Crocodiles in the Water: Incentive Plans and Employee Responses

Today I went to the Sungei Buloh wetlands reserve in Singapore and spent time looking at a flock of storks that were feeding in a pond. At some point four of them came across a crocodile party hidden in the water. They were interested in this unfamiliar creature, but decided that it was safer to cross it at the tail end than the front end (see the picture below). Good choice; even a full crocodile will be sorely tempted when food walks in front of its mouth.

I can imagine that bankers are also worried about crocodiles in the water these days, as they are putting in place new systems to control risk while rewarding high performance in response to rule changes and various cases of misconduct (see my earlier posting). The crocodile, of course, is that the newly designed systems will backfire and cause damage, just as the old ones did. I can imagine that much effort is spent thinking about the design of these systems, and probably it is also helped by economic models of how individuals respond to incentives.

What the bankers probably know, and anyone designing an incentive system should know, is that their best planning and the best economic models still is not enough ensure that the system will be passing the tail end of the crocodile, and not the rear. The problem has two sides: the manager creating the system is not sufficiently rational, and the employee inside the system is more creative than the manager thinks. As a result, the employee gradually learns to trick the system in ways that the designer had not imagined. Various pieces of evidence in favor of this proposition has been available before, often from blue-collar workers on piece-rate systems, but now Tomasz Obloj and Metin Sengul have produced strong evidence on incentive system in banking, no less.

They showed that a new incentive system initially increased productivity and gave a high share of this increase to the bank, while still rewarding the employees. Over time, two things happen. First, the employees learn to capture more of the value created by their extra productivity. Second, the tricks they use in order to make that happen are risky from the bank’s point of view, because they can raise costs and may lead to lost sales (the article has the details on why that happens, as well as many other interesting findings).

The storks could safely navigate the crocodile in front of them because it was only half hidden in the water. Managers designing incentive systems are facing future employee behaviors that are completely invisible because the employees themselves would not have thought of them until they saw the incentive system. How confident are we that the managers will be right more often than the storks?

Obloj, T. & Sengul, M. 2012. Incentive Life-cycles: Learning and the Division of Value in Firms. Administrative Science Quarterly, 57(2): 305-347.

Knight Capital Group: Did an Accidentally Evil Computer Knock Down a Trading House?

Knight Capital Group (www.knight.com) is a trading house that helps others access financial markets by executing their trades. It serves as a designated market marker, which means that it provides buy/sell orders so that others can always execute a trade against it, for more than 600 securities on the NYSE and NASDAQ stock exchanges. It also serves as a market maker for many other securities. Because market making and trading are key activities in financial markets, requiring reliable and honest dealing, it is no wonder that its web site carries the slogan “The Standard of Trust.”

So what is one to think of the incident that took place on August 1, where a flurry of trades from Knight led to it accumulating a trading position of $7 billion, far more than it could sustain, leading to a concerted effort to drive the position down to a less risky level? In its rush to reduce its risk exposure, it inevitably sold some of its holdings cheaply (also known as a fire sale), and ended up losing $440 million. Even against the standards of losses that we have become used to in this financial crisis, it was a very bad day for Knight. Since then, Knight has been able to find investors with fresh capital of $400 million, essentially the same amount that it lost, which will stabilize the firm if it suffers no more catastrophic losses.

It has also investigated the reason for the sudden surge in purchase orders. Here the information is a little unclear, but Wall Street Journal reports an unexpected reason: A botched update of computer systems. What seems to have happened is that the new computer systems were installed and worked correctly, but they were not installed on all trading platforms (each system has to be replicated across all trading platforms). This led to old systems trading on some platforms while new systems traded on others, and apparently it was the old systems that went awry. Exactly how this is possible is unclear because the old systems had obviously worked well before, but a possible reason is that the old systems no longer posted their trades to the risk management system, so the contribution of their trades to the total risk went undetected. This explanation is speculative, but if the reports that the new system functioned well are correct, then the huge buildup of buy orders suggests that there must have been some information being dropped from the risk assessment system.

This tale of computer error starts and ends with human error. People failed to install the new system across all trading platforms, and people failed to stop trades when NYSE trading-floor officials noticed the unusual trades and warned Knight that it was the source of unusual trading movements. But the key point here is that the computer systems were so fast and effective in their work that there was little time to stop them once they got going. This is a phenomenon well known from research on organizational accidents. It is also a major cause of misconduct, as I have noted in work with colleagues Don Palmer and Jo-Ellen Pozner. In the case of Knight, the trades were arguably so hazardous that it is a judgment call whether the firm has upheld its duties for proper risk management (lawsuits, anyone?). However, assigning responsibility will be difficult because these trades were accidental, and the accident occurred in the interface between fast and faulty computers, and slower humans trying to catch up.

