Firm-Specific Human Capital, Organizational Incentives, and Agency Costs: Evidence from Retail Banking Douglas Frank and Tomasz Obloj Strategic Management Journal (2014) Presented by Tom DeBerge, 9/27/2018

Objectives To explore the conflicting implications of firm-specific human capital (FSHC) on firm performance, by considering the agency costs associated with high-powered incentives and adverse learning by those with high FSHC. Extant literature identifies a complementary relationship between FSHC and performance Anecdotal evidence suggests otherwise (e.g., Enron scandal) The proposed trade-off: specialized knowledge and skills that can generate profits for the firm, thereby leading to increased incentives, can also be exploited by the very same knowledge and skills.

Theory and Hypotheses FSHC and Productivity (well-established in the literature) H1: High firm-specific human capital will be associated with greater productivity. FSHC and Agency Costs (contradictory findings in the literature) H2: High firm-specific human capital will be associated with an increased incidence of incentive gaming. FSHC and Firm Performance (unfounded in literature > competing hypotheses) H3a: The net effect of high firm-specific human capital on organizational performance will be positive. H3b: The net effect of high firm-specific human capital on organizational performance will be negative. FSHC and Adverse Learning (extension of H2, counter to previous literature) H4: Agency losses will increase at a faster rate for high levels of firm-specific human capital.

Method and Context Retail Banking Industry Information Asymmetry > Monitoring Problem > Relative autonomy of managers over certain decisions “..an imperfectly informed principal facing boundedly rational agents” (1298). Firm-Specific Human Capital (FSHC) Measured by the manager’s ability to predict sales targets set by executives Assumes insights into the specific processes of the bank Loans Incentives tied to loan sales Loan terms are often subject to managerial discretion

Results: H1 Supported This result supports the literature and also lends credibility to the measure of FSHC.

Results: H2 Supported “I know at all times where I stand with regard to the sales target. If I’m behind, I do all I can to catch up. If I’m ahead I take it easy.” - Bank Manager

Results: Not H3a, but H3b supported Profit losses based on two benchmarks Fourth-Week Effect Benchmark Monopoly Pricing Benchmark

Results: H4 supported “They [managers] all try to game the system. Fortunately it takes them time to figure out how to do it. In fact, as soon as I realize that they have figured out how to game, I start to think about the new structure of incentives.” – Sales Director

Discussion and Implications Results highlight a previously unrecognized trade-off between human capital and incentives; Complementarity not universal. Results offer a new answer to the question about why all employees do not behave opportunistically > They don’t know how (yet). Results imply that even initially optimal contracts may become sub- optimal over time because of ‘adverse learning’ Several possible remedies may be able to restructure incentives, increase monitoring, or introduce other safeguards

Questions What about dis-incentives? Do the authors consider that ‘adverse learning’ may be more a function of learning that ‘gaming’ goes unpunished? (‘They [managers] all try to game the system’… ‘Of course we give discounts. Everybody does.’) The authors emphasize the context-specific nature of their empirical work. Do we see evidence (even anecdotal) in contexts familiar to us?