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COLUMN-Our rules-based system has failed, culture is only remedy: James Saft
May 8, 2017 / 8:16 PM / 5 months ago

COLUMN-Our rules-based system has failed, culture is only remedy: James Saft

(The opinions expressed here are those of the author, a columnist for Reuters)

By James Saft

May 8 (Reuters) - In regulation and in business, our decades-long obsession with rules-based systems is a failure.

A replacement system which keeps bankers, fund managers and company executives working for the best interests of their stakeholders will emphasize good conduct and right action.

This does not mean the end of rules, either in executive compensation, fund management or financial regulation, but an acknowledgement of economist Charles Goodhart’s axiom that “When a measure become a target it ceases to be a good measure.”

Indeed, many of the concepts at the heart of our business culture start with the assumption that individuals will act in their own best interests to maximize their advantage, in essence giving up on right behavior from the start.

Consider the failures of the era of rules:

Banks put the global economy at risk arguably in large part because their culture of risk taking was based on skirting and arbitraging rules, both internal ones and regulatory requirements. Wrong conduct led to more than $140 billion of fines, so far, paid out by banks for the mis-selling of U.S. mortgages and nearly $40 billion in payouts by UK banks over rip-offs like Payment Protection Insurance.

Much of this came out of a culture at banks which put targets and profits at the apex of goals, a point underscored by the Wells Fargo cross-selling fraud, where employees often simply created accounts for customers without permission to try to reach “stretch” goals.

Warren Buffett, a Wells Fargo shareholder, gets the wrong end of this particular stick, asserting that company management’s failure was in setting the wrong target and failing to figure that out quickly enough.

“There is nothing wrong with incentive systems, but you have to be very careful with what you incentivize. You can incentivize bad behavior and you have to have a system for recognizing it,” Buffett said on Saturday at the Berkshire Hathaway annual meeting.

The problem isn’t just these particular incentives but the philosophy of shareholder value maximization which underlies them. This holds that companies only exist to maximize value for equity owners, and that this is best done by linking manager pay with stock market performance.

Time and again, it simply does not work, enriching those who work in the system rather than owners, all while often abusing clients.

HOMO SAPIENS OR ECONOMIC MAN?

By taking an essentially amoral worldview at the start, one which assumes no one will do “something for nothing,” the system, built on rules and targets, hard-wires self-interested and ultimately economically destructive behavior into many corporate cultures.

This mindset took hold in the 1970s and 80s when concepts which were useful rules of thumb in economics, such as the idea that people act on their own rational best interest, got hard-wired into management as if that was always judged by people in dollars and cents, and never in terms of right action.

It leads not just to bank mis-selling but systematic under-investment, as everyone plays the game, as did Wells Fargo, of meeting quarterly per-share profit targets, often by buying back shares rather than investing and innovating.

Investment management uses targets, benchmarking against an index or peer group, as a way to try to grapple with the same issues. Owners of capital, like shareholders, need to hire people to manage for them and can’t know in advance if they are talented or honest.

In assuming they may not be the first and are only opportunistically the latter, the system of hiring and firing fund managers based on how they do against the ruler of index or peer performance ends in bubbles and mal-investment, as shown by research by Paul Woolley of the London School of Economics. Fund managers shadow the index, buying what is going up, in order to minimize their own career risk under the rules of operation they’ve been given. (here)

In fund management, the system of rules and targets leads to self-dealing around the edges, rather than bank-style scandal, but elsewhere regulators are taking conduct issues increasingly seriously.

“Regulators have been particularly tough in those instances where poor consumer or counterparty outcomes have gone hand in hand with high profit margins for firms,” David Lawton, of consultants Alvarez & Marsal wrote in a note to clients. (here)

The answer, in company and investment management, is probably something that includes elements common to the Hippocratic Oath that has governed doctors and the Fiduciary Rule often used in financial services.

Trust, long built up, and safeguards can do what rules never will. (Editing by James Dalgleish) )

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