Are Clawbacks An Admission of Poor Risk Management?

A number of firms are beginning to become more active in using clawback provisions (see WSJ article). The clawback rules are being put in place to allow firms to take back money paid to traders and others whose trading positions blow-up at a later time. Such provisions are believe to help keep employees from entering into positions or strategies that may be too risky, but which may provide a large initial return and subsequent nice bonus. The worry of course is that such rules may cause some traders to become too careful, essentially shying away from necessary and manageable risk. There is also a worry that good traders may move on to other firms with less restrictive provisions.

What is probably most unnerving about such provisions is that it implies that the companies utilizing such a provision really have no idea what their risk levels are, or how to go about managing such risk. With risk management policies in place, especially those that elevate risk management functions within a firm and properly reward both traders and risk managers that at least attempt to manage and price such risk, a company should be able to better understand the risk they are taking and prevent traders from entering positions with excessive risk. If a properly analyzed trade later blows-up because of unforeseen events, then it could be argued that it is just the cost of doing business. Sure, if traders circumvent risk management procedures put in place at the firms, or are negligent in obtaining the necessary data or developing the best possible model, then by all means penalize them, regardless of whether the trade worked out or not. But as long as the traders and risk analysts accessed the risk based on the available data and models, and have their work approved by the risk managers, then it seems counterproductive to penalize traders for events outside their control. Sure, you will recover some bonuses, but you will lose much more in terms of talent, reputation, and lost capital. Recovering a rogue traders bonus may be too little too late and of little value, other than helping to pay the bankruptcy lawyers.