Perverse incentives in the banking and finance sector
29 June 2012
I guess that few people will be all that surprised by the latest tales of ‘dodgy’ practices in the banking and finance sector. The coverage of this scandal is re-visiting an assortment of related recent stories ranging from the adequacy of self-regulation, to banking and citizenship, to the moral equivalence between alleged fraud in the City and being jailed for stealing a bottle of water in the 2011 riots. For The Work Foundation there are also strong echoes of last month’s Annual Debate on whether the UK needs a new kind of business, as well as last year’s Good Work Commission, which discovered that only 4 in 10 of British workers felt that their senior leaders acted with integrity.
Earlier this month, in my column for HR Magazine, I focused on whether those in HR roles should bear some of the responsibility for errant behaviour at the top of modern businesses. Whether, indeed, HR could be more of a ‘moral compass’ for business. If it’s not too narcissistic to quote myself, I said that:
‘I get very anxious about whether the deliberations of some remuneration committees are informed in any substantive way by the advice of HR specialists. The risks of bonuses or share options containing 'perverse' incentives or focusing on short-term gain or ignoring the wider principles of distributive justice within an organisation are well documented. HR faces a big challenge if it is to re-establish a credible and moderating influence here.’
This latest example from banking raises the perverse incentives issue yet again. In the Reward Strategy textbooks it says that a business should determine its business strategy informed by a clear vision of where it has competitive advantage, and then devise pay systems which incentivise or reward (an important distinction, by the way) behaviour and performance that help deliver this strategy. The Credit Crunch of 2008, and this week’s news about alleged interest rate manipulation, have turned this orthodoxy on its head. We now have several examples of businesses whose strategies look like they are focused on developing complex financial products aimed mainly at maximising the earnings of those who create and apply them.
We have to ask tougher questions about the way these reward packages are put together and whether they pass muster ethically. Perhaps it’s been too easy to bamboozle well-meaning HR folk with the detail of these bonus schemes, especially if they can be presented as delivering greater profits. After all, HR loves to demonstrate that it is supporting the business to deliver financial ‘success’. Amazingly, this is not an area where we are especially over-endowed with proper research. However, one study has caught my eye.
Looking at the impact of incentive pay among bank staff in Chicago whose job it was to make loans to small businesses, Sumit Agarwal and Faye Wang found that the bank lost money by switching to incentive pay because, while it led to a 47 % increase in the loan approval rate, it also led to a 24 %increase in the default rate. Essentially, these loan officers were approving more risky loans because of the incentive pay scheme. If we scale this up to so-called ‘casino banking’, I think we can begin to understand the potential damage that a carelessly calibrated incentive arrangement can do. Except that in the case of the Libor rate manipulation which has been exposed this week, it seems that the calibration was anything but careless.