Skip to content

FRM Part I · FRM Exam Part I · The Governance of Risk Management

Before the crisis, several firms paid traders annual bonuses based on year-end profits from positions that could lose money in later years. Which compensation reform best addresses the resulting governance problem?

Deferring a meaningful share of bonuses and making it adjustable or recoverable based on later outcomes and risk-adjusted performance best fixes the problem. It aligns the horizon of pay with the horizon of risk, reducing incentives to take hidden tail risks for short-term profit.

  1. AIncrease the cash share of bonuses so traders are paid sooner
  2. BDefer a significant part of bonuses and make it subject to clawback or adjustment based on later risk outcomes and risk-adjusted performanceCorrect
  3. CBase bonuses solely on trading revenue to simplify measurement
  4. DPay all bonuses in the form of fixed salary regardless of performance

Explanation

The problem is a mismatch between short-term rewards and long-term risk. Deferral, clawback and risk-adjusted measures align pay with the time horizon of risk. Paying more cash up front or using revenue alone worsens the incentive to take hidden tail risk.

Did you get it right without looking?

One question tells you little. A timed set on The Governance of Risk Management shows your real accuracy, how long you take and where you lose marks.

Practise The Governance of Risk ManagementFree diagnostic mock

More The Governance of Risk Management questions