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Unintended Consequences and Perverse Incentives

In the perfect, abstract world of traditional economics, everyone behaves in a way that maximizes his or her benefit and no one acts against his or her self-interest. Unfortunately, as the emergent field of behavioral economics has shown, human beings are remarkably unpredictable and given to myriad biases and random, non-rational (and irrational) influences.  This complicates the compliance and ethics professional’s job, especially with respect to incentives and discipline. Even more dishearteningly, even when we are able to predict initial effects, unintended consequences frequently exacerbate the very problem we were trying to solve.

History is full of examples of incentives systems gone wrong. Some famous examples:

  • In the 19th century, Hanoi (then French Indochina) was overrun by rats. The French colonial government placed a bounty on rats. The result: widespread rat farming which actually exacerbated the problem.
  • In the former Soviet Union, managers of glass plants were at one time rewarded according to the tons of sheet glass produced. Not surprisingly, most plants produced sheet glass so thick that it was nearly opaque. The rules were changed so that they were instead rewarded according to the square meters of glass produced. Under the new rules, firms produced glass so thin that it was easily broken.
  • During the deportation of criminals from Great Britain to Australia, the transport companies were compensated based on the number of prisoners shipped, not the number delivered. There was therefore no economic reason to keep them alive on the boats and a large percentage of the prisoners consequently perished on-board. Eventually, the government changed the metric from prisoners shipped to the number who arrived alive.
  • Perhaps the most striking example from recent history was the bailout of financial services firms during the financial crisis of 2008.  Firms that were prudent in their lending, grew at a reasonable pace, and managed their balance sheet and risk well were not granted government loans under TARP or other programs. The firms that acted irresponsibly by growing too quickly and gathering market share without consideration for long-term consequences found themselves awash in government funds because they were “too big to fail”.  The very action that caused the problem (growing too large to fail without systemic impact) was ultimately rewarded.

These examples point out how complex systems (like firms and markets) make predicting cause and effect difficult. Even the most seemingly straightforward incentives can have unintended consequences, perversely incentivizing exactly the behaviour we wish to eradicate. There are specific examples from compliance that illustrate exactly this point:

  • Some companies, in an attempt to create a “speak up” culture that encourages employees to openly discuss compliance concerns, have given cash rewards for reporting compliance and ethics failures. This could easily backfire by encouraging false reporting and ultimately creates a culture of distrust.
  • The Dodd-Frank Act of 2010 offers a “whistle-blower bounty” for employees who report wrongdoing to the SEC.  This could remove the motivation to either put a stop to such wrongdoing or report it to internal compliance programs.

The U.S. Sentencing guidelines mandate that compliance programs provide for both incentives and discipline to encourage ethical behaviour. While this looks at first glance like one of the easier guidelines to operationalize, the unpredictable character of human behaviour actually makes it among the most difficult. Whenever designing systems of incentives and discipline, great care and consideration need to be taken in order to avoid unintended consequences and perverse incentives.

James D. Meacham

James Meacham is Director of Consulting on SAI Global’s Advisory Services team and specializes in business ethics, cultural and behavioral influences on ethics risk and compliance, strategic corporate governance, and GRC technologies.

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