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?
