The Skin in the Game Heuristic for Protection against Tail Events (Digest Summary)

The authors offer the concept of “skin in the game” (i.e., the exposure to some damage as a result of individual action) as a heuristic for a safe and just society. The heuristic is particularly relevant in opaque environments characterized by unpredictability, in which certain economic agents face incentives and opportunities to hide risk. Those agents can benefit from the upside when things go well without having to pay for the downside when unfavorable events unfold. Opaqueness is increased by the presence of information asymmetries and the existence of probability distributions characterized by fat tails and skewness. There can be little doubt that these elements are present in financial markets.

The authors discuss a number of situations in which the skin in the game heuristic can help in the avoidance of costly crises. First, they argue against big government by pointing out that decentralized and smaller units of government are typically characterized by a clear assignment of responsibility. In contrast, possible sources of error in large and centralized political systems are not easily identified because it becomes possible to hide behind bureaucratic anonymity.

Second, they point out that the option-like form of management remuneration needs to be changed in a way that forces managers to give back previous bonus payments or even to incur negative ones. Third, they call attention to the fact that applied and theoretical economists, quantitative modelers, and policy advisers do not have to worry about any kind of penalty for faulty models that cause risks and harm others. Because no mechanism for the enforcement of skin in the game exists, the authors suggest that these groups should be barred from teaching practitioners.

Fourth, prediction in the socioeconomic domain cannot be expected to work, but the predictors are rarely harmed by their errors. At the same time, the availability of a numerical prediction increases risk taking by individuals beyond reasonable levels and thus is harmful. The authors suggest that the only information that should be taken into account by investors is the action actually taken by the forecaster.

The opposite of skin in the game is the unethical practice of taking all the praise and benefits of good fortune but disassociating from the results of bad luck or error.

The starting point for the authors is the realization that opaque systems that are full of uncertainty and thus lack trustworthy tools for analysis and prediction are prone to manipulation: Economic agents have numerous opportunities to benefit from the upside, without taking responsibility for the downside. Enforcing a skin in the game approach is an effective counter-measure that was already well understood by ancient moral philosophers. The authors provide several applications for the heuristic. Next, they develop a mathematical model to analyze the probabilistic mismatch of tail risks and returns in the presence of a principal–agent problem. An agent who has the upside of the payoff with no downside has an incentive to hide risks in the left tail by using an asymmetrical distribution for the performance.

In the final sections, the authors link the rule to a range of philosophical approaches. They provide several examples to show that the objection to negative asymmetry constitutes the core of some of the oldest moral and social contract theories. They link altruism and egoism to the skin in the game heuristic. Although no skin in the game is linked to negative asymmetry, skin in someone else’s game, which is associated with altruism, leads to positive asymmetry.

As the authors point out, the idea of skin in the game has a long tradition in moral philosophy. As its relevance increases with increasing uncertainty, it is highly applicable to financial markets in particular. If practiced consistently, it is likely to contribute to increased market stability.