Performance management in banking;

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Performance management in banking;

investigating the effectiveness of incentive systems

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University of Groningen

MScBA Organization and Management Control

Master Thesis

Performance management within banking; investigating the

effectiveness of incentive systems

Name: Sytse Johan Visser

Address: Hoendiep 49a, 9718TC Groningen

Student number: s1546236

Telephone number: +31 6 10116310

E-mail address: sjvisser@gmail.com

Faculty supervision

Supervisor prof. dr. D.M. Swagerman

Co-assessor: dr. E.P. Jansen

External supervision BDO

Supervisor: M. van der Berg, MSc. (Senior Consultant HR)

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Acknowledgements

This thesis was written as a final assignment of the master’s degree in Organization and Management Control at the University of Groningen. The research was conducted during my internship at BDO Consultancy in Utrecht.

Even though I am the author of this thesis, without the received support from BDO I would not have been able to complete it. Special thanks goes to Mieke van der Berg. Mieke, thank you for your support during the my internship at BDO and arranging the interviews with the banks. Also I would like to thank Geertje Strampel MSc, senior manager risk advisory services, who was a great support during the gathering of the data.

Furthermore, I would like to thank the faculty supervisor, prof. dr. Swagerman, for his support and constructive feedback during the research process and his 24/7 availability. Also thanks goes to prof. Jansen, for contributing as co-assessor.

Looking back on my internship, BDO enabled me to explore the field of management control and consultancy. This opportunity together with the friendly atmosphere and colleagues made that I really enjoyed my internship. I am therefore also very honored that I may start my working career at BDO in March. In addition, writing this thesis enabled me to improve my scientific research skills.

Last but definitely not least, I would like to thank my parents and my girlfriend for their support and confidence during this research.

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1 Introduction

The current financial crisis is known for its complexity and global impact. Being a heavily debated topic, numerous critical analyses are being made which question the function and functioning of financial service organizational in contemporary settings. Issues under investigation range from concrete aspects like the array of product and services being provided, the capital requirements needed, to more abstract issues, like the role of financial organizations in and for society.

Another major issue which is heavily scrutinized is the role of the bonus. Due to the influence of large foreign banks, variable financial rewards have become an ever greater part of an employee’s total remuneration in the Dutch financial sector1. Theoretically, the goal of these incentive mechanisms is to induce motivation (Merchant et al., 2003) and focus employees’ efforts towards the result areas of importance (Merchant & Van der Stede, 2007). By making employees’ rewards dependent on important areas of organizational performance, this form of control has long been thought to be an effective management tool to align employees’ interests with those of the organization thereby enhancing performance (Bonner & Sprinklé, 2002; Ferreira & Otley, 2009).

Whilst sounding promising, these incentive practices have also been regarded to be a co-contributor to the current financial crisis. Organizations oftentimes designed these systems with a specific focus on high short-term financial goals which, when successfully attained, led to generous bonus payments to employees. However, these systems were implemented oblivious for the long-term risks they imposed on their firms, since employees could engage in excessive risk-taking activities towards receiving their bonuses (Financial Stability Forum, 2009). These financial institutions were left with fewer resources to absorb the losses as these risks materialized. From the perspective of management control, these incentive mechanisms produced the effects which were desired on the short-term, however, it has become obvious that these systems did not always contributed to the long-term objectives of the organizations. In response, regulatory authorities have come up with laws and regulations which should limit these effects. In the Netherlands, legislation concerning Sound Remuneration (in Dutch: Regeling Beheerste Beloningsbeleid2) has caused many financial institutions to adapt their variable remuneration schemes in such ways that do not provide these ‘perverse incentives’.

Alternatively, others scholars have indicated that management often overestimates the power of monetary rewards (Kohn, 1999; Heath, 1999). In his paper on the myths about compensation, Pfeffer (1998) states organizations which seek to improve performance or resolve organizational issues by simply pulling the lever of compensation probably see two effects: one, nothing will happen, and two, the spend a lot of money. He indicates that ‘people do work for money, however they work even more to have fun and to have meaning in their lives’. This is substantiated by other researchers who have

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Adviescommissie Toekomst Banken; Naar herstel van vertrouwen. (2009) p.23 2

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mentioned more nonfinancial, intrinsic rewards could be provided in incentive contracting (Merchant et al., 2003; Morrell, 2011) which have a deeper and longer-lasting motivational effect (Armstrong, 2010) and could result in improved revenues through greater productivity, less absenteeism and lower employee turnover rates (Appelbaum & Kamal, 2000).

1.2 Research Problem

From a management control perspective, a continuous challenge lies in the ability for managers to ensure that employees behave as desired. As stated above, one popular mechanism by which desired behavior is stimulated is by the provision of organizational incentives (Merchant & Van der Stede, 2007). However, how to design effective incentive mechanisms that motivate employees and subsequently contribute to the attainment of organizational goals, remains challenging. Two distinct problems can be identified:

First, as stated above, the main purpose of incentives is to induce motivation. However, as indicated in their extensive review, Merchant et al. (2003) describe that the vast majority of studies have adopted an economic perspective towards understanding these systems. As such, the use of financial, extrinsic reward is investigated towards achieving motivation and performance. Alternatively, approaches based on behavioral theories, argue that individuals have other, nonfinancial needs that needs to be addressed in order to become motivated (Armstrong, 2010; Appelbaum & Kamal, 2000). However, the use of these nonfinancial rewards within incentive compensation has been investigated to a limited extent (Merchant et al., 2003). Therefore, it is unclear whether there is a difference in incentive effectiveness due to the choice of rewards incorporated in their designs.

Simultaneously, the larger part of empirical incentive system research has investigated the

effectiveness of these mechanisms from a performance measure output analysis. Apart from the fact that there are divergent results stemming from these studies, it has been shown that these systems might produce, and actually encourage employee behaviors that are inconsistent with organizational objectives. Therefore, evaluating the effectiveness of incentive mechanisms in terms of one

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1.2 Research Objective

In overcoming these problems, the objective is to develop insights into how different forms of rewards (i.e., financial and nonfinancial) in incentive compensation systems lead to employee motivation, and subsequently, organizational performance. In doing so, this paper aims to provide a process analysis by which the incentive system operates and functions. As such, this paper tries to enhance present knowledge on how to implement incentive systems for the purpose of management control.

