How to make liars and cheaters work hard on your behalf

Human beings are not as nice as some people would like to assume. A new academic paper points out that people are mostly out to maximize their own gains, and that this causes serious problems for employers who are trying to get all the liars and cheaters to work for them instead.

Ivar Ekland, a mathematician at Dauphine University in Paris, engages in some horribly complex calculations to work out what employers can do about this. In a world afflicted by moral hazard (defined as asymmetric information and absolution from bearing the costs of risky behaviours) and limited liability (employees don't share in the responsibility for a business's debt), Ekland arrives at a horribly simple conclusion: As an employer you must pay perfidious employees a huge amount of money to buy their scrupulousness. Worse: you must pay them more and more with each passing year. In his analysis, the employee, or agent, is always trying to take advantage of the employer, or principal.

"If you cannot punish the agent (limited liability), and cannot monitor what she is doing (moral hazard), all you can do is pay her so much that she will feel she owns the project," writes Ekland. "- The principal has to pay the agent more and more to do less and less, and when he can no longer afford her (diminishing) services, he has to pension her off comfortably."

The parallels with banking have not escaped Ekland. "People will renege on promises, or simply cheat, if they can get away with it....Moral hazard and limited liability are the core of the finance industry," he writes.

In an interview, Ekland said that the essence of the problem in banking is how banks pay their most successful (untrustworthy) staff. "If you have a banking guy who is very successful and making you a lot of money, you will want him to make you even more in future. If you can't monitor him properly, you will want to incentivize him to act in your best interests. You will give him a share of the money he makes, and the more successful he is, the larger the share you will give him."

Ultimately, predicts Ekland, it will all come to an unfortunate end. "The guy is so successful and you're paying him so much that at some point he just ends up being too costly," he said. At this point, Ekland suggested the cheat in question will be let go - or compelled to retire.

Barclays seems to fit the Ekland template. As we noted yesterday, its investment bankers made more and more money for the bank and Barclays paid them more and more to perpetuate this. If Ekland is right, all that remains is for Barclays investment bankers to be put into retirement.

Introducing moral hazard and unlimited liability

Alternatively, Ekland said untrustworthy bankers need exposure to the full forces of moral hazard and unlimited liability.

"Adam Smith identified limited liability as a risk in the Wealth of Nations," said Ekland. "He correctly identified that where limited liability exists for employees, managers will try to enrich themselves at the cost of the stockholders."

Ekland said regulation must be ramped up too. Banks need more careful monitoring than before. "This would require society to invest much more in monitoring and regulation agencies than it does at present," he writes.

Sony Kapoor, managing director of the think-tank Re-Define, said Ekland's theory makes intuitive sense but that it's grossly over-simplistic- banks and shareholders have effectively colluded to take money from taxpayers. Kapoor said it would be impossible to introduce unlimited liability in a modern, complex, financial system, but that things are moving slowly in the right direction. "We now have bail-ins [whereby bondholders lose money if a bank nears bankruptcy], bonus clawbacks, and depositors being burnt in Cyprus," he told us. "All of this will make bank funding more expensive in future and will dissuade banks from funding risky activities and from paying excessive amounts to staff."