Limits of Incentives and the changing paradigms in a downturn

By Procyon Mukherjee

Incentives seem to be the magic word driving change in the modern world; they act to
steer choices in a certain direction, whether it be government, the private sector or even
in education. Incentives act to influence the pay off structure of the utility function; it
helps 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. The
transaction can only happen if both the parties find the course of action a better path to
take in presence of incentives to do so. In absence of incentives the outcomes could be
quite different and less efficient.

The origin of incentives can be traced back to the government actions to generate
employment or generate money for the treasury. In absence of incentives both these
outcomes proved to be much less impactful. Whether it is providing tax breaks for setting
up new industries or providing retention incentives, the government acted to generate
employment in a certain region and continued to incentivize such actions to retain the
benefits on an on-going basis. This extended to providing incentives on investments or on
growth (sales volumes) or on cost (10% cost reduction). The results of these programs
vindicate the fact that incentives tend to channelize actions towards maximizing the
objective function or the pay off function to the mutual benefit of both government and
the party involved.

The act of incentivizing people to deliver superior results took a much forceful
connotation 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 did
not mean to say this). Management started to believe that if a strong top down incentive
structure could be put it could drive behavior towards generating greater value for the
shareholder. 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 such
incentivization failed to return a similar end-result in the phase of the downturn. But
since the world had seen very mild downturns it never had been an area of study, whether
one could continue to incentivize people using the same yardsticks in a downturn as in an
upturn.

Incentives designed to drive behavior are being realigned after the current debacle in the
financial sector. The U turn is equally significant. The very recent example is the putting
of 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 in
the upturn where the Principal parted with a large sum without insuring the risk? Is the
recent action by the ‘new Principals’ going to trigger any different kind of behavior? Is
the latest action going to bring in more risk averseness that would not improve
performance 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 taking
was rewarded during the upturn without imposing limits (Akerlof and Shiller in their
book Animal Spirits bring out this aspect quite succinctly), excessive risk averseness
cannot improve performance and if incentives or avoidance of incentives spur such type
of behavior, the downturn only would be prolonged.

Downturn cannot be whisked away as an external event. Managers have to deal with the
issue of a deep slump in the market, which are partially their own creation; no one can
shirk away from the responsibility. It was Jack Welch who last week pointed out that it is
not the GDP that influences company performance but it is the other way around. It is the
performance of companies that influences the GDP. So it is the end of pointing and
giving excuses. In the same discussion he pointed out that creating share holder value is
no strategy, it is an end result (FT 12th March ’09). So the current style of leadership has
to change and the way to change is to design incentives so that the right behavior is
demonstrated that would lead to the right actions.

Incentives in an upturn were designed to spur a positive movement, managers, at least

some of them misused them and took excessive risk, without informing the Principal
about 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 crisis
of banks. The bank CEOs were given Return on Equity as the key performance criteria
for their incentives. The CEOs therefore indulged in excessive risk taking that would lead
to increase in net income (the numerator), but simultaneously ensuring that the
Shareholder’s equity (denominator) did not increase. The net income for banks can only
be increased by higher lending (and riskier lending); it would automatically mean raising
more capital either in form of debt or in form of equity. The Bank CEOs did not raise
capital through the equity route, thus when they moved to higher gearing ratios or higher
leveraging there debt equity ratios exploded. When the asset prices collapsed, their
liabilities remained while the assets shrunk in size, thus their net worth shrank. If their
incentives were not based on Return on Equity as set by the principal (the principals
wanted to reap benefits of all the profits without making the pool larger for sharing the
profits) 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 the
incentives or the failure of incentives. It was partially due to the absence of proper stress
testing systems and procedures in the banks and the proper understanding of some of the
risky instruments was lagging in some cases. However the initial motivation to move
towards this higher risk portfolio stemmed from the misalignment of the incentives with
the 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 most
companies. The incentives merely based on the profit metric were unable to segregate the
market effects. But the managers being motivated by the incentives overlooked the fact
that the profits were a proxy for the market sentiments and were they to return to its
normal 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 incentives
with actual managerial performance to drive share holder value for the long term. The
incentives missed to capture the regression with the market. For example if a company
improved its top line due to sheer improvement of market fundamentals that came from
the growing economy, then that should have a regression with the company’s growth and
incentives should factor this regression. This is true for pricing as well. This would tend
to constantly keep our focus on internal actions which are specific and measurable that
drives results and therefore would continue to play a leading role in spite of markets
performing differently when the business cycles change. This would actually provide as
insurance during the downturn that many managers would fail to recognize.

