Such performance-insensitive pay packages seem to defy both common sense and established economic theory on optimal incentives. Top management compensation packages guarantee a high level of pay, but are often only weakly linked to the performance of the firm relative to its industry competitors. Why, then, do company boards and shareholders of most firms approve those packages?
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We propose an answer to that question in our new research paper. By endorsing performance-insensitive compensation packages, broadly diversified investors are indeed incentivizing CEOs for good performance. Except that the performance that they’re rewarding is industry performance, not company performance. Why? These days, most firms’ most powerful shareholders tend to benefit more from the performance of the entire industry than the performance of an individual firm.
To understand this new explanation for seemingly exorbitant CEO pay, it’s important to understand a recent, fundamental shift in the ownership of U.S. public companies. Nowadays, the same handful of large, diversified asset management companies controls a significant proportion of US corporations.
For example, BlackRock is the largest shareholder of about one in five publicly-listed US corporations, often including the largest competitors in the same industry. Similarly, Fidelity is the largest shareholder of one in ten public companies and frequently owns stakes of 10-15% or more. Even Bill Gates’ ownership of about 5% of Microsoft’s stock is small compared to the top five diversified institutional owners’ holdings, which amount to more than 23%.
This sweeping development known as “common ownership” – the same firms owning the competing firms in the same industry – is relatively new. Twenty years ago, BlackRock and Vanguard were only very rarely among the top ten shareholders of any firm. On average, common ownership concentration has almost doubled in the last 20 years in the construction, manufacturing, finance, and services sectors.
Our research reveals that common ownership has had a significant impact on the structure of executive compensation. In industries with high common ownership concentration, top executives are rewarded less for the performance of their own firm but rewarded more just for general industry performance.
To understand the effect of common ownership on CEO pay packages, we analyzed total pay (including the value of stock and option grants) of the top five executives of S&P 1500 firms (which cover 90% of U.S. market capitalization) and 500 additional public companies. We studied those pay packages in relation to the firm’s performance, rival firms’ performance, measures of market concentration, and common ownership of the industry. We also examined interactions of profit, concentration, and common ownership variables. This allowed us to estimate both the sensitivity of CEO compensation to the performance of their own firm and of the industry’s other firms, as well the impact that common ownership has on these sensitivities. (We used a variation in ownership caused by a mutual fund trading scandal in 2003 to strengthen a causal interpretation of the link between common ownership concentration and top management incentives.)
We found that when firms in an industry are more commonly owned, top managers receive pay packages that are much less performance-sensitive. In other words, these managers are rewarded less for outperforming their competitors. This difference in compensation has a sizeable effect. In industries with little common ownership, executive pay is about 50% more responsive to changes in their own firm’s shareholder wealth than in industries with high common ownership.
What’s more, in industries with high common ownership, top managers receive almost twice as much pay for the good performance of their competitors as managers do in industries with low common ownership. This effect is even more pronounced for CEOs alone. Essentially, CEOs are rewarded more for the good performance of their competitors than they are for the performance of the company they run.
It’s not just the incentive package. The base pay reflects this, too. Our research shows that top managers’ base pay – the part of pay that does not depend on firm or industry performance – is also higher in industries with high common ownership.
In short, our research suggests that BlackRock, Vanguard, State Street, and other large asset management companies may be endorsing high, performance-insensitive compensation packages, because those don’t encourage competition among portfolio firms. These packages may be inducing managers to carefully consider the impact of their strategic choices on other portfolio firms.
Large asset managers have economic reasons not to incentivize competition among firms they own. After all, their revenue and their investors’ wealth depend on the total value of the portfolios they hold. As a result, it is not in their interest that one portfolio firm competes vigorously against another firm in their portfolio, such as engaging in a price war.
It is not clear that large, diversified shareholders such as BlackRock intentionally choose performance-insensitive CEO compensation for the explicit goal of discouraging intra-industry competition. They may choose it for other reasons, for example, to encourage cooperation or innovation. Maybe it’s not a conscious choice at all. It could simply be that large, diversified investors let performance-insensitive executive compensation slide because their corporate governance efforts are more passive than those of undiversified activist investors.
A question left open by the previous research is exactly how investors manage to convince the top executives of portfolio firms not to engage in costly price wars against each other, and instead to practice restraint when it comes to competitive strategy. One way to induce managers to act in their investors’ economic interest is executive pay.
But paying executives more when they outperform a competitor (academics call such a reward scheme “relative performance evaluation”) would have the effect of pitting one firm’s CEO against the other and of inducing such costly price wars.
