Failure is not an option: perverse incentives

Citation

Mainelli, M. (2009), "Failure is not an option: perverse incentives", Journal of Risk Finance, Vol. 10 No. 1. https://doi.org/10.1108/jrf.2009.29410aaa.001

Failure is not an option: perverse incentives

Article Type: Commentary From: The Journal of Risk Finance, Volume 10, Issue 1

The person or the performance?

Some years ago, I had the interesting experience of watching an Italian company evaluating two finance directors, one running the UK and the other running part of the Italian business. Let us call them George and Fabio. The evaluation consisted of reviewing performance, then assessing personal strengths and weaknesses, finally concluding with a pay decision. George was a heavy drinker, married yet a womanizer, with a penchant for rude stories and gambling. Fabio was a dapper, almost delicate, man with a lovely family and a deep, religious concern for his community. George was a hard-hitting accountant with a nose for numbers and an aptitude for tough tax negotiations, possibly the best tax person I have known. Fabio was, to put it mildly, a bit disorganized and his staff were constantly picking up the pieces and, sometimes, even covering for him.

They both received about the same message from their pay packet, good performance. In George’s case, the firm evaluated his performance in the role. The firm ignored his errant personal life and focused on his service to the firm. In Fabio’s case, the firm looked at his virtues as a person, “he’s a good man, with a lovely wife and children whom he dotes upon.” In the UK, the reaction to Fabio’s pay rise was incredulity. “How could they? Fabio’s useless without his team.” In Italy, the reaction to George’s pay rise was incredulity. “How could they? How do they even trust George with the firm’s money?” There are clearly some cultural nuggets to be mined, but the basic point here is that firms conflate performance and the person. But, is there an objective viewpoint?

There are several threads to the credit crunch. I tend to focus on four themes – liquidity inflation, deluded demutualization, regulatory dissonance, and perverse incentives. This paper explores those perverse incentives. The more we focus on linking performance to pay, the more we move away from Fabio and towards George. To paraphrase Gandhi, “there are people in the world so greedy that God cannot appear to them except in the form of money.” It is worth re-reading the former Chairman of the US Federal Reserve Board, Alan Greenspan, in testimony to the US Congress in 2002:

An infectious greed seemed to grip much of our business community. Our historical guardians of financial information were overwhelmed. Too many corporate executives sought ways to “harvest” some of those stock market gains. As a result, the highly desirable spread of shareholding and options among business managers perversely created incentives to artificially inflate reported earnings in order to keep stock prices high and rising. This outcome suggests that the options were poorly structured, and, consequently, they failed to properly align the long-term interests of shareholders and managers, the paradigm so essential for effective corporate governance. The incentives they created overcame the good judgment of too many corporate managers. It is not that humans have become any more greedy than in generations past. It is that the avenues to express greed had grown so enormously (July 16, 2002, www.federalreserve.gov/boarddocs/hh/2002/july/testimony.htm).

And it is hardly ceased. At a dinner last year with Greenspan’s predecessor, Paul Volcker, Mr Volcker highlighted inequality as an important source of greed and corruption. With corporate US and UK executive remuneration frequently hitting $300,000 per day, Mr Volcker questioned how executives could ever work. They have a full-time job just spending their money.

What we have here is a failure to perform

In agency theory, performance incentives are part of a principal-agent problem – employers/employees, politicians/civil servants, stockholders/executives, and donors/charities. The problem is how to motivate one party, the agent, to act on behalf of another, the principal. The issues are clarity about what the principal wants, the cost to the agent of providing what the principal wants, and the cost of evaluating the elements of performance. In economic jargon, the conditions are that the principal-agent relationship exists in an environment of information asymmetry, uncertainty, and risk. The information asymmetry leads to further problems of moral hazard, e.g. agents take risks without bearing the consequences, and adverse selection, e.g. being unable to find the good managers because the principal is unable to determine whether their representations are true. Paradoxically, a really smart person is someone who is intellectually below average for a job, but smart enough to get paid above average. Now that is adverse selection. The key approach to solving principal-agent problems is aligning risk and reward.

There are many areas where risks and rewards between principals and agents are misaligned, take stock options. While it is true that less buoyant markets and new requirements to “expense” options have lessened their attractiveness, it is arguable that options should ever be used for management remuneration. Options increase in value as share price volatility increases, thus rewarding managers who create volatility in their company’s shares. Empirical studies show that shareholders value companies with lower volatility, so options perversely give managers incentives to decrease shareholder value. Thus, options, ab initio, divide the interests of managers and shareholders. Options have clearly caused significant problems in the governance of our major corporations. Genuine equity in “restricted” stock and longer-term incentives based on competitive benchmarks are, possibly, the way to go. Nevertheless, so long as options are an option (sic) quick-fixers will opt for these non-optimal methods. When agents extract value from others without making any contribution to productivity, and sometimes at the expense of sustainability, these behaviors are termed “rent-seeking” or the “extraction of rents.”

So why do remuneration committees recommend options if they are such a bad idea for shareholders? Well, there are a lot of conflicts of interest. The remuneration committees are typically appointed, and remunerated, by managers not shareholders. The committee members would not mind seeing some of these highly leveraged options themselves one day. And anyway, if the options pay out, the shareholders will have done well, would not they?

Divide and conquer or basic values?

