Citigroup and Prince: Too-Risky Business

On the other hand, when things start to go bad, the tendency on Wall Street is to discount it as a random event rather than the beginning of a self-reinforcing pattern in which everyone winds up selling or refusing to extend credit all at the same time.

In the case of Chuck Prince, it is probably unrealistic to think he would be the best judge of all the risks associated with exotic new financial instruments. But it is fair to expect a chief executive to notice when his trading desks or investment banks are earning ridiculous amounts of money for adding little value and taking what are advertised as low risks -- and to understand that those kinds of windfalls can't last.

What is also clear is that, for all his reforms, Prince never bothered to change the incentive structures that have always encouraged excessive risk-taking on Wall Street, whether financial or ethical.

Another young Darden professor, Jared Harris, has recently studied all the accounting restatements made by major corporations from 1997 to 2002 that were found to be the result of intentional misrepresentation. And what he found was that the propensity to cheat was highly correlated with executive compensation packages heavily weighted (75 percent or more) toward performance pay.

In a sense, that is the idea behind performance pay -- to give executives the incentive to take the risks that offer the big payoffs for investors, and then manage those risks. But what Harris found is that at a particular point, when performance pay tops 90 percent, the incentive becomes so strong that it encourages bad risks as well. And that would apply equally, he reasons, to financial risks as it does to the ethical ones he studied.

There is, of course, nowhere on earth where pay packages are larger or more tilted toward performance pay than on Wall Street, where it is not uncommon for top traders and unit managers to earn bonuses of $10 million or $20 million in a good year. The problem is that when those "good" bets suddenly turn "bad," there's no requirement for those outsized bonuses to be returned. And it is that heads-I-win, tails-you-lose structure that goes a long way in explaining why Citigroup, Merrill Lynch and UBS got in the trouble they are now in.

Steven Pearlstein can be reached atpearlsteins@washpost.com.