Ability, Adverse Learning and Agency Costs: Evidence from Retail Banking

53 Pages Posted: 8 Apr 2009 Last revised: 29 Oct 2009

See all articles by Douglas H. Frank

Douglas H. Frank

The Catholic University of America

Tomasz Obloj

HEC Paris - Strategy & Business Policy

Date Written: October 27, 2009

Abstract

The literature on incentive contracting suggests that the optimal performance pay contract depends on a tradeoff between productivity and agency costs. The effect of employee ability on this tradeoff is theoretically ambiguous, as the employee’s private gains (through more sophisticated gaming responses) may exceed the employer’s productive benefits. Similarly, employees’ “adverse learning” about how to game their incentives may outweigh their productive learning. Existing research has not examined these possible perverse effects. We observe branch managers of a large retail bank following the introduction of a new incentive plan. We use a novel empirical strategy to estimate the profits the bank loses through managers’ manipulation of loan sizes and interest rates, and find that these agency costs are between three and twelve percent of profits on average. Managers’ formal education (“book smarts”) has no impact on agency costs, but their ability to infer undisclosed information about the incentive plan (“street smarts”) does. More-able managers in the latter sense cost the bank an extra two percent of profits. Finally, agency costs are increasing over time, suggesting that adverse learning dominates productive learning. We find suggestive, but inconclusive, evidence that higher levels of “street smarts”are associated with a higher rate of adverse learning.

Keywords: Agency Costs, Incentives, Performance Pay, Multitasking, Employee Learning, Adverse Learning, Ability, Human Capital

Suggested Citation

Frank, Douglas H. and Obloj, Tomasz, Ability, Adverse Learning and Agency Costs: Evidence from Retail Banking (October 27, 2009). INSEAD Working Paper No. 2009/56/ST, Available at SSRN: https://ssrn.com/abstract=1374784 or http://dx.doi.org/10.2139/ssrn.1374784

Douglas H. Frank (Contact Author)

The Catholic University of America

Washington, DC 20064
United States

Tomasz Obloj

HEC Paris - Strategy & Business Policy ( email )

Jouy-en-Josas Cedex, 78351
France

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