Business and the curse of short-term incentives

Judo’s Joseph Healy and David Hornery. Pic: Britta Campion

The banking industry, in fact the corporate world in general, is undermined by the very things that are supposed to drive it forward – that is, short term incentives (STIs), otherwise known as cash bonuses.

There is a fascinating experiment taking place in running a bank without bonuses, led by two former NAB bankers who have turned their backs on the STI culture: Joseph Healy and David Hornery. It’s called Judo Bank, a specialist SME bank started four years ago.

Judo pays only two forms of remuneration: salary and equity.

(An extract from a book written by Joseph Healy and published last week, called “Breaking The Banks – What went wrong with Australian banking?”, appeared in these pages on Saturday.)

Read more: Insider launches bank pay attack | Extract: Sharing blame for bank’s faults |

Judo keeps its options open on ASX listing

Healy and Hornery were executives together at NAB. Healy ran NAB’s business bank up to 2014, reporting directly to the CEO, and Hornery was an EGM covering corporate and government banking, as well as chairing the bank’s Asia Management Board.

In 2015 these two career bankers decided that banking needed to change so got together to start a new one from scratch - they called it Judo Bank because in judo a small person can use leverage to topple someone bigger.

In effect, Judo Bank is a lab experiment in the right way to run a bank.

Those years, 2014-15, were the beginnings of the Australian banking sector’s five-year (and counting) nightmare. In May 2014, the ABC’s Four Corners kicked it all off with an expose of the sales culture at Commonwealth Bank, and a Senate inquiry into the matter subsequently recommended a royal commission, which was picked up by the ALP.

During 2015, NAB itself joined the party with stories that it had been paying off customers for bad financial advice, and some NAB advisers were banned by ASIC. There were stories about new foreign exchange scandals. This, don’t forget, was 11 years after NAB traders were sent to prison and both the chairman and CEO were sacked after a $360 million trading scandal, amid promises from those left behind to do better in future.

As their employer started to get caught in the brambles of scandal in 2014-15, which eventually ended with the fall of both chairman and CEO, Healy and Hornery were thinking about what would they do if they had a blank sheet of paper. How would you do banking better?

It was clear from my conversation with Healy last week that the key thing he and Hornery wanted to do was get rid of STIs – short term incentives.

STIs, says Healy, are “corrupting”, and were a major factor in the banks’ problems. That’s because they don’t incentivise at all – staff simply see them as deferred salary, paid once a year.

“If bankers don’t get 100 per cent of their bonus, they get upset. And they can’t really incentivise because most profits are locked into the system at the start of the year: there’s very little that an individual banker can do to change that one way or another.”

Also individual STIs send the wrong message – that a person’s own sales volumes matter above all. There’s a chapter in Healy’s book headed: “The curse of the sales culture”.

Judo Bank pays no bonuses or STIs. Everyone just gets a salary and performance is rewarded with equity in the business, that’s it.

Most importantly, no individual is assessed on individual performance – it’s all based on the overall performance of the business, which they are assumed to have contributed to. It means an important part of the HR process at Judo is the six-month probation, during which non-team players and non-contributors can be weeded out.

The amount of equity is calculated by reference to the STI bonuses the person would have been entitled to at their old job (usually with a big four bank), taken over five years and multiplied by a factor of two or three.

So if someone was on a $100,000 salary with a potential STI of $20,000, they would be paid the same base salary and they would be entitled to two or three times five years’ worth of the potential bonus, awarded over time as equity, or $200,000-$300,000 worth of equity at current valuation.

The recruitment process involves a three-hour “credit test” on an SME case study, the pass rate for which has never been above 50 per cent. You can’t know whether those who get through will fit into the business, which is where the probation period comes in.

I asked Healy whether the big four banks could, and should, also get rid of STIs. “Yes, definitely,” he said. “In fact the pressure do it is going to grow. It’s because of the corrupting nature of them – they are one of the main reasons for the banks’ problems.”

It’s true: The so-called “soft” measures of performance are rarely applied rigorously. As the prudential review of CBA in 2018 found: “it was extremely rare for the CEO and group executives to have remuneration reduced on risk grounds. The Board Remuneration Committee’s review of CEO and group executive remuneration was based on extremely brief commentary from management, with a narrow focus on realised financial and reputational impacts.”

Healy and Hornery have simplified the whole absurdly complicated remuneration structure that occupied, for example, 30 dense pages of NAB’s latest annual report, down to just two things: salary, and a stake in the business.

The question is: is it scalable? What happens if/when Judo Bank has 10,000 staff?

Healy believes it will still work then, and would work with NAB now, if they had to courage to do it. Of course the management structure wouldn’t be as flat, but salary plus equity would still be an adequate way to pay people, that would provide the right incentives: that is, an incentive to work together to build the whole business.

* Alan Kohler is Editor in Chief of InvestSMART.com.au