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Sunday, May 02, 2010

"Reputational Capital and Incentives in Organizations"

Rajiv Sethi notes that if "the preservation of its reputation for serving the interests of its clients was a major organizational goal for Goldman, then something clearly went terribly wrong."  Rajiv argues there are two ways to get employees to avoid pursuing strategies that are profitable for the individual, but may put the firm's reputation at risk. One is to create the proper financial incentives, and the other is to "hire individuals who are predisposed to behave in a principled manner even in the face of incentives not to do so." He goes on to argue that the first solution, the use of financial incentives, is infeasible. Thus, firm's ought to hire people "who are predisposed to behave in a manner that meets organizational objectives: to place a premium not only on ability but also on character."

But how do we find such irrational individuals? After all, putting the interests of the firm ahead of your own interests sounds like a departure from the rational self-interest seeking behavior assumed in economic models. In fact, it sounds anti-capitalist to assume that individuals will work for the common good first and foremost rather than for what's best individually. Rajiv argues that this type of behavior may not be irrational after all. The absence of self-interested behavior can result in payoffs that are larger than when individuals maximize individual gains, and hence such behavioral traits -- the traits necessary for allegiance to what's best for the group even if it comes at the expense of individual incentives -- is rational:

Reputational Capital and Incentives in Organizations, by Rajiv Sethi: The following passage, jarring in light of recent revelations, appears in the opening pages of Akerlof and Kranton's recently published book on Identity Economics:

On Wall Street, reputedly, the name of the game is making money. Charles Ellis' history of Goldman Sachs shows that, paradoxically, the partnership's success comes from subordinating that goal, at least in the short run. Rather, the company's financial success has stemmed from an ideal remarkably like that of the U.S. Air Force: "Service before Self." Employees believe, above all, that they are to serve the firm. As a managing director recently told us: "At Goldman we run to the fire." Goldman Sachs' Business Principles, fourteen of them, were composed in the 1970s by the firm's co-chairman, John Whitehead, who feared that the firm might lose its core values as it grew. The first Principle is "Our clients' interests always come first. Our experience shows that if we serve our clients well, our own success will follow." The principles also mandate dedication to teamwork, innovation, and strict adherence to rules and standards. The final principle is "Integrity and honesty are at the heart of our business. We expect our people to maintain high ethical standards in everything they do, both in their work for the firm and in their personal lives."

If the preservation of its reputation for serving the interests of its clients was a major organizational goal for Goldman, then something clearly went terribly wrong. Consider, for example, Chris Nicholson's report on the manner in which the bank managed to shed its holdings of mortgage backed securities shortly before they collapsed in value, allegedly serving itself "at the expense of its clients." ...

This is a form of tail risk that is not unlike that taken by the folks at the AIG financial products division when they sold vast amounts of credit protection in the mistaken belief that they would never be faced with significant collateral calls. ... As in the case of tail risks arising from the sale of credit protection, damage to the firm's franchise value does not appear in standard compensation benchmarks. The problem in Goldman's case was not that such damage was "a hit worth taking" but rather that the incentives faced by its employees did not adequately reflect the value of the firm's reputation in the first place. To the extent that employee behavior is responsive to such incentives, the sacrifice of reputation for immediate profit will be made regardless of whether or not, in the broader scheme of things, the damage to franchise value exceeds the short term gains.

How, then, might a firm accomplish the subordination of short term goals to long term objectives in practice? There are two possibilities: one could hire individuals who are predisposed to behave in a principled manner even in the face of incentives not to do so, or one could design compensation schemes that adequately reward actions that preserve or enhance reputation. Economists, being fervent believers in the power of incentives, usually tend to favor the latter approach. But in this particular context, there are two possible problems with this. First, the contribution of any given transaction to the reputation of the firm is generally much more difficult to ascertain and quantify than any contribution to the firm's balance sheet. This makes it difficult to assign reward appropriately. Second, in order to serve as credible commitments to clients and customers, compensation schemes must be easily observable and not subject to renegotiation after the fact. This is seldom the case.

The alternative is to hire individuals who are predisposed to behave in a manner that meets organizational objectives: to place a premium not only on ability but also on character. But would this not create incentives for potential employees to simply misrepresent their values? As Groucho Marx famously said: "The secret of life is honesty and fair dealing... if you can fake that, you've got it made." 

Fortunately, the consistent misrepresentation of personality traits is often infeasible or prohibitively costly. There is an interesting line of research in economics, dating back to Schelling and continuing through Hirshleifer and Frank, that explores the commitment value of traits that are costly to fake. Hirshleifer went so far as to argue that the "absence of self-interest can pay off even measured in terms of material selfish gain, and... the loss of control that makes calculated behavior impossible can be more profitable than calculated optimization... we ought not to prejudge the question as to whether the observed limitations upon the human ability to pursue self-interested rationality are really no more than imperfections -- might not these seeming disabilities actually be functional?" 

One could take this a step further: not only might limitations on the unbridled pursuit of material self-interest be functional for individuals, they may also be functional for the organizations to which they belong. And in the long run, firms that manage to identify and promote such individuals will prosper at the expense of those who are unable or unwilling to do so.

Update: More on business reputation from Richard Green:

What Milton Friedman got wrong, by Richard Green: Friedman had two fundamental problems with business regulation. His first is that the business would capture the regulator, and therefore use regulation to establish monopoly power. My field leads me to find this line of argument compelling: real estate developers love (regulatory) barriers to entry that keep competitors from building.

His second, though, is just wrong. He argues that in order to preserve their reputations, businesses will self-regulate. Among other things, this ignores that managers often have short-term horizons. It also ignores that when large businesses implode, they leave victims with whom they never engaged in a transaction in their wake. BP did nothing illegal--how's that reputation thing working out? And having now read a whole lot on Goldman-Abacus (including the SEC complaint, the response on GS's web site, the offering circular, and excellent commentary from James Surowiecki, Yves Smith and others), it is not clear to me that Goldman did anything illegal or actionable (but I could be persuaded to change my mind). It is just that what it did (including investing long in CDS) should be unambiguously illegal and actionable. I can't think of anyone who had a bigger reputation franchise than Goldman.

As Rajiv notes, "If the preservation of its reputation for serving the interests of its clients was a major organizational goal for Goldman, then something clearly went terribly wrong."

    Posted by on Sunday, May 2, 2010 at 11:52 AM in Economics, Methodology | Permalink  Comments (49)


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