Short term concentration on KPIs which are tied up with incentives have always been and always will be a recipe for disaster. LOUIS COUTTS
By Louis Coutts
The historian Arnold Toynbee, in his monumental work “A study of history”, said something like this (I can’t quite remember the exact phrase): “There are two things we ought to learn from history; one is that we are no better than our forefathers, and the second is that we are lesser people if we don’t learn from them”.
If our predecessors made stupid mistakes, we can identify them from an historic perspective and we constantly do so. Just think of the recent past. Enron was celebrated as one of the great companies as was Lehman Bros as was Bears Sterns as was Ansett (do you remember this iconic Australian airline?).
Let us broaden our horizons and think of our economy. How many recessions have we had since World War II? Recessions are terrible events because of the social disruption and irreversible disasters inflicted upon those who are least able to manage financially.
Companies continue to go bust, economies go bust, and the people least able to cope with the fall out end up on the street. It has ever been thus. What did Toynbee say? Our inability to learn from our mistakes is quite alarming and in this brief visitation of a complex issue, I have attempted to summarise where we are constantly going wrong.
The philosopher Lord Russell at one stage likened civilisation to a group of people on an air conditioned train, drinking champagne and eating caviar and having one hell of a time. Unfortunately, the train had no brakes and was heading at a great speed towards a cliff at which point the rails stopped.
What was worse, everyone on the train knew that disaster was ahead but kept enjoying the moment. The attraction of the present outweighs the disasters that lie in the future. Let’s worry about that problem when it comes along!
It is difficult to plan for the unknown but easy to participate in the events of today. The downfall of civilisations, the failure of companies and the evaporation of economies seem to have one thing in common, and that is a pre-occupation with the present and an inability to prevent present activities from causing future calamities.
The real question is “why is this so?” (To use the phrase of that famous physicist and promoter of a celebrated brand of chocolate). It seems to me, and this is just a postulate, that it is to do with that cursed measurement we have come to call a KPI.
Without revisiting the history of civilisations to discover the reason for the failure of such enterprises as the Roman Empire or Easter Island, let us examine just two modern phenomena; the role of central banks and the performance of companies, and particularly banks in the past few years.
Central banks seem to perform two functions. The first is to make unintelligible comments on the economy and the second is to adjust interest rates. Bankers would deny this and argue that their main responsibility is to manage the economy. If that is the case, then they ought all get the sack and central banks should be closed.
I suspect however, that beneath the appearance of what they do (make statements and adjust interest rates) there is a more sinister dynamic. It is my guess that secretly, central banks have to meet an important KPI, which is to control inflation, and it has nothing to do with managing the economy.
So, if bankers are required to control inflation and the only tool they have is to manage interest rates, what do they do? Yep! They don’t wait for inflation to show its head, they use the only tool at their disposal to control inflation even though it doesn’t exist. They sniff it out in the cupboards; they see some young guy with a decent job having a drink with his mates on a Friday evening having fun; they see people going into shops and buying things and they think “hell, we better stop this otherwise there will be inflation and we won’t make our KPI”.
Every recession follows high interest rates and one of the reasons is that as the cost of money increases, so does inflation. Bankers must know this, otherwise they are incredibly inept historians, and yet they persist with this mistaken belief that they can control the economy by managing interest rates.
All they are doing is taking steps to achieve their KPI of keeping inflation under control. At some point in time, if they listen to Toynbee, they will come to the realisation that they haven’t learnt a thing. Regrettably, we are therefore confronted with a boom and bust environment.
Now let us look at the banks worldwide and particularly in the USA.
What has been the KPI for CEOs of banks and all of the other great companies on the NYSE and around the world? The maxim rings like some dogma from the Bible: “Enhance shareholder value.”
So, the reward for the CEO is determined by the extent to which she or he enhances shareholder value. The KPI is tomorrow’s number on the stock exchange.
So what happens when one KPI above all else is there as the carrot for the bonus? You do whatever is necessary to get that carrot. Dramatically increasing the price of electricity to California in a heat wave (Enron); dealing in sub-prime mortgages and sophisticated instruments such as collateralised debt obligations or risking big bets on foreign currency movements or lending big to companies with a growth story but no equity or pumping money into margin lending or buying up smaller financial businesses without due diligence in order to “grow” (banks).
The driver of many decisions of CEOs is next week’s stock price. “Shareholder value” has been drummed into them in business schools, by business commentators and by members of the board. The other side of reward is risk and gradually, when traditional mechanisms for growth are exhausted, fresh rewards in the form of executive remuneration, call for risk.
The ANZ bank provided a classic example of the extent to which this maxim of shareholder value is dominating managerial thinking. When the RBA initially dropped interest rates, the ANZ bank took the view that it could not pass on the total amount of the rate cut because they had to protect their shareholders and to hell with their customers.
The primary function of a business is not to enhance shareholder value. Shareholders take the risk on the success or failure of their investment. The primary function of any business is to bring value to the exchange that takes place between the business and the customer. Once we lose sight of this, we start doing silly things.
If we successfully bring value to the exchange, the company makes a profit and the shareholder is rewarded. However, if a company takes its eye off the ball and fails to provide this beneficial exchange to its customers, the company and its shareholders will ultimately suffer.
If we can just alter our thinking and concentrate on this fundamental factor in the equation of business and constantly work on bringing value to the exchange, we will then be concentrating on an enduring principle rather than a fly-by-night new-beaut maxim that fixes us on the short term.
History repeatedly tells us that when we concentrate on KPIs that tempt us to take short cuts, catastrophes are not far off. We know this, and yet we don’t learn the lesson, and so we have recessions, company disasters, people getting the sack left right and centre, economies going into tail spins and the people down the food chain picking up the cheque along with the next generation taxpayer.
Short term concentration on KPIs that are unrelated to bringing value to the exchange between seller and buyer, but which are tied up with incentives, have always been and always will be a recipe for disaster. We know this and yet we perversely persist in ignoring the lessons of history.
Another maxim, closely related to that of shareholder value, is “growth”. In fact, growth is often pursued in an attempt to secure increased shareholder value. The pursuit of growth for growth’s sake can often take us out of our comfort zone, often results in us doing silly things, like AOL destroying the value of Time Warner in the belief that growth and synergies would create a miraculous 2 + 2 = 5.
If those wise guys had have worked through the issue of how the merger was going to enhance the value of the exchange with their customers, they may well have decided to stay at home and ironically shareholders would have been happier.
So, as we start the new year, let’s hope that we can learn something from history.
The boys at Reserve Banks around the world can acknowledge that this obsession with inflation has resulted in persistent disasters. Fix an interest rate (a statistician in five minutes can tell you the mean interest rate that will work); set it in concrete and go home and never worry us again.
People in business forget about the fast buck and today’s share price and concentrate on constantly bringing fair value to the exchange with your customers. We won’t have years where the profits go through the roof, but we won’t have years when we go broke and have to sack staff.
However, sadly, Toynbee was wrong. There is a third thing that we can learn from a study of history, and that is that we have an enormous capacity to make the same mistakes as our forefathers.
Louis Coutts left law and became a successful entrepreneur. His blog examines the mistakes, follies and strokes of genius that create bigger, better businesses. Click here to find out more.
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