1.3 Research Questions

Derived from the paragraphs above, the main research question on which this paper will be focused is the following:

How and why do financial versus nonfinancial rewards in organizational incentive designs, differ in their effectiveness?

By answering this question, the research problem will be addressed as it tries to clarify whether and how the choice of rewards in incentive mechanisms will result in desired effects concerning employee motivation as well as the different effects towards the attainment of organizational performance. Several sub questions are necessary in order the answer the main research question:

1) How are incentive systems constructed? 2) When are incentive systems effective?

1.4 Structure

The paper will be structured as follows: The first section will provide a overview of what previous researchers have discovered concerning the field of incentive systems. Afterwards, a research

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1 Literature and background

2.1 Introducing incentives

It has for a long time been recognized that incentive systems can be used as a mechanism to align individual’s goals with those of the organization (Hopwood, 1972). Theoretically, by tying employee rewards to performance, problems of effort avoidance and disappointing organizational results could be greatly reduced. Whilst this proposition has received a growing amount of attention over the past three decades, no clear answers have been found to the question of how these structures should be designed to function effectively. However, within this field, two distinct understandings can be found in how these systems should operate.

The early days of incentive system literature has been dominated by the field of economics, based on assumptions of stability and rationality (Hopper et al., 2001; Chenhall, 2011). Starting point here is the agency theory, which is the application of microeconomic theory to some management control

problems, particularly those who are related to the design of optimal incentive contracts (Merchant & Otley, 2007). The basic assumptions rests in the presence of rational individuals who seek to

maximize their own utility and are risk-averse (Eisenhardt, 1989). This implies an inherent divergence of interests between management and employee. Consequently, the agent can act in a manner that is not beneficial to the principal (Eisenhardt, 1989). By making the agents rewards dependent on performance (i.e. organizational objectives) the principal is able to efficiently align the agents’ interests with those of the organization. Incentive systems based on this theory of economics mainly suggests that financial rewards play a crucial role in inducing motivation as well as controlling performance because individuals have utility for increases in wealth (Bonner & Sprinklé, 2002). Empirical tests based on this economics-based perspective often include simple indicators of the incentive system, such as the mere existence of a bonus, in relation to an output measures of performance, leaving the process of incentivizing omitted (Merchant et al., 2003). Therefore, it has been recognized that much of the agency literature remains abstracted from real life and provides little practical relevance (Merchant & Otley, 2007).

In a later stage, international management control research recognized that there was a gap between theory and practice which led researchers move away from this economic view (Scapens, 2006). Instead, they realized organizations were influenced by complex sets of interdependencies (Chenhall, 2011) which could not be explained with pure economic reasoning. Subsequently, this led to the adoption of more social and behavioral-based theories in management control research. Concerning the use of incentives, these behavioral perspectives provided more insights in the process of

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employee motivation in manners that enhance the focus on organizational objectives is relevant for the field of management control. This paper will therefore focus on the process of the incentive system.

2.2 Defining incentives

Stimulating individuals by creating mechanisms that state ‘Do this and we will make it worthwhile’, can be found in everyday life, all the time. For example, a mother promising her child an ice-cream when she finishes her homework. Consequently, they are meant to induce direct motivation. Armstrong (2010) defines these tools as follows:

“Incentives are intended mechanisms to encourage people to work harder and achieve more” Within organizations, these mechanisms usually take shape by tying rewards to employee performance evaluations (Merchant & Van der Stede, 2007). By doing so, employees become concerned about their actions since the consequences of their behavior will directly impact the amount of rewards they receive. Based on this reasoning, management can direct and induce motivation towards specific performance areas of organizational importance. Therefore, the effects following the incentive process involve two sequential effects; (1) the enhancement of employee motivation and subsequently, (2) the improvement of organizational performance (Bonner & Sprinklé, 2002).

2.3 Performance management

Whilst the term ‘incentive’ suggests that it is a specific and independent system within organizations, the provision of incentives is generally an integrative part of a broader form of control framework. As indicated by Prendergast (1999), incentives are provided by the compensation practices in firms. Many researchers have noted that incentives can be incorporated into management controls. Be it the

diagnostic controls by Simons (1995), results controls by Merchant & Van der Stede (2007) or the performance management framework by Ferreira & Otley (2009), incentives are often integrated in a framework which is generally constructed on four sequential steps, which are repeated after the performance management period. For the purpose of this paper, we have adopted the framework of Otley (1999) since it provides a useful and practical guideline for describing performance management activities within firms. From this framework, we deducted four steps which we deem these most closely related to the functioning of incentives3.

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Organizations implement incentives with the purpose of enhancing specific areas of performance which should contribute to the overall success of the organization (Otley, 1999). Defining the right performance dimensions from which performance achievements can be assessed is important since they shape employee’s perspective of what is regarded to be important (Merchant & Van der Stede, 2007).

2) Setting targets

Subsequently, defining the level of performance is needed to guarantee success. The targets resulting from this process provide the employees with the clarity needed to know which targets to strive for since it distinguishes good from poor performance whilst simultaneously provides clear feedback to employees about both status and outcome of performance (Merchant & Van der Stede, 2007). 3) Performance Evaluation

During, and more importantly, after the period, the performance evaluation process measures and tries to explain whether the performance targets are achieved or not.

4) Providing Rewards

Ex ante to the performance period, information about the rewards to be granted can be given in relation to the performance to be achieved. From this relation (‘do this and you will get that’), the organization can derive motivational value. Ex ante, based on the performance evaluation process, the actual rewards can be given in relation to performance achieved.

Figure 1: Performance management framework

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2.3 The role of rewards within incentive contracts

Within the field of incentive system research, the influence of the type of rewards within incentive system design is investigated only to a limited extent. The following section will therefore elaborate on what can be defined as a reward. Next, a reward typology is presented as well as their effect on the incentive process.

2.3.1 Rewards defined

As mentioned earlier, the vast majority of incentive research has been based upon economic theories like the agency theory (Merchant et al., 2003). Whilst this theory has provided useful insights concerning compensation issues, it has a tendency to focus specifically on the provision of monetary rewards. This economical premise states that financial rewards are always preferable over other types since money represents a general claim on a resource which can be exchanged for other rewards (Baker et al., 1988). However, these propositions are found to be oversimplified and lack practical relevance (Merchant & Otley, 2007).

