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Some firms have a compensation structure that encourages risk-taking while insulating employees from the bad consequences of their decisions. This creates the potential for moral hazard.

I started thinking about this because of what happened at AIG. For those unfamiliar with the situation, a small division (AIG Financial Products) in a huge insurance company was able to bankrupt the entire company. Incentives were very lop-sided for division management relative to the risks they were taking. Even though management was making millions, they were taking risks an order of magnitude larger than that. If they lost billions, they would only lose their future income (assuming they would be fired).

My question is, how do you align management/employee incentives at the institutional level in order to prevent this types of moral hazard?

Two things to note:

  1. The situation at AIG is just an example. I'm not asking for solutions specific to AIG (e.g. limiting leverage) or financial firms in general. Many firms face this type of moral hazard with the CEO (i.e. a "golden parachute").

  2. Aside from not being "at the institutional level", I doubt regulation is the answer. While there's a place for regulation, regulators seem to — at least initially — react to crises instead of prevent them (though there's no counter-factual for crises regulators may have prevented).

With those two things in mind, I appreciate your thoughts!

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Have you been watching "Inside Job?" –  user8077 Oct 11 '11 at 22:06
    
Sorry, never heard of Inside Job. I don't watch much TV or movies though. –  Joshua Ulrich Oct 11 '11 at 22:26
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@JoshuaUlrich, you should. It is a documentary about the crisis. Any economist should watch it. It features big names such as Hubbard, Mishkin, Roubini. –  Vivi Oct 11 '11 at 23:27
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