Quantitative Risk Management: A Practical Guide to Financial Risk, + Website

3.1 Manage People

Managing people means thinking carefully about incentives and compensation. Although I do not pretend to have the answers for personnel or incentive structures, I do want to emphasize the importance of compensation and incentive schemes for managing risk and building a robust organization that can withstand the inevitable buffeting by the winds of fortune. Managing risk is always difficult for financial products and financial firms, but the principal-agent issues introduced by the separation of ownership and management substantially complicate the problems for most organizations.

As discussed in Chapter 2, risk involves both the uncertainty of outcomes and the utility of outcomes. The distribution of outcomes is objective in the sense that it can, conceptually at least, be observed and agreed upon by everyone. The utility of outcomes, in contrast, depends on individual preferences and is in essence subjective. The preferences that matter are the preferences of the ultimate owner or beneficiary. Consider an individual investor making his own risk decisions. The problem, although difficult, is conceptually straightforward because the individual is making his own decisions about his own preferences. Although preferences might be difficult to uncover, in this case at least it is only the preferences of the owner (who is also the manager of the risk) that matter.

Now consider instead a publicly traded firm—say, a bank or investment firm. The ultimate beneficiaries ...