Alternatively, the study of motivation tries to explain more in-depth why people behave as they do in terms of effort, directions and persistence (Armstrong, 2010). The motivational strength of any reward can be understood by using the expectancy theory by Vroom (1964)4. This theory emphasizes the psychological forces which affect an individual’s motivation in relation to its specific needs (Armstrong, 2003). The expectancy theory proposes that an individual’s motivation is a function of two factors: first, the expectancy about the relationship between effort and a particular outcome (e.g. a certain level of compensation for a certain level of performance). And second, the value (valence) that the individual places on this compensation in relation to the person’s needs, goals and values. A function of these factors leads individuals to select effort levels that they believe to lead to desired outcomes (Bonner & Sprinklé, 2002).

Based on this latter perspective, rewards should be understood in the widest possible sense, and not be restricted to just short-term financial rewards, important though these may well be. Therefore, in this paper, rewards refer to:

anything that an employee values or dislikes (Merchant & Van der Stede, 2007)

This can be a positive reward (e.g. bonus, praise, recognition, autonomy, power, special job assignments) or forms of punishments (e.g. loss of autonomy, demotion, humiliation).

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Several other motivational theories are the self-efficacy theory of Bandura (1986), the equity-theory of Adams (1964), the

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2.3.4 Reward types

Based upon this definition, managers need to consider all aspects of the work experience which hold value to employees and which can fulfill their needs as potential rewards. In general, the employee compensation infrastructure in contemporary organizations is comprised of two categories of rewards; financial and nonfinancial rewards (Chiang & Birtch, 2012). The next section will elaborate on reward types for and different motivational properties that satisfy certain needs.

2.3.4.1 Financial rewards

Financial rewards comprise all rewards that hold a quantifiable market value (Merchant et al., 2003). These usually include salary (increases), bonuses or additional employee benefits, stock options. From the theory of motivation, it is undoubted that financial rewards serve as a motivator since they fulfill an employee’s primary need to purchase goods and services. Furthermore, financial rewards may also motivate indirectly as they also hold symbolic values since they portray indications of success, achievement and persons ‘value’ in society (Thierry, 2008). Whilst it is understood that under the right circumstances these extrinsic motivating rewards can have immediate and powerful effects on motivation, it is often stated that these only produce short-term compliance and that the motivational effect dissolves when the reward is removed (Kohn, 1999). In that sense, the relationship between employer and employee has a transactional character (Armstrong, 2010).

2.3.4.2 Nonfinancial rewards

Many behavioral theorists acknowledge the importance of financial rewards: As stated by Latham and Locke (1979); ‘Money is obviously the primary incentive, however money alone is not enough to motivate high performance’. Most of the nonfinancial rewards are unconsciously provided and are generally perceived as those that are related towards intrinsic motivation, i.e., self-generated rewards from the doing the task itself. These often involve needs of recognition, sense of achievement, responsibility in work, autonomy (i.e. freedom to make decision and act independently) and personal growth (i.e. learning and development) (Armstrong, 2010). Other nonfinancial rewards include recognition and feedback, which are extrinsic of nature, but can have important motivational

implications related to needs of self-esteem and status. When employees perceive that these needs are being fulfilled, or that the organization is willing to invest in them (e.g. training and development), strong motivational power can be deducted from these rewards (Chiang & Birtch, 2012). These, more relational incentives, are generally accepted as having deeper and longer-lasting motivational effects (Armstrong, 2010).

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negligible amounts of rewards can even produce counterproductive effects (Merchant & Van der Stede, 2007).

2.4 Incentive process effectiveness

As indicated earlier, incentive research has the tendency to interpret the effectiveness of incentive systems by investigating the implementation of the mechanism in relation to the effect it has on a given measure of organizational performance. Based on the economic perspective towards incentives, the most commonly and ‘simple’ assessments of incentive effects come in the form of an improvement of productivity in manufacturing sites (e.g. Lazear, 2000) or increase in sales retail establishments (e.g. Banker, 1996) due to the implementation of an incentive mechanism. Where significant positive results can be found within these situations, the appropriateness of indicating the effectiveness based on this approach is rather questionable in contemporary organizations, due to the fact that employees often have a multitask job description (Baker, 2002). Here, it has been frequently found that focusing on one organizational objective might actually cause conflicting results towards another objective, limiting, or even cause a negative the net performance improvement due to the incentive (Baker, 2002; Bouwens & Van Lent, 2006). Therefore, in this paper, we choose to assess the effectiveness of the incentive mechanism in terms of its contribution towards maintaining good control. For obvious reasons, perfect controls do not exist. This would mean that these controls could guarantee good behaviors in all circumstances. However, maintaining good control means that management can be reasonably confident that no unpleasant surprises will emerge, and employees do what is expected of them (Merchant & Van der Stede, 2007). Even though assessing good control is difficult and

subjective, the appropriateness of any control measure depends on whether all the relevant dimensions which could influence behavior are desirable. Therefore, a process perspective towards the functioning of incentives is appropriate. We have identified several factors which could limit the effectiveness of incentive systems regarding the two effects of motivation and subsequently, performance.

2.4.1 Motivational effect

Many scholars have indicated that the mere provision of variable rewards does not necessarily lead to enhanced employee motivation. The motivational effect is dependent upon several factors which influence the strength of this effect of an incentive systems. Besides the reward type, which was discussed in the previous section, we address the most relevant dimensions below.

Quality of performance measure

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which they cannot influence since no desirable behaviors can be stimulated. Furthermore, in order to measure the results which are under the control of the employee, the measures used should be as precise, objective and understandable as possible (Merchant & Van der Stede, 2007). These can significantly affect the degree to which employees are motivated to behave in a desired direction as uncontrollable measures provide limited informational value on what to do (Bonner & Sprinklé, 2002).

