Destructive Agents, Financial Firm’s
Compensation Schemes
and Excessive Risk-Taking
Prepared for the
Operational Risk Conference, Frankfurt March, 2015
N. Bilkic, T. Gries
University of Paderborn, Germany
WWW.C-I-E.org
•Motivation
•Model, contract
•Individual firm
•Market failure
•Conclusion
1. Motivation
Going back to the financial crisis……
„…. Between 1998 and 2008 Rubin was a top official at Citigroup,
where he received a cumulative $150 million in compensation. His
main impact on bank policy was to push for the kind of aggressive
risk taking that crashed the firm. ...“
New York Times. 2008, Nov/23,
The Reckoning: Citigroup pays
for a rush to risk.
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Thomas Gries
1. Motivation
•Motivation
•Model, contract
•Individual firm
•Market failure
•Conclusion
„… Financial markets based compensation has become the norm in
modern American capitalism. …. Unfortunately, the idea of market
based compensation is both remarkably alluring and deeply flawed.
The result has been the creation of perhaps the largest and most
pernicious bubble of all: a giant financial incentive bubble, ...“
M. Desai, Harvard Business
Review, p.124, March, 2012.
→ Popular claims:
Greedy managers are responsible for an excessive risk
taking and caused the 2008 crash.
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Thomas Gries
1. Motivation
•Motivation
•Model, contract
•Individual firm
•Market failure
•Conclusion
Questions:
 Can asymmetric information, moral hazard, and hidden
action in finance firms explain excessive risk-taking?
 More precise,
• does the principal-agent problem matter in this context?
• how do contractual incentives in finance firms cause
excessive risk-taking at individual firm level
• as well as at sector level?
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Thomas Gries
1. Motivation
•Motivation
•Model, contract
•Individual firm
•Market failure
•Conclusion
Answer:
Using a “delegated portfolio choice” approach with
performance contracts we show that
- if we allow for the existence of destructive agents
(disloyal or even harming agents when
maximizing their private utility)
→ each finance firm and the segments in the sector
will take excessive risk.
→ An adverse selection process for agents leads to
the employment of the greediest applicant
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Thomas Gries
1. Motivation
•Motivation
•Model, contract
•Individual firm
•Market failure
•Conclusion
Answer:
The major point of this paper is that
“… if we lure people with super large compensations we
may attract super talents, however, we should not be
surprised if we simultaneously attract super greedy, and
super unscrupulous agents with all consequences.”
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Thomas Gries
1. Motivation
Related Strands of Literature and Novelties
•Motivation
•Model, contract
•Individual firm
•Market failure
•Conclusion
 Modified Delegated Portfolio Choice:
as started e.g. by Bhattacharya/Pfleiderer (1985), survey Stracca (2005)
 Information Asymmetry in Contract Theory
- hidden information,
- hidden action,
- moral hazard
 Destructive Agent:
Baumol (1990) (destructive entrepreneur), Murphy et al. (1991, 1993), Torvik
(2002) (rent seeking and allocation of talents), Philippon/Reshef (2012)
• follows his own interest with all consequences, even if
he is destructively disloyal or harming to the principal.
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Thomas Gries
•Motivation
•Model, contract
•Individual firm
•Market failure
•Conclusion
Contents
 Motivation
 Model of delegated portfolio choice
• Individual firm and contract design
• Individual firm and adverse selection
 Market failure & excessive risk-taking
 Conclusion and implications
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Thomas Gries
2. Model of delegated portfolio choice
2.1 Individual Firm Description
•Motivation
•Model, contract
•Individual firm
•Market failure
•Conclusion
Financial Firm,
• General Description :
- firm’s business is to manage a given wealth
- either owned by the principal herself
- or the principal is liable for wealth deposited
- no leverage (no bank-specific model, can be easily
included)
- revenues come from returns of the portfolio
- no operating or monitoring costs
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2. Model of delegated portfolio choice
2.1 Individual Firm Description
•Motivation
•Model, contract
•Individual firm
•Market failure
•Conclusion
• Portfolio:
- risk-free asset, with return RB and portfolio share (1-b)
- risky asset representing a risky project chosen out of
a set of projects in the economy with
- normal distributed returns RK expected return ERK [>RB]
- observable volatility  and K
- a publicly unknown idiosyncratic part of observable K
- idiosyncratic volatility is the
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- relevant risk indicator from perspective of the firm,
- firm specific risk (purely the result of the portfolio and project
choice)
2. Model of delegated portfolio choice
2.1 Individual Firm Description
•Motivation
•Model, contract
•Individual firm
•Market failure
•Conclusion
• Principal (risk averse (0 < U)):
- can observe portfolio returns and volatility
- cannot observe idiosyncratic share of total volatility
- delegates portfolio choice to an agent recruited from
a competitive agent market (no search costs)
- bargains about a performance contract by
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- evaluating performance by ER and idiosyncratic volatility
- offering an optimal contract with wf, (fixed payment ) and α
(linear reward on performance above a close competitor’s
performance)
- trusting the agent when he reveals the idiosyncratic share of
volatility which is not directly observable by the principal
2. Model of delegated portfolio choice
2.1 Individual Firm Description
•Motivation
•Model, contract
•Individual firm
•Market failure
•Conclusion
• Destructive Agent (is risk averse (0 < ηu)):
- will fulfill his promises concerning the perceivable
portfolio performance - when hired.
- manipulates perceived risk through interpretation of
observable information, that is
- conceals idiosyncratic risk with concealing effort q
(only share 1/q of total observable risk K obtains an
idiosyncratic interpretation and identification)
- marginal concealing costs c, and
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2. Model of delegated portfolio choice
2.2 Contract Negotiation and Contract Design
•Motivation
•Model, contract
•Individual firm
•Market failure
•Conclusion
Agent’s optimal choices:
• maximizes expected utility for a given performance
contract
and the outside option 
by an optimal choice of
- the portfolio share of the risky asset b
- the concealing effort q and
s.t.