There’s evidence of this dynamic in the tension between smaller undiversified investors (such as hedge funds) and large asset management companies. Whereas the former fight for more performance-sensitive pay that is benchmarked against competitors, the latter vote against them, instead often passing high and performance-insensitive pay that discourages competition between firms in the same industry.
This is an issue – and a tension – that we expect to grow as the trend toward common ownership continues. Our research sheds light on the changing nature of executive compensation, and apparent negative effects of weaker competition and more performance-insensitive pay. However, there may also be positive effects to common ownership. It’s possible that increased cooperation between firms benefits consumers. Certainly, people have benefited from the low-cost, diversified exposure to the stock market that large asset managers offer.
We hope our findings will lead to a better understanding of the effects of common ownership. Shareholders appear to benefit from diversification and higher industry profitability, and there are potential benefits to society from greater cooperation between firms. However, there is a negative impact on consumers due to reduced competition. Ultimately, we hope effective solutions can be reached to resolve the growing tension between shareholders, consumers, and society.
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Adopting German-style system requires changes to UK corporate culture
The question of why the UK economy cannot be more like Germany’s has been a perennial concern of British policymakers down the decades. Where, they ask, are the indigenous high-productivity companies? Where is the spirit of co-operation rather than confrontation in industrial relations?
A solution often mooted is to adopt the German practice of worker-directors — members of boards elected by the employees. This has popped up again as part of the changes to corporate governance mooted by Theresa May’s government, backed by the Trades Union Congress.
Worker-directors can fulfil useful functions, have played a supporting role in the success of some German corporations, and indeed of companies in other European countries. Yet airlifting them into the UK’s very different institutional context is only likely to work if it is part of a bigger shift in employee and corporate culture.
German “co-determination” is an idea deeply embedded into the country’s corporate tradition. The idea is that by making trade unions — and workers — partners rather than adversaries, companies can improve information flow and productivity, and avoid strikes. Worker-directors are often credited with having helped in Germany’s postwar economic miracle, providing a wider range of perspectives and binding the workforce more closely to management decisions.
They may be less useful in today’s business environment. Most growth in modern economies is driven by small and medium-sized companies where the co-determination rules do not apply, usually in the service sector. Germany has retained a cohort of highly successful export-oriented manufacturers, but has been less impressive at creating dynamic service companies.
Whether or not they are the future for Germany, implanting worker-directors into a British corporate context will be intrinsically tricky. German companies have a two-tier structure with a management and a supervisory board, with the legally mandated worker-directors sitting on the latter.
This does not translate directly into the UK practice of a unitary board, whose members are charged with pursuing the interests of the company as a whole. The governance of UK companies could certainly do with improvement. If worker-directors turned employees into partners rather than adversaries or widened the range of perspectives around the board table on issues such as executive pay, that would be progress. But making the board a collection of individual representatives of different interests within the company is not the way to do it.
The principle of worker-directors also requires a degree of co-operation from employees and unions. Where a workforce is unionised, it seems likely that the worker-directors will be union officials. But unlike its German counterpart, the British trade union movement has traditionally operated on the principle of free collective bargaining rather than corporatist co-operation.
Effecting a culture change within unions to make them part of the management process is unlikely to be straightforward. In parts of the economy where there is still an antagonistic relationship between unions and management, such as the rail sector, putting an employee representative on the board is more likely to result in stasis or conflict than co-operation.
If worker-directors could form part of a shift towards co-operation in the mindset of employees, they could play a useful role. But it is optimistic to imagine that a governance function can cross borders without requiring wider changes in practice along the way.
In early September Wells Fargo agreed to pay a $185 million fine and return $5 million in fees wrongly charged to customers. The settlement stems from the bank’s employees allegedly opening more than 2 million bank and credit card accounts without customers’ permission. The CEO of Wells Fargo, John Stumpf, apologized in front of a congressional panel Tuesday, saying in a statement, “I accept full responsibility for all unethical sales practices.”
That speaks to why they did this in the first place: To meet sales quotas and earn incentives.
This is certainly not the first time that a high-profile sales scandal like this has hit the press. In the early 1990s Sears sought to restore its reputation with $46 million in coupons because some employees of its automotive repair division (who were paid a commission on sales of parts and services) had allegedly enticed customers into authorizing and paying for needless repairs. In 2005 the world’s largest insurance broker, Marsh Inc., paid $850 million in fines in the aftermath of accusations that it had received kickbacks from insurance companies for steering business their way — a scheme at odds with Marsh’s commitment to finding the best deal for customers.
