PRODUCTIVITY SPECTATOR: Incentivised to be dirty

Productivity Spectator

The unemployed masses in struggling European nations might be forgiven for taking some time off from wondering where they'll find a job to celebrate the departure of Bob Diamond as chief executive of Barclays Bank.

It will probably be a short lived celebration once they realise Diamond will have a £105 million nest egg to ease his transition into unemployment.

It may well end up that there will be plenty of culprits in the disgraceful manipulation of the key lending rate that affects every one of us but it might help to re-read the emails that sparked such outrage in the first place.

Following a request to set rates artificially low, one Barclays banker writes: "Done ... for you big boy". The response from his colleague… "Dude, I owe you big time! Come over one day after work and I'm opening a bottle of Bollinger".

These are the same bankers that profited so hugely from manufacturing increasingly complex credit instruments that suckered in investors, home-owners and governments alike and are the same bankers who are holding the eurozone to ransom for their inability to service what said bankers would have described at the time as ‘a very good deal'.

Barclays wasn't one of the UK banks that received over £1 trillion in bailouts and guarantees from the British Government. But the culture of risk and reward that was fostered by Bob Diamond is at the heart of why our finance system needs to be thoroughly cleaned out and why the ‘light-touch' regulation that was a hallmark of the British banking system has been clearly such an abject failure.

Diamond championed a bonus culture that effectively incentivised a gambling mentality.

Since the 2008 crisis, there has been much investigation into how these incentives affect behaviour. Research by Jose Scheinkmann, of Princeton University shows a clear correlation between compensation and the amount of risk executives take. Yet there is no clear evidence that greater compensation results in better returns for shareholders.

That means the incentives are skewed under the current compensation culture.

The short-termist approach to pocketing bonuses as quickly as possible increases risky behaviour and the more executives earn, the greater the bonuses need to be to encourage risk-driven returns. And it seems that aligning banking executives to the long term future of the firm does little to discourage risky behaviour. Research by Bruce Kogut of Columbia Business School into 117 US financial firms found that equity based incentives (either in shares or stock options) was a significant contributor to the risk-based culture that led to the financial crisis, and did not dissuade executives from taking risk for fear of losing value of their holdings. (Indeed Lehman and Bear Stearns execs cashed out over $2 billion between 2000 and 2008).

Kogut, who is professor of leadership and ethics at Columbia Business School says that ethical breaches start at the top and that such activities are not one-off events but actions that require someone to stand up and say ‘no' at some point along the decision making process. Kogut says that in situations like that at Barclays, the firm has to send a clear message almost immediately.

For gross ethical errors, the people involved should be fired. It sends a strong statement about what will not be tolerated. Not only that, he says, but bonuses paid should be clawed back.

There is a lot of dirty laundry yet to be aired over the manipulation of Libor.

A Barclays executive confessed to the British Banking Association "We're clean, but we're dirty clean, rather than clean-clean," he said.

The BBA officials response: "No-one's clean-clean."

Clearly light regulation is not the answer in managing the banking system. Let the UK remain a lesson for us in Australia.