Going the Distance: Kenyan runners chase success. Photo by Jos van Zetten via Flickr

Before Linet Masai delivered to Kenya a gold medal in the 10,000m at the 2009 World Athletics Championships, her father made an investment decision: he sold enough cows to finance the costs of her full-time training regime.

Like Linet, most aspiring Kenyan runners are young and penniless, so the money required to support this career first comes from family, friends and other social institutions. Sponsors assist prospective runners because they believe that after a few years, the runner will earn substantial prize money, some of which will return to the original investor.

Missing Moral Hazard

Yet investing precious savings in a would-be professional runner exposes the sponsor to various sources of risk. Not only might the runner fail on account of accident or injury but she also must move away from her family to the highlands, which offers the most conducive environment for training.

When a runner is living apart from family and friends, these sponsors cannot monitor the consistency of that runner’s commitment to the training required to realising wealth through racing abroad. This presents the possibility of moral hazard, which happens when someone is responsible for the interests of another but has an opportunity to put her self-interest first.

Moral hazard could occur amongst Kenyan runners if rather than training intensively for greater future payoffs, they chose simply to enjoy living for the moment on sponsorship money. In reality, truancy and negligence are rare. Once given financial backing, it is highly unusual for a Kenyan athlete to act dishonourably or to endanger the investment that has been made in her talent. Why is this, and what does this mean for our understanding of healthy risk-taking in wealthy societies?

The risk model surrounding Kenyan runners provides creative lessons for countries looking to crack down on reckless risk-taking in their own societies. Healthy risk-taking can be nurtured when we reconfigure our apparatus of incentives to include strong, credible and personal punishments; international finance is likely to stabilise when risk-takers are systematically forced to assume the consequences of their own decisions.

Stripping The Knight

If a runner performs poorly, she does not earn prize money. If she does not earn, her backers lose vital resources and she too suffers because her opportunity to completely transform her standard of living, and that of her family, comes and goes for good.  Her options are few; the next-best choice is farming, a disappointing alternative to the glamour of international athletics. In short, the consequences for failure are personal, known in advance and deliver a penalty roughly proportionate to the large prospective rewards.

Not unlike the runner’s family, who are unable to monitor the intensity of her training effort, investors who entrust private wealth and borrowed capital to wealth managers do so without a way to monitor fully whether those bankers’ decisions are reckless or prudent.

Yet remuneration in the financial sector follows a completely different structure of risks and rewards. Negligence from a Kenyan runner carries severe penalties, whereas bankers, as columnist Will Hutton wryly points out, “always get more bucks or mega-bucks – never fewer bucks”.

Financiers often receive bonuses for short-term performance and no matter what the outcome, they are able to reap significant personal gain.  Little wonder they succumb to temptation and take undue short-term risks. The solution is clear: no one should receive such exceptional rewards without any threat of loss.

For instance, the judgement to strip the knighthood from Fred Goodwin, former chief executive of the Royal Bank of Scotland, represents precisely the kind of personal deterrent that would foster a healthy level of fear among financiers, yet to date this action has been isolated and ad hoc. We must set rigorous and creative terms for penalties that would be known to all beforehand and then stand by the result.

Insurer of Last Resort

The model of Kenyan runners offers a second lesson. While runners enjoy the carrot if they succeed and suffer the stick if they fail, the local community also shares some of the loss so as to protect athletes from the most volatile effects of their decisions.

If she fails, a runner is not then forced to repay every Kenyan shilling of the money invested in her: the sponsor bears most of this burden. If the runner were to repay this debt in full, she would end up unable to afford food or shelter. Death as a consequence of failure is unacceptable.

It is paramount that individual financiers have some personal stake at risk, whether it be salary, bonuses, knighthood, even the very jobs that they hold.  Yet other consequences of risk-taking activities should be spread across banks, private investors and the state in order to protect and sustain our global economic system.

Economist Ricardo Cabellero has proposed a concrete solution. Rather than being solely lenders of last resort, governments should pre-emptively set up insurance mechanisms. The firms most in need would be able to acquire the necessary insurance in a flexible market of tradable insurance credits. In this way, the appetite for risk would be sustained at a fraction of the cost of pure capital injections, as happened when theUS government infused its banks with billions of bailout dollars.

Lessons from Kenya

Non-Western countries offer lessons that can help us to understand that healthy risk taking in wealthy societies must occur in a context of incentives and threats permeating the entire economy.  International bankers and Kenyan runners are each in pursuit of financial gain but only the runner is a true stakeholder; she pays dearly for lack of performance whereas the banker enjoys great reward for both good or bad performance.  In short, taking risks in the face of real consequences for failure is not easy but it is untenable that we should to continue to reward negligence.