Incentives, risk and accountability in organizations

Abstract

T his chapter discusses incentives and risk management in organizations and how economists have thought about these issues. Risk is not merely the possibility of ‘bad things happening’, such as damage, loss and accidents. Any deviation from expected outcomes constitutes risk, whether it is positive or negative. Clearly no organization can hope to achieve its objectives without putting its resources at risk to some degree. An excessive focus on risk minimization leads to forgone opportunities. The issue is striking the right balance between the risk that an organization is exposed to and achieving its objectives (e.g. shareholder value if it is a for-profit firm). A direct implication of this is that risk management and fulfilling the objectives of the firm are interrelated and cannot be studied in isolation from one another (see, for example, Poynter 2004). An organization can mitigate risk by buying insurance, diversifying its portfolio and maintaining sufficient solvency. However, it is impossible to eliminate all risk. If this was possible so that the earnings of the organization were invariant irrespective of its performance, this would also eliminate the drive to perform well. Therefore inevitably the problem of risk comes back to understanding how actors in an organization make key decisions that affect risk exposure. Variability of returns needs to be interpreted by managers and investors to determine whether their strategies are working.

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