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rationality constraint
2. Model of delegated portfolio choice
2.2 Contract Negotiation and Contract Design
Principal’s optimal choices:
• maximizes expected utility by
s.t.
rationality constraint
incentive constraint
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•Motivation
•Model, contract
•Individual firm
•Market failure
•Conclusion
2. Model of delegated portfolio choice
2.2 Contract Negotiation and Contract Design
•Motivation
•Model, contract
•Individual firm
•Market failure
•Conclusion
Proposition 1 (contract): With asymmetric information and
hidden action there exists a potential contract in which
(i) the agent chooses an optimal portfolio share of the risky
asset b* and an optimal risk concealing effort q* given the
principal’s offer of fixed payments wf and a performance share
α
(ii) the principal chooses optimal fixed payments wf* and an
optimal performance share α* given the perceived performance
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2. Model of delegated portfolio choice
2.3 Contract and Implications
•Motivation
•Model, contract
•Individual firm
•Market failure
•Conclusion
Proposition 2 (principal’s utility from agent’s attributes):
When the principal recruits a potential agent
i.“ostensible (indirect) utilities” from perceived performance
increase with agent’s having decreasing risk aversion u and
decreasing concealing costs c
ii.“true (indirect) utilities” from the true firm performance
decrease with decreasing risk aversion u and decreasing
concealing costs c
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2. Model of delegated portfolio choice
2.3 Contract and Implications
•Motivation
•Model, contract
•Individual firm
•Market failure
•Conclusion
Proposition 3 (principal’s adverse selection of agent):
(i) For a set of competing agents differing only by concealing
costs c, or risk aversion u the principal chooses the agent with
• lowest concealing costs cmin and lowest risk aversion u min
• largest share of risky assets and
• hence the most risky portfolio
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2. Model of delegated portfolio choice
2.3 Contract and Implications
•Motivation
•Model, contract
•Individual firm
•Market failure
•Conclusion
Proposition 3 (cont.) (principal’s adverse selection of agent):
(ii) This choice implies the lowest expected “true (indirect)
utility” for the principal
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2. Model of delegated portfolio choice
2.3 Contract and Implications
•Motivation
•Model, contract
•Individual firm
•Market failure
•Conclusion
Summary: Proposition 1-3 for contract of principal i
with agent j
Principal’s
Principal’s utility according
true utility
to observable information true portfolio risk
i ,qij*,bij*
U*(cj)
U*true
imax
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cmin
ηmin
cj, , ηj
cmin
ηmin
U*min
true
cj , ηj
cmin
ηmin
cj , ηj
3. Financial market failure & excessive risk
3.1 Market portfolio and aggregate risk
•Motivation
•Model, contract
•Individual firm
•Market failure
•Conclusion
Corollary 4 (aggregate market portfolio and risk):
i.
If
for all firms the above considered firm represents the
behavior of any other firm accept for different values of U.
ii. Then
in markets in which firms offer performance contracts all
principals choose the agent with attribute cmin and u min, and
the market portfolio becomes the most risky portfolio max
the economy would choose.
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3. Financial market failure & excessive risk
3.2 Destructive agents and systemic risk
•Motivation
•Model, contract
•Individual firm
•Market failure
•Conclusion
Theorem 6 (destructive agents and excessive risk-taking):
If destructive agents exist in this delegated portfolio model,
performance contracts designed to beat close competitors
lead to excessive risk-taking by the design of the compensation
scheme.
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4. Conclusions and implications?
Economic interpretation with respect to reality
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•Motivation
•Model, contract
•Individual firm
•Market failure
•Conclusion
 The point of this paper
• is not to claim that a P-A-problem within financial firms
is the ultimate source of
- excessive risk or
- the financial crisis.
• is simple, if we lure people with
- super-large compensations
we not only attract
- super talents,
we should not be surprised to also attract
- super greedy and super unscrupulous agents
with all consequences
Thomas Gries
4. Conclusions and implications?
Summary of Economic Reasoning:
•Motivation
•Model, contract
•Individual firm
•Market failure
•Conclusion
 Asymmetric information and perform. payments provoke
• hidden actions
• portfolios with higher return and extra risk
 Since extra risk is not fully observable by the principal, she
• rewards this action which apparently improve the
performance of financial services
• selects the worst agent
 Hence portfolios are inefficient and contain excessive risk
 Malfunctioning of financial firms causes excessive risk in
the segments of financial sector
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Thomas Gries
4. Conclusions and implications?
Summary of Economic-Technical Mechanism:
•Motivation
•Model, contract
•Individual firm
•Market failure
•Conclusion
 Destructive agent deliberately introduces an externality
within a hidden action (allocates hidden risk to principal)
 Principal does not observe the risk and compensates for
high returns and perceived low risk
 Destructive agent also carries the risk, however he is
compensated for his risk taking by the performance pay
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Thomas Gries
4. Conclusions and implications?
•Motivation
•Model, contract
•Individual firm
•Market failure
•Conclusion
 What is a good second best solution?
• Fixed payment contracts? → How to motivate?
• Monitoring of agents: → who and how, Risk Officer?
• Moral standards and ethic behavior?
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Thomas Gries
Destructive Agents, Financial Firm’s Compensation Schemes
and Excessive Risk-Taking
by Thomas Gries
Thank you for your attention!
University of Paderborn, Germany
WWW.C-I-E.org
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Thomas Gries
•Motivation
•Model, contract
•Individual firm
•Market failure
•Conclusion