We need to improve our ability to distinguish between skill and luck. Simultaneously we need to draw the adequate conclusions from the difficulties that will always exist in signal extraction on this issue. Excessive risk-taking: lack of knowledge... Let me now turn to the question of financial risk-taking. Overall, there is no (expected) return and no growth without risk so we have to be careful to foster a sufficiently pro-risk society. But risk calculus – weighing the marginal advantages and disadvantages of taking more risk – is a difficult exercise. It is difficult because it entails probabilities, that are hard to assess, over future scenarios which are themselves often hard to describe fully and accurately. And the difficulty increases by an additional step if there is an externality, that is, if the private and social cost and benefit of additional risk-taking differ. One can plausibly  2  2  Wilmott, P. (2009) “Financial Modelers’ Manifesto”, available at www.willmott.com, January 2009. BIS central bankers’ speeches  argue that the recent financial crisis was, to some extent, the result of excessive risk-taking. For the proponents of this hypothesis, the ultimate cause is in question. One possibility is that this excessive risk-taking was the result of wrong incentives, with decision-makers wilfully taking more risk for themselves or their institutions than would have been privately or socially desirable. The alternative would be that a misperception of the probabilities and possible consequences of the decisions was the prime cause: a lack of knowledge or competence.
Since I will essentially concentrate on the first possibility, i.e. incentives, let me recall, by a way of contrast, a recent study by Fahlenbrach and Stulz (2011). These authors show that the losses of the banks whose managers’ incentives were most closely aligned with the long-term interests of the firm they managed were at least as large, in the last crisis, as those at the financial institutions where governance was more obviously lacking. This suggests that wrong incentives were not the only factor in the behaviour and decisions that led to the crisis. Knowledge and competence were also at play. ... or a misalignment of incentives? Incentives are an important component in risk and risk-taking. If there is an important lesson in economics and finance that has not been invalidated by the financial crisis, it is that incentives really do matter. The excessive risk-taking that was observed prior to the financial crisis is likely to have been – among other things – the result of the fact that key decisionmakers were not provided with the right incentives to carefully analyse and balance the possible consequences of the risks they agreed to take. Let us take a bank as an example. The main relevant stakeholders are the depositors, the shareholders, the managers and the bondholders.