Think Tank Tuesday: Unintended Consequences

by Duke Magazine

The term “cobra effect” is often used to describe a situation whereby an intended solution to a problem inadvertently worsens the problem itself. The term originated back in Colonial India, during a time when the British government was growing concerns amid the increasing number of venomous cobras ravaging the city of Delhi, India. In an attempt to rid the city of this problem, the government offered a bounty in exchange for each cobra skin. At first, the incentive seemed like a sensible solution and appeared to be working. But some individuals discovered a loophole by leveraging on that tangible gesture from the government and began to breed cobras for the monetary gift. Eventually, the government found out this insensitive development and rescinded their decision. The breeders grew fury with the stance of the government, and then set the snakes free, which in turn made the basic problem even worse. 

This anecdote provides an excellent example of how a well-intended incentive can sometimes produce the opposite of the expected outcome.

There is no doubt a power-base employed by incentives, but what about unintended effects like the cobra effect? By their very nature, these situations are difficult to avoid since the outcomes are never intentional. Let’s explore a few examples.

In 2016, Wells Fargo, a highly regarded financial institution in the United States, faced a whirlwind of issues stemming from problems with its incentive scheme. The company had long had a reputation of strong retail footprint, low-cost deposit base, and high customer satisfaction. Investors has always been appraising the bank for having several touch points with its clients. Wells Fargo’s incentives were designed to further deepen relationships through sales targets that promoted selling multiple products to customers. But somewhere along the line, some lagging employees who struggled to meet these targets started cutting corners by opening deposit and credit card accounts for customers without their knowledge. This act resulted in the opening of about two million unauthorized accounts between 2011 and 2016. This consequently led to the retrenchment of 5,300 employees by the company, and further abandoned the sales targets, and faced significant public scrutiny. The CEO of the company was also put under fire for his resignation. To the foregoing, Wells Fargo is a recent example of the cobra effect, as management had logical incentives in place to promote increased customer satisfaction and profitability, but the incentive structure produced an unintended effect, which had quite the opposite effect. There are several examples of companies that have hit a debacle like this. 

Assessing Home Capital Group’s issues with fraud stemming from the mortgage broker network, in 2014 and 2015. The broker network was incentivized by volume growth, which encouraged some less-ethical brokers to submit fraudulent documentation to increase mortgage volumes, and, ultimately, their compensation. Contrary to the aim of this incentive structure, the scandal resulted in lower mortgage growth as the company was later forced to deal with operational and regulatory challenges, not to mention a defamed reputation.

One of the most profound examples of incentives gone wrong was during the financial crisis of 2008/2009. A major factor that encouraged financial institutions to create and sell instruments that were not fully understood was the desire to keep pace with industry earnings expectations. There were also those individuals at these institutions whose personal incentives were aligned with promoting these products. While these choices may have benefited certain individuals in the short-term, the financial institutions they worked for faced significant long-term implications, including financial and reputation concerns.

There are many more examples of companies who have faced challenges (or successes) because of incentives. 

It is then believed that studying behavioral economics can help explain what drives individuals, management teams, and even stock market participants. A central tenant of behavioral economics is that incentives drive human behavior. While businesses often use this knowledge to influence the actions and direction of employees, the power of unintended effects can get in the way at times. There will always be individuals manipulating the system to selfishly obtain a desired outcome in a faster or easier way.

To analyze a company’s incentive structure to mitigate potential unintended effects, there are a few critical features that must be looked for, including a simple incentive structure that is transparent, varied, and easy for employees to understand. Using a simple structure also makes it easier for management to consider some potential unintended effects cropping up beforehand. Additionally, it is safe to look for incentives that are balanced on a lot of measures and time horizons. There is a keen preference for companies who consider short-term and long-term incentives, and balance both individual and company-wide goals. While each business is unique and requires a different set of goals, there must always be an advocacy of paying good attention to return on capital and profitability on a per-share basis. Return on capital balances growth in profitability while considering the level of capital investment needed to achieve that growth. Focusing on increasing the per-share value of a business encourages management to strive for value enhancing growth, and think critically before issuing new equity. Furthermore, a strong correlation of interests triggers management and employees to be creative and proactive where necessary. Management who invests their own money with shareholders demonstrates their commitment to the business and not just their pay-cheque.

Nevertheless, every well-thought-out compensation plans are at risk of human abuse, but it is even more important for companies to enhance a culture of trust and integrity, and be willing to pinpoint anomalies with adequate fixing when necessary. Strong organizations typically install the right controls into their processes to catch unintended effects early. But if something slithers through the cracks, a culture of candor and a lack of ego may help companies respond and move forward. A company’s business decisions can also tell you a lot about their culture and predispositions.

The analysis of incentive structures is an important aspect of reaching out to investment process because it allows for a holistic look into what goals, management, and the organization are striving for and quantify how they measure success. 

Charlie Munger said it best: “Never ever think about something else when you should be thinking about the power of incentives.” Irrespective of this, the examples noted above will not be the end of incentives that have gone awry. Just like in Colonial India, unintended effects will always be a risk in business and in life. Whether it’s related to compensation or otherwise, the laws of behavioral economics will prevail.

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