Global Strategy - blog

In strategic management literature, the human capital implicated in a firm's employees has already for a couple of decades been considered as an important strategic resource (or asset) for a firm. Obviously, in "knowledge economy", the value of this particular type of knowledge has become increasingly important, especially in knowledge-intensive and creative industries (such as financial services, IT, or biotechnology)

Yet, as a particular type of strategic asset, employees and human capital have a special characteristic -- actually a disadvantage. Namely, there are rather stringent limitations to the extent that a firm can be considered to possess or own its employees -- and thereby, the knowledge, skills, and capabilities residing in the employees' minds, or hands. This presents, currently, acute problems for e.g. financial services firms.

Of course, firms have employment contracts with their employees and these contracts hinder employees from escaping from the firm on a day's notice.  Employees may also be tied by contracts that prevent them from moving to the service of the firm's competitors for one or two years after leaving the firm.

Nevertheless, the (legal) power of these contracts is in most countries quite limited -- resulting in the fact that any employee can escape a firm's "possession" in just a few months or weeks, even days, and take his/her human capital with him/her. As a matter of fact, this significantly undermines the strategic value of human capital as a source of (sustained) competitive advantage. (After all, in order to be a true source of competitive advantage, a resource must not only have the characteristic of valuability but also the characteristics of durability and appropriability; see e.g. Barney, 1986; Grant, 1991; Peteraf, 1993).

Due to the precarious nature of human capital, a firm and its executives (as well as investors) should carefully assess the risks that the firm faces in terms of losing the employees and human capital on which the firm's business operations rely on. In fact, the risks, degrees, and potential consequences of "brain drain" should be analyzed as part of the firm's standard risk management practices.

Furthermore, the risk for an actual "employee default" (or, "human capital default") should be taken seriously into account. Employee default will be a development of events in which a significant part of the firm's employees leave the firm within a short period, which, in turn, causes the firm's business to become practically non-functional or to cease altogether. Analogous to financial/credit default, employee default is a severe condition (which can actually lead to financial default, as well). In fact, a major part of a firm's business -- and (market) valuation -- may vanish over-night.

For instance, if two thirds of a drug development firm's scientist team walk away from the firm, the firm will probably find itself close to an employee default: the firm's research efforts will likely suffer a deadly shock.

And even more significant than for corporate R&D departments, the risks of brain drain and employee default are for businesses whose immediate credibility in the eyes of customers hinges upon employees. Financial brokerage, wealth management, and corporate finance businesses are good examples: if two thirds of a brokerage firm's or an investment bank's employees leave the firm, the customers often the follow the employees (since a significant part of the customers' trust in the firm is actually about personal trust in its particular employees). The same applies to corporate law and management consultancy firms, to name but a few.

A firm has basically two ways through which it may attempt to ensure the retention of its human capital. First, a firm may attempt to tie its employees to itself more strongly with various incentives (e.g. salary, working conditions). Second, the firm may attempt to better codify the (tacit) knowledge and skills of its workers, thus making the firm less reliant on any individual employees. Indeed, codifying employees' working practices into explicit processes and information systems (i.e., kind of work instructions and manuals) leads to decreased dependence on any individual employee. This is because with the explicit processes in place, the needed skills and working practices can be more swiftly taught to new recruits in case the current employees  leave the firm.

Financial services firms, for example, have traditionally relied on the former means, i.e. setting salaries and other incentives at extremely high levels. However, the government bailouts, unfavorable public opinion, and poor financial conditions have now limited many financial firms' possibilities to pay their traditional sky-high salaries. This has led especially the large publicly-listed banking corporations (e.g. Morgan Stanley, Citigroup, Goldman Sachs, Bank of America) to lose their employees to private hedge funds and wealth management firms, which are still able to pay their employees handsomely (see e.g. a recent NYTimes article). 

So, perhaps it is now time -- in the banks as well as firms in general -- to start putting more effort to codifying the doings and skills of the firm's employees into explicit processes and systems.