Behavioral finance FAQ / Glossary (Perverse)

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Dates of related message(s) in the
Behavioral-Finance group 

Year/month, d: developed / discussed,
i: incidental

Perverse effect, incentive



04/6i,7i + see incentive, unintended
consequence, moral hazard,
public
choice, agent-principal, self defeating
prophecies

Self-defeating good intentions,
or botched implementation?

Definition:

A perverse effect of a decision or action, is

An unintended consequence (see that phrase) that

differs from, or is even the opposite of
   what was expected

in a counterproductive or even
   disastrous
way.

Here are main economic examples:

Some taxes, subsidies or regulations can be self-defeating,


Some management objectives or benchmarks (and related 

bonuses offered to reach them), can neglect other goals.

For example, it can lead:

In corporate management, to ignore long term aims if those
    incentives favor short term results that are easier to measure
   ...or manipulate 

In investing, to be happy to beat a stock market benchmark 

by losing less than the index (relative instead of absolute
performance).


Some economic investment or project are counterproductive

(is it really smart to use badly needed cereals to make car fuel ?).

Some specific cases are also related to perverse incentives and moral
hazards
(see the "incentive" and "moral hazard" glossary articles).

Are bank traders' bonuses
    perverse incentives?

Should they play with my money and get the reward...

...while leaving me the risk?


There is a current issue about how justified are salary bonuses as performance
rewards given to bank staff active in short term trading for the bank's own
account ("proprietary trading") that involves high leverage operations and a
massive use of derivative financial instruments.

Pros and cons

The rationale is that trading gains are sizeable factor in banking
    profits, thus they boost the bank means to make their traditional
    profession

The pitfall is that this speculative activity (see speculation) is much
    riskier than traditional banking, as events have shown, notably the
    subprime crisis bubble and crash).

Large bonuses for trading gains encourages the related staff to take
high risks.

Whatever precautions are taken, it might endanger the bank and
therefore its customers' deposits
.

Your money is on the roulette table, the gains are theirs, the
losses are yours!

How to limit that risk?


Two constraints could be considered:

The banks that are active in proprietary trading need
    higher equity requirements.

A part of their gains (for example equivalent to the bonuses given to
    traders) should feed a reserve account as a guarantee for deposits.

Or better, that portion should be credited to a global bank deposit
    guarantee
fund, linked for example to the International Monetary
    Fund).

(*) To find those messages: reach that BF group and, once there,
      1) click "messages", 2) enter your query in "search archives".

Members of the BF Group, please
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This page last update: 25/08/15  

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