McKinsey once got a study from a major shipping company whose bottom line was suffering because the managers in its ports were keeping too many containers on hand. No one wanted to be short of containers and delay a shipment, so they all made sure to have enough and then some. Containers are a big cost item and management was keen to figure out how to get by with fewer.
Now the team could easily have had great fun building a big model of shipping flows and likely variability and done lots of analysis to figure out what the minimum needed level of containers was and how to have the right decision rules. Instead, the team changed the pay for port managers, so that on the one hand, they’d still be penalized if shipments were delayed, but they would be rewarded for minimizing the number of containers they had. Almost immediately, port managers were sending containers away and complaining if an influx of shipments left them holding a lot. The shipper was quickly able to reduce its stock of containers.
Since the crisis, there has been lots of debate on what to do about incentives in the financial services industry with little in the way of action. That’s because we maintain the fiction that major capital markets firm are private sector companies. Despite the fact that they enjoy subsidies vastly in excess of other industries, we can’t possibly treat them like the welfare queens they are and ride herd on their compensation levels.
But it’s still worth pondering the issue of what ought to be done, since pretty much every investor I know expects another big crisis in two to five years. We had better get it right next time.
The germ of a very interesting idea came in a VoxEU paper last March which I had wanted to highlight and somehow let slip. One of the problems with the big end of financial services industry is that it is highly interconnected, so if one firm gets in serious trouble, it is likely to bring the whole network down. Yet because bankers have perverse incentives (annual pay cycles and business unit level pay for most producers, both of which encourage narrow views of risks), banks routinely try to shift risk onto their counterparites, which is fine in normal times, but a destructive posture when markets become risky (the blow up of AIG and the monolines is a classic example).
Here is Hans Gersbach’s solution:
When banks failed, the government paid up. But the bankers responsible kept their bonuses from the years of excess. This column argues for “crisis contracts”….
Crisis contracts are designed specifically for members of the bank’s management. The nature of a crisis contract is as follows:
Definition of a crisis: A crisis occurs when the average equity capital in the banking system (relative to the assets) falls below a critical predefined threshold.
When a crisis occurs, the top managers of major or highly interconnected banks contribute a portion of their earnings from the previous years to a rescue fund for the recapitalisation of the banking system.
I think this idea is promising but would tweak it: a much longer lookback period (at least three years, with fund set aside rather than having to be clawed back) and including a broader base of managers (you’d want to include all profit centers running meaningful balance sheet risks).
This would also have the significant advantage of increasing incentives throughout the industry to monitor risks of counterparties, which also might even lead them to inform regulators if they thought a firm was engaging in risky practices.
Reader suggestions as to how to refine this idea very much appreciated.