The inappropriate financial incentives of the Global financial crisis
Instructions: To what extent was the global financial crisis of 2007/08 caused by inappropriate incentives? Have these incentives been changed sufficiently by subsequent reforms?
Solution.
The inappropriate financial incentives of the Global financial crisis
Introduction
Amid the global financial crisis of 2007008, financial analysts and experts reported that financial incentives provided to the bankers as the major cause. For example, the UK’s Chairman of the Financial Services Authority, Adair Turner, stated that allocation of inappropriate incentives and bonus structures was a contributory factor to the financial crisis during the period. Conversely, the Inquiry Commission formed in the United States found out that the global financial crisis was partly caused by the failure of corporate governance, and exacerbated compensation to financial executives on a short term basis (Allison, 2012, 113).
Employees are provided with incentives such as stock options and bonuses as a way of improving the organizational performance. However, this practice would lead to unethical behaviors, foster discontent and envy among the employees, and fuel turnover. By investing heavily on extrinsic motivation, companies tend to spend excessively on their employees leading to economic slowdown (Watkins & Brook, 2016, 47). Experts have stated that bankers should focus more on intrinsic motivation to cut their expenses and improve the performance at the same time. Companies should design jobs that build interpersonal relationship among the stakeholders and develop skills as well.
In short, financial experts are against the use of inappropriate incentives to motivate employees because they are the major causes of financial crisis. This paper explores the relationship between monetary incentives and global financial crisis. Respective methods of incentives and how they cause crisis will be examined. Lastly, the study outlines several methods that can be employed by the government in order to curb the financial menaces listed in the paper.
Relationship between Inappropriate incentives and the banking sector
Bankers are provided with incentives to encourage their performance and make more money to their employers. However, such actions are more likely to expose the economy to economic breakdown. To clearly understand how inappropriate monetary incentives affect the company’s and economic performance, the scenario below should be considered (Bebchuk, 2010, 61).
When an investor borrows money from financial institutions to invest in promising investment opportunities, a problem described as the “asset substitution” is created. If the invested does not yield returns, the investors would seek to be declared bankruptcy and the debt holders would have to bear the cost of the debt (Bettinger, 2010, 76). Such investors are provided with leverage that protects them from high risks and motivates them to take more debts. The government in other hand, bails out the underperforming public companies leading to a costly financial crisis in the future (University of Pennsyvania, 2011, 32).
Some of the famous ethical fiascoes and corporate scandals, i.e. the Enron scandal, the WorldCom Scandal and the Tyco Scandal, that shattered the performance of the U.S economy have been attributed to the excessive incentive to the employees (Watkins & Brook, 2016, 81).
Since the 1970s, the role of corporate leadership has been focused on maximizing the shareholders’ interests through maximizing and financialization of their value (Johnson & Kwak , 2011, 123). As time passed by, the practice became a norm. To remain competitive in the market, both the lower- level and middle-level organizations have turned into offering financial incentives to its employees to improve their performance. The idea has always been: by providing high incentives, the employees become motivated and perform better which translates to better performance of the firm in the industry (Lai, 2012, 54). For instance, a study conducted in the U.S. found out that only 10% of the public held companies’ shares were held by the executives. However, at the end of 2003, the shares had increased to approximately 70%. Top executive members were heavily rewarded for their short term performances which proved to be disastrous during the 2007-08 financial crisis (Bettinger, 2010, 18).
Likewise, a study conducted in the U.S to investigate the trend of compensation of executives in the 50 U.S. leading firms found out that the bonuses offered to the CEOs increased by 30% between 2014 and 2015 financial years. However, I am not suggesting that companies should abandon financial incentives. A lot of studies have shown that such kind of incentives leads to higher productivity and performance levels. Extreme use of incentives to motivate employees is costly to the companies and economy (Watkins & Brook, 2016, 37).
