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The Globe and Mail

Distorted incentives behind the financial crisis

Kerry Stirton is a New York-based investment manager, formerly of Goldman Sachs. Each week Mr. Stirton examines a facet of the current economic situation.

Events of the past year have thrown up no shortage of theories about the causes of the financial crisis but an alluring new entry picking up steam comes from Roger Martin, dean of the Rotman School of Management at the University of Toronto.

In his view, a skewed theory about management incentives - paying for share price increases over any other measurement - was a major factor in distorting the corporate world. If it had not become so widely held, and taken to such extremes, the crisis might have been averted.

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He makes his case in the following interview:

You haven't been afraid of disturbing the status quo, and have advanced the Rotman School in some audacious ways. But how does this latest foray into the excesses of shareholder value theory, and its role in the financial crisis, fit into the overall thrust of what you are leading at Rotman?

There is an answer to that. Our Centre for Integrative Thinking focuses on the study of how CEOs and other business people, investors included, make decisions. The financial crisis was caused by a broad range of executive decisions.

People may think they are just making decisions on the basis of some interest or perceived interest in the moment, but they are usually governed by a background theory.

In this case, I've been trying to unwind the crisis through an explanation of the distorted theories that formed the basis of a lot of stupid corporate and investment decision-making on the part of so many people who are actually not at all stupid. So it relates to that fascination. We are reverse engineering the decision-making processes. How could they have made so many bad decisions, causing the cataclysm we've been enduring?

What is your conclusion?

Unfortunately, the well-regarded and deeply entrenched theory of "shareholder value" - in which it is believed that the main job of executives is to maximize the share prices of the companies they run - was permitted to extend far past its appropriate boundaries. Practically speaking, the theory originated in the 1970s, by Jensen and Meckling, and it sought to reconcile the potential misalignment of interests between company shareholders and company managements. It did so by constructing packages of stock and stock options packages that would guide executive compensation. But it got completely out of control.

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Through a kind of kitchen logic, executives of all sorts of companies, and especially some financial companies, started forgetting about what the real purpose of their company was, and they allowed only stock price considerations to drive their incentives and hence their conduct. That undermined the entire system.

Can you elaborate? It surely can't be the case that company managements focused only on their stock prices?

The empirical basis of the case is very strong. If you examine U.S. compensation patterns since the 1960s, and look at the ratio of how much net income a company generates relative to the annual compensation of its top executive, you will see that between the 1976 Jensen-Meckling paper, and the early 2000s, the amount of compensation earned by CEOs, relative to the real value they created, grew by more than 600 per cent.

Some of this growth was perhaps a function of companies having done better substantively, but the stock market's increase in value was caused, in sizable part, by executives who were being more frequently, and in larger magnitudes, incentivized to drive their stock prices up - whether their companies' cash flows rose commensurately or not.

You don't think the recent collapse of the financial system had more to do with financial institution excesses than regular corporate practices and compensation systems?

Both of those groups' incentive systems were polluted and ultimately caused the crash. Think about it by analogy to a hockey team.

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In the NHL, a real game of hockey is played, and at the end of it, there have been some goals scored and allowed, with a clear winner and a clear loser. The players ultimately get compensated on the basis of how well they contribute, and their play can be broken down into clear statistical outcomes. This is the real game.

Associated with that, you have a betting market which deals in expectations. You know: "I will take the Penguins over the Hurricanes by one goal". But whatever the outcome in the expectations game, the players are still incentivized to play well in the real game. They can't distort or exaggerate their performance. It is what it is.

Likewise, in business and the capital markets, you have a real market - what the company's cash flow is, how many cars it produced in a year - and you have an expectations market, represented by stock prices in the stock market.

But that's where the hockey analogy breaks down. Because the shareholder value theory has caused compensation consultants, boards, and CEOs to push managers' stock-based compensation to such ridiculous heights, the managers now have huge personal incentives to tell expectations-raising stories, for the "benefit" of the stock.

But they simply can't keep expectations rising forever. Expectations are inherently cyclical. They have never been otherwise.

But don't you think the financial market had more distortions built into it? Isn't it easier to tell a story about the value of your securities' book and real estate holdings than how many airplanes you sold?

Yes. The financial market players' incentives became even more dramatically unhinged. In the world where proprietary trading and investing became a much bigger part of their profit equation, something that used to temper a company's zeal for its stock became untethered.

Think of a company like Procter & Gamble. Its real game is to make the lives of consumers a little better every day. It cares about shareholder value, incentive alignment and its stock price as well, but it knows it needs to keep the service mission in place.

Contrast that with Wall Street, where the only value in play seems to be how to profit from stock prices (or bond prices). The goal of making a higher quality product for a real consumer got pushed way into the background.

So how do we unravel ourselves and get back to a position of balance, where the virtue of shareholder alignment can be enjoyed without the excesses?

It won't be easy. The kitchen logic version of the theory is still thoroughly entrenched. People are just talking about how to "tweak" stock incentive plans. But they need to get rid of them. And at Rotman, we're doing our part to put things in perspective. Hopefully others will get on board soon. The real market is where it's at. We have to return to the real game, as soon as we possibly can.

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