Beyond the fines, Wells Fargo has fired at least 5,300 employees for “inappropriate sales conduct,” and the bank is making changes to its quota system. Stumpf said in an earlier statement: “We are eliminating product sales goals because we want to make certain our customers have full confidence that our retail bankers are always focused on the best interests of customers.” Politicians, predictably, have railed against the leadership at Wells Fargo and have called for Stumpf’s resignation. One of the intriguing facts to come to light is that the fraudulent account openings continued even after the bank was aware of it and had fired employees for it starting in 2011.
That suggests that firing employees was not enough to curb the actions. Will eliminating sales goals do it? Before answering this question, it is useful to understand why and how such sales practices begin and spread within an organization.
In these and many other similar (but often less high-profile) cases, much of the blame gets placed on the sales goals and incentives. Salespeople are offered a large monetary reward linked to the achievement of sales goals — goals that employees perceive as excessively high. Sales managers, too, are rewarded for goal achievement, so they put pressure on salespeople to deliver. Salespeople are enticed by the promise of the large reward, or perhaps they are fearful of losing their jobs. Either way, they do whatever it takes to make sales goals.
But large rewards tied to challenging sales goals do not have to be a deadly combination. Many companies have great success using incentives and stretch goals to motivate the sales force and drive revenue. The culture in such sales forces may be sales-oriented and even competitive, yet salespeople still behave ethically and remain focused on meeting customers’ needs.
What differentiates sales teams that play by the rules from those that break them?
Large-scale unethical sales practices often begin with minor ethical compromises. Things escalate and spread from there. Consider the following sequence:
A bank account manager, under pressure to make a sales goal, pushes a customer to add a credit card, even though the account manager knows it’s not in the customer’s interest
Still short of the goal, the account manager asks his friends and family to open accounts. (The accounts are to be closed shortly thereafter.)
With the goal still not achieved, the account manager opens accounts without asking customers and transfers a small amount of money. (The accounts are closed shortly thereafter and the money is transferred back.) As soon as the account manager gets away with the first unethical act, it’s not a big step to the fraudulent ones. The justification moves from “it’s legal” to “no one is harmed” to “no one will notice.” When such practices are tolerated, they escalate in severity and spread throughout the organization.
To prevent that, the sales culture has to stop the first level of compromise, because the slippery slope begins there. As Wells Fargo has discovered in the last five years, even a strong compliance function — one that began firing people in 2011 — can’t counteract a compromised culture.
When things escalate to such a scale, the problems won’t stop with salespeople. Managers and leaders may be looking the other way, or aiding and abetting the behaviors.
What’s most insidious is that managers and leaders may be engaging in similar behaviors in their spheres and domains — in how they deal with other people inside the company, with partners, and with suppliers. Often, bringing about change requires going right to the top of the sales organization and bringing in a new leader who isn’t connected to the history of what’s happened. This individual can build a new culture based on appropriate values and the right workstyle.
Though not a question for customers and regulators, companies such as Wells Fargo have to ask how they can succeed in a sales world without heavy reliance on goals and incentives.
In 2011, about the same time that Wells Fargo began firing employees for questionable sales practices, we wrote a piece for HBR.org addressing that very issue. We called it “Is Your Sales Force Addicted to Incentives?” As we wrote back then, the key to success will be a new culture built around a more balanced approach to managing sales. This new approach will require using tools other than incentives — for example, interesting work, enhanced processes for selecting salespeople and managers, training and coaching, information sharing, empowerment, teamwork, manager assistance and supervision, and improved performance management systems — to motivate salespeople and guide and control sales behaviors.
If the bank is successful in transforming to this balanced sales culture, then perhaps the money it once used for employee incentives can instead go to customer incentives — for example, a no-fee credit card or a better interest rate for opening a new high-balance account. Other companies would be wise to take the time to examine their own sales culture and ask whether incentives might be clouding otherwise good judgment.
To withstand new regulatory pressures, investor expectations, and innovative competitors, banks need to reset their value focus and digitize their credit risk processes.
External and internal pressures are requiring banks to reevaluate the cost efficiency and sustainability of their risk-management models and processes. Some of the pressure comes, directly or indirectly, from regulators; some from investors and new competitors; and some from the banks’ own customers.
The impact is being felt on the bottom line. In 2012, the share of risk and compliance in total banking costs was about 10 percent; in the coming year the cost is expected to rise to around 15 percent. Overall, return on equity in banking globally remains below the cost of capital, due to additional capital requirements, fines, and lagging cost efficiency. All of this puts sustained pressure on risk management, as banks are finding it increasingly difficult to mitigate risk through incremental improvements in risk-management processes.
