Monday, 19 April 2010

Northern rocks

Two former senior executives at Northern Rock have been fined by the Financial Services Authority (FSA) for misreporting the bank’s arrears figures affecting near 2000 bad loans, masking its true health. One of them was the former deputy chief executive, David Baker, fined over £1/2m. ‘Alarm bells about Rock’s dangerous reliance on the wholesale credit markets might have sounded sooner if the true picture of rising arrears had been revealed in January 2007 when Baker made misleading statements to the City’ (Nils Pratley, ‘Financial Viewpoint’, the Guardian, 14 April 2010). When Baker discovered malpractice by the bank’s debt management unit, he failed to report the situation to the risk management committee or to the chief executive.

Pratley goes on to mention the “peer and market pressure on junior employees to hit targets on arrears. That’s a cultural failure …”, he claims. To be more precise, the failure of the culture lies in the bank’s values and the absence of a message to all employees that bad numbers cannot be hidden. By contrast, the targets are an aspect of how the system was designed to support those values. There are two points worth making here: the first on targets and the second on the nature of pressure to hit them.

Targets work in the sense that they do get results. People who are in receipt of targets take them seriously. Hitting the targets helps people’s job reputation and often their pocket too. But remember that these targets are mere proxies; they are arbitrary, imperfect but measurable inventions that try to capture something that is important but not directly measurable that lies behind the target (like improving the bank’s state of health). This nature of a target carries the risk that the target may be hit while missing what really matters. In this case, employees had to hit targets on arrears. Employees know that the target matters to them but may lose sight of what lies behind it (they may not even be told what really matters); and that can lead to short cuts and malpractice, especially if employees are given discretion about how to achieve their target, as in this instance.

While this was going on in the debt management unit, elsewhere in the system employees were being encouraged to make reckless loans; Northern Rock allowed customers to borrow more than the value of their homes as it sought market share. This too conveyed general messages to employees about the bank’s values and the risks it was prepared to take.

Besides ‘inviting’ employees to cheat (and then managers turning a blind eye), in systems terms there is always a price to be paid for hitting a target. This price needs to be understood, though it may be deemed a price worth paying. The problem is that a target applies to one component in a system that has been singled out for special attention. To achieve the target requires that it be given priority over other non-targeted functions. If people give more attention, time, energy, funds and resources to one area, they can do so only by privileging this area at the expense of others. There may be unintended consequences, some of them perverse or contradictory. One way or another, the performance of the whole will suffer. To believe otherwise is like saying at a child’s birthday party that the child whose birthday it is can have an extra large piece of cake, but that the other guests shouldn’t have a smaller piece as a consequence.

The second point is that pressure to hit targets can be insidious, implied and assumed. Employees don’t need to have a manager standing over them with a whip. Managers can make their wishes known more subtly. In the collapse of the Royal Bank of Scotland, staff around the CEO Fred Goodwin would get together to discuss what they thought Goodwin would want. Perhaps Baker worked out what his boss Applegarth would and would not want to be told. There was pressure on Baker as well as on the bean counters.