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How Can We Incentivize Prudence?

Question: How can firms incentivize prudent financial transactions?

 

Richard Thaler: One simple step firms can take is make sure that people that are getting paid a lot of money, say more than a million or two, that a big chunk of that money is deferred. That’s going to change the whole ballgame. The money has to be deferred with what they call “clawback,” which means they can get it back if I lose it all. So that guy making ten million a year selling credit default swaps, if we’re going to keep five million of it in escrow for ten years, and with the right to go back and get it, if he starts losing money, then we’re going to give people the right incentives not too take so much risk.

The same with the mortgage brokers that were selling people mortgages they couldn’t afford. We shouldn’t pay them on each mortgage they write. They should have what they call “skin in the game,” where they’ve got to reimburse us if the guy who sold the mortgage defaults.

I think that there are lessons that the financial services industry can learn and, as I said, they should either aggressively take these steps on their own or expect Congress to act.

 

Recorded on: June 19, 2009.

Richard Thaler wants more "skin in the game" to encourage money managers to avoid risks.

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