Those of you who regularly read this blog (both of you) know that a continued theme is one of management decision making and behavior in the face of economics incentives. A friend recently characterized this as "if long term customer success is such a powerful idea, why don't firms do it?"
Well, it's interesting to study management decision making in a different context to see if anything can be learned. Most of us are tuned in daily to congressional testimony (yeah right) so I'm sure that this piece from Andrew Lo of MIT's Sloan School didn't escape your notice. Skip past the theory and you get this interesting behavioral vignette:
"Consider, for example, the case of a Chief Risk Officer (CRO) of a major investment bank XYZ, a firm actively engaged in issuing and trading collateralized debt obligations (CDO’s) in 2004. Suppose this CRO was convinced that U.S. residential real estate was a bubble that was about to burst, and based on a simple scenario analysis, realized there would be devastating consequences for his firm. What possible actions could he have taken to protect his shareholders? He might ask the firm to exit the CDO business, to which his superiors would respond that the CDO business was one of the most profitable over the past decade with considerable growth potential,other competitors are getting into the business, not leaving, and the historical data suggest that real-estate values are unlikely to fall by more than 1 or 2 percent per year, so why should XYZ consider exiting and giving up its precious market share? Unable to convince senior management of the likelihood of a real-estate downturn, the CRO suggests a compromise—reduce the firm’s CDO exposure by half. Senior management’s likely response would be that such a reduction in XYZ’s CDO business will decrease the group’s profits by half, causing the most talented members of the group to leave the firm, either to join XYZ’s competitors or to start their own hedge fund. Given the cost of assembling and training these professionals, and the fact that they have generated sizable profits over the recent past, scaling down their business is also difficult to justify. Finally, suppose the CRO takes matters into his own hands and implements a hedging strategy using OTC derivatives to bet against the CDO market. From 2004 to 2006, such a hedging strategy would likely have yielded significant losses,and the reduction in XYZ’s earnings due to this hedge, coupled with the strong performance of the CDO business for XYZ and its competitors, would be sufficient grounds for dismissing the CRO."
Drop the reference to CDO's and insert "bad profits" in a customer context. What Lo is saying is that an ability to foresee future economic positives and negatives (in our world through NPS) does not necessarily result in management being able to take action. Competitive context (we are as bad to our customers as our competitors are) together with short term profit motives from shareholders combine to incent management into the wrong behavior. In the CDO example, it's an economic cliff. In the NPS example, it can be an economic spiral that's equally powerful and negative.
The solution (of course) is to focus efforts on building a robust metric that provides boards and management with a long term view of their business economics through the eyes of their customers. At least then, they may be aware of the precipice, or opportunity, ahead. Then again, doing something about it is an altogether different story.