Talent Management Column

More Lessons from the Financial Crisis

More Lessons from the Financial Crisis | Human Resource Executive Online "Pushing the envelope" to meet performance and organizational goals has contributed to the meltdown of the economy. Paying for performance without assessing the quality of the performance can be a recipe for disaster.

Monday, October 13, 2008
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My column last month was about some of the management lessons from the financial crisis. When I wrote that column, I believed -- like most people -- that we would be focused on some other issue this month, probably the U.S. presidential election.

Unfortunately, that's not the case.

No single set of events in a generation is likely to have a bigger effect on the lives of as many people as the continuing meltdown of the world financial system. So forgive me for dwelling on it a little more.

There is no single villain behind this crisis, but as the story unfolds, we see a theme played out in different settings that is at the center of the crisis. And that is an effort to "push the envelope."

The envelope included pushing the government, especially the U.S. Securities and Exchange Commission, to back away from regulations and their enforcement within the retail banks and then, the investment banks. It included pushing the limits on prudent risk-management practices as well as the limits of acceptable accounting practices so others could see what was going on. And at the level of the individual loan officer or investment broker, we saw limits pushed on individual transactions.

The common factor motivating these actions across all these settings was big financial incentives to meet and exceed company and individual performance targets.

One of the big trends in the field of management over the past decade or so has been to improve overall financial performance of companies, first, by identifying those aspects of individual jobs that have the biggest and most direct effect on company performance and that can be measured most straight-forwardly; second, by making individuals feel accountable for their performance in those tasks by getting them to establish clear goals for themselves and then pushing to s-t-r-e-t-c-h those goals to a level such that achieving them will represent a real challenge.

And finally, we load on rewards: Meet the goals and get a big compensation payout. More recently, the pressure has been on to deal more aggressively with those who fail to achieve their targets.

While this approach is highly motivating, it is not good at nuance. The aspects of jobs that are being measured and rewarded tend to be quite narrow.

Think about how this relates to the current financial crisis.

Let's start at the bottom of the food chain -- at the bank making mortgage loans for houses. The loan officers are assessed based on the number of loans they make as well as on the size of those loans. They typically are paid commissions for each loan sold.

Mortgage brokers, who play the intermediary role of matching lenders and borrowers, are also paid on commission -- even more aggressively than the loan officers.

Both the loan officers and the 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 their loan, and by that time, the mortgage could well be at a different bank -- as could the loan officer. 

So the goal is just to get the loans through the approval process. There is no downside if one is less than careful in checking references or in establishing current income; thus pushing the envelope on the standards.

Consider the next player in this process, the assessor, whose job it is to certify whether the value of the house merits the size of the loan. Assessors get paid no matter what their appraisal is of the property. But the loan does not go through if the property assessment is too low. The unhappy lender then reminds the assessor that future engagements are at the pleasure of the lender.

Then we get up to the bank itself, where it is now in the business of selling the mortgages to other financial institutions.

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Mortgages with higher returns are worth more, while those that are risky are worth less. 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 whose mortgages are less valuable, possibly because of a more accurate assessment of the risk, go begging. 

All this brings me to a now very timely academic study about some of the motivations to cheat about meeting workplace goals.

In "Goal Setting as a Motivator of Unethical Behavior," a study by Maurice E. Schweitzer, Lisa Ordonez, and Bambi Douma that was published in 2004 in the Academy of Management Journal, 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; while a third had financial rewards tied to achieving those rewards.

The 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.

Especially in the world of finance, we have moved away from performance assessments based on a wide range of job and personal outcomes and moved toward a much simpler model that focuses on a small number of outcomes and rewards those heavily.

This approach encourages employees to push the envelope to hit their numbers, to get the rewards and to avoid the equally big punishments. What can't be captured with this simple approach are all the other aspects of employee behavior, which include the costs of pushing that envelope. In this case, those costs ended up being pretty big. 

Peter Cappelli is the George W. Taylor Professor of Management and director of the Center for Human Resources at the Wharton School of Business.

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