Conflicts of interest are rife in finance – auditor and consultant, rating agency and paying company, industry insider and regulator. Typical responses to conflicts of interest are elimination, disclosure, recusal, and third-party audit. Sometimes one can just eliminate conflicts by removing a key party. Sometimes disclosure works, for example requiring disclosure of fees paid to auditing firms separately from consultancy fees. Sometimes recusal works, removing oneself from decisions related to specific interests. Finally, third-party audit, or just the threat of possible audit, helps to promote transparency.

However, these methods of accountability may well make principal-agent problems worse, as Baroness Onora O’Neill explored in her Reith Lectures in 2002 (www.bbc.co.uk/radio4/reith2002/). In an era of accountability and audit, we do not seem to have better performance. We get caught up in the process and paperwork of audit. Baroness O’Neill points out that accountability reviews are often provided directly to the state and its regulators rather than to the “accountable” organization. We develop defensive organizations and public bodies. We preach ethics but then remove opportunities to employ professional judgment and discretion. We set farcical, contradictory targets, e.g. increasing university intake in the UK by 50 percent without decreasing standards for degrees or providing all customers with the “best” service.

Another approach is to move away from George and towards Fabio by inculcating some set of basic values in every person. Long-term problems such as running a business sustainably are too complex to be specified in a set of auditable standards. Instead, we should imbue everyone with a set of virtues that permit them to make the right decisions. The summary of a Tomorrow’s Company event on September 24, 2008 at Mansion House in London is typical:

Of particular interest was the emerging focus of discussions at the event on the cumulative impact of environmental, social and governance factors on securing sustainable, long-term returns – rather than being about a simplistic notion of “doing good.” The discussion kept on returning to the importance of a clear sense of purpose, and of being deeply rooted in values, in charting a course during these uncertain and turbulent times (www.tomorrowscompany.com/news.aspx).

A top-down, taxonomic, checklist approach conflicts with a bottom-up, values and virtues approach encouraging people throughout the system to make responsible decisions. Unfortunately, the trite response, “we want both,” is not so trite. What happens when the top-down taxonomy meets a virtuous person who believes the correct decision does not accord with the checklist?

What we have here is a failure to remunerate

There are at least three conflicts that emerge from our desire to link remuneration with accountability. The first conflict is that we tend to value “commission over omission.” We want to believe that people made a difference. We over-pay for luck, we under-appreciate preparedness and we under-penalize failure to anticipate. Remuneration committees find it difficult to account for luck.

The second conflict is that we value “losses over gains.” Remuneration committees are happy to pay out when things are going well. In fact, when things go very well they pay out too much. They tend to make people with losses suffer too much for both accidents and mistakes. Given that losses are so disproportionately penalized, yet remuneration only kicks in for positive results, an unintended result is to increase risk-taking rather than reduce it. If you donot get paid except for gains, but get kicked out for small mistakes, you might as well-risk a big mistake.

The third conflict is that we value “present over future.” Preparing a company for the future is not as important as good results today. This leads to under-investment. We tend to discount the future at such a rate that we over-penalize the cautious. We tend to penalize the person who plans for a rainy day if the rainy day does not arrive. We tend to reward the person who does not plan for a rainy day, so long as it does not rain or, when it does, everyone else is rained on too. Further, we benchmark performance based on current results rather than having the remuneration committee take joint responsibility for sensible future stewardship by agreeing that evaluating management’s current performance needs to take future probabilities into account.

Popularity pressures

Sure, methods of accountability require measurement, but evaluation also requires judgment. Measurement can displace judgment. Professor Marilyn Strathern’s statement of Goodhart’s Law is “When a measure becomes a target, it ceases to be a good measure.” As a former central banker, Charles Goodhart was referring to the fact that measures such as money supply tend to fail to measure well when too much weight is placed upon them. The original form of Goodhart’s Law was, “As soon as the government attempts to regulate any particular set of financial assets, these become unreliable as indicators of economic trends.” As he noted, “financial institutions can … easily devise new types of financial assets.” Goodhart’s original expression evolved to his preferred formulation: “Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.”

One corollary to Goodhart’s Law, I would like to explore in closing is that “When a target is overtaken by time pressures, it turns into a measure of popularity.” There are numerous examples where remuneration committees either cannot or would not take responsibility for agreeing that today’s actions are a responsible response for the future. Remuneration committees overuse numerical benchmarks. Instead of evaluating a fund manager on long-term prospects (tough if he or she has just had a bad year), they evaluate on just this year’s performance, killing the fund manager’s interest in long-term prospects. Further, current available measures are more likely to be “popularity” measures such as growth of funds under management, which arises from good marketing or public relations rather than good investment performance.

This pursuit of popularity is evident in CEOs seeking the front covers of business magazines, in managers pursuing popular strategies rather than correct ones (no one ever got fired for following the herd), in regulators pushing people to do what others are doing or remuneration committees relying on outside consultants who can only judge whether or not management are doing what everyone else is doing. Popularity may be the way to evaluate social performance at a high school, but it is a terrible way to run a sustainable business. In a financial system where we value commission over omission, losses over gains and present over future, all the while measuring popularity, it is no surprise that we increase risk.

Corresponding author

Michael MainelliZ/Yen Group Limited, London, UK

Michael Mainelli can be contacted at: michael_mainelli@zyen.com