Friday, August 28, 2009

Can Guaranteed Bonuses Induce Excessive Risk Taking?

Yes, according to Lucian Bebchuck, a law professor from Harvard Law School. A guaranteed bonus may, to certain extent, create distortion in determining the business risk of a company. By having the benefit to receive a guaranteed bonus no matter what the performance of the company, there would be a considerable pressure for the management to meet the company's business target or even exceed such target. As a result of this, the management may take unnecessary risks in doing the business just for the sake of getting better performance. We need to understand that in some cases, riskier business decisions may provide higher results, but they may also cause greater losses. When the results are losses, who would be the largest victim? The Company and also the shareholders.

Further, Prof. Bebchuk theorizes that if the bonuses of the management were distributed based on the overall performance of the company, say after reaching a minimum amount of annual profit, the management will have better consideration in doing the business, i.e. they would only take the risks if the odd of getting the intended performance are higher than the odd of getting a lower results. Why? Since the management bonuses are now tied to the performance of the company, it would be dangerous for them to take too much risks because if the results are bad, they will also lose their bonuses. As a result, they would play safer.

Again, this shows how incentives work in our life. I would love to see how this will be implemented in Indonesian regulations. While I absolutely don't agree if the regulator is trying to limit the amount of benefits that can be obtained by the management, a policy on how to structure the best benefit package should be okay, provided that companies can freely choose to adopt such policy or not (as will be determined by the shareholders and, if possible, an independent remuneration committee).

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