Remuneration, risk, and financial crisis

The sharp deterioration in the subprime mortgage market in the United States in 2007 triggered a decline in confidence in global financial markets of unprecedented scale. The sizable losses that resulted in many financial institutions revealed significant weaknesses in basic market practices and principles-notably deteriorating lending and underwriting standards; excessive (undercapitalized) risk-taking; inadequate risk management processes; undue reliance on ratings of structured products; and an almost obsessive focus on actions driving short-term results with little consideration of long-term implications. In the aftermath, the attention of regulators has turned to the structure of remuneration in financial institutions, and in particular, the failure of these structures to adequately capture and adjust for the risk taken in order to earn returns. This chapter asserts that the efficacy of risk-adjusted remuneration structures relies on the resolution of three main factors: (1) risk appetite can be defined and translated into ex-ante risk measures; (2) agency problems that arise with the use of risk-adjusted performance measures can be resolved; and (3) managerial overconfidence in assessing risk can be taken into consideration in the design of remuneration structures.