Lenders Should Beware of Perverse Financial Incentives

Around 2004 or 2005, I can't remember which, dentists suddenly started doing far more fillings and far less root canals.

A few years later, German hospitals suddenly started doing lots more caesarean sections than previously.

A few years after that, financial advisors in the UK suddenly started advising their clients to put their money in different in investments.

All these things are linked by one thing: at the time these changes occurred, all the people involved had to change the way they earn money.

• Dentists' contracts were changed so that they got paid more for fillings and less for root canals.
• German hospitals were allowed to charge much more for caesareans than for natural births.
• Financial advisors were banned from taking commission from investment funds when they sold their products. (My colleague Jane wrote about that yesterday in Financial Advice is Improving.)

Everyone follows the money

In short, all of them are, or were, suffering a severe case of perverse financial incentives.

Financial incentives have insidious effects that are incredibly hard to resist, because, most of the time, most people aren't even aware these effects are happening to them.

It is human nature for us to excuse our behaviour and to find arguments that support what we deeply wish to be true, while swiftly rejecting anything that we don't want to hear.

Even many people you'd be happy to have as your neighbour will succumb. After all, they have bills to pay, families to feed, a social life to maintain and respect to earn.

As the economist J. K. Galbraith once said: “In the choice between changing ones mind and proving there's no need to do so, most people get busy on the proof.”

P2P lending will have the same issues

There is no doubt that we shall uncover issues of perverse financial incentives in P2P lending. I'm not just talking about the usual exaggerated marketing, but more serious issues.

Like new P2P lending companies claiming to be safe when they have no record and then going on to suffer an awful lot of bad debts. You can be almost sure that they really believe they are safe. They have to believe it. Otherwise they're in serious trouble.

You'll also find that some directors are paid and incentivised based on growing their businesses. They, in turn, incentivise their employees to help them with that goal. When the titanic growth in this industry slows and stops there will be immense pressure to do the wrong things to keep up the momentum.

Not at all the P2P lending companies. There will be enough of them who keep their heads. But some will fall off a cliff.

Then you'll find P2P lending companies that understate the risks without even realising that they're doing so. You'll see that many of these opportunities are being sold in some places like simple savings accounts, not investment products where you could lose your initial investment.

Perverse incentives should concern you whenever you're investing, buying a product or service, hiring somebody, or doing your day job. Or P2P lending.

4thWay attempts to be immune

We are very sensitive to perverse financial incentives here at 4thWay and not just because we're looking out for you.

We accept commission here, so there's the potential of being biased towards the companies that pay us money.

Knowing how hard it is to avoid that bias – even doctors and dentists unconsciously fall for it! – we use a lot of methods to prevent ourselves “looking for the proof” that it's okay to mislead you. Among other things, we use checklists, have regular trustworthiness meetings, separate commission from our comparison tables, and search for negative things to write about P2P lending.

And we're also searching hard for individuals like you to join our first Panel of Peers so that you can have a real say in this website and even have the power to order us to correct any biases, add any important missing information and fix other issues. We're going to ensure you won't have your work cut out for you.