Lessons from the Financial Services Crisis

The financial world has taken the nation on a roller coaster. Consider the collapse of Lehman Brothers, a venerable investment bank in operation since 1844; the sale of Merrill Lynch to Bank of America; the federal bailout of insurance giant AIG; and the government takeover of two major mortgage loan and loan guarantee companies, Fannie Mae and Freddie Mac.

Before that, citizens watched in horror at the collapse of private mortgage companies, Countrywide Financial being the largest. And before the current crop of failures hit, there was the spectacular collapse of the Long-Term Capital Management hedge fund and the announcement in January 2008 of a $7.2 billion loss from an employee’s fraudulent trading at Societé Generale, the third-largest investment bank in the Euro Zone. The global effects were reflected in the credit and stock markets. Through mid-October 2008, U.S. investors suffered more than $9 trillion in losses, at least $2 trillion of that in retirement savings.

No single villain lurks behind this crisis, but as the story has unfolded, a common theme has played out across the failed companies—efforts to “push the envelope.” These efforts included pushing the government, especially the U.S. Securities and Exchange Commission, to back away from regulations and enforcement within the retail banking sector and investment banks; it also included pushing the limits on prudent risk management and acceptable accounting practices.

At the level of the individual loan officer or investment broker, people pushed limits on fiscally prudent individual transactions. How could the executives at these troubled institutions ignore or fail to see the level of risk their companies were assuming? The common factor motivating these actions across all settings was major financial incentives to meet and exceed company and individual performance targets.

The collection of failures in the financial industry matters for human resource leaders because all were caused by management failures, including the failure to manage HR risks—challenges that stem from people, programs and processes. Such risks include, among other things:

• Financial incentives in the form of performance-based pay that create pressures to push the envelope of prudent risk management.
• Insufficient attention to ethics and tone at the top.
• Inadequate reporting and disclosure structures.
• Insufficient training and development programs.
• Poor alignment of pay and performance.

An October 2008 report by Ernst & Young, based on a survey of global finance, HR and risk executives at Fortune 1000 companies, found disturbing evidence of these failures. Only 34 percent reported that their boards of directors formally review traditional corporate risk matters quarterly, and 41 percent reported that their boards either never formally review their companies’ HR risk profiles or review them only on an ad hoc basis. Only 39 percent said they communicate results from HR risk management teams to those responsible for the broader corporate risk management process.

Rewards Systems

Now consider several related failures, namely, the rewards systems in place, with attention to some key jobs in the financial services industry; the focus on individual talent rather than broader management systems; and organizational culture, ethics and values. Results of this study engender a call for HR leadership—and a set of lessons learned from this painful experience.

Incentive systems are powerful drivers of behavior. As the adage states, “What gets rewarded gets done.” Or as Hicks Waldron, former chairman and chief executive officer of Avon Products Inc., famously said, “It took me a long while to learn that people do what you pay them to do, not what you ask them to do.” One veteran salesman explained it this way: “Look, you make the rules, we’ll play the game.”

Problems in financial services companies began with individuals and groups of individuals taking risks that their organizations as a whole would never have approved of, and then covering up losses that would have made their own performance look worse. This is not surprising, in light of the Ernst & Young results. Could it be that the incentive plans underlying their performance had unintended consequences? Certainly, history provides ample precedent, as reflected in Steven Kerr’s classic 1975 management article, “On the folly of rewarding A while hoping for B,” in the Academy of Management Journal.

The management approach that led to these problems went something like this. First, identify those aspects of individual jobs that have the largest, most direct effects on company performance and that can be measured most straightforwardly. Second, make individuals feel accountable for their performance in those tasks by having them establish clear goals for themselves, and then push them to stretch those goals to a level where achieving them represents a real challenge. Finally, load on rewards: Meet the goals and get a big payout. While this approach is highly motivating, often the aspects of performance measured and rewarded tend to be quite narrow.

Let’s start at the bottom of the food chain at the bank: making mortgage loans for houses. The loan officers are evaluated on the number and size of the loans they make. They typically are paid commissions—a certain amount for each loan sold. Mortgage brokers, or intermediaries who match lenders and borrowers, also receive commissions—even more aggressively than the loan officers.

Both loan officers and brokers are likely to lose their jobs if they are not processing loans. There are no penalties in either role for making “bad” loans. After all, it would likely be years before someone defaulted on a loan, and by that time the mortgage could be at a different bank—as could the loan officer. So the goal is just to get the loans through the approval process. Assessing the quality of the loans is someone else’s problem, with no downside if one is less than careful in checking references or establishing current income. There are no penalties for putting forward loans that get turned down.

Consider the next player, the property assessor who certifies whether the value of the house merits the size of the loan. Assessors get paid no matter what their appraisals are, but loans do not go through if assessments are too low. The lenders are then unhappy and remind assessors that future engagements depend on the pleasure of the lenders. The assessors look around and see others overvaluing properties. They get the message.