Stimulating the right behavior should be the motive of incentives. Channelizing actions
that would actually increase risk instead of reducing it is a classic example how
incentives failed to stimulate the right behavior. The agent in this case was also at fault to
have 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 companies
have beaten the market downturn and have returned better results. The example is Nestle
or Mitsubishi conglomerate. Such companies however are rare who could lead and be
outliers. Nestle kept a careful eye on the range of products it launched and the target
markets where it launched them. While it had products that were of high value that the
rich only could afford, it had similarly products that could be targeted to low income
families as well. In a recession these two types of products targeted at two different
segments helped to fetch them superior returns compared to the competition. Mitsubishi
on the other hand as a conglomerate worked on the principle of saving during the upturn
to be able to invest and buy businesses in the downturn, an unusual strategy that made
them aware of the limits of markets in the boom time and when to withdraw in these
extreme times of exuberance as the prices could be irrationally beaten up without any
logical reason.

There are examples in the banking community itself (Hudson City Bank Corp. where net
income rose 50% last year as per Wall Street Journal 23rd March), where in there are
some of the smaller banks in Wall Street itself that did much better even during the
Banking crisis.

Do the same incentives that generated so much of positive returns (till they turned toxic
as well) apply when it comes to the downturn? Is there a need to change the very
structure of incentives to avoid excessive risk taking? Can behaviors be actually changed
through the incentives?

There is an asymmetry that one would realize while looking at the same incentives during
an upturn as in a downturn.

The whole designing of incentives need to be carefully reviewed if this asymmetry has to
be resolved. If managers are rewarded when it is the upturn of the business cycle that
contributed to wealth creation because of a multiplicity of factors both external and
internal, they should not be rewarded again when it is the downturn by the same logic, the
downturn itself cannot be sighted for the lack of performance. But this puzzle of
incentives could be tackled by segregating the external factors from the internal ones, but
it would call for alignment of objectives between the principal and the agent.

I would like to go back to the Jack Welch example, when he sighted the example of GDP.
Text books would define GDP to be the cumulative income of all the individuals and
companies and government in an economy. Although there is an intertwined relationship
between the income of any company and the income of the whole economy, but one
cannot simply use the logic to suit an end. The fallacy of the logic can be seen if we try to
see what actually happens when the income grows. The income of a company can grow
when the sales growth takes place because of an innovation or the cost comes down
because of a productivity increase. These are the basic factors for income to grow for an
economy as well. However there are economic conditions either created by the
government or by the market or by both which aid this process of income growth. By
pointing at the conditions alone the managers cannot shy away from the responsibility
that they could not raise productivity standards or could not create innovation, which are
the basic functions of management.

However for management to do this, there are incentives needed to drive a particular type
of behavior. The principal or the owner for whom the agent or the management works
create these incentives to serve the purpose of ‘motivating’ the change process to reach
the desired objectives. The history of incentives however is rather short, at least the
monetary part.

I would like to take examples of incentives in the area of Electricity tariffs that drove a
different kind of behavior amongst the consumers and thus helped to create a win-win
condition for the utility companies as well. We all know that electricity consumption is
never steady, it has its peaks and valleys in the different parts of the day, peaking during
the evening hours. While this is the case for the urban consumers, for the offices and
industries the consumption pattern could be quite different. This consumption pattern
would mean that while one class of consumers are not using electricity, the no-load losses
increase for the utility, while when another class has the increased need, servicing that
need also becomes difficult because it would mean creating a higher supply capability
only for a short duration. Added to this is the problem of cost of electricity itself, which is
different for the different classes, as the transmission and distribution losses are different
for the HT consumers (Industrial) as compared to the LT consumers (domestic).

This asymmetry riddle could be solved with the design of incentives for one class of
consumers, because otherwise it would have meant one class subsidizing for the other,
which would not have been a good practice. The solution was that the industrial
consumers were given something called the Time of Day Tariff (TOD) which meant that
they had different rates for the different times of the day, the highest tariff was accorded
for the peak hours (evening) and the lowest for the off peak hours (late night after 10
p.m.). What this meant was that an industrial consumer could gain by maximizing its use
of electricity during the off peak hours and could lose if it wanted to use it in the peak
hours, thus the utility function could be maximized for both the parties, the HT
consumers and the Utility itself.