To expand despite the new pressures, banks need to digitize their credit processes. Lending continues to be a key source of bank revenue across the retail, small and medium-size enterprise (SME), and corporate segments. Digital transformation in credit risk management brings greater transparency to risk profiles. With a firmer grip on risk, banks may expand their business, through more targeted risk-based pricing, faster client service without sacrifice in risk levels, and more effective management of existing portfolios.
Incumbents under pressure
Five fundamental pressures that relate directly to risk management are being exerted on banks’ current business model: customer expectations for digitally managed services; regulatory expectations of a high-performing risk function; the growing importance of strong data management and advanced analytics; new digital attackers disrupting traditional business models; and increasing pressure on costs and returns, especially from financial-technology (fintech) companies (Exhibit 1).
Customer expectations. Traditionally reliant on physical distribution, banks are finding it difficult to meet changing customer needs for speed and simplicity, such as fast online credit approvals.
Regulatory and supervisory road map. Regulators are expecting the risk function to take a more active role in the context of new, digitized business models. New regulations are being put in place to address cyberrisk, automation of controls, and issues relating to risk-data aggregation. Directives pertaining to the Comprehensive Capital Analysis and Review, BCBS 239, and asset-quality reviews specify requirements for data management and the accuracy and timeliness of the data used in stress testing.1
Data management and analytics. Rising customer use of digital-banking services and the increased data this generates create new opportunities and risks. First, banks can integrate new data sources and make them available for risk modeling. This can enhance the visibility of changing risk profiles—from individuals to segments to the bank as a whole. Second, as they collect customers’ personal and financial data, banks are mandated to address privacy concerns and especially protect against security breaches.
Fintech companies and other innovative attackers. The digitally savvy segments have responded to innovative offerings from new nontraditional competitors, especially fintech companies and digital-only banks. These start-ups are extending innovation throughout the digital-banking space, creating a competitive threat to traditional banks but also potentially valuable opportunities for partnerships (Exhibit 2).
Pressure on cost and returns. The new competitors are beginning to threaten incumbents’ revenues and their cost models. Without the traditional burden of banking operations, branch networks, and legacy IT systems, fintech companies can operate at much lower cost-to-income ratios—below 40 percent.
Banks are beginning to respond to these trends, albeit slowly. Over the past several years, leading banks have begun to digitize core processes to increase efficiency—in particular, risk-related processes, where the largest share of banks’ costs are typically concentrated. Most banks started with retail credit processes, where the potential efficiency gains are most significant. Digital approaches can be more easily adopted from well-established online retailers: mobile applications, for example, can be developed to enable the origination of tailored personal loans possible instantaneously at the point of sale. More recently, banks have begun to capture efficiency gains in the SME and commercial-banking segments by digitizing key steps of credit processes, such as the automation of credit decision engines.
The automation of credit processes and the digitization of the key steps in the credit value chain can yield cost savings of up to 50 percent. The benefits of digitizing credit risk go well beyond even these improvements. Digitization can also protect bank revenue, potentially reducing leakage by 5 to 10 percent.
To give an example, by putting in place real-time credit decision making in the front line, banks reduce the risk of losing creditworthy clients to competitors as a result of slow approval processes. Additionally, banks can generate credit leads by integrating into their suite of products new digital offerings from third parties and fintech companies, such as unsecured lending platforms for business. Finally, credit risk costs can be further reduced through the integration of new data sources and the application of advanced-analytics techniques. These improvements generate richer insights for better risk decisions and ensure more effective and forward-looking credit risk monitoring. The use of machine-learning techniques, for example, can help banks improve the predictability of credit early-warning systems by up to 25 percent (Exhibit 3).
Good progress has been made, but it is only a beginning. Many risk-related processes remain beyond the digital capabilities of most banks. Significant effort has been expended on the digital credit risk interface, but the translation of existing credit processes into the online world falls far short of customer expectations for simple digital management of their finances.
There is plenty of room for digital improvement in client-facing processes, but banks also need to go deeper into the credit risk value chain to find opportunities to create value through digitization. The systematic mapping and analysis of the entire credit risk work flow is the best way to begin capturing such opportunities. The key steps—from setting risk appetite and limits to collection and restructuring—can be mapped in detail to reveal digitization opportunities. The potential for revenue improvement, cost reduction, and credit risk mitigation for each step should be weighed against implementation cost to identify high-value areas for digitization (Exhibit 4).
