Governing financial services’ common-pool resources: how Ostrom’s game theory could lead to policy improvement

Published December, 2017 |

Cross-financial services Print

Gaming can be used to turn largely ideological questions about the regulation of financial markets and its potential consequences on market participants, their actions and overall equilibrium, into something more empirical. Games have increasingly become a standard experimental method of economic research: although by no means holistic, they can provide an additional source of insight to inform the current debate around the reform of financial market institutions. Games and simulations can also help uncover the potential unintended consequences of proposed policies and regulations.

A number of recent regulations in financial services have focused on ensuring markets’ stability, including executive compensation and responsibility. Beyond regulations, the narrative around the role of financial services in the wider sustainability debate has intensified, with the sector exploring how to support governments and NGOs through their core capabilities.

What is the Ostrom common-pool theory and how is it relevant to financial services?

Elinor Ostrom studied thousands of different common pool resources (CPR) and the strategies adopted by those with rights to use them (aka appropriators). Ostrom found that appropriators, often without state involvement or private ownership of the resources, created rules that allowed for the long-lived sustainability of the CPR.

As yet, this type of thinking has not been widely applied to financial services, despite the concerns about their sustainability. A significant feature of many financial services systems is the widespread use of bonus payments. Bonuses perform a very useful function in financial services, and at one stage were perceived as essential for a sustainable sector.

More recently however, academic focus on game theory and agency problems have flipped that perception. It argues that employees share the reward while the loss is being absorbed by the institution (and ultimately the taxpayer). Regulating bonuses is seen as a way of incentivising individuals to behave sustainably.

The central point of Ostrom’s work was the importance of the appropriators having a real role in governing their own CPRs. Sometimes, external parties (i.e., governments) were needed or were useful but often their influence was destructive. For instance, appropriators will make rules that work well for their purpose in their environment, whereas governmental authorities tend to use one set of operational rules across the board. Communication between appropriators and rule-following, rule-monitoring and an attitude fostering reciprocity among appropriators were also found to be key elements in successful CPRs.

The purpose of this article is to apply one tool that Ostrom developed – a multi-participant, multi-round sustainability game with the aim of discovering if the use of bonuses results in unsustainable exploitation of the natural system.

Good and bad news for sustainability

Forest@Risk is a team simulation game in which a forest acts as a resource for a community, providing timber on the one hand and acting as a buffer against flooding on the other. To play, players spend their “action points” on cutting trees or planting them – the effects on the state of the forest are immediately visible to all players. When all decisions have been made, the simulation plays and presents the outcome to the teams: their income and potential flood damage that also depends on the forest state.

The game exposes participants to the concept of the “tragedy of the commons” and to the difficult job of preventing excessive exploitation of common resources by self-interested entities in the absence of strong rules. It also reveals difficulties that arise in self-regulation and in the introduction of external governance policies and sanctions.

To simulate something akin to a bankers’ bonus, two rounds provided for a monetary reward (these were the only monetary rewards in the game). In rounds 2 and 6, a prize of €50 was offered to the team that made the “most profit” in that round.

The results of the game can be interpreted as positive by both sides of the banking sustainability debate. On the one hand, nearly all of the trees were cut down and the environment was unsustainably degraded. This seems to show that individuals will destroy a common-pool resource unless an external party has some power to modify the individuals’ natural behavior. And it also shows the power of incentives, and that badly designed incentives can have adverse outcomes for all. On the other hand, some of the participants showed themselves capable of resisting the temptation of a short-term reward and looked to a longer term sustainable future.

It is important to acknowledge that individuals communicated and tried to self-create a cooperative, sustainable system using rules that they created. They were also evolving to monitor and self-sanction each other. In the end, the number of trees was growing and participants were creating a more sustainable system. Participants grappled with the social problem of regulating themselves and each other to create a sustainable system. However, they were only beginning this process when the game ended.

Both interpretations of the results are consistent with Elinor Ostrom’s research. Creating a sustainable system is complex and not every sustainable resource can actually be sustained. However, Ostrom’s work makes us focus on the heterogeneity of the participants and the heterogeneity of their reactions to the same risks and rewards. We can see that different teams behaved in different ways, and that some were capable of producing sustainable behavior.

What has it have to do with financial services bonus systems?

Ostrom and her colleagues identified certain common features on successful CPRs. Focusing on bonuses, we can ask how well does the financial services system measures up to a selection of these features:

Ostrom and her colleagues identified certain common features on successful CPRs. Focusing on bonuses, we can ask how well does the financial services system measures up to a selection of these features:

1. Clearly defined boundaries: financial services is a global system. One that has shifted quite quickly from very local, especially in-country systems, and there are many new players at the edges of the system (for example, shadow banking and FinTech). Therefore, we would expect to see a system that has been, and remains, under sustainability stress.

2. Congruence between appropriation and provisions rules and local conditions: Ostrom’s findings suggest that appropriation rules restricting time, place, technology, and/or quantity of resource units are related to local conditions and to provision rules requiring labor, material, and/or money. But instead, we see a quest for global rules and consistency among larger areas (for example, top-down bonus rules that apply right across all the different banking cultures in the EU). 

3. Collective-choice arrangements: does the financial services industry itself still have the power to influence the rules under which it must operate? For example, even participants in the industry who thought that the previous bonus culture had acted as a perverse incentive were not in favor of the top-down rigid solutions imposed by the EU.

4. Recognition of rights to organize: a poignant feature of the game was the rudimentary attempt by individuals to self-create rules to preserve the forest. As Ostrom would have expected, the individuals were willing to extend reciprocity to each other and to curtail their own behavior. This may be the critical missing feature of the current financial system: the extent to which financial institutions are willing and able come together to discuss and argue out common behaviors that are essential for a sustainable financial system. 

This ability to self-govern has been a feature of financial systems in the past, but is now largely gone – in fact it’s possibly illegal for industry participants to come together and agree local market- specific bonus rules. This is, potentially, the real tragedy of the commons.

This may be the critical missing feature of the current financial system: the extent to which financial institutions are willing and able come together to discuss and argue out common behaviors that are essential for a sustainable financial system."

Beyond a black and white view of the FS sector

The dominant public narrative around financial services is built around a self-centered behavior of the bankers (and by extension, other financial services employees). Painting them as one homogeneous block. Our early findings point to the opposite conclusion, that the same risks and rewards will cause very different behaviors. The tragedy of commons is not a foregone conclusion. Our research is very much in early stages, and so is the prioritization of sustainability in financial services. Both require significant further work.

As a society, we need to move beyond the simplistic view of the unsustainable dynamic, where we see the regulators of the financial services industry as “wise and ecologically aware altruists.” The participants in the industry as “myopic, self-interested and ecologically unaware hedonists.” The reality is more nuanced, and this is what we will continue to research.