Target setting process

The use of preset targets for the management of performance is almost universal as it is widely

acknowledged that employee motivation is enhanced when individuals have specific goals to focus on. Simultaneously, the target setting process reflects a universal tension between what is desired by the organization and what is thought feasible by employee (Ferreira & Otley, 2009). Where management benefits most when targets are high, employees benefit when targets are low. However, very

challenging targets might result in high performance, however can also produce manipulation and game-playing. However, setting the target too low, there will be virtually no motivation effect to improve performance (Merchant & Van der Stede, 2007). Furthermore, the process of target setting might be as important as the actual target outcome. By negotiating targets, rather than imposing a target, employees become actively involved and create commitment and engagement to the target, which stimulate energy, importance and focus towards attaining the target (Gruman & Saks, 2011). In general, research has shown that motivation is highest when targets are challenging, but achievable (Merchant & Van der Stede, 2007).

Performance evaluation process

Evaluating the performance that is achieved is critical and difficult. The most obvious indication of the level of performance achieved is comparing performance results with the targets set earlier in the process. This objective evaluation approach provides employees with a clear outcome, since there is no room for ambiguity. These evaluation forms are suitable in situations where input-output relations are clear. However, if the performance measure lacks this quality and this relationship is vague, it does not account for possible flaws in the systems which follow from uncontrollable factors (Baker, 2002). Subjective approaches have the advantage that they can correct for these flaws (Gibbs et al., 2004), however with the risk of bias from the evaluator (Moers, 2005) and at the cost of expensive

managerial time (Ferreira & Otley, 2009). However, the bias effect can be overcome when the

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2.4.2 Improvement of organizational performance

Whenever there is a strong motivational effect due to the implementation of an incentive systems, and the employee is motivated to perform, it has been frequently recognized that this in itself does not contribute to an enhancement of the overall organizational performance (Prendergast, 1999). Outcome congruence

Several authors have presented evidence that the lack of effectiveness of incentive mechanisms is often attributable to outcome incongruence (Prendergast, 1999; Baker, 2002). When this is the case, the firm actually reduces the strength of the incentive system, not because of employees motivational issues, but due to rewarding the wrong behaviors. Behavioral displacement occurs when an

organization bases the incentive systems upon performance measures that ultimately do not contribute to the organization’s true objectives (Merchant & Otley, 2007). For example, when an incentive system is focused on enhancing product quantity, this might result in highly motivated employees, it might come at the expense of product quality. In this situation, employees are motivated and mean well, however the performance measure lacks congruence. Alternatively, employees might also be motivated to deliberately manipulate data, which refers to gaming (Baker, 2002; Cools, 2005).

2.5 Frame of reference

From the previous section, different variables can now be defined. The incentive system is the variable which influences the performance of an organization and is therefore the independent variable. In turn, the performance effect is labeled as the dependent variable. The mediator is the motivation effect. The variables which can influence the relation between the independent variable and the mediators, i.e. the incentive system and the motivation effect, are rewards, the quality of performance, target setting and performance evaluation and are labeled as the moderator. Outcome congruence is also a moderator since it influences the relation between the moderator and the dependent variable. From this, the following theoretical framework can be constructed on the functioning of incentive systems.

Incentive system Motivational effects Performance effect +  Rewards  Quality of performance measure

 Target setting process

 Performance evaluation  Outcome congruence

+

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3 Methodology

The methodology section contains the methodological approach of this study. In this chapter the research type, data collection and how the approach to analyzed the data are explained.

3.1 Research type

Where the majority of previous studies have investigated the functioning of incentive systems primarily based on surveys or archival methods (Merchant et al., 2003), we argue that these often provide only limited insights into the effects of incentive systems. From the theoretical framework stated above, we have argued that the effectiveness of an incentive system depends on several complex contextual elements which influence the relationship between rewards, motivation and performance. In order to incorporate all these contextual elements and to understand the complexity of the incentive process, an in-depth analysis is needed. Therefore a case study design is an appropriate way for investigating the research problem due to the holistic characteristic of this research method (Yin, 2009; Marchan-Piekkary & Welch, 2004). In addition, as the focus of this study is to explore the relationship between the type of reward provided and the effectiveness of the incentive system, this study is exploratory of nature. Based upon the research question of this paper, this comparative case study approach is aimed at discovering contrasting results, for which anticipatable reasons can be identified (Yin, 2009).

3.2 Data collection

Empirical data was collected by using multiple sources of evidence in order to develop converging lines of inquiry. In doing so, triangulation is used to improve construct validity (Yin, 2009). Advantage of using triangulation, is that it produces a more holistic and contextual portrait of the object of this study (Marchan-Piekkary & Welch, 2004). The sources included the use of desk research and semi-structured interviews. These different sources complement each other by compensating for the weaknesses of each method (Yin, 2009). Desk research is concerned with the gathering of

company documentation (e.g. annual reports, remuneration policy reports and performance evaluation tools) as well as third-party documentation (e.g. newspaper articles, publications). These documents provided a preliminary understanding towards specific elements of the company’s incentive systems. In order to provide in-depth information concerning the design and effectiveness of organizational incentives, semi-structured interviews were conducted on different levels of the organizations under study. By performing interviews with employees on different levels we made effort in collecting a multiple viewpoint on the research problem and made it possible to compare data between

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necessary information. The interviews held were digitally taped with the permission of the

interviewees. The associated audio files have been transcribed into detailed written interview reports. Afterwards, the audio files have been deleted. By combining the written documentation and the interviews, a clear understanding of the incentive process was envisioned and the results are presented

in the results section below. Furthermore, with the aid of the stated framework and the interview

questions which can be supplied on request, the same case can be replicated, enhancing its reliability.

3.3 Data analysis

The first step in the analysis is to provide the reader with background information regarding the selected cases. Here, the case profiles and strategic objectives are described, to provide an understanding of the direction in which the organizations are heading. Following, detailed descriptions of both incentive designs are given. Subsequently, the next step consist of a detailed analysis of the incentive design elaboration of the cases with the aid of pattern matching. Here, we compare the empirically based data with the predicted, theoretical framework (Marchan-Piekkary &

Welch, 2004), and do this in a question-and-answer form to enhance readability (Yin, 2009). By

making use of pattern matching we try to archive the best possible internal validity (Yin, 2009). Based upon the theoretical framework established above, detailed descriptions of the functioning of two organizational incentive systems will now be provided. Finally, in the cross section analyses, both cases are compared in which the similarities and differences are elaborated.

3.4 Case selection

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4 Case study: Bank X

In this section, we investigate the functioning of the organizational incentive system within Bank X. After presenting the company’s profile, a description of the organization’s strategic objectives is given which is followed by a description of the performance management systematics. Thereafter, an

analysis is given of how the system affects the motivational and performance effects.

