Wednesday, 30 January 2013

Banking scandals, corporate memory and incentives

I have not blogged here for some time, which is not because I have tired of the subject. Many people would yawn at the mere thought of corporate governance but it holds a fascination just because it is actually not some arcane discipline beloved by crusty academics and dull accountants: it is about everyday life. It is about "why do people behave like that and what can be done?". My slowing blog writing arises from my failure in the realm of answers. I find I keep coming back to words like integrity rather than being able to suggest smart procedures that will solve our problems.

And what a host of problems we have. As an example, it is hard to open a newspaper without reading about legal actions by regulators and law enforcement authorities against banks in America, many of them British. There is the Libor scandal that encompasses many of them, accusations of helping drug lords to launder their ill gotten gains, accusations of helping countries evade UN and US imposed sanctions. In the UK there is the massive scandal of miss-sold loan protection insurance. You may want to click across and look at Forbes list of scandals...

I am not just picking on banks but they happen to provide such good examples. The question is, why do these things keep happening? What is it about the structure of these organizations or the incentives they offer (which is surely much the same thing) that makes it keep happening? It is not as though such behaviour is good for the these organizations. If you look at the size of some of the fines and settlements then you must conclude that their size swamps any gains. You may argue that there are lots of such scams that do not come to light but I am rather inclined to think that, eventually, most of them do and then again, there is the size of the penalties: HSBC, for example, recently settled for $1.9bn.

Then Daniel Finklestein, writing in the Times, discussed the private interests of public servants. In doing so he evoked the 'Mandy Rice Davis principle'.

It was June 30, 1963, and the second day of the trial of the osteopath Stephen Ward, charged with living off immoral earnings while Miss Rice-Davies was his tenant. The dancer was asked about her claim to have slept with Lord Astor.
Do you know, asked Ward’s defence lawyer, that Lord Astor has denied these allegations of yours? And Miss Rice-Davies gave her immortal reply: “He would, wouldn’t he.”
He would, wouldn’t he. The Rice-Davies principle. Much (most?) of what people say and do in politics and in life can be most readily understood by appreciating their incentives, by understanding what they have to gain or lose.
He went on to mention the work of economist James Buchanan in researching such incentives in the public realm.

Finally, to complete my parcel of evidence, came a private conversation with a friend that ranged over these banking scandals and touched on the work of a mutual friend, Arnold Kransdorff, who writes about corporate memory and the perils of losing those memories. My friend then observed that there is nobody left in any senior position in the City of London who remembers the pre-Big Bang world. And there you have it.....

In those old, forgotten days, incentives were lower (still high but not so high) and an individual's reputation for integrity mattered - if you were rumoured to be a bit shifty then you were shunned and struggled to do business with or work for a City firm. What has happened since 'Big Bang' is that the rewards for success have grown so dramatically that they have overwhelmed the role of integrity as a restraint and have made it far more worthwhile to take the risk of being caught doing wrong.

The answer...? It comes from the top. First of all, the top team must talk about values and set an example and must live the talk. Too often the prime wrongdoers are the guys at the top. When they are seen to take outrageous rewards then you can hardly expect the little guys not to try to feather their nests too. But assuming a good example is set from the top and that they talk about values, promote values and reward values then they must also punish wrongdoers - when they get away with it then that encourages others to cheat. Secondly, rewards and incentives must be reduced to reduce the incentive to cheat. It is hard to do, seems to go against liberal economic sense but in the long run these incentives are not sensible because they encourage behaviours that have a massive long-term cost when you all get caught. Some of this is discussed in a book, The Value of Talent (due to be updated next year).

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