Then, look at the bank and its capital markets group in the business of selling mortgages to other financial institutions. In “bundling,” individual mortgages—or in many cases, pieces of individual mortgages—are pooled and sold as financial instruments to investors. These mortgage-backed instruments are worth more if they have higher returns. Risky ones are worth less.

Banks get their money from the sale of these assets upfront, meaning they need a continual stream of mortgages to bundle and sell to keep revenue coming in. Employees in the capital markets groups are paid bonuses, often large ones, based on the stream of revenue they generate—revenue based on the number of and prices for mortgage-backed assets they sell. If one is less than transparent about the risk involved in a given mortgage, it is easier to sell it at a higher price. The bank and the traders get rewarded when the mortgages sell for more money: The banks supplying the highest-yielding mortgages get all the business, while those with less-valuable mortgages, possibly because of more-accurate assessment of their riskiness, go begging.

Back inside the bank, the pressure is on at various levels to keep the flow of mortgages coming—pressure on the loan officers to get more business and, at least informally, pressure on the underwriters and the quality control groups overseeing the loan officers to let more loans through. At the corporate level, the performance of executives is judged by, and their compensation is determined by, overall bank performance, which is typically measured by share prices. Keeping profits up requires keeping the loans flowing, and that message easily becomes part of the culture. No one has to say that pushing the envelope on each task in the loan process is required for that message to get through.

Focus on Individual Talent

Another aspect of the management failures behind the financial crisis has to do with the focus on individual talent. Stars, rainmakers, “A” players—regardless of the name, every organization wanted to attract and retain them. In investment banking, the competition was intense to find top traders, analysts and dealmakers. What constitutes talent in these contexts? Individual performance. McKinsey & Co. called that “the war for talent” in a book by the same name (Harvard Business School Press, 2001) and preached a simple mantra: Having better individuals at all levels is how you outperform competitors. Nowhere was that practiced more zealously than at an earlier massive failure,

Enron, whose leaders boasted of having “the smartest guys in the room.”

Yet the shortcomings of a narrow focus on talent were identified clearly by Charles O’Reilly and Jeffrey Pfeffer. Their 2000 book, Hidden value (Harvard Business School Press), describes how systems for managing people were the real sources of competitive advantage, even with employees of average ability. Those same shortcomings were unmasked completely in a 2002 article in The New Yorker by Malcolm Gladwell, “The Talent Myth—Are Smart People Overrated?” The problem in the argument begins, according to Gladwell, with the simple fact that the observed correlation between IQ and job performance is only between 0.2 and 0.3; statistically, a value of zero indicates the complete absence of a relationship. In other words, IQ explains only a small percentage of the variance in actual job performance—less than 10 percent—so there is obviously a lot more than individual ability in the making of a successful employee, let alone a successful company. That said, general mental ability tests are useful predictors of subsequent job performance.

To illustrate how extreme the focus on individual ability has been, consider a comment from Jimmy Cayne, former CEO of Bear Stearns and a former professional bridge player. “People, for whatever reason, think if you’re a good bridge player, you’ve got a good brain, so I might as well do business with you.”

By one account, Cayne viewed his role as Bear Stearns’ CEO as similar to that of manager Joe Torre in his New York Yankees’ heyday: Cayne was managing a team of superstars, and he expected them to handle whatever problems might appear in the company’s highly leveraged, mortgage-related hedge funds. They didn’t, Cayne’s hands-off management style kept him in the dark, and the company subsequently failed following a liquidity crisis.

Current events clearly support Gladwell’s theories when he argues that the broader failing of those who espouse the talent myth is that they believe in stars because they don’t believe in systems. Companies don’t just do the creative work where individuals excel. They execute, compete and coordinate the efforts of many people. The organizations most successful at those tasks are the ones where systems are the stars. Examples of companies where systems are the stars include Goldman Sachs, Southwest Airlines, SAS Institute, and Procter & Gamble.

Culture, Ethics and values

Organizational culture—shared values, expectations and behaviors—sets the context for everything a company does. Indeed, a strong culture is a common denominator among the most admired companies. All have consensus at the top regarding cultural priorities, and those values focus not on individuals but on the organization and its goals. Rather than giving culture a few lines in the company handbook, leaders in the most admired companies live their cultures every day and go out of their way to communicate their cultural identities to employees as well as prospective new hires. They are absolutely clear about their values and how those values define their organizations and determine how the organizations run.

Now, back to the financial crisis. The troubled mortgage operations and investment banks also have strong cultures, but they are cultures characterized by rampant individualism, little attention or oversight from supervisors, and huge rewards for successful performance. Those values generate tremendous pressure to maximize individual performance and payouts, often by taking outsize risks and hiding failures.