Important Risks associated with inappropriate financial incentives
First, In the 1970s, the Green Giant (a leading company in the Milling Company) identified that frozen peas from one of its plants had been packed together with parts of insects. To improve the cleanliness and quality of its products, the managers created an incentive plan that would provide bonuses to the employees who found parts of insects from the products (Stevens, 2006, 5). To take advantage of the opportunity, the employees brought insect parts from their houses, plant them in the packages containing frozen peas and then “find” them so as to earn bonuses from the employees. This is a basic example where incentive have led to inappropriate/ unethical behaviors by employees (Johnson & Kwak , 2011, 96).
Although financial incentives are used to improve performance, employees do not follow ethical ways to earn them; as in the case of the Green Giant. There is a higher chance that people do engage in unethical behaviors when bonuses have been rewarded for achieving the organizational goals (Berk, 2008, 113). Moreover, unethical behaviors are more likely to occur when employees cannot meet their goals. For example, they would pack unfinished products, and produce poor quality products to earn extra money to pay for recreation for their families among other behaviors generally, it has become a normalcy to engage in unethical behaviors by employees (Bebchuk, 2010, 59).
Second, by encouraging unethical behaviors, monetary incentives leads to the creation of pay inequality that results into harm performance and fuel turnover. When the employees are rewarded based on their performance, employees performing similar tasks would be compensated differently (Allison, 2014, 112). Such methods of compensation are deemed to be unfair: numerous studies have shown that employee’s judge fairness by comparing the amounts they earn to those of their colleagues. Pay inequalities lead to jealousy, frustration, disappointment, envy and resentment. Compensation is used to show the status and value of employees in an organization. For example, in 2004, Google Company provided stock grants to the employees who made enormous contributions to its achievements (Johnson & Kwak , 2011, 115). Although the objective was to identify, reward, retain as well as attract key employees, the plan backfired because the employees who were not recognized felt overlooked, unrecognized and less important to the Corporation.
Like in the case of Google, there is enough evidence stating that organization that experience pay inequality are affected by greater employee and manager turnover. The high payments offered to encourage high performance among employees is outweighed by the high cost incurred from poor performance (Watkins & Brook, 2016, 89). When employees feel that they have been unfairly treated they are more likely to reduce their level of performance. This would, in turn, lead to low level of productivity and hence poor economic performance. Conversely, companies with high level of pay inequality experience low shareholders’ return as well as low market-to-book value ratio. In short, inappropriate financial incentives undermines employee collaboration, retention, and performance (University of Pennsyvania, 2011, 44).
Third, inappropriate financial incentives lead to the reduction of intrinsic motivation. Several studies have shown that employees would only work when rewards are involved. People tend to stop working when the rewards have been withdrawn. The intrinsic interest to work has been overshadowed by the strong financial incentives. Companies are forced to offer more monetary benefits to its employees so as to keep them working (Berk, 2008, 161). Based on this assumption, financial incentives acts as an expense rather than a motivating factor. It comes with extra costs with less productivity which have an immense effect on global economic performance.
The last cause of the financial crisis is more likely to arise from the housing bubble within the banking sector. In this case, banks are forced to lower their interest rates to attract more investors to their securities. For example, mortgage-backs allows banks to operate using higher leverage. With leverages, banks offer bonuses to their employees based on short-term sales and not long term profitability. The situation represents a mismatch between long-term financial assets, liquidity risks and short-term debts (Bettinger, 2010, 156). During the financial crisis, the financial institution is forced to deal with risks long after bonuses have been provided to the employees. Even during the crisis, banks have to offer incentives to its employees to encourage high performance. Employees are encouraged to engage in mortgage-back only to increase their personal earnings at the expense of the company’s future. Flawed incentives (that is when the government encourages the application of foreign currencies to provide low corporate tax and incomplete regulation of agencies) leads to the financial crisis (Allison, 2014, 167).
Methods of controlling inappropriate financial incentives
First, the government should curb the size of bank investments. For example, although financial failures cannot be eliminated during the crisis, keeping them smaller would not adversely endanger the economy. Likewise, the government should not bail out financial institutions that offer securities at lower rates to attract investors. Without bailout from the government, debt holders will be forced to aggressively monitor their institutions to reduce the possibility of occurrence of the financial crisis in future (Stevens, 2006, 201).
