Business and Markets

What Incentives Would Make Big Banks Change Their Ways?

November 10, 2016  • Judith F. Samuelson

Key Points

  • Wells Fargo has the opportunity to innovate and get the system on a better track for its industry—and its customers.
  • The new Wells Fargo CEO will have to closely examine his own pay and incentive system.

John Stumpf’s departure as chairman and CEO of Wells Fargo may have been abrupt, as The New York Times labeled it, but it was not shocking. With new stories of the pressure-cooker sales culture emerging daily from disenfranchised employees on the frontlines of the consumer bank, the company needed to radically change the conversation. Timothy Sloan, the new CEO, has both an opportunity and mandate to try something new.

What will have to be true to drive the kind of culture change that begins to rebuild the bank’s reputation? Sloan might start by studying up on the power of incentives. He has lots of teachers to turn to, including Oliver Hart of Harvard and Bengt Holmstrom of MIT, who were recently decorated as the 2016 Nobel Laureates in Economics.

What will have to be true to drive the kind of culture change that begins to rebuild the bank’s reputation? Sloan might start by studying up on the power of incentives.

The problem the new CEO faces is how to better connect individual performance to the values, purpose, and goals of the corporation—to the long-term health of the enterprise. This is a big challenge at a public company like Wells Fargo, which faces pressure from the public markets to push out metrics linked to steady increases in the stock price. It’s a problem everywhere we turn, including at other banks and financial institutions that have been scanning their own data to see if they are at risk for the same kind of behavior.

Charles Munger, vice-chairman of Berkshire Hathaway, tells a story about Fedex in a speech that he gave in 1995 on the importance of getting the incentives right on the proverbial shop floor. The integrity of the FedEx system relies on rapid and accurate transfer of packages from inbound airplanes to their final destinations, but a lot of this happens in the middle of the night.

“Federal Express had one hell of a time getting the night shift to do the right thing. They tried everything in the world without luck. And, finally, somebody got the thought that it was foolish to pay the night shift by the hour—when what the company wanted was not maximized billable hours, but fault-free, rapid performance of a particular task,” Munger said.

Turns out, in this case, what worked better than individual incentives was to pay the employees by the shift, and let them go home early as soon as all the planes were properly loaded. Teamwork kicked in. Lo and behold, the solution worked.

Can the bank connect employees around shared goals to both protect the integrity of the system and deliver what the customer wants most of all? Wells Fargo has the opportunity to innovate and get the system on a better track for its industry—and its customers.

The typical approach taken by the banks—to reverse-engineer broad corporate goals into individual performance indicators—is doomed for failure.

Todd Baker, a former bank executive, writes in American Banker that the typical approach taken by the banks—to reverse-engineer broad corporate goals into individual performance indicators—is doomed for failure.

Four management researchers from the business schools at the University of Arizona, Penn, Northwestern and Harvard have studied these kinds of systems. They make the case that goals-setting down to the individual level has been “over-prescribed,” much like medication. When managers focus in on narrow goals and ignore the hard-to-measure stuff like good judgment, listening to the customer, and teamwork—we get a situation like Wells Fargo: “A rise in unethical behavior, distorted risk preferences, corrosion of organizational culture, and reduced intrinsic motivation,” the researchers said.

Organizations working to improve consumer banking, like the Center for Financial Services Innovation, point out that with the wrong incentives we lose “agency”—the engagement of the very employees that Wells Fargo should be most eager to attract and retain: Those keen to deliver critical financial services to customers who need them most. The 2015 story about the Southwest flight that turned back to the gate to help a passenger who had just learned her son was in a coma is still making the rounds on the internet. It is a great example of agency—the product of a culture that rewards good judgment, leading to goodwill and well-earned customer accolades.

CFSI has eight key indicators for the financial health of individuals and families—things like spending less than you make, savings, and a “sustainable” debt load. The question CFSI pursues is how to reward sales agents for services that support customers on the path to greater financial security, in the context of both product offerings and profitability for the bank. What would that system look like?

These eminent scholars remind us that we get what we pay for—which is not always what we truly want.

This month, two economists were awarded the Nobel Prize for their work on contracts—the bane of every law student. It turns out their work is accessible, interesting and timely. One of their interests is how individuals are influenced by rewards for specific behaviors. These eminent scholars remind us that we get what we pay for—which is not always what we truly want.

Factory workers who are paid by the piece lose focus on quality. Teachers rewarded for test scores fail to teach their kids to enjoy reading. Sales agents incentivized to open more accounts while ignoring complex goals can put the financial health of their consumer (and their institution) at risk. Our Nobel Laureates raise questions about specific incentives, like “pay for (stock) performance” when executives, like teachers, need to multi-task to do their jobs well.

Translating customer well-being into measurable goals at the level of sales agents is certainly challenging enough, but that is only part of the job that lies ahead for the new CEO of Wells Fargo. The second part begins with his own pay and incentive system.

Understanding the power of stock-centric pay, and how that metric is translated as is moves down the chain of command, needs to be on the top of the list.

It was widely reported that John Stumpf booked $19 million in income in his last year. He was forced to give up $41 million, though,  in a “clawback” for bad performance. A review of public filings, however, suggests that still leaves Stumpf with close to $75 million, earned over the course of his tenure as CEO.

Underneath that generous compensation package is the incentive for continuous growth in the stock price, and the need to “make the number” that lies behind the constant growth in sales—which brings us back to the firing of 5,300 employees for cooking the books.

There are a lot of issues that emerge in the Wells Fargo case, including governance issues like director independence. Understanding the power of stock-centric pay, and how that metric is translated as is moves down the chain of command, needs to be on the top of the list.