation is so excessive they don’t really rely on the equity portion to pay off.

Having the executives’, and the institution’s, financial welfare on the line would bring a much needed injection of caution into the system. By tying executive pay to their performance they get the true effect of the motivation for success and the prudence to avoid failure.

“When these were private partnerships their whole net worth was on the line. Therefore, they were much more careful about the business lines they got into,” Cohan goes on to say. “They weren’t using other people’s money to make huge, risky bets while paying themselves outrageous salaries and bonuses.”