## Wednesday, March 20, 2013

### Important work by cobrapost that illuminates high-powered incentives

The investigative journalism by cobrapost, their videos, and Monika Halan in Mint add up to an important story.

Most of us have enormous respect for the achievements of Axis Bank, HDFC Bank and ICICI Bank. But as Monika emphasises, there are also genuine problems there. We saw it first with the hard-driving mis-selling in recent years, particularly with ULIPs, and now we see it here, with staffpersons supporting illegal activities.

Ordinarily, a media outlet in India bringing such information out has to worry about brazen strong-arm tactics being deployed against them, such as filing of criminal cases. In this case, luckily, there is a certain decency about these three organisations which precludes such concerns. It is ironic that the Indian media vigorously reports on the misdeeds of civilised people, and tends to be silent about uncivilised people.

In India, most of us are reverential about the power of incentives. To make people work, we think, you have to have high powered incentives. We revere incentive packages, stock options, stock grants, which whip the staffperson into a frenzy of hard work.

Economists led this charge, starting with Jensen and Murphy, 1990. The notion that high powered incentives are a good thing came out of academia and went into the real world. But increasingly, it has become clear that there are problems. By 2004, Jensen and Murphy themselves were saying that we should be more circumspect about using high powered incentives.

A person facing high powered incentives tends to focus on one thing. There is an excessive pursuit of that one thing, and all other considerations tend to evaporate. Similarly, when there are quantitative goals alongside qualitative goals, high-powered incentives will generate a focus on quantitative goals and tend to crowd out qualitative goals. Employees of a bank that are given powerful incentives to hit targets for deposit growth (sacked if you don't, given a 100% bonus if you do) are more likely to try to pull in that deposit growth by hook or by crook. If the internal controls of an organisation are weak, then employees are likely to achieve their targets by dubious means.

For all of us in India, coming from a backdrop of socialism and State, it is natural to have extreme hostility to the absence of incentive for a civil servant to do his job. We have seen how private organisations have triumphed by giving employees more incentive. But it's easy for us to overdo this message. In many situations, I feel it's better to go from no incentive to low-powered incentives, but not all the way to high powered incentives.

These issues are widely discussed in the global debate. When we transplant these ideas into India, a big difference lies in the weak governance environment. Super-charged employees in private firms seem to be willing to break laws in their pursuit of profit. Since CEOs weigh the costs and benefits of unethical behaviour, we may argue that when, in a weak governance environment, the expected punishment is small, an increase in the gains from unethical behaviour (through high-powered incentives) results in reduced fairplay.

This suggests two things. First, HR managers needs to be more sophisticated in how the objectives of an employee are defined. If we could be more nuanced in clarifying what the employee is to maximise, this could yield better results. The second issue is about internal controls. When internal controls are strong, they become a non-negotiable constraint within which growing sales or profit has to be done. Unfortunately, once the top managers of an organisation are really hard-driving, chasing growth and profitability, these kinds of niceties (of both kinds) tend to fall by the wayside.

One of the most important mechanisms through which we get high powered incentives is : an entrepreneur who manages a company with family members, and who has dominant shareholding. The one area where this gets us into the most trouble is: Finance. A series of papers that have analysed the Great Recession have found that financial firms where CEOs had more high powered incentives got into more trouble. I am a great advocate of less public sector and more private sector in finance, but we have to be cautious about high powered incentives e.g. those that go with dominant entrepreneurs in a family business.

A prominent example of this debate has been `financial market infrastructure institutions' (FMIIs), a category that comprises organisations like exchanges, depositories, clearing corporations, all of which produce public goods for the financial system. In all these areas, the organisation is unique in that, alongside the goal of maximising profit, there is a regulatory function. This tiny handful of firms is unique, when compared with essentially any other part of capitalism, in that some government functions of regulation and supervision are placed in private, profit-maximising hands. High powered incentives to produce profit or valuation will lead to a dilution or worse of regulatory and supervisory functions. If profit-seeking owners/managers of these organisations under-emphasise or abuse the regulatory and supervisory functions in the quest for profit, this has far-ranging externalities. Failures of regulation and supervision at exchanges have given macroeconomic crises in India in 1992 and 2001. Hence, even though the revenues and profits of these firms is truly tiny on the scale of the economy, this conflict of interest is an important issue for policy makers.

Similarly, there has been a vigorous debate about entry by private banks. As a working approximation, we have to assume that RBI supervision is less than perfect. In this case, I feel that we should be quite circumspect about banks led by entrepreneurs.

1. I see clash of interest everywhere. Question comes to mind how do we lead towards a better world. But first question is who make the changing coming. It has to be people (who are impacted the most); but then they are too busy in making their living and all, that they don't care to be involved in the larger picture. They say that they are not impacted or they are too small to make a change. But then I see we are the fat layer at bottom of pyramid who can make the change.
Let me say first simple change could be all so called literate class decide to cast their vote. They owner their right to vote. If they vote for the right person, may be he will fail in one election but one day he will surely succeed and as more good people come to parliament, things may change. As these are the people who will bring the change. We have to enable them and make them accountable.

2. Ajay, In the entire course of this debate the incentive issue as you have pointed out is the key. Reading the riot act about money laundering is good and necessary, but the sufficiency proof is whether such money can enter a system undetected. It plainly didn't in this case, as no accounts were opened. Till that breach occurs the fact there is a temptation from the environment is the only conclusion that one reaches from this episode, I suspect

1. Dear Subhomoy,

It is possible to argue that the sales persons were merely going along with the reporter until the point where the actual transaction was about to be consummated, and at that point the internal controls would kick in and the transaction would get blocked.

I would be delighted if we could find a benign explanation for the evidence that has been amassed by cobrapost. However, I disagree with this particular explanation for two reasons:

1. Do spend some time watching the videos. The bank employees are dead intent about what they doing and appear to be completely credible in the mechanisms that they are showing. I would be truly surprised if those mechanisms did not work out as promised.

2. I feel that the law does not define malfeasance as the transaction. It defines malfeasance as the proposition. Hence, the bank employees are in violation. The red line that they should have not crossed is at the proposition itself. When the customer walked in and said I'm trying to solve this problem of a politician with suitcases of cash, the law requires the bank employee to say no.

In the best of times, in society, we have a bias in favour of too little criticism. If investigative journalism was asked a higher standard of proof -- of actually doing transactions -- then this will lead to a shrivelling of such criticism, because the journalist will then be vulnerable to the accusation that he was part of a crime. It would be possible to bring pressure upon the journalist in this fashion. This has happened in India before.

3. Every nice good product becomes a problem. Hdfc brought home loans to the masses. Now the BFSI space has about Rs. 500,000 crores in this industry. Remove it and housing becomes affordable. Index funds and term insurance are just not exciting. Journalists need complicated products so that they can write orgasmic articles like 'best performing funds' or such shit. Given the scenario 'blaming' these kids and 'praising' the story breakers sounds amusing to say the least. LIC policies for 'cleaning' the money is old hat is it not? what is so 'breaking' about this breaking news? beats me.

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