Some improvement opportunities will cut across client segments, while others will be segment specific. In origination, for example, most banks will probably find that several segments benefit from a digitally connected, paperless credit underwriting process (with live access to customer data). At the stage of credit monitoring and early warning, furthermore, advanced analytics and fully leveraged internal and external data could improve risk models for identifying issues across different segments. Back-office and loan-administration tools such as straight-through processing and automated collateral valuation are also cross-cutting improvements, as are the automation and interactivity of risk reporting.
On the other hand, in credit analysis and decision making, banks will likely find that instant credit decisions are mostly relevant in the retail and SME segments, while the corporate and institutional segments would benefit more from smarter work-flow solutions. The application of geospatial data, combined with advanced analytics, for example, can yield a high-performing asset-valuation model for mortgages in the retail segment. For collection and restructuring, automated propensity models will match customers in the retail and SME segments with specific actions, while for the corporate segment banks will likely need to develop debt restructuring-simulation tools, with a digital interface to identify and assess optimal strategies in a more efficient and structured way.
How digital credit creates value
Several leading banks have implemented digital credit initiatives that already created significant value. These are a few compelling cases:
Sales and planning. One financial institution’s journey to an interactive front line involved the construction of a digital workbench for relationship managers (RMs). The challenges to optimal frontline performance were numerous and included the lack of systematic skill building, customer-relationship-management (CRM) systems with a fragmented overview of clients, and difficulty gathering relevant client and industry data. Onboarding, credit, and after-sales processes required many hours of paperwork, drawing frontline attention away from new client meetings. By engaging RMs with the IT solutions providers, the bank’s transformation team created a complete set of frontline tools for a single digital platform, including best-practice CRM approaches and product-specialist availability. The front line soon increased client interactions four to six times while cutting administrative and preparation time in half.
The mortgage process. This presents a large opportunity for capturing digital value. One European bank achieved significant revenue uplift, cost reduction, and risk mitigation by fully automating mortgage-loan decisions. Much higher data quality was obtained through exchange-to-exchange systems and work-flow tools. Manual errors were eliminated as systems were automated and integrated, and top management obtained transparency through real-time data processing, monitoring, and reporting. Decisions were improved and errors of judgment reduced through rule-based decision making, automated valuation of collateral, and machine-learning algorithms. The bank’s automated real-estate valuation model uses publicly known sale prices to derive the amount of real-estate collateral available as a credit risk mitigant. The model, verified and continuously updated with new data, attained the same level of accuracy as a professional appraiser. Recognized by the regulator, it is saving the bank considerable time and expense in making credit decisions on actions ranging from underwriting to capital calculation and allocation. Losses were further minimized by automated monitoring of customers and optimized restructuring solutions. The digital engine moved decision making from 5 percent automated to 70 percent, reducing decision time from days to seconds.
Insights and analysis. By making machine learning a part of the effort to digitize credit risk processes, banks can capture nearer-term gains while building a key capability for the overall transformation. Machine learning can be applied in early-warning systems (EWS), for example. Here it can enable deeper insights to emerge from large, complex data sets, without the fixed limits of standardized statistical analysis. At one financial institution, a machine learning–enhanced EWS enabled automated reporting, portfolio monitoring, and recommendations for potential actions, including an optimal approach for each case in workout and recovery. Debtor finances and recovery approaches are evaluated, while qualitative factors are automatically assessed, based on the incorporation of large volumes of nontraditional (but legally obtained) data. Expert judgment is embedded using advanced-analytics algorithms. In the SME segment, this institution achieved an improvement of 70 to 90 percent in its model’s ability accurately to predict late payments six or more months prior to delinquency.
The approach: Working on two levels
While the potential value in the digital enablement of credit risk management can be significant for early movers, a complete transformation may be required to achieve the bank’s target ambitions. This would involve building new capabilities across the organization and close collaboration among the risk function, operations, and the businesses. Given the complexity of the effort, banks should embark on this journey by prioritizing the areas where digitization can unlock the most value in a reasonable amount of time: significant impact from applying digital levers can be tangible in weeks.
Rather than designing a master plan in advance, banks can in this context develop a digital approach to one area of credit risk management based on existing technology and business value. Each bank may develop initiatives based on their specific priorities. Banks that most need to increase regulatory compliance and the quality of their execution may begin with initiatives in process reengineering to reduce the number of manual processes or to build a fully digital credit risk engine. Those looking to improve customer value from greater speed and efficiency might implement such initiatives as a state-of-the-art digital credit-underwriting interface, a digitally enabled sales force, data-driven pricing, or straight-through credit decision processing. Banks needing to mitigate risk through better decision making may develop initiatives to automate and integrate early-warning and recovery tools and create an automated, flexible risk-reporting mechanism (a “digital-risk cockpit”).
