Incentive pay as a factor in the financial crisis from behavioral and neuroscientific perspectives

Mojdana Drasic & Lilia Velinova

Student thesis: Master thesis


The purpose of the current study is to explore the role of managerial behavior in the recent sub-prime mortgage crisis by looking at the link between incentive pay at American financial institutions and risk-taking. In the few years prior to the crisis, executive compensation in the US financial industry was at one of its highest levels in the past two decades, with nondepository lender institutions, among which sub-prime mortgage originators, and broker and dealer institutions, among which investment banks, paying their executives the most. Stock options and bonuses, both of which encourage maximizing short-term profitability at the expense of long-term stability, represented the bigger part of the compensation packages. We explore the link between incentive pay and increased risk-taking by looking at the amount and structure of incentive pay, as well as at the short-term evaluation horizon on which it is based. We approach the problem using two paradigms – first a behavioral economics one, and then a neuroeconomics one. Since the sub-prime mortgage crisis is in fact an example of the fallibility of human behavior, behavioral economics is an especially advantageous framework to use, as it is concerned with analyzing phenomena that disprove the rationality assumption behind neo-classical economics. While behavioral economics takes a descriptive approach, neuroeconomics adds value by uncovering the neural mechanisms that directed risk-taking behavior in response to incentive pay. From a behavioral perspective, the peer comparison evaluation inherent in incentive pay encourages herding behavior in the direction of risk-taking. The convex-shaped performancebased evaluation structure further contributes to risk-taking by making investment an asymmetric bet. From a neuroscientific perspective, the amount of incentive pay matters, as high rewards induce excessive activation in the reward-approach structure of the brain, which may lead to a risk-taking error. Monetary rewards, both anticipated and experienced, lead to an increase of the levels of dopamine, a hormone associated with happiness, and activate the same regions of the brain as primary reinforcers, such as food. The short-term evaluation horizon is also related to increased risk-taking. On a neurological level, annual bonuses are time-discounted via a different mechanism than compensation with delay of more than a year.

EducationsMSc in Applied Economics and Finance, (Graduate Programme) Final Thesis
Publication date2011
Number of pages120