More Skin in the Game in 2013

NEW YORK – Those who have the upside are not necessarily those who incur the downside. For example, bankers and corporate managers get bonuses for “performance,” but not reverse bonuses for negative performance, and they have an incentive to bury risks in the tails of the distribution – in other words, to delay blowups.

The ancients were fully aware of this incentive to hide risks, and implemented very simple but potent heuristics. About 3,800 years ago, the Code of Hammurabi specified that if a house collapses and causes the death of its owner, the house’s builder shall be put to death.

This simple tenet is at the origin of “an eye for an eye” and the Golden Rule in ethics (“Do unto others as you would have them do unto you”). But, beyond ethics, this was simply the best risk-management rule ever.

The ancients understood that the builder always knows more about the risks than the client, and can hide sources of fragility and improve his profitability by cutting corners. The foundation is the best place to hide risk. The builder can also fool the inspector; the person hiding risk has a large informational advantage over the one who has to find it.