“Compensation was flawed top to bottom,” said Lucian A. Bebchuk, a professor at Harvard Law School and an expert on compensation. “The whole organization was responding to distorted incentives.” Even Wall Streeters concede they were dazzled by the money. To earn bigger bonuses, many traders ignored or played down the risks they took until their bonuses were paid. Their bosses often turned a blind eye because it was in their interest as well. “That’s a call that senior management or risk management should question, but of course their pay was tied to it too,” said Brian Lin, a former mortgage trader at Merrill Lynch.
To be effective, risk management must have the authority and the independence to adjust incentive programs based on the risk appetite of the organization. If risk managers are participating in the very incentive programs that they are charged with overseeing, then a blind-eye will always be turned toward excessive risk-taking.
[...] The response from AIG shows a fatal flaw in their ERM program. The risk managers in the Financial Products unit had no formal ties to the ERM organization or the Chief Risk Officer. As a result, their compensation was directly linked to the performance of the unit. This provided no incentive for them to raise red flags that may negatively impact their pay and ultimately cost them their jobs. When the valuation of the credit default swaps were unreasonably high, the risk managers simply turned a blind eye. This is precisely the situation that was described in the ERM Current™ blog post on December 19, 2008 entitled “Turning a Blind-eye Toward Risks.” [...]
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