Right incentive system crucial for Financial Services

21 July 2015 Consultancy.uk

Complexity is in the nature of the financial services beast, however, with the right incentives, it can be managed. New rules around bonuses, according to Oliver Wyman, may have the opposite of their intended effect, incentivising generalised centralised decision making over discretionary local autonomy.

In its ‘Managing complexity – The state of the financial services industry 2015’ report, Oliver Wyman maps out the complexity within financial institutions, which, according to the firm forms an integral part of the financial system story. The firm, however, finds that complexity in many areas of financial institutions can be deleterious to the effective operation of the institution. It may create unintended risks or sucking away managerial resources better spent on managing and developing core services.

Top 5 future sources of complexity in financial institutions

In recent years, financial regulators have come down hard on financial institutions and the opacity created by their sheer size and complexity – particularly after the financial crisis and the fraudulent business culture that existed in firms. In its report, the consulting firm considers whether the regulatory moves intended to mitigate the risks associated with complexity, are creating the right incentives for the transparent operation of firms and the development of a business culture not toxic to the societies in which the institution are permitted to operate. 

One way in which to improve the functioning of a large organisation is to create the conditions in which the organisation is well managed. According to the researchers, financial firms should not be centrally managed. The implementation of even optimally implemented CRM or other generalising tools have the downside of failing to capture a vast amount of customer information relevant to local context. Decision making discretion should exist around the rules created to protect the brand, manage risk and inhibit misconduct; rules which should not become authoritarian and overbearing. They must “provide enough latitude for staff with superior knowledge of the customer, product or local market to make decisions based on that knowledge.”

Whereas regulators are seeking better managed firms, the consultancy worries that new rules imposed on financial institutions to limit bonus payments relative to base pay, may have unintended negative consequences instead of achieving better managed institutions: “Staff who do not face a material portion of the costs and benefits of their decisions have little incentive to make optimal trade-offs.”

Compensation structure of CEOs & Direct reports

Long-term incentives & mandatory deferrals were reduced from around 40% of CEO pay in 2011 to around 20% in 2014. According to Oliver Wyman, the new regulator rules, around bonus delivery may in point of fact be deterring efforts to tackle the complexity created by centralised and over management. The regulation is creating a disincentive to bring about long term cultural changes to financial institutions that will ultimately reduce their opacity, create a less toxic relationship with the society that permits their offerings and decrease systematic risk.

The report highlights that the use of bonuses provides central managers with a tool to create an environment in which ‘informationally privileged staff’ are given the right incentives to have discretion based decision making powers. If this does not exist, the firm may keep a centralised model for decision making, which hinders the making of anything but generalised decisions since local knowledge does not fit in the ‘tick boxes’ defined by central CRM.

Creating the right incentive system, and thereby empowering decentralised staff, increases “the enthusiasm and entrepreneurial spirit of junior management and other staff.” Furthermore, it saves managers from the ‘tyranny of committees’ and liberates senior managers from the chore of micro-management, allowing them to devote themselves to the strategic decision making. A firm with performance transparency, automated surveillance, a sound culture and properly empowered staff can succeed with far less hands-on management, allowing it to cut costs by stripping out layers of middle managers and operating officers.

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