A credit risk transformation thus requires banks to work on two levels. First, look for initiatives that are within easy technological reach and that will also advance the core business priorities. Launching initiatives that bring in savings quickly will help the transformation effort become self-funding over time. Once a first wave of savings is captured, investments can be made in building the digital capabilities and developing the foundation for the overall transformation. Based on what has been learned in early-wave initiatives, moreover, new initiatives can be designed and rolled out in further waves. Typical first-wave initiatives digitize underwriting processes, including frontline decision making and reporting. Risk reporting is another likely candidate for early digitization, since digitization reduces production time and leads to faster decision making.
Building digital capabilities: Talent, IT, data, and culture
The experience of specific initiatives will help shape digital capabilities for the long term. These will be needed to support the overall digital transformation of credit risk management and keep the analytics and technology current. To begin, banks can examine their current capabilities and assess gaps based on the needs of the transformation. The talent focus in risk and across the organization will likely shift as a result toward a greater emphasis on IT expertise and quantitative analytics.
In addition to enhancing their talent profiles, banks will have to shift the direction of their IT architecture. The target will likely be two-speed IT, a model in which the bank’s IT architecture is divided into two segments. Accordingly, the bank’s core (often legacy) IT systems constitute a slower and reliable back end, while a flexible and agile front end faces customers. Without a two-speed capability, the agility needed for digital credit risk management would not be attainable.
Along with the supporting IT architecture and analytics talent, improved data infrastructure is an essential digital capability for the credit risk-management transformation. The uses of data are disparate throughout the bank and will continually change. For big data–analytics projects, great quantities of data are needed, but how they should be structured is not usually apparent at the outset. The construction of separate data sets for each use, furthermore, creates as many data silos within the organization as there are projects.
For these reasons, some leading companies are moving toward utilizing a “data lake”—an enterprise-wide platform that stores all data in the original unstructured form. This approach can improve organizational agility, but it requires that each project has the capability to structure the data and understand data biases. All types of data infrastructure also pose security risks, moreover, which can be addressed only by IT experts. Finally, the reconfiguration of the data infrastructure needs to be done using methods that carefully respect legal privacy barriers and meet all regulatory requirements.
Last, building and maintaining a strong digital-risk culture will be of critical importance in ensuring the success of the risk function of the future. A shift in culture and mind-set is needed among employees, top executives, and regulators, as they acclimate themselves to the new digital credit environment. Here, machines and automation have a much greater role, while human capabilities are developed to support the continual improvement of the risk culture. The focus shifts from executing a risk process to managing true control systems that continuously detect, assess, and mitigate risks.
Toward a flexible digital-risk end state
From data input and management to decision making, from customer contact to execution, the initiatives should build step by step toward a seamless and interactive digital-risk function. The initiative-first approach builds in the capability of agile adaptation to changes in customer demand or the competitive and regulatory environments. The digital opportunities and the way banks address them, in other words, will continually evolve, and the digital end state must support such changes while maintaining enhanced risk-management and client-service capabilities.
The digital transformation of existing credit risk tools, processes, and systems can address rising costs, regulatory complexity, and new customer preferences. The digital enablement of credit risk management means the automation of processes, a better customer experience, sounder decision making, and rapid delivery. Digital-risk management will be the norm in the industry in five years, and banks that act now can attain enduring competitive advantage.
More people are working in big, bureaucratic organizations than ever before. Yet there’s compelling evidence that bureaucracy creates a significant drag on productivity and organizational resilience and innovation. By our reckoning, the cost of excess bureaucracy in the U.S. economy amounts to more than $3 trillion in lost economic output, or about 17% of GDP.
Here’s the arithmetic. According to our analysis of occupational data provided by the U.S. Bureau of Labor Statistics, there were 23.8 million managers, first-line supervisors, and administrators in the American workforce in 2014. (This figure includes both the public and private sectors but does not include individuals in IT-related functions.) That works out to one manager and administrator for every 4.7 employees. Overall, managers and administrators made up 17.6% of the U.S. workforce and received nearly 30% of total compensation.
How many of these 23.8 million overseers do we actually need? We can get an answer by looking at the management practices of a small but growing number of post-bureaucratic pioneers. Their experience suggests it’s possible to run complex businesses with less than half the managerial load typically found in large companies.
Among the vanguard are Nucor (America’s most profitable steel maker), Morning Star (the world’s largest tomato processor), W.L. Gore (a $3 billion high-tech company famous for its Gore-Tex fabrics), Svenska Handelsbanken (a Stockholm-based bank with more than 800 branches across Northern Europe and the UK), Sun Hydraulics (a class-leading manufacturer of hydraulic components), Valve (a pioneering developer of online games), and General Electric’s jet engine plant in Durham, North Carolina.
