Baffled by bankers’ bonuses? Read agency theory

I am writing this post, as is my wont, to record some notes from a paper I read:

Azevado, R.E and Akdere, M.  (2011). Examining Agency Theory in Training and Development: Understanding Self-Interest Behaviors in the Organization.  Human Resources Development Review, Volume No Not Known, 18 pages. If you want a copy, both authors are presently at the University of Minnesota.

I read the paper because agency theory is the theory behind the big bonuses that are provoking so much controversy.

The application of agency theory to Training is new and nothing to do with bonuses.  But I wanted to tidy up my own thinking about agency theory and if you do too, I’d recommend reading Azevado and Akdere’s paper.  They explain the basic precepts of that school of thinking very well.

I don’t like agency theory and I wanted to pinpoint exactly why I think it is misguided.  I’ve boiled my objections down to three essential points:  the distaste agency theorists have for self-interest, their belief in a zero-sum game, and their belief that the world is so static and unchanging that any one person knows best.

Self-interest

Adam Smith said:

“It is not from the benevolence of the butcher, the brewer, or the baker, that we can expect our dinner, but from their regard to their own interest”.

Some people are sincerely concerned about self-interest, and like the far left, so are agency theorists.

Personally, I am delighted that the self-interest of the butcher, the baker and the brewer leads to a butcher, a bakery and a pub on the high street. I believe in caveat emptor (buyer beware) but I am not panicking that the butcher, the baker and the brewer might from time-to-time charge me 1p too much.

I also don’t panic that today the butcher tries to sell me something that he is trying to ‘move’.  Provided he has taken my self-interest into account and sold me something to fit my needs, we are ‘square’.

I get my needs met now. I get my needs met over the long term because his shop stays open.  And my business does better because he can buy from me!

(Funny that – the last female butcher that I met was my own grandmother.)

Generativity vs zero-sum gains

Agency theorists begin with an assumption that if I pursue my self-interest, then I am not pursuing yours.

Or at least, they believe that inherent in belonging to an organization is the need for the organization to ask me not to pursue my self-interest in some form or another.

It certainly is the case, for example in a soccer game, that I shouldn’t pass the ball to the opposition on purpose, or showing off to my mates in the crowd and not pay attention to the game.

But why should my self-interest be sacrificed as a matter of principle or practice?  If we need to sacrifice anything, let’s compromise and make sacrifices all round.  And wouldn’t it better to put our efforts into making a business environment which is rich enough for us all to pursue our self-interest?

To take a simple example, does it matter if I am miner, metallurgist, engineer, accountant or diamond cutter, provided that all of us work together to mine the diamonds safely and sell them profitably to people who want them?

I’ve found that where people stand on this point is fairly key to their choice of work and choice of organization.  Some people want quick returns. They really don’t believe an organization is more than the sum of its parts.  So be it. We’ll help them go where they need to go.

Those of us who don’t believe that life is zero sum game should stay away from organizations run in terms of agency theory. We will hate them.  And we need to put our money where our mouth is. We have to make our own organizations as good as we want them to be – and successful commercially.

‘Gap’ thinking vs positive management

Agency theory seems tremendously old school to me in the notion that there is a right way to do things and that someone somewhere knows what this right thing is.

Now there are definitely wrong ways to do things.  There have to be things we wouldn’t countenance no matter what.

Expertise is also real. And it takes time, a long time to learn.  Indeed, good organizations arrange themselves so that people can develop expertise and learn from each other.

But the idea that we know the whole answer and we can insist that people do things our way is very unrealistic.  If it was ever possible, it is not possible in today’s world where we rely on networks of experts.  We each bring our own perspective to a problem and we are richer for it.

Returning to agency theory, if no one knows what the best answer is until we have discussed, how do we evaluate whether our agents are pursuing our interests vigorously?

Worse, if we do not allow the room to work out what our interests are, haven’t we built into the organization the very thing that we fear most – that our agents withhold information that is valuable to us?

So in short, these are my three objections to agency theory.

I think self-interest is good, not bad.  We want people to think about their self-interest because we will have a healthier, sounder and more resilient organization (and economy).