Clearly this story has important lessons for how organizations think about management of risk and quality control, especially as they make more and more of their key systems automatic. It is also a reminder that financial markets contain human traders, who can be quite faulty in their judgments, and replacing them with computers sometimes makes the judgments even worse. And finally, if you have ever had a software upgrade go bad, think of Knight Capital and how much worse it could have been: I doubt you have ever experienced a computer upgrade that withdrew money from your bank account and distributed it to strangers.

Greve, H. R. , Palmer, D. and Pozner, J. 2010. Organizations Gone Wild: The Causes,

Processes,and Consequences of Organizational Misconduct. The Academy of Management Annals, 4: 1, 53 – 107.

Patterson, S., J. Strasburg, and J. Bunge. 2012. Knight Upgrade Triggered Old Trading System, Big Losses. Wall Street Journal, 15.8.2012.

The Academy of Management: Studying those who manage you

This week the Academy of Management has its annual meetings in Boston. The Academy of Management is a professional association for scholars who do research and teaching on management and organizations. It has more than 19,000 members, mostly professors but also others with an interest in management research. I will be there.

What do management scholars do, and why should there be an association for them? Maybe we can begin by asking whether management is an important occupation. Taking US data, simply because they are so easy to find, the Bureau of Labor Statistics reports that 6.183 million people are in management occupations in the US (267,000 of them are chief executives) of a total of 128 million persons employed. That comes to 328 managers per management scholar, which may seem like a lot of scholars per research subject! But a more relevant figure is that 4.8 percent of all employed individuals are managers. Those are just the professional managers, because it omits owner-managers who manage their own business. Still, it is only a small part of the picture. Management is important because it affects those who are managed as well as the managers, and as I just noted there are 128 million people employed in the US. That’s a more reasonable 6,734 per researcher, but the Academy of Management is an international association and its scholars seek to understand management all over the world.

What do managers do that might be interesting to study? At the smallest level, managers set the conditions and climate for individual work. For good or for bad, they have a big impact on well-being at work, personal and professional development, and teamwork. Remarkably, one of four persons in the US report having missed work as a result of work-related stress. It seems important to investigate how managers affect workers, and how workers affect each other. 

Moving to larger outcomes, managers are in charge of organizational units that function either for the regular production of the organization or for its future development, and though they rely on others for advice, they are often left with the final decision. Decisions matter. We just got news that the iPhone was nearly stopped during development because it seemed flawed beyond hope (yes, if you have one, pull it out of your pocket and look at the nearly-canceled product). That was a story that ended well, but many other close calls have gone the wrong way, leaving managers ruing missed opportunities. In some cases, incorrect decisions have had consequences that can be measured in lost lives, as when managers in charge the upkeep of safety standards have been slack. Managers also design organizational structures and procedures, and these can make a major difference to the effectiveness and quality of organizational work. The improvements gained by many organizations (not all!) through quality and six-sigma programs testify to the importance of organizational design.

At the broadest level, managers work together to form and execute strategies for their firms. Finnish company Nokia rocketed to prominence through its early and successful entry into the mobile phone market; it has fallen hard as a result of being slow to commit to the newer generation of smart phones. As is often the case with strategic decisions, it is a lot easier to point to a mistake afterwards than beforehand; it was by no means clear when and how the smart phone market would develop. 

Strategies in turn determine the viability of the firm and the livelihoods of many who depend on it, either in the firm itself or in the many other firms that depend on it, or its employees, for their business. I just clicked on a web site listing foreclosures in Detroit, center of the US auto industry, and I found 6,880 listings including 3-bedroom house going for $15,850 ($11 per square foot). I can think of no better illustration of what strategic decisions gone wrong can do for a community that is heavily dependent on a few firms. Going to the other end, the many successes in Silicon Valley has led prosperity in its communities, with a similar house as the Detroit one going for $567 per square foot. For that price, let’s hope the Silicon Valley house has been maintained well. And more importantly, let us make sure that the research done by the 19,000 management professors can provide some help for firm strategies, organizational structures, management decisions, and workplace conditions around the world.