Question

The economic and finance professions are committed to the idea that using tangible incentives (rewards and punishments) to align Agent and Principle interests is the best strategy to control agency problems in Corporate Governance.  Do you believe that this is true? Why or why not?  Are there other approaches to controlling conflicts of interests and agency problems that could be equally or more effective?

Answer 1

The economic and finance professions are committed to Outcome Based Control rather than Behaviour Based Control. While the major behavioral drivers in making such decisions are Greed and Fear, nonetheless it is pertinent to take a logic based approach in decision making with structured risk analysis and mitigation strategies. Suppose a hedge fund manager makes a huge bet on short-selling a security based on some individual analysis that is "propreitary" and cannot be shared with the sponsors. However, the manager can obviously share a broad structure outlining his decision tree for such investments without giving details of the "secret" information he has on this investment. Also a manager who takes unnecessary risks in his portfolio putting most of the bets on a single outcome, should be discouraged because risks in such investment decisions outweigh probability for a windfall reward. In all such cases, the hedge fund manager gets rewarded if even for some black swan event his investment decision pays off which is sad but true. Truth be told, behaviour based control can mitigate much of these kind of reckless risk taking endeavors by putting weightages on decision variables and utlining the macro and micro economic constraints. A probability tree with distribution can be constructed where ethical risk taking can also be promoted while risk taking based on insider information can be discouraged. If we can change the control system of such decision making in economic and financial professions, investors may get less reward in short term, but in the long run their returns will be sustainable and consist less damage to the capital market, macro economy and even society as well as environments. Therefore I strongly believe that the agents incentive structure must be based on behavior based control to maximixe tripple bottomline of everyone in the economic value chain. This is the only way to devise a sustainable positive sum economic game in finance sector.