The case of Svenska Handelsbanken is illustrative. Its return on equity has surpassed that of its European peers every year since 1971. In the organization of 12,000 associates, there are only three levels. Operating decisions are almost entirely decentralized. Each branch makes its own loan decisions, sets its own pricing on loans and deposits, controls its own marketing budget, runs its own website (on a shared platform), and serves all customer segments — from individuals to multinationals — within its catchment area. Nearly all of these practices run counter to conventional banking wisdom, which holds that to be efficient a bank must consolidate operational activities and centralize decision making on matters like pricing and lending. Svenska Handelsbanken has consistently posted industry-beating cost-to-income and loan-loss ratios.
The average span of control in these and other vanguard organizations is more than double the U.S. average. GE’s Durham plant, to take a dramatic example, employs more than 300 technicians and a single supervisor: the plant manager. The facility is more than twice as productive as its sister plants in GE Aviation.
The experience of the vanguard suggests it should be possible to double the ratio of employees to managers and administrators, from 4.7:1 to 10:1. Doing so would free up 12.5 million individuals for other work that is more creative and productive.
There would be indirect savings as well. A myriad of studies have documented the time lost to low-value management processes, from budgeting to theperformance review. On the basis of this evidence (further discussed here), it’s reasonable to assume that as much as 50% of all internal compliance activity is of questionable value. If we assume that the 111 million Americans workers who are not managers, supervisors, and administrators (or unincorporated self-employed) are spending roughly 16% of their time on internal compliance (an estimate from a Deloitte Economics study) and that half of that time is wasted, this translates into an annual waste of about 8.9 million worker years.
In total, then, there are 21.4 million employees in the U.S. workforce — 12.5 million managers and the equivalent of 8.9 million individual contributors, who, through no fault of their own, are creating little or no economic value. This means the U.S. could achieve current levels of economic output with 15% fewer people in the labor force. That would, in effect, boost GDP per worker from $120,000 to $141,000.
The goal, of course, isn’t to put 21.4 million people out of work, but to redeploy them into value-creating activities. If these individuals were contributing an average of $141,000 each to economic output each year, rather than adding nothing, U.S. GDP could grow by $3 trillion — and the actual figure would likely be higher. Managers and administrators tend to be better educated than the workforce at large and typically possess technical or functional skills. Given that, we should expect them to deliver better than average output per capita once reassigned to more productive, and potentially more satisfying, work.
Then there are the large but difficult-to-quantify benefits that would come from a newly empowered workforce that is no longer paralyzed by process. More freedom and responsibility would mean more initiative, innovation, and institutional flexibility — which would further boost productivity. These side benefits are far from trivial. For example, a number of highly respected leaders in the pharmaceutical industry have argued that the only way to raise R&D productivity, and thereby reduce the soaring costs of drug discovery, is to dismantle bureaucracy. Roger Perlmutter, the president of Merck Research Laboratories, suggested that a good start would be to “scrape off the top five levels of management, including myself.”
Three trillion dollars represents 17% of U.S. GDP. If this burden was reduced by half over the next 10 years, productivity growth would increase by a compounded rate of 1.3% annually, essentially doubling the post-2007 productivity growth rate.
The productivity bonanza would be even larger outside the U.S. In 2014 the combined GDP of the 35 countries that make up the OECD amounted to $49.7 trillion, of which the non-U.S. share was $32 trillion. If bureaucracy is as ubiquitous in these economies as it is in the U.S., and there’s little reason to believe it isn’t, cutting the number of managers in half would save another $5.4 trillion — an amount that exceeds the value of the entire Japanese economy.
Many of the world’s largest economies are in a prolonged productivity slump. In Europe and the U.S., stagnating incomes and diminished economic hopes are feeding a growing appetite for protectionism and spawning divisive, us-versus-them political forces. While some hold out hope that robots, genomics, and the internet of things will one day yield a productivity bonanza, we believe a concerted effort to reverse the rising tide of bureaucracy offers a more immediate and less speculative route to enhanced economic performance.
A cornerstone of efficient and transparent markets is freely available information. Information drives financial activity, and ensuring equitable access to that information is seen as critical to a well-functioning marketplace.
But does the mere action of placing a piece of financial news in the public domain make it readily seen and efficiently reflected in stock prices? According to my and others’ research, not necessarily.