That same pressure often causes players to push the envelope as to acceptable ethical behavior. We know, for example, that the pressure on publicly held corporations to meet investor expectations of quarterly returns causes them to “manage” earnings. Although one should expect actual earnings, on average, to undershoot expectations as often as they overshoot them, in practice, earnings reports virtually always overshoot expectations. Even the father of the view that financial incentives can solve virtually every management problem, former Harvard professor Michael Jensen, notes that managers end up cheating on practices such as budgeting because it makes their lives easier.

This brings us to a now-timely academic study about how individual goals create the motivation to cheat. In the Academy of Management Journal’s “Goal Setting as a Motivator of Unethical Behavior,” the authors created a context where one group of individuals was told to “do your very best” at meeting some challenges, a second group was told to set challenging goals for the same task, and a third had financial rewards tied to achieving those ends. The 2004 study also created the opportunity for participants to lie about achieving their goals. Simply asking people to set goals caused them to cheat a lot more frequently. Rewarding them for meeting those goals caused them to cheat even more—three to four times more frequently. The relationship between goal setting and unethical behavior was particularly strong when people fell just short of reaching their goals.

Especially in the world of finance, at least some managers have moved away from performance assessments based on a range of job and personal outcomes, and toward a simpler model that focuses on, and heavily rewards, a small number of outcomes. This approach encourages employees to push the envelope to hit their numbers, get rewards and avoid equally big punishments. What can’t be captured with this simple approach are all the other aspects of employee behavior, including the costs of pushing that envelope. In this case, those costs ended up being pretty big.

It is no coincidence that Goldman Sachs—formerly an investment bank and now a bank holding company engaged in investment banking—remains one of few banks standing as a solvent, independent entity. The company continues to be known for paying careful attention to selecting new employees, to teamwork, to maintaining a healthy organizational culture based on positive values and, more generally, for taking the management of people seriously. In an Oct. 10, 2008, interview, Kerr, former chief learning officer at Goldman Sachs, described a selection process that may include as many as 20 interviews prior to hire. He described a team-oriented culture at the investment bank, with managers typically involved in six to eight meetings per day. “Making any decision requires checks with many people, and before we make a decision to invest, many eyes have seen the proposal,” he says.

Charles Ellis, author of The Partnership: The Making of Goldman Sachs (The Penguin Press, 2008), bases his account on the stories of vast numbers of current and former Goldman executives. He concludes that the teamwork approach meant that Goldman wasn’t always the fastest to arrive in a promising new area, but company officials made far fewer blunders tied to any single executive’s hubris. The company has experienced periodic scandals since its founding in 1869, but none has been fatal. According to Ellis, culprits were identified, fines were paid, and Goldman emerged with better controls and procedures each time.

According to Kerr, Goldman regularly reviews the values or business principles that guide its everyday operations by asking questions such as, “Which are we most or least faithful to?” and “Which need freshening or reaffirming?” For example, in contrast to institutions where employees face great fear of being terminated for disclosing bad news or the results of bad decisions, hoping that somehow the market will make everything right, at Goldman Sachs the message is, “You will suffer if you don’t bring us the bad news. You won’t necessarily be fired, but it is your responsibility to get us out of this.”

Finally, according to Kerr, to ensure that there are no misunderstandings about ethical principles or the investment bank’s code of conduct, Goldman Sachs sponsors six-hour ethics seminars and requires all managing directors to attend. Under then-CEO Hank Paulson, most of the remaining employees attended subsequent seminars, with participants of the initial seminars becoming discussion leaders for their teams and departments.

By setting a tone of high ethical conduct at the top, Goldman leaders are clear about how they expect their entire workforce to act. This approach carried over into the investment bank’s performance management processes, which feature face-to-face performance reviews, narratives on each direct report, and 360-degree feedback from supervisors, subordinates and peers. Individuals in the lowest quartile of performance receive more-frequent feedback to address performance problems.

From Failure to Opportunity

What can HR professionals learn from these failures? To be sure, there is more to the current financial crisis than just the incentives of executives and employees; the focus on individual talent; and the cultures, ethics and values that have brought down so many institutions. That complication can easily distract business executives from seeing a disturbing pattern, namely, that virtually every corporate scandal during the past decade or so has been about financial impropriety, often exacerbated by a lack of management controls.

From WorldCom to Enron to Adelphia to Arthur Andersen to Global Crossing to Tyco to a series of smaller scandals at AOL Time Warner, Bristol-Myers, Qwest Communications, and Reliant Energy, all in 2002—it is almost impossible to list them all—every scandal has involved executives pushing the financial and accounting envelope to the point of breaking to inflate profits, cover losses and make their own performances look better.

Wayne F. Cascio is U.S. Bank Term professor of management at the University of Colorado Denver. Peter Cappelli is the George W. Taylor professor and director of the Center for Human Resources at the Wharton School, University of Pennsylvania, in Philadelphia.

Web Extras

• Online sidebar: Interviews with SHRM Special Expertise Panel members on incentive pay By Wayne Cascio
• Online sidebar: Authors’ reference list