(The opinions expressed here are those of the author, a
columnist for Reuters)
By James Saft
May 8 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
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
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
“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
(Editing by James Dalgleish)