4.1 Company profile

Bank X is an independent private bank with a rich history in the Dutch banking sector. Spread across several offices in the Netherlands, this bank distinguished itself from retail banking, as it is dedicated to wealthy individuals and small and medium sized institutions. In general, this entails that a client needs to have a substantial amount of disposable asserts available, which are placed under the management of the bank. Their financial services compose of comprehensive advisory services with regard to financial planning, investment and financing issues, brought to the clients in a personal manner to help them managing their financial ambitions.

4.2 Strategic objectives

Because of this personal approach to banking, one of the primary concerns of Bank X is to manage a strong relationship with its clients. Since the outset of the crisis however, this focus has been tightened due to the fact that the perceived trustworthiness of financial organizations and their advisors by the general public was negatively affected. Therefore, it is necessary to (re)establish a strong, trustworthy long-term relationship with clients. Additionally, the majority of new clientele is brought into contact with Bank X on the recommendation of existing clients, which makes managing a strong long-term customer relationship is essential for establishing and maintaining opportunities to grow.

Like many banks, the economic developments during the financial crisis has had, and still has impact on Bank X. The crisis has learned that significant internal and external risks are present within the financial sector. These include financial risks (e.g. solvability, liquidity, market, credit risks) as well as several nonfinancial risks (e.g. business risks, compliance risks, ICT-risk). Managing these risks accordingly is found to be of upmost importance in order to remain a sound and healthy bank. Due to the relatively small size of the organization in comparison with larger banks, it is difficult to be competitive in times of crisis. Since laws and regulations are the same for every bank in the

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4.3 Performance management

As mentioned earlier, our interest lies in the relationship between the provision of an incentive, employee motivation and subsequently, its contribution to organizational performance. In this section, we focus on the design of the incentive system of Bank X by describing the performance management framework, posted in figure 1. Bank X’s incentive system is applicable to the commercial staff of the organization, which can be divided into two groups: (1) the bankers and (2) the commercial support staff. Non-commercial employees are not eligible to an incentive. For the purpose of enhancing readability, the

4.3.1 Defining desired performance and target setting

Prior to the start of the year, the desired organizational performance objectives and targets are identified by Bank X’s executive management. These contain of goals which reflect the interests of multiple stakeholders and can take shape in financial, nonfinancial, quantitative or qualitative objectives. A selection of these objectives are subsequently translated down to both office level, and the level of the individual staff member. In doing so, there is explicit attention to make these goals and targets ‘SMART’, that is to make the objective specific, measurable, attainable, relevant and time-bound (Doran, 1981).The set of objectives included in the incentive contract depends of the factors which the individual can control. Besides factors of risk management, integrity and quality of services, a specific goal for bankers with regard to the organization’s financial performance is focused on the growth of the AuM, that is, the value of investments. During the year, this value can fluctuate due to the financial markets effects, but also in the bankers ability to retain and expand the amount of clientele and their investments at the bank. At Bank X, it is therefore the objective of the commercial staff to let the AuM grow. After consulting with the individual member of the commercial staff, the target is anchored into a written arrangements with, for the commercial staff, controllable performance agreements.

4.3.2 Performance evaluation

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these integrity requirements can significantly influence the height of the variable reward to be granted. Together with the performance targets, these comprise of the complete performance evaluation which are relevant to the attainment of the variable reward. At the end of the year, an oral performance review between manager and employee provides the opportunity to exchange thoughts about the actual performance, after which the manager makes a judgment about the final evaluation outcome.

4.3.3 Provision of rewards

As mentioned above, two groups of commercial staff are eligible for the variable financial reward within the incentive system of Bank X. However, some distinctions can be made between the groups. The first group of bankers can earn a variable financial reward which is capped at 50 percent of annual fixed salary. For the second group of commercial support staff, this remuneration is maximized at 25 percent. Based upon the performance evaluation process stated above, three conditions influence the height of the cash bonus. The first is related to the targets which are set at the beginning of the period, which is based upon the results of three levels of performance; individual targets, office-level targets and company targets. Together, the achievement of these separate targets can account for the

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4.4 Analyzing the incentive system at Bank X

In the process of answering our research question, the next section will analyze the effectiveness of the incentive system based on the frame of reference provided in paragraph 2.5. We will first address the role of the type of rewards included in the incentive design, after which the other effectiveness criteria will be discussed. Finally, we conclude upon the overall effectiveness of the incentive mechanism at Bank X.

4.4.1 Rewards

The abovementioned description of the incentive system at Bank X has revealed several important aspects which might influence the systems effectiveness. Theoretically, a maximum variable reward of 50 and 25 percent can be earned by the bankers and commercial support staff respectively. However, this maximum has been said that one needs to perform “excellent” to attain personal targets as well as all the integrity requirements. Next to this, individual are also dependent on others for attaining the office-level and company targets. Because of these conditions, the actual variable rewards generally granted to the commercial staff generally relates to around 5 percent of annual fixed salary. Therefore, there is a substantial difference between the rewards that could be granted following the incentive design, and the rewards that are granted to the individual employee in reality. This clearly influences the impact of the financial reward on employee motivation (Merchant & Van der Stede, 2007). Simultaneously, from the interviews it became apparent that the financial variable reward holds limited value to the commercial staff. One distinct reason for this lies in the fact that the majority of the staff at Bank X consists of senior bank personnel, which already have had a long career with other banks in the financial sector. As indicated by the HR-manager:

“These experienced individuals often come to work for Bank X since they are given the freedom to act independently (within the limits of regulations and strategy), as well as having close contact with the clients. The possibility of earning this relatively small variable financial reward contributes little towards getting these employees motivated”.

Moreover, the banker noted:

“We receive a competitive base salary, which is far better than those in other sectors. I am motivated to work since my work is fun to do. The financial bonus does not stimulate me to do more for Bank X than I do at this moment. Instead, we need to be worried about making the banker a credible and trustworthy profession again”.

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what value of this bonus system was for the company. Here, it became clear that the function of this reward was not primarily focused towards motivation. As the HR-manager noted:

“The purpose of this incentive mechanism is to be able to attract qualified bankers from the market. When no variable rewards are given, you simply cannot compete with other financial institutions”.

