Moral Hazard is Corporate Kryptonite

In *Thinking Fast and Slow*, Kahneman relates a story told to him by Richard Thaler. It goes like this:

Once there was a gathering of executives from a large company. Each were asked about taking risky projects with a positive risk-adjusted expected value. The middle managers, who would be taking those risks, took a pass: put my job on the line? No thanks.

The CEO, on the other hand, wanted them to go for it. Kahneman’s explanation, which I like, is that the CEO benefits from diversification while the middle managers do not. A losing bet could cost them their job, but if they all make the bet, the CEO will take credit for the (very likely) subsequent growth.

There are some assumptions built into this assessment, though. Here is another story, from Arnold Kling:

Although I took no formal survey, I got the impression that most of them [middle managers] would agree with the following statements:

• Corporations should give middle managers more freedom to take risk.
• Corporations should be more willing to make mistakes and accept failure.
• Corporations should offer more rewards and incentives for innovation.

…Suppose we re-phrase [these points] in terms of economic risk and reward. We might express them as:

• Corporations should enable middle managers to make larger bets with corporate resources than is the case currently.
• The downside risk of these bets should be borne more by the corporation and less by the middle manager than is the case currently.
• More of the upside of these bets should accrue to middle managers than is the case currently.

…Middle managers understandably do not want the same degree of personal downside risk as entrepreneurs. However, in the absence of personal downside risk, the middle manager’s incentives would be skewed toward taking unjustifiable risks. Bureaucratic controls and limits on upside incentives may be an appropriate adaptation for correcting this potential bias.

As happens all the time when evaluating risks, we think statistical when we should be thinking behavioral. The risk changes depending on who is facing it and with what incentives (ie how hard they will work).

The point, I suppose, is that risk, which is rather an abstract sort of thing, in most businesses it is really a measure of the degree to which someone will be up to the task and can be controlled by highly skilled and motivated players. Real motivation, though, only comes when your ass is on the line. This is unacceptable for most people. Excellence, this line of thought goes, is driven by incentives (risk), and so is rare.

Bureaucracy is the blunt instrument that protects an organization from its most potent threat: risk without accountability. Moral hazard.

The result, as Arnold says here, is mediocrity. The base case for all organizations.