Second, governments and other financial experts should consider aligning the incentives offered to the employees based on the long-term organizational performance instead of short-term performance.
Third, the government should reconstruct the corporate structure of the banking sector. When providing financial incentives, institutions should not depend entirely on an employee’s performance but on his/ her previous performance as well (Watkins & Brook, 2016, 171). Employees and managers should become partners to the investment banks which would reduce the chances of the financial crisis: Through the partnership, employees and the manager would protect their banks from the crisis by controlling the amount of incentives they earn for the better performance of the bank (Lai, 2012, 211).
Fourth, Employees should be granted with an autonomy to make their own choices. When employees are provided with autonomy they invest more energy and time in their work, develop innovative and efficient processes and produce high-quality products. When employees are allowed to exercise their choices about tasks, work schedules, goals, and work methods are likely to increase their performance and motivation without necessarily using financial incentives (Berk, 2008, 109).
Fifth, the employees should be encouraged to develop mastery skills that are an opportunity to develop specialized skills, knowledge, and expertise without depending on the management. The employees with mastery skills are more likely to prevent problems and future financial crisis (Bebchuk, 2010, 137).
Last, the stakeholders within the banking industry should encourage the sense of belongingness, value, and connection. Although, financial incentives are used to support connection among people, they also lead to paying inequalities. Several studies have shown that employee turnover is not influenced by the level of compensation, but rather by the degree of relationship between employees and the co-workers, supervisors, and customers. Therefore, companies should focus on creating a strong connection with its employees for the basis of motivation and retention instead of using financial incentives (Bettinger, 2010, 145).
Conclusion
Financial incentives have been used by companies to enhance their performance by motivating its employees. Bonuses are used to encourage employees to do things that favor its performance and discourage the activities that hinder positive performance. However, flawed or inappropriate incentives have led to unethical reactions aimed at maximizing their personal gains at the expense of the company and to a larger extent, the economy (Bettinger, 2010, 102). A good example is in the case of the Green Giant where the employees brought parts of insects to the factory to take advantage of the incentive that had been offered by the management. In short, flawed financial incentives adversely influence the occurrence of financial crisis globally (Stevens, 2006, 213).
To reduce the adverse impacts of the financial incentives, the following methods have been recommended (a) financial incentives should only be used for jobs that are not interesting to employees, (b) this form of incentives should be used in small portions to avoid undermining intrinsic type of motivation and (c) extrinsic motivation should be integrated with other initiatives to aid intrinsic motivation (Bebchuk, 2010, 227).
References List
Allison, J. A., 2012. The Financial Crisis and the Free Market Cure: Why Pure Capitalism is the World Economy’s Only Hope. 1 ed. New York: McGraw-Hill Education.
Allison, J. A., 2014. The Leadership Crisis and the Free Market Cure: Why the Future of Business Depends on the Return to Life, Liberty, and the Pursuit of Happiness. 1 ed. Washington, DC: McGraw-Hill Education.
Bebchuk, L. A., 2010. The Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000-2008. Center for Law, Economics, and Business Discussion Paper.
Berk, J. B., 2008. Incentives and the Financial Crisis, Chicago: Stanford Business.
Bettinger, E. P., 2010. Paying to Learn: The Effect of Financial Incentives on Elementary School Test Scores. NBER Working Paper, Volume 16333.
Johnson , S. & Kwak , J., 2011. 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown. 2 ed. New York: Vintage.
Lai, J., 2012. Financial Crisis and Institutional Change in East Asia. 1 ed. New Jersey: Palgrave Macmillan.
Stevens, R. P., 2006. Doing God’s Business: Meaning and Motivation for the Marketplace. New York: Eerdmans.
University of Pennsylvania, 2011. The Problem with Financial Incentives — and What to Do About It, Chicago: University of Pennsylvania.
Watkins, D. & Brook, Y., 2016. Equal Is Unfair: America’s Misguided Fight Against Income Inequality. 2 ed. London: St. Martin’s Press.