This indicates another objective of incentive mechanisms within organizational settings, which is not related to the enhancement of motivation to perform as desired. Even though such alternative

functions of incentives have been acknowledged (Merchant & Van der Stede, 2007), it has also been argued that these alternative motives might actually influence the design and use of these mechanisms (Merchant et al., 2003).

As described above, there are several issues which influence the strength of the motivational effect. Besides the form provision of rewards, which we discussed in the previous section, these refer to the quality of the performance measure, the target setting procedure and the performance evaluation process. Here, we will discuss the influence of these factors on their effect towards enhancing motivation.

The quality of the performance measure and target setting process

The primary objectives of the incentive system of Bank X is to enhanc growth and profitability of the organization which, in principle, is a performance area controllable for the commercial staff. However, the fact that these performance objectives are distributed over three organizational layers (individual, office-level and organization), limits the degree to which a single employee can influence these objectives since there are many other factors which impact these results. One controllability issue is related to the changes in AuM due to forces of the market. However, these uncontrollable factors are deliberately incorporated since it is the banker’s job to adjust to these developments. Alternatively, internal factors primarily related to the actions of direct and indirect coworkers cause that individuals have little control over the office- and organization-level targets in particular. Due to the fact that the performance measures and targets incorporated into the design are developed to be ‘SMART’5, this approach provides the employees with a clear understanding of what needs to be strived for on an annual basis. Despite the fact that the target level is predominantly determined by the management, the targets are perceived as being realistic. As the banker indicated:

“The targets need to be real, since ‘squeezing’ the client to take on additional product is just not in line with being a private bank. Here, it’s all about the client.”

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So even though these processes are predominantly based on top-down configurations, they are translated into clear and achievable targets. Simultaneously, it can be argued that there is only limited control over the objectives to enhance since there are many intervening variables involved.

From the abovementioned, it is noticeable that Bank X approaches the process of initial performance evaluation in a fairly objective and formulaic manner. After mapping the performance achievements per employee, an ex post correction is included in terms of integrity. Even though this occurs afterwards, these requirements are known to employees so they can anticipate upon them in the next period. These latter, more subjective assessments of employee performance ensure the other

organizational objectives are safeguarded whilst simultaneously portraying a more complete picture of the employees’ overall actions during the period. When asked whether this approach towards

evaluation provided an accurate assessment of the bankers activities the banker mentioned:

“Even though the evaluation process is quite strict and well defined, at the end of the day it’s all about the ‘story’ behind the performance outcome. When there are significant

‘uncontrollables’ or whether other important events happened, adjustments in the evaluation outcome can be made when explained appropriately”.

Therefore, it is recognized that the bankers’ activities, and other uncontrollable factors, are often too complex to assess fully with the help of such strict policies. Explaining the relevant events can therefore hold great informational value. Simultaneously, within the relatively small department of bankers, this approach towards performance evaluation is transparent and open, which provides the basis for a trustworthy process (Burney et al., 2009). As a consequence, feelings of inequity between evaluation outcomes of different bankers are limited.

4.4.3 Performance effect

Even though an increase in motivation as a result of the incentive provided seems limited in Bank X, this is not the only effect. In order to function as an effective management tool, we argued that the incentive should furthermore contribute to enhancing performance, indicated by the level of outcome congruence. Within Bank X, the incentive design is mainly focused towards attaining certain levels of financial performance. Despite the fact that it may contribute to achieving this financial strategic objective, this design as such could cause severe incongruence towards their customer focus as well as their risk management. Due to the inclusion of integrity requirements, these strategic objectives are secured to certain extent. However, this ex post process towards correcting for actions taken during the year has some limitations. Most importantly, the integrity requirements concerned with risk

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4.5 Conclusion

From the abovementioned, several important implications can be distilled concerning the effectiveness of the incentive system at Bank X, and their contribution towards the attainment of organizational objectives. Whilst being primarily interested in the effects of the type of reward provided in these incentive mechanisms, the analysis has shown that the financial reward provided results only limited motivational strength since it holds little additional value and has a small impact to the behaviors of the commercial staff. Also, the other factors which influence the motivational effect of the incentive mechanism (as stated in the frame of reference in figure 2) hold limited motivational value. In addition, is has been shown that intrinsic rewards following the work itself hold more motivational value to employees than this additional financial reward. Simultaneously, this analysis shows that the incentive system does not function independently. The additional integrity requirements which influence the functioning of the incentive system, shows that the system can be complemented with other management controls. In this case, these additional results controls which are separated from the target and focused on general job descriptions ensure a focus towards other organizational objectives, limiting the chance of incongruent employee performance. Furthermore, it has shown that incentive systems are not necessarily intended for motivation purposes. Since Bank X implemented this

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5 Case Study: Triodos Bank

In the next section, a detailed description is given of the performance management systematics at Triodos Bank. The following sections describe the company’s profile, followed by a description of the strategic objectives. Subsequently, we delineate the performance management systematics. Thereafter, an analysis is given of how the system affects the motivational and performance effects.

5.1 Company profile

Triodos Bank NV is an independent bank which adopts an alternative approach towards banking in comparison to the majority of banks. Since its foundation in 1980, Triodos is based on its fundamental belief that economic activity should have a positive impact on society, culture and the environment. Therefore, the bank aims to promote human dignity, environmental conservation and a focus on people’s quality of life in general. Key to this is a genuinely responsible approach to business, transparency and using money more consciously. The bank argues that this does not contradict the banks entrepreneurship or financial returns, however it puts these into a broader perspective. By means of five branches in the Netherlands, Belgium, United Kingdom, Spain and Germany, Triodos Bank connects savers and investors with companies and entrepreneurs who are doing business in a sustainable way.

Triodos Bank’s activities are split down into three lines of business. The Retail and Business banking activities are concerned with the provision of quality services to customers. These include the

provision payments and savings counts, lending and investments opportunities. Furthermore, the Business bank only lends money to organizations working to bring about positive and lasting change. Triodos Investment Management invests in themes such as sustainable trade, organic agriculture, climate and energy, sustainable real estate, arts and culture, or in listed companies with above average environmental, social and governance performance. Triodos Private Banking offers a broad range of financial and nonfinancial services to wealthier people, foundations, associations and institutions. That this approach towards banking is successful can be seen from its growth over the last years. In terms of financial figures, amounts of customers and the number of ‘co-workers’6, Triodos is expanding rapidly and becomes an ever more important player on the European financial markets.

