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Limits of Incentives and the changing paradigms in a downturnBy Procyon MukherjeeIncentives seem to be the magic word driving change in the modern world; they act tosteer choices in a certain direction, whether it be government, the private sector or evenin education. Incentives act to influence the pay off structure of the utility function; ithelps to create value for both the transacting entities. Between the two alternatives,incentives serve to offer a better choice in which there is gain from both sides. Thetransaction can only happen if both the parties find the course of action a better path totake in presence of incentives to do so. In absence of incentives the outcomes could bequite different and less efficient.The origin of incentives can be traced back to the government actions to generateemployment or generate money for the treasury. In absence of incentives both theseoutcomes proved to be much less impactful. Whether it is providing tax breaks for settingup new industries or providing retention incentives, the government acted to generateemployment in a certain region and continued to incentivize such actions to retain thebenefits on an on-going basis. This extended to providing incentives on investments or ongrowth (sales volumes) or on cost (10% cost reduction). The results of these programsvindicate the fact that incentives tend to channelize actions towards maximizing theobjective function or the pay off function to the mutual benefit of both government andthe party involved.The act of incentivizing people to deliver superior results took a much forcefulconnotation in the 1990s, when there was an increased focus put on creation of shareholder value (some trace this back to the speech by Jack Welch, but actually he didnot mean to say this). Management started to believe that if a strong top down incentivestructure could be put it could drive behavior towards generating greater value for theshareholder. The shareholders believed it too and there were strong evidence in favor of such a denouement particularly in the boom phase of the business cycles. However suchincentivization failed to return a similar end-result in the phase of the downturn. Butsince the world had seen very mild downturns it never had been an area of study, whetherone could continue to incentivize people using the same yardsticks in a downturn as in anupturn.Incentives designed to drive behavior are being realigned after the current debacle in thefinancial sector. The U turn is equally significant. The very recent example is the puttingof 90% tax on Wall Street bonuses on executives of firms bailed out by the tax payers.Tax payers as owners or the new Principal are putting in controls to see that large part of the share of the incentives is routed back to them. The question is why this was missed inthe upturn where the Principal parted with a large sum without insuring the risk? Is therecent action by the ‘new Principals’ going to trigger any different kind of behavior? Isthe latest action going to bring in more risk averseness that would not improveperformance at all, which is the very core strategy of incentive design?
 
 I would try to deal with the issue of incentives in a downturn. When excessive risk takingwas rewarded during the upturn without imposing limits (Akerlof and Shiller in theirbook Animal Spirits bring out this aspect quite succinctly), excessive risk aversenesscannot improve performance and if incentives or avoidance of incentives spur such typeof behavior, the downturn only would be prolonged.Downturn cannot be whisked away as an external event. Managers have to deal with theissue of a deep slump in the market, which are partially their own creation; no one canshirk away from the responsibility. It was Jack Welch who last week pointed out that it isnot the GDP that influences company performance but it is the other way around. It is theperformance of companies that influences the GDP. So it is the end of pointing andgiving excuses. In the same discussion he pointed out that creating share holder value isno strategy, it is an end result (FT 12
th
March ’09). So the current style of leadership hasto change and the way to change is to design incentives so that the right behavior isdemonstrated that would lead to the right actions.Incentives in an upturn were designed to spur a positive movement, managers, at leastsome of them misused them and took excessive risk, without informing the Principalabout the implications in the longer term. This I would term as a clear case of failure of incentives. The most recent case of incentive failure is so much in evidence in the crisisof banks. The bank CEOs were given Return on Equity as the key performance criteriafor their incentives. The CEOs therefore indulged in excessive risk taking that would leadto increase in net income (the numerator), but simultaneously ensuring that theShareholder’s equity (denominator) did not increase. The net income for banks can onlybe increased by higher lending (and riskier lending); it would automatically mean raisingmore capital either in form of debt or in form of equity. The Bank CEOs did not raisecapital through the equity route, thus when they moved to higher gearing ratios or higherleveraging there debt equity ratios exploded. When the asset prices collapsed, theirliabilities remained while the assets shrunk in size, thus their net worth shrank. If theirincentives were not based on Return on Equity as set by the principal (the principalswanted to reap benefits of all the profits without making the pool larger for sharing theprofits) perhaps the banking crisis could have been avoided. However the increase of assets that turned toxic was a wrong doing that entirely cannot be attributed to theincentives or the failure of incentives. It was partially due to the absence of proper stresstesting systems and procedures in the banks and the proper understanding of some of therisky instruments was lagging in some cases. However the initial motivation to movetowards this higher risk portfolio stemmed from the misalignment of the incentives withthe risks that the CEOs were taking.There is another behavioral aspect that one would notice in an upturn. The growth of markets and explosion of commodity prices gave enormous profit opportunities to mostcompanies. The incentives merely based on the profit metric were unable to segregate themarket effects. But the managers being motivated by the incentives overlooked the factthat the profits were a proxy for the market sentiments and were they to return to itsnormal levels the profits would have melted. But the self-deification by managers in an
 
upturn when the prices moved up exponentially point to the misalignment of incentiveswith actual managerial performance to drive share holder value for the long term. Theincentives missed to capture the regression with the market. For example if a companyimproved its top line due to sheer improvement of market fundamentals that came fromthe growing economy, then that should have a regression with the company’s growth andincentives should factor this regression. This is true for pricing as well. This would tendto constantly keep our focus on internal actions which are specific and measurable thatdrives results and therefore would continue to play a leading role in spite of marketsperforming differently when the business cycles change. This would actually provide asinsurance during the downturn that many managers would fail to recognize.Stimulating the right behavior should be the motive of incentives. Channelizing actionsthat would actually increase risk instead of reducing it is a classic example howincentives failed to stimulate the right behavior. The agent in this case was also at fault tohave missed the over-sight processes to see how it was itself bringing its own peril.However thankfully there are better examples already available that some companieshave beaten the market downturn and have returned better results. The example is Nestleor Mitsubishi conglomerate. Such companies however are rare who could lead and beoutliers. Nestle kept a careful eye on the range of products it launched and the targetmarkets where it launched them. While it had products that were of high value that therich only could afford, it had similarly products that could be targeted to low incomefamilies as well. In a recession these two types of products targeted at two differentsegments helped to fetch them superior returns compared to the competition. Mitsubishion the other hand as a conglomerate worked on the principle of saving during the upturnto be able to invest and buy businesses in the downturn, an unusual strategy that madethem aware of the limits of markets in the boom time and when to withdraw in theseextreme times of exuberance as the prices could be irrationally beaten up without anylogical reason.There are examples in the banking community itself (Hudson City Bank Corp. where netincome rose 50% last year as per Wall Street Journal 23
rd
March), where in there aresome of the smaller banks in Wall Street itself that did much better even during theBanking crisis.Do the same incentives that generated so much of positive returns (till they turned toxicas well) apply when it comes to the downturn? Is there a need to change the verystructure of incentives to avoid excessive risk taking? Can behaviors be actually changedthrough the incentives?There is an asymmetry that one would realize while looking at the same incentives duringan upturn as in a downturn.The whole designing of incentives need to be carefully reviewed if this asymmetry has tobe resolved. If managers are rewarded when it is the upturn of the business cycle thatcontributed to wealth creation because of a multiplicity of factors both external and
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