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February 27, 2020

Common Purpose: Moral Hazard & Observability

Your partner for international expansion Bram van Kleef Andersson Book now Calendly profile picture best strategy practices management expansions international
by: bram van kleef

Introduction

So here is the big news, I am a devoted supporter of AZ Alkmaar. In my wardrobe, I have a 2008/2009 shirt covering their main sponsor DSB bank. The DSB bank has been instrumental in the successful seasons we had in the 00’s. However, in 2009 that main sponsor DSB bank got in deep trouble. A run on savings was inevitable after major concerns about the bank’s practices were published in newspapers on television. In the aftermath it became clear that the bank had little interest in their clients and the risks associated with a loan at the DSB bank. Many employees faced a moral hazard, and in the years prior to the collapse many of them left the bank and mentioned the bad practices in newspapers. I could not think of a more illustrative example to present the choices faced in a moral hazard.

Imagine yourself as a client for complex B2B services, or someone in the fortunate position to look for expensive goods like cars and boats. Then it becomes a problem that you lack the information required to strike a good or fair deal. So what can you do? That is a though question to answer, but what if you are the leader of that free enterprise. Right, you can support a culture of good ethics, sustain good contracts or observing your sales team the entire day like Michael Scott!

https://www.youtube.com/watch?v=1QQBB3cwNM0

What is it about?

The paper by Bengt Holmström talks about the “moral hazard” in principal-agent relationships. In many of my presentations, I get questions about the moral hazard and what it exactly is. That’s why I think this paper is of great benefit. A moral hazard is a situation in which the sales representative can make a significant amount of money by selling a product which will not suit your explicit en implicit needs, but a car that puts you in debt, because he has the wrong incentive. This has not everything to do with the moral compass of the sales representative, but as well with the contracts and compensations that are in place. Getting the contract and incentives right means that every stakeholder could be satisfied, and that is referred to as Pareto efficiency.

What did they discover?

In the paper, a quantitive solution for optimal risk-sharing is presented. It talks about observability in the sense that people are literally looking over your shoulder to see if you are doing the right thing. This proves to be very inefficient. And from personal experience, it creates a very cringy atmosphere. The paper concludes with clearly stating that just the pay-off (i.e the target, bonus, etc.) itself is not enough of an indicator to reach the first-best solution.

Why should members of the modern free enterprise understand this?

On a frequent basis, I have interviews with sales representatives and leaders to evaluate their organizations against certain measures. This paper has been an important guide for me in establishing a framework for a few relevant questions. If only Dirk Scheringa, the owner of the DSB bank had read the paper by Bengt a lot of families and employees would have been better of. Dirk Scheringa was a notorious observer in the sense that he directed the company like it was a small business, even though the balance sheet covered around 4 billion euros. Employees did not feel trusted and felt no support in making the right choice for their clients. Effectively, the information asymmetry and wrong incentives created a clear moral hazard which ultimately led to the collapse of the DSB bank.

Our key learning here should be that value goes beyond the spreadsheet and therefore beyond financial compensation. Shared consciousness and purpose align people on a deeper level and creates the foundation for stronger execution of strategic plans, and ultimately leads to better and more sustainable companies.

Important Notes

Full credit goes to Bengt Holmström as the author of the original paper. This article oversimplifies some of the original content to create quick and easy understanding. The one-and-only aim of this paper is to further promote it’s content to a wider audience. For the original paper please visit: https://www.jstor.org/stable/3003320

Author

Bram van Kleef is a consultant in the field of sales operations @ VanKleef/Andersson and is located in Amsterdam. He holds an MSc in Business Administration: International Business & Marketing from the Kristianstad University in Sweden. For inquiries: Bram@vankleefandersson.com