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5.2 Strategic objectives

Being dedicated to have this positive influence on the world, Triodos aims maximize sustainability. They aim to realize their mission by adopting objectives in three different ways7:

As a sustainable service provider - Bank customers do no not only come to Triodos for their sustainable products and services, they simultaneously seek for competitive prices and professional service. Therefore, the bank tries to offer a collective package of banking services to promote sustainable development. Aiming on a broad customer base consisting of both private and corporate customers which are consciously choosing to bank at Triodos.

As a product innovator - A second strategic objective of Triodos is to develop innovative products and services and sell them to direct customers and third parties. More than half of the growth in the Triodos funds now comes from distribution via third parties, bringing the bank’s products to a broader audience.

As a reference point - Triodos aims to stimulate the public debate concerning themes as quality of life, sustainable banking and corporate social responsibility. Even though these debates go further than the bank itself, Triodos aims to portray its vision and opinions concerning important social trends, thereby strengthening the Triodos brand and reputation.

5.3 Performance management

As mentioned earlier, our interest lies in the relationship between the provision of an incentive,

employee motivation and subsequently, its contribution to organizational performance. Within Triodos Bank, managing performance and creating goals to strive for is an important part of their management activities. The next section will provide a description of the process by which performance is managed within Triodos Bank by using the performance management framework, as presented in figure 1.

5.3.1 Defining desired performance and target setting

Being highly focused towards providing sustainable banking activities, a substantial part of the performance objectives are related with qualitative result areas as: finding new way of financing durable energy or having ‘impact’ in certain sustainable sectors. This latter refers to the provision of a transparent picture to its stakeholders of the banks wider role concerning people, environment and culture8. Simultaneously, it is also necessary for Triodos to be economically viable and to deliver returns to their certificate holders. Therefore, executive management also focuses on financial and market objectives concerned with levels of profit, growth of AuM and the amount of new clients to attract. Without these goals, the continuity of the organization is at stake.

7

Triodos Bank; Half-year report 2012

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However, these hard and abstract performance objectives are rarely passed on into individual

performance targets in this same form. Together, department managers and individual employees, are given a high degree of freedom by higher management to translate these corporate targets into context relevant, individual targets which contribute to the employee’s personal development. As such, targets can be shaped into a large variety of objectives that are relevant within a given situation.

Simultaneously, department managers have their own specific targets, which have a higher level of abstraction towards organizational goals. It is therefore implicit to the manager to ensure that the employee’s target does not limit them in the ability to achieve their own target. As such, it is the responsibility of the managers to make sure that the employee targets comply to both individual needs as well as the attainment of organizational goals.

5.3.2 Performance evaluation

Since the objectives and targets are a result of this one-on-one agreement between manager and employee, evaluating on the achievement of the relevant performance dimensions is performed in a similar manner. Twice a year, a review takes place between manager and employee upon the functioning of the employee. Here, multiple issues are evaluated with regard to external and internal contact, the commitment with Triodos, personal development plans as well as the achievement of results. This review is based on a conversation, guided by an assessment form. Concerning the individual targets, achieving the results does not mean that good performance was achieved.

Simultaneously, not attaining the results does not imply that performance was poor. Here, the review is corrected for the context in which performance was established. Moreover, the results only form a small part of overall evaluation. Therefore, other competences are also taken into account.

Furthermore, concerning the performance agreements, the subjective performance evaluations of the employees are discussed per business unit or department. Here, all the managers who have evaluated the performance of their staff gather to compare all assessments to create some form of calibration on performance levels. In this way, consistency in evaluations is secured.

5.3.3 Provision of rewards

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5.4 Analyzing the incentive systems at Triodos Bank

Based on the description of the performance management systematics at Triodos Bank outlined above, in the next section we will analyze the effectiveness of this control mechanism. However, during the case selection stage of our study, we searched for appropriate candidates for the investigation of our research question. Triodos Bank was chosen based on the following reasoning: First, it was found that Triodos controlled employees on results9. Second, it was known to us that financial incentives were not provided to employees at Triodos. Therefore, we assumed that the performance-related rewards provided would be nonfinancial. However, based upon the description presented above, the

relationship between results and rewards was found to be nonexistent, both in financial as well as nonfinancial terms. Even though this finding has significant implication for answering our research question, it simultaneously provides an interesting twist to this study. This is because we can now analyze the functioning of the performance management system without the presence of a

predetermined performance dependent reward. The following section will first describe and then analyze the functioning.

5.4.1 Rewards

Since its foundation, Triodos Bank has operated without the provision of financial incentives. This is based on the believe that the provision of short-term financial incentives is not an appropriate way towards sustainable employee motivation. Furthermore, concerning their clients, Triodos postulates that a banks should be focus on building strong relationships, instead of focusing on transactions. According to the HR-manager:

“An incentive represents an effect with a short duration. When it is taken away, the behavior will disappear. Therefore, we prefer investing in long-term behavior by inspiring employees, which causes them to think along with the organization”.

Even though there are no intended performance dependent rewards present in controlling employee behavior, Triodos provides several financial and nonfinancial rewards by which management tries to inspire their employees. Firstly, a vast amount of attention is given to the personal development of Triodos employees. Educational programs are provided whenever this is found to be the right tool to improve the development of the employee and thereby, the organization. Along this line, staff is stimulated to apply internally for new vacancies. Whenever positions become available, these are presented internally for two weeks before external candidates can apply. Furthermore, promotion opportunities are provided whenever possible. However, because of the small size of the

organization10, these opportunities are relatively scarce. Simultaneously, due to the rapid growth of the

9

Based upon a confidential interview between BDO and Triodos Bank.which is not to be disclosed.

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organization, new positions can be created in order to take the full advantage of the qualities of the employee.

Moreover, several discretionary financial rewards can be provided to employees in the form of so called ‘Tokens of Appreciation’ (ToA). An end-of-year collective gratification between 300–500 euro is usually given to all Triodos employees, which resembles a gesture of gratitude by executive management for overall achievements and contribution of the staff. Moreover, around 5 percent of employees may become eligible for an individual ToA’s. This form of recognition is given whenever employees have performed exceptionally well on activities that lay outside their regular job

description. These are always granted afterwards and on a discretionary basis by management in consultation with HR. This cash reward varies in height between 250 euros and one-month’s salary, with a 10.000 euro gross maximum. These tokens may be claimed back at hindsight whenever there is evidence of misbehavior.

