Aligning compensation systems with risk management objectives

Corporations, economics and business lines are effectively systems of people and other inputs. As such, they are subject to breakage if their construct is brittle or subject to 'breaking badly'. A culture of risk awareness helps to create ductile systems that, on the other hand, break well. Such systems lead to more effective deployment of capital and generate substantial value. Of particular interest is the impact of incentives on the brittleness of a system. Darley's Law is a good warning to organizations that employ overly objective incentive systems and likewise to those who pursue risk management as primarily a control tool or quantitative science. Humans are quite adept at manipulating rules to personal benefit. Success in recognizing this and in aligning compensation, particularly incentives, with behavioral objectives, means that incentives must be carefully crafted so that the mix of measurable and qualitative inputs to the award match the behavior desired from the individual being incented. We must, as a first root, understand how humans respond to incentives and controls before we are able to build structures to match desired behaviors with compensation. Second, we must recognize that there is an ultimate reliance on high morals from risk managers in a structure where incentives are reviewed for consistency with the risk appetite of an organization