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In 2001 professors Gur Huberman and Tomer Regev of Columbia University drew attention to a peculiar sequence of market reactions to news regarding a cancer research breakthrough licensed by biotech firm EntreMed. The initial news release, printed as a scientific piece in Nature and reported in the popular press in November 1997, was accompanied by a 30% increase in EntreMed’s stock price. In May 1998, over five months after the initial breakthrough, the New York Times published a front-page piece with almost identical information. EntreMed’s stock price surged by over 300%. Whether the initial reaction in November was insufficient, or the frenzy in May was irrational, one thing was clear: The positioning of news, not just its newness, plays a pivotal role in how financial markets incorporate information.
In my research, I find that similar instances of too much and too little attention to financial news persist today. For instance, I find that news articles placed on the front page or at the top of news websites garner more reads. Readers also pay more attention to news about larger and better-known companies, to news published earlier in the week, and to negative news. And reprints of old news continue to spur market reactions. This might not surprise journalists or news junkies, but it challenges the idea that financial markets absorb all news equally, based only on financial relevance.
These pitfalls of news consumption emerge predictably from human psychology. A sizable literature documents the role that distraction plays: When faced with multiple competing cues, people have difficulty focusing their attention on the relevant information. The more complex the network of signals, the more difficult it is to extract pertinent information. For example, professors David Hirshleifer, Sonya Lim, and Siew Teoh of the University of California and DePaul University show that the market is less efficient in processing earnings announcements when a large number of releases occur at the same time. In “When Can the Market Identify Stale News?” James Hodson and I suggest that reactions to reprints of old news are likewise driven by complexity. Market participants are much more likely to mistake old news for new when the old information is drawn from multiple sources than when it is directly reprinted from a single previous story.
But although the market as a whole displays a variety of biases in processing financial news, not all finance professionals consume news in the same way. Some are faster, more active, and more sophisticated in identifying novel news. In “News Consumption: From Information to Returns,” I compare the news consumption patterns of different finance professionals. Broker dealers and hedge funds are much quicker, on average, to click on any given piece of news than banks or large investment management companies.
Hedge funds are also much more likely to be the first to get a piece of news. Hedge funds are only 8% of all financial professionals reading financial news. However, for 27% of all news articles, the very first click comes from a hedge fund reader. That means that even when a piece of information is public, hedge funds are more likely than other investors to find it first.
Hedge fund readers, along with family offices, private equity firms, and some broker dealers, are also among the least likely to read a piece of news that reprints old content. And they read far more news than any other group of finance professionals.
Does the more sophisticated consumption of news translate to more impact on the market? Yes. Increased attention by the more-active news readers like hedge fund investors is more predictive of stock price moves and trading volumes than increased attention by other investors, including large investment managers and pension funds. A one-standard-deviation increase in hedge fund attention corresponds to a 30 basis point larger return over the next day and a 3–4% higher trading volume.
These market swings occur because news consumption creates disagreement among investors about an investment’s prospects. In general, there are two main sources of trading volume: liquidity needs, where investors need to trade due to flows or portfolio rebalancing, and disagreement, where traders who hold different opinions make bets against each other. Since news releases (such as earnings announcements) do not systematically coincide with liquidity shocks, increased trading around news is attributed to disagreement. But why would public news increase disagreement?
In “Disagreement after News: Gradual Information Diffusion or Differences of Opinion?” I show that a large portion of disagreement around news is driven by people getting the news at different times. An investor who has not yet seen the news forms a willing counterparty to a trade put on by someone who has. A large portion of market activity is driven by something as simple as some people taking longer to read and process public news releases than others. In fact, moving from perfect information flows to perfect dispersion of readership causes trading volumes to surge by an additional 160%.
Bringing information into the public domain is extremely important. But so is sophisticated processing of the public information, especially given how quickly the news environment is changing.
As Tom Glocer, former CEO of news and financial information provider Reuters Group PLC, puts it: “A huge amount of time and effort is devoted by public companies to managing the divide between public and private potentially market-moving information. I can envision a future in which we abandon concepts like 10-Qs and 8-Ks in favor of a continuous stream of relevant performance data. This would be quite harrowing at first for public company executives, and contribute to daily volatility; however, over the long term, investors and managements would adjust.”
Such a future is exciting but could raise its own challenges. Modern-day proliferation of news, including reprints or repackaging of old articles, makes the market’s task of processing information ever more complex. Publishers exercise discretion over which news to print and where; investors read and trade on these public releases. Both sides are vitally important for financial markets’ stability and efficiency, especially at a time when daily news releases number in the millions.
Thx to Anastassia Fedyk is a Ph.D. Candidate in business economics at Harvard Business School. Her research focuses on finance and behavioral economics.