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What do the Gulf oil spill and the recent financial crash have in common? Both involve risk taking gone bad.
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Free Slides fromEd Dolan’s Econ Blog
http://dolanecon.blogspot.com/
What Oil Spills and Financial Crashes Have in Common: Gambling with
Other People’s MoneyPost prepared , June 6, 2010
Terms of Use: These slides are made available under Creative Commons License Attribution—Share Alike 3.0 . You are free to use these slides as a resource for your economics
classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics, from BVT Publishers.
Post P100606 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
All Business is Risky
All business is risky Entrepreneurs do not try to
avoid all risk—managing risk is an essential part of their job
Public policy cannot protect everyone from risk, but it should encourage people to manage risk responsibly
Source: pdclipart.com
Post P100606 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
Risking your Own Money as an Entrepreneur
Suppose you are entrepreneur risking your own money on a project.
What you want is a project that has an expected value of revenue that is greater than the estimated cost
Sometimes your investment will pay off, sometimes not, but on average, over time, you will earn a profit from this kind of venture
Post P100606 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
Recreational Gambling
If you buy lottery tickets or otherwise gamble for fun you may prefer a different kind of riskSmall chance of huge prizeLimited maximum loss—not
more than you can affordExpected value of prize
less than cost of ticket In money terms, you lose on
average, but you enjoy the game and the dream of a pot of gold
Source: pdclipart.com
Post P100606 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
Gambling with Other People’s Money
If you have a chance to gamble with other peoples’ money, you may choose a third kind of riskMake a small gain almost
all the timeRun a small risk of a
disastrous loss You know that if a disaster
does occur, the game is over, but you hope to go home with past winnings in the bank, and stick someone else with the loss
Source: pdclipart.com
Post P100606 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
Symmetrical and Skewed Risks
Each kind of risk has a name Symmetrical risk —
balanced gain and loss Positively skewed risk —
small chance of very large gain
Negatively skewed risk —small chance of very large loss
Post P100606 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
Negatively Skewed Risks and Executive Compensation
In the world of business, executive compensation plans often create incentives to take negatively skewed risksMost of the time, the company
makes money and the executive earns an annual bonus
If a huge loss comes, the executive is fired, but may collect a “golden parachute” retirement bonus
There is rarely any “clawback” of previously earned bonuses even when risky decisions later turn out to produce big losses
Source: pdclipart.com
Example of incentive to take negatively-skewed risk
Strategy A 5 quarters of $100 million profit 5 quarters of $10 million loss 10-quarter net for shareholders:
profit of $449.5 million 10-quarter result for executive:
total bonuses of $500,000
Strategy B 9 quarters of $200 million profit 1 quarter of $2,000 million loss 10-quarter net for shareholders:
loss of $201.8 million 10-quarter result for executive:
total bonuses of $1.8 million
Negatively skewed strategy B has higher payoff for the executive but lower payoff for shareholders
Assume a bonus plan that pays 0.1% of net profit each quarter
Post P100606 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
Post P100606 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
Not Just Top Executives
Top executives are not the only ones who may have incentives to gamble with other peoples’ money
Mid-level managers, traders, analysts, even engineers and production workers may earn bonuses or promotions if their work results in short-run profits for the company
If they take hidden risks that later result in huge losses, often the worst that can happen is that they are fired. Source: pdclipart.com
Post P100606 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
Negatively Skewed Risks and the Financial Crisis
Before the financial crisis, Wall-Street was full of opportunities to gamble with other peoples’ money
Selling credit default swaps on complex securities backed by subprime loans
Risky trading strategies “Gaming” federal regulations in order to
increase leverage of banks and other financial institutions
Manipulating ratings to put “AAA” seal of safety on risky securities
Source: pdclipart.com
Post P100606 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
Negatively Skewed Risks and the Gulf Oil Spill
Investigators are trying to find out if BP
or its contractors made decisions
in the interest of profit or cost-cutting
but with small risks of large losses What kind of technical decisions were
made in the last days and hours before the blowout?
Blowout preventers usually work, but are fail-safe systems needed in the rare occasions when they don’t?
Should BP have spent more to plan for a worst-case spill even though the probability of such a spill was small?
Source: www.whitehouse.gov
Post P100606 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/
What can be done?
What, if anything, can be done to protect against
the temptation to gamble with other peoples’ money at the risk of disaster? Stricter regulations—but who will regulate the regulators? Who will
prevent “capture” of regulators by special interests? Improve executive compensation—fewer short-term bonuses, more long-
term stock ownership, more “clawback” mechanisms. But if shareholders don’t insist on these things—and often they do not—can government regulations really be effective?
Strict legal liability for losses—but the law is slow and costly, and the individuals who made the bad decisions may not be the ones who pay even when their corporations are found liable
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