I don’t see the world as a zero-sum game. I don’t see the world as a cake to be divided up.  At best I see the world as having no cake until we’ve baked it.  And there are cakes and cakes. Real wizards will make us a cake even when the ingredients for their favourite recipe are not available.

I don’t think we know upfront what our self-interest is.  Good organizations are forum where negotiations and bargaining lead to mutually prosperous ventures.

How does any of this help me understand bankers’ bonuses?  Well they are mystery, to be sure.    Agency theory is not standard organization and management theory but to turn away from thinking that captures attention with promises of large rewards, we need not only an alternative but an understanding of the thinking itself.  Do read Azevado and Akdere’s paper.  I found it helpful even though, or possibly because it was about the less emotive topic of Training.

3 reasons why non-Americans care about American healthcare

#1 Is the political system broken?

America is big.  America is a fiercely democratic as any place bar India.  So decision making takes time and is hard-work.

Too many people had given up on their ability to get along with others.  Too many people had given up in a two party process that thrashes things out until a decision is made.

America did not give up this time.  That is why we care.  America did not give up on itself.

And if America, large and committed to hearing everyone out, did not give up; then we don’t have to give up either.

That’s why we care.   America you have done it again.  Democracy may be hard work but it works when we work.

#2 We do business with America and your policies affect us

I’m in the HR world and I work with Americans.  You may be my clients.  You may be my competitors.

You angst about pensions and health care.

Employers elsewhere take more responsibility, contribute more to their employees health care, yet interfere with individual decisions less.  You do “get your knickers in a knot”.  You also seem to arrange your affairs so that you have wicked levels of liability that could bankrupt you.

You could learn from us.  But I am not trying to sell you anything.

Rather I know that your policies at home affect the policies of your subsidiaries and your subsidiaries affect our business environment and the competitive landscape.

So we watch you carefully.  We know you angst about insurance.  Carry on!  You spend time & money worrying about what the rest of us get straightened out at the outset.  We like that!  It gives us competitive advantage.

Here is a good link to the health care to what was voted through last night.

#3  A happy America is a stable America

But we care.  Really we do.

We care because we care.  And of course a happy healthy America is an America that will be a good citizen of the world.  We don’t want a country as big and as rich as you descending into civil strife.  And believe me, large disparities in wealth and well-being go in that direction.

Now you have done health care, live with it!  Make it work.  And get back to what you are good at.  Over paid, oversexed and over here!

There’s a life to be lived and more people should be able to live it with vigor.  That should benefit everyone. Even those for find the new schemes unfamiliar.

Anyway.  That’s why we care.  Beyond the human emotion of caring about our friends.

Pay professionals – data slurpers – data visualizers – wanted

Do you believe that executives are worth their pay?

85% of people voting on The Economist debate beginning today vote NO.

You can vote as well! 

Yes or No?

Do you have a professional interest in pay?

If you are a

  • work & organizational psychologist
  • HR manager
  • union official
  • manager
  • politician
  • political activist

I encourage you to log in to the debate and read the comments.  It is free.

I usually skim over the contributions from the public because I doubt anyone is reading.

But this time, the comments from the public on executive pay provide invaluable data.

Would you like to join a research team on the executive pay debate?

This is an unusual opportunity to document the pay debate and to establish a reputation in compensation management.

Could you help with

  • recording the comments (or slurping them off the net)?
  • listing the arguments by parsing and analyzing them with software or by hand?
  • summarizing which questions were asked & answered?
  • writing up the report?
  • preparing compelling visual presentations?
  • marketing & distributing the report?

Please let me know what you can do, and I will put together a team.  If you aren’t particularly internet-literate, that is fine too.  We could do with people who contribute substantive questions and who review and edit the project as it proceeds.

0 steps to redress scandalous bonuses?

In the UK, talk about reclaiming bonuses’ and pensions was quickly swatted away without serious debate.

There may be legal grounds to recover scandalous bonuses

I was interested to see this article about the general legal position of excessive bonuses in the Harvard Business School blog from a former GE internal counsel and now Senior Fellow at Harvard Law School.

