Magazine article Workforce Management

Comp Collapse

Magazine article Workforce Management

Comp Collapse

Article excerpt

Several errors and omissions by the compensation function played a major role in the excessive risk taking by loan officers and the buyers and sellers of mortgage derivatives.

THE LAST WORD

WHO IS TO BLAME for the collapse of Wall Street icons like Lehman Brothers and Merrill Lynch? Is there a common denominator in the simultaneous fall of these icons, along with countless other banks, insurance firms and mortgage brokers?

These are questions everyone is asking, but few in HR seem to be taking responsibility. Everyone agrees that one of the primary causes was excessive risk taking. Mortgage brokers and banks sold loans to extremely high-risk individuals and then packaged those debts into insanely complex derivative products that were bought and sold with little consideration of the risky foundation on which the products were based.

You can blame the lack of government oversight, but a lack of regulation doesn't force risk taking; it only allows it. The blame should fall solely on the firms that engaged in such behavior. So the key question should be: What incentives drove such risk taking inside the firms themselves? Obviously executive expectations played a role, but the compensation function also needs to be looked at when assessing the blame. Several errors and omissions by the compensation function played a major role in the excessive risk taking by loan officers and the buyers and sellers of mortgage derivatives:

Excessive rewards: If you look at a list of failed firms, from Enron to Bear Stearns to Lehman Brothers, you'll find a consistent pattern of paying out what can only be described as huge bonuses. Obviously, rewards for performance are a good thing unless the amounts offered become so staggering that people lose their sense of ethics and are driven to exceed reasonable limits on risk. Whose job is it, in conjunction with management, to create pay-for-performance plans? The compensation function, of course.

Compensation design failed to forecast the desired level of risk taking: Compensation focuses on pay and rewards but seldom ties either to risk models. Compensation professionals need to assume partial ownership of risk (along with the controller), because just as compensation can drive desired behavior, when misaligned or unthrottled it can also drive disastrous behavior. Whenever incentive or bonus plans are drafted, it's critical that the design process evaluate and forecast what level of risk taking will be rewarded by the plans so that senior managers can be informed and held accountable for approving them. …

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