5.4.2 Functionality of rewards

Even though these rewards are related to the performance achieved (individually or collectively), they differ in the respect that employees cannot focus their behavior on specific, predetermined levels of performance in order to receive them. However, in order to derive motivational (and inspirational) effects from these rewards, it can be argued that they still need to be valued and hold a level of impact (Merchant & Van der Stede, 2007). Though, the responses of employees towards this approach of rewarding, and motivation in general, is found to be mixed. As the HR-manager explained:

“Because of our rapid growth, many employees come from other organizations within the sector. Some experience working at Triodos as refreshing and a sense of relief. Others find it somewhat difficult since it requires a vast amount of self-reflection and knowledge on what you want to accomplish within our organization.”

This indicates that the strong norms and values towards sustainability are not necessarily suitable to all bankers. Therefore, the bank always seeks for a level of affection when attracting new employees, to ensure that their approach will deliver what is desired, and to contribute to a strong corporate culture towards sustainability. However, when congruence exists upon these norms and values, these rewards concerned with training and personal development opportunities are found to be highly valued since they correspond to ones intrinsic motivation to be sustainable.

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can be recognized and rewarded. The motivational effect from the individual Token of Appreciation might therefore not originate from the monetary value of the reward alone. As one banker indicated:

“Occasionally, an employee receives a Token of Appreciation, however, these financial rewards represents a more symbolic gesture for exceptional work, than a fair compensation for the effort that the individual put in.”

This substantiates the view of Thierry (2008) that, other than monetary values, many different values can be attached to financial rewards related to status and recognition. As such, the interpretation of the value of a certain reward cannot be made independent from the context in which it is given.

As described earlier, there are several other factors which influence the strength of the motivational effect following the provision of incentives. Even though these explicit stimuli are absent within the case of Triodos, this in fact addresses an important and interesting matter within the field of

performance management and incentive mechanisms; whether these predetermined performance dependent rewards are in fact necessary to ensure employee motivation, and the attainment of organizational objectives. In order to assess the strength of the motivational effect, we therefore now turn to analyze other intervening variables related to this effect.

Quality of performance measure and target setting

Based upon the description of the performance management system of Triodos, we have found that individual goals and targets are largely constructed based on a cooperative process between manager and the individual employee. The reason for this approach stems from the belief that a manager and employee have their own vision on how to accomplish certain results. Whenever higher management would interfere within this relationship, the ‘energy’ is taken out of this process. Because of the strong corporate culture, and the genuine belief that employees are connected to the mission of the

organization, management beliefs that no hard controls towards performance management is needed. Therefore, it is likely that these jointly agreed targets are generally highly controllable. This form of empowerment substantiate the arguments of Gruman and Saks (2011), which state that this enhances engagement and motivation. As the corporate lending manager explained:

“Recently, I received my new lending target for the upcoming year which I needed to divide amongst the employees. In first instance, I let them choose the target level which they want to attain. To my surprise, some took in a higher target than I expected them to do, based on past experience”.

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might not observe how their target contributes to attaining strategic goals, and therefore not perceive it as strategically important (Burney et al., 2009).

Based on the abovementioned, evaluating individual performance results within Triodos is primarily based upon subjective assessments. Since the targets are often set in a jointly agreed manner, highly relevant to the context specific situation of employees, this approach follows logically. As mentioned above, this produces the risk of bias and distrust (Gibbs et al., 2004). However, these risks are largely obviated by the process by which all business unit/department managers meet to discuss all the relevant employee performance evaluations. This ‘inter-subjective’ approach might not remove all uncertainties for employees, however it provides employees with the knowledge that their

performance is evaluated in an equitable manner with those of the direct colleagues. Whilst it has not found to be a significant matter of importance at Triodos, such determinants of justice provides employees with a perception of fairness and trust (Burney et al., 2009). This system also applies to the ToA. Whilst this system can compensate for deficiencies in both subjective and objective approaches, it takes a significant amount of precious management time at significant costs (Ferreira & Otley, 2009). Where the strong corporate culture has found to have significant advantages concerned with motivating employees, it is also noted that managerial feedback during performance evaluation is difficult. Noted by the interviewee:

“The family-culture at Triodos creates high levels of commitment, however when feedback is given about poor performance, or the failure to achieve certain targets, employees find it difficult to accept feedback as they easily perceive it as criticism”.

5.4.3 Performance effect

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5.4.4 Conclusion

From the analysis presented above, several conclusions can be drawn on the effectiveness of the performance management at Triodos Bank. In investigating the motivational effect following the system, the most striking finding lies in the fact that no explicitly intended incentive mechanisms are found which are based upon predetermined targets. Alternatively, there are performance dependent rewards, however no predetermined target can be linked to them. This has the effect that there are no specific behaviors to focus upon. Since it has been vastly acknowledged that ‘what you measure is what you get’, the lack of such direct relationship between pay and performance might actually be beneficial in complex contemporary settings (Prendergast, 1999). However, such an approach is in contrast with many of the existing theories towards motivation, since these do not make the employees accountable for their actions, in achieving performance targets (Merchant & Van der Stede, 2007). In addition, it is found that the financial reward granted holds value of recognition instead of pure financial value. This indicates the fact that there are multiple employee needs which can be fulfilled with both financial and nonfinancial rewards, and that no reward can be judged independent upon the person who receives it.

Within Triodos, additional motivational effects can be derived from the other variables mentioned in figure 2. Their approach towards defining objectives, target setting and performance evaluation is based upon individual agreements between manager and individual employee. This joint agreement approach towards establishing performance agreements creates high level commitment at the level of the individual employee (Gruman & Saks, 2011). In addition, the strong corporate culture contributes to the motivational effects. This in fact, might make explicit incentive mechanisms obsolete for motivational purposes.

Concerning the performance effect, the fact that no hard controls are put through down into individual employees makes it difficult to check whether these results agreements contribute to the attainment of organizational objectives. Here again, the strong corporate culture of Triodos can provide management with the trust that employees behave as desired.

Performance management in banking;

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