This kind of incentives drove the industrial consumers to design their processes in such a
way that they could get the maximum benefit by using as little electricity as possible in
the peak hours. The shift pattern of consumption got completely revised in some
industries to get mileage from this. Thus more power was available in the peak hours to
be distributed to the domestic consumers. This incentive program of TOD Tariff was a
significant change in the history of incentives, because it was for the first time that the
importance of collective benefit was understood in the realm of incentives.

The same incentive problem when looked at from the domestic consumer’s view point
who is living as a tenant in a house whose electricity bill is paid by the owner of the
house, does not drive a savings motive. This is the example of moral hazard, because his
honest intention to save does not give him any pay off and his behavior of wasting energy
would also not lead to any penalty.

Thus an incentive program that does not take care of the moral hazard problem is bound
to fail; the best example in our current times is the issue of toxic assets and their disposal.
The government through the designing of incentives have failed to realize that the public
private partnership cannot succeed unless the issue of moral hazard is solved; increasing
pay offs to the private sector for the gains and extending the ownership for the bulk of the
failures and the pay offs thereby to the government would not incentivize taking cautious
actions that would stop creation of such toxic assets. When we talk of incentives we need
to keep in mind that to stymie any effort that leads to counter-productive denouements,
should be meted out with disincentives or punishments as well. To stop moral hazard the
only way out is to provide for punitive measures that would restrict people from showing
that type of behavior. If the tenant is penalized for wasting electricity that is paid for by
the owner of the house, surely the tenant would behave differently.

These examples bring us to the central theme of any incentive program; it must be able to
drive a certain kind of behavior that gives benefits to all constituencies. Giving benefits
to some while delivering little to others, does not lead to sustenance of the program. Also
there must be punishments instituted to ensure that one would not go beyond the limits to
bring peril for the long term.

This problem can be seen in the area of incentives between a customer and supplier in
sharing profit. When one class excessively tries to derive all the benefits by virtue of its
superior positioning or power, the incentives for one turns out to be the disincentive for
the other. This is also a case of failure of incentives. For a particular duration it works
fine but the one from whom the incentives are gradually withdrawn would be waiting for
the opportunity to strike back as well. Many of the contracts signed between two parties
are found to have one sided incentives. These contracts do not generate long term value
for both the parties.
Let us go back to the example of the banks and the incentives. The failure of the
incentives was on many counts, I would like to point out to some of them.

1. Return on Equity as a metric sparked off a deluge of actions that exploited a given
market situation that had a relatively low risk free rate and people were looking
for an opportunity to invest in the right engines of growth. The rise in money
supply sparked off an asset bubble that the banks helped to create but not stymie it
as the incentives were not in favor. The market amongst many things caught on
the bandwagon that more demand for assets would essentially mean more asset
prices, regardless of the economy’s ability to sustain such demand pattern. The
overall gain for the society from these incentives were such that each gained from
the run, and if the gains of one were to be reversed it would have brought peril to
all others. This clearly is a seed for the eventual collapse.
2. The cap was missing: The incentives never had a ceiling, thus there was no end to
one’s rewards, which would mean that one could increase the stakes to any extent.
The principal was initially rewarded handsomely from this run, so there was no
need felt to cap such incentives with a ceiling, because they probably felt that it
would be bringing in a ceiling for their earnings as well.
3. Incentives were unidirectional and did not look at all the constituencies and the
various elements of risks and their impacts. There was no parameter that could
weigh this aspect for the medium term or longer term. Since Bank balance sheets
could hide some of these portfolios and there is actually evidence that off-balance
sheet transactions stymied the effects of some of these excessive risk taking
overtures, there was no way that anyone could clearly discern the true
performance after factoring the risk. By spreading the risks, the banks thus created
a common risk pool for risk, thus alienating themselves from the eventuality as
their ultimate failure could never be traced to one single entity.
4. The regression was missing with the market factors when incentives were
designed, there was a hallow effect that had to be discounted, but which no one
did. When asset prices assumed the most outrageous levels people believed that it
was never the peak (Some Banks predicted oil to reach $200 a barrel when it was
hovering around unprecedented $145 per barrel)
5. The incentives used much higher discounting rates, meaning that pay offs were
higher in the shorter term than in the longer term.

