The Twelve Principles of Incentive Pay

Abstract

The incentive mechanisms used in the financial services industry in particular, but also in many other contexts, reward income generated almost regardless of risk, with negligent and faulty risk measurement and unjustified risk taking as predictable results. A number of economists warned financial, industrial and service corporations against these practices, reminding them that, in designing incentive mechanisms, it is necessary to take account of the risks taken or incurred to avoid what economists and insurers call “moral hazard.” I review incentive pay based on first principles of the economics of organization. Clearly, in many cases, those principles were not followed, which led to a governance crisis, a financial crisis and an economic crisis.

Keywords: Incentive mechanisms, risk, incentive pay