“Moreover, countless legal experts have already suggested numerous reasons why it is likely that there is no ironclad legal obligation to pay the bonuses to the people who caused the problem. These range from legal theories about non-performance to equitable theories of recission or reformation due to fraud or unconscionable terms to the doctrine that governmental take-over excuses bonus payment because the point of the contract has been destroyed. “

HR needs to become more incisive

Why are we in the UK quite so fuzzy about what is going on?  Did CIPD discuss these matters during its recent conference on Managing through a Downturn?

Who is taking seriously the reformation of HR that must happen as we work out way out of the recession?

About 30 people a day come to this blog looking for information on HR and the recession. What are the best links you have found?

Please drop a comment telling me of the best work you have found!

First, understand the business!

Business-oriented HRM curriculum

I am teaching undergraduate and postgraduate HRM and for the last 8 weeks I have been walking the post-graduates, in particular, through a simple heuristic for understanding a business model and its HRM implications.

Of the many different businesses they have chosen to work on, two please me in particular: the first is Islamic banking and the second is insurance broking (in Cameroon).

Simple heuristic for understanding a business

I am grateful to Michael Riley of Sussex University for learning (via his writing) a simple heuristic for understanding a business.

Inspect the revenue graphs and understand how revenue varies

  • as a trend (increasing or decreasing)
  • seasonally
  • with events
  • and randomly in the short term.

Once we understand ‘sales demand”, we can look at the derived labor demand.  In manufacturing, labor demand may be mediated by technology.  In services, like banking and insurance broking, labor demand is far more direct.  When we have a good feel about who we will need, when and where, then we can set about managing our labor supply.

Variability in Islamic banking

My Islamic banker, after shyly announcing he was an Islamic banker and taking the trouble to educate me on the principle of “no interest” and the products they sell, reacted as most people do when they talk about HR.  He started describing the HR systems and described a business that was ultra-stable.  Because Michael Riley’s heuristic had cued us to look for variability, we asked a few more questions and this is what we come up with.

  • Their long term growth or contraction depends upon reputation.
  • They have three Islamic festivals, such as the Eid which is coming up shortly, when as at Christmas, spending (and borrowing) is very high.
  • As with all banks, they are affected by weather, economic and political events which they monitor closely.
  • After 9/11, they came under suspicion even from Islamic customers.

Now that we understand how the need for service varies, we can imagine when line managers will be calling for skill and the skills they will call for.  And we have a fair chance of matching labor supply to labor demand.

When we achieve this match (which will never be perfect), then we can contribute to the ‘bottom line’ of the organization.

How we do that is the technical skill of HRM.  But to use our tools, first we must have a mental image of the match we are trying to achieve.

Insurance Broking in Cameroon

The insurance brokers in Cameroon, as far as I can see, are structured as any independent insurance brokers would be.  They are a family owned firm.  Their business peaks at the calendar year end and has a steady though variable stream of business throughout the year.

Once again, once we understand this pattern, we can easily see what is necessary to match the demand with supply.

Sales Demand and the Credit Crunch

Interestingly, the cause of the credit crunch seems to be some back-room sales activity: borrowing money on the wholesale markets.  I think if HR Directors had fully understood the sales demand of their firm, they might (and this is speculative) have partitioned the business and noticed earlier that the non-wholesale parts could not sustain their payrolls.  They might certainly have taken active steps to protect the pension funds which is a serious obligation if they are also Trustees.

I remember working with the HR Director of a combined investment, corporate and retail bank.  She had noticed that their payroll exceeded their interest income (not relevant to an Islamic bank!) and they were being sustained by fees.  On that basis, she had carefully structured her payroll into ‘columns’ beginning with the essentials (basic pay, state insurance, pension, health insurance, etc) moving across the page to luxuries.  She then brokered a signed agreement with employee representatives that in a downturn, they would start removing benefits from the right hand side first.  This is proactive, sensible HR policy.

As all the above is absolutely speculative, I wonder if anyone has information on the HR and the credit crunch?  And if anyone else uses Michael Riley’s heuristic?

UPDATE: For an HR Managers perspective on the Recession, I have written a summary on a new post.