This last point needs to be elaborated. The incentive design is based on short term results,
which is very important. But the pay-offs could be staggered thus creating the need to see
that the results are sustainable. This wasn’t the case because the banking community
assumed much higher value to the discounting factor for money. Money now was made
to look far more precious than money two years from now, where as the long term
interest rates were actually hovering around 2.5% to 3.5%, not a very great number.

This looks rather odd and highly unexplained human behavior.

However the stock options as a vehicle to drive behavior helped to support this long term
aspect, but only to a limited extent. The stock options with the right kind of strike prices
(presumably using the Black Scholes model) helped to do two things, firstly it aligned the
agents motives with the motives of the principal and secondly it helped to create a long
term view of results and pay offs. In an upturn this model worked very well, but during a
downturn this form of incentivization has fallen flat as most of the strike prices are way
above the current market prices and this seems to be drawing sharp reactions from the
same community of mangers who originally designed them to make managers behave as
owners. The asymmetry that one sees when it comes to making a sacrifice against making
a gain is similar to the asymmetry that one sees when a person is confronted with the
dilemma of taking a risk against possible losses versus taking a risk against possible
gains. Human beings tend to take more risk when it comes to insuring against loss versus
insuring against a gain.

The world is being shaped in a different way, the banks are partially being bailed out with
public funds, that would need a different leadership for the banks that would be more
prudent and risk sensitive; there is a dichotomy that would need to be solved that the
Basel 2 would be recommending higher capital adequacy ratios and reserves for the
difficult days that would necessitate higher capital needs for banks, while the current
situation would demand that the banks start lending as soon as possible and as much as
possible. The risk aversion would have to be met with risk proneness. This would
invariably lead us to a low credit environment for a long time as the money needed to get
the toxic assets out of bank balance sheets is itself a very tricky affair. The incentives in
this new environment to spur the right kind of behavior must understand this.

The business models must understand this. The automotive businesses would have to
confront the reality that the old model of replacing cars every four years is probably gone
for quite some time. The building segment would have to understand that housing starts
would remain to be at the subdued levels for a very long time. The entire consumer
industry that relied on personal finance and much relaxed environment of credit would
have to deal with a different situation.

When the markets are down because of lack of credit or otherwise, the top line has two
kinds of pressures; the first is the lack of saleable volumes and the second is the lack of
ability to get the right prices. The second one stems from the excess capacity that exists
in the market. But the market will slowly adjust this capacity, as no one would like to
make cash losses, those that are in the wrong side of the cost curve would have to close
down. The more this keeps happening capacity over-hang would get adjusted, but at a
phase lag. So there is actually no deep pressure in the market to lower prices; in a
downturn like this unless someone wants to trade cash against profit in a very distressful
manner. Thus being on the right side of the cost curve is of paramount importance during
the downturn.

Quite unknowingly what played so well during an upturn in the pricing game, the
incentives fail to attract any strategic decision making process during a downturn. The
supply side game stumbles upon the demand side problem. The problem actually shifts to
cost leadership or innovation. In fact even innovation stumbles as the markets targeted for
such products also return a lukewarm response in a downturn.

At the end there is nothing left but cost, and there is no alternative to this. Most winners
know to do this well. So the incentives must be so designed that this gets a distinct
visibility. Actually the gains so derived from these actions could last forever. The
survival in the short term provides a strong footing to build on and product differentiation
or supply chain designs that deliver a better value become effective strategies for the
future. In that respect incentives designed that tries to focus on the process rather than the
results could actually be more effective during a downturn. Who knows they could be
extended to upturns as well and with superior results?

The action by government to tame large scale risk taking that could bring in entire
economies to a grinding halt is the hot topic of today. By taking these actions we could
surely put to rest the long held fear of leaving the markets to decide our destiny, entirely.
But the question is whether these punitive actions would serve as the right kind of
incentives for spurring the current demand, the dearth of which is the root of the problem
that we can hardly ignore. Expecting that increased lending again could solve all
economic problems in a downturn and incentivizing those actions that help to achieve
this end may not be the solution, it could just be a part.

Financial instruments alone could make limited impact and there lies the challenge of
incentives.

Procyon Mukherjee
Zurich
24th March 2009

Procyon Mukherjee lives in Zurich.