How Banks (and Companies) Diversify Their Way Into Incompetence

I read my first management book at the age of 11, not because it was a management book, but a best seller at the time, And it may have been imprinted by it more than I realized. The Peter Principle says that managers are promoted until they reach their level of incompetence. The classic example is promoting the best salesman to be a sales manager. The joke (all too true) is that you both lose your best salesman and gain a lousy supervisor.

That pattern says that organizations as a whole are not very capable (if they recognize this danger, they should try to manage against it, but the popularity of The Peter Principle did not change corporate practice one jot, at least as far as I can tell). And of course, it explains why there are so many crappy managers and executives.

John Kay of the Financial Times applies this idea to financial firms, arguing that they diversify their way into incompetence:

Financial institutions diversify into their level of incompetence. They extend their scope into activities they understand less…

The principle of diversification into incompetence applies from the largest financial institution to the smallest. AIG was America’s leading insurance company. The company did not just undertake credit insurance, but was the largest trader in the credit default swap market. That is how its financial products group, employing 120 people in London, brought about the collapse of a business that employed 120,000.

Yves here. Citigroup is another example. It isn’t so much that Citi made a disastrous acquisition as it dedicated itself to massive reach as a corporate imperative: be as global and be in every conceivable product niche. That is a prescription for being unable to manage yourself, which is the essence of the big bank’s problems. Back to Kay:

The boredom factor is important. Much of traditional banking is quite boring. The desire to find new challenges is an admirable human trait. It is, however, very expensive for shareholders to allow their chief executives to indulge it.

Public sector bodies are usually constrained in their activities, so deregulation is often a trigger for expensive experimentation. In Britain, many of the efficiency gains from privatisation were squandered in diversification: I watched senior managers spending 80 per cent of their time on activities that generated 1 per cent of turnover and minus 10 per cent of profit. But it is more fun to go on jollies to Buenos Aires than to fix leaking pipes.

To win an auction when you don’t know what you are bidding for is often to lose. This winner’s curse is often behind bad acquisitions because the successful purchaser is the bidder most willing to pay too much. Hence the contest between Royal Bank of Scotland and Barclays as to which bank would court bankruptcy by buying ABN Amro. Ignorance of products may also be a problem. When you are the newcomer and know little, the business that gravitates to you will be the business no one else wants.

But the driving factor is hubris. Jim Collins’s well-timed study of How the Mighty Fall applies to every business I have mentioned. The financial services industry is particularly vulnerable to hubris because sections of it are not very competitive, and randomness plays a large role in the outcome of speculative transactions. It is therefore particularly easy for those who work in financial institutions to make the mistake of believing that their success is the result of exceptional skill rather than good fortune. What more natural to believe than that extraordinary talent will find pots of gold under other rainbows? Until vanity is vanquished, I anticipate that diversification to the level of incompetence will continue to be a powerful element in business behaviour.

With all due respect, I think Kay has the essence of this wrong. First, deals are engrossing and sexy. They are very intense, the top executives are the focus of Big Decisions, and they have a horde of high priced talent catering to them (well actually, leading them by the nose, but they are usually so adept at it that the client often does not realize he is no longer in control).

But the big driver is that bank CEO pay is correlated with the size of the institution. And it is much easier to get big fast by acquisition than organically. Big deals are a wallet-lining activity, and the advisors understand that very well.

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  1. attempter

    I don't doubt Yves is right about the top-down influence, but I think there's also something to the boredom argument.

    It's long seemed to me that e.g where it comes to computers and gadgets in general that the engineers seem to want to tinker and gratuitously change things and add superfluous features all way beyond what customers want, and even where it doesn't add to revenue (rent-seeking).

    The designers have a fundamentally different, non-market mindset. A customer probably just wants a basic product that functions well, but for the engineer this is his toy, his "creative outlet."

    I long suspected this, and recently I've started seeing pieces which agree with me, like in some of the NYT tech columns.

    So I don't doubt there may be something similar going on with financial "engineering", although there of course the rent-seeking is a far greater motive.

  2. skippy

    Like in the Military Kill Ratios or Counts get you noticed, promoted because its a sexy statistic (see Vietnam). Not consolidation of ones position in order to blunt the oppositions maneuver (see victory with out death).

    skippy…"A solider will fight long and hard for a bit of ribbon" Napoleon Bonaparte.

  3. Ina Pickle

    The problem is not just the organization, but self-selection and the process involved in getting to the top. They choose for risk-taking personalities for whom boredom is a serious issue – and who have a serious bias towards action over inaction, risk-taking over safety, etc.

    I once had the CFO of a very large corporation tell me that, if I could tell him that he had a 50/50 chance of keeping the assets he wanted to acquire — a coin toss — he would go ahead with the merger.

    We have reached a point where our idea of who is executive material involves a macho type who conflates decisiveness with risk-taking, when really they are two different things. Just my opinion.

  4. DownSouth

    This is evidence as to why classical economics and all its begats–Marxism, libertarianism, neo-liberalism, etc—are all failed ideologies. All are predicated on the assumption that man is motivated solely by materialistic objectives, or, as Reinhold Niebuhr put it, "all human desires are determinate and all human ambitions ordinate."

    As Niebuhr goes on to explain in The Irony of American History:

    The false abstraction of "economic man" remains a permanent defect in all bourgeois-liberal ideology. It seems to know nothing of what Thomas Hobbes termed "the continual competition for honor and dignity" in human affairs. It understands neither the traditional ethnic and cultural loyalties which qualify a consistent economic rationalism; nor the deep and complex motives in the human psyche which express themselves in the desire for "power and glory." All the conflicts in human society involving passions and ambitions, hatreds and loves, envies and ideals not recorded in the market place, are beyond the comprehension of the typical bourgeios ethos.

    Or as George Orwell put it:

    The energy that actually shapes the world springs from emotions–racial pride, leader-worship, religious belief, love of war–which liberal intellectuals mechanically write off as anachronisms, and which they have usually destroyed so completely in themselves as to have lost all power of action.

    Orwell uses H.G. Wells as the poster child of a failed bourgeois-liberal ideologue:

    He was, and still is, quite incapable of understanding that nationalism, religious bigotry and feudal loyalty are far more powerful forces than what he himself would describe as sanity. Creatures out of the Dark Ages have come marching into the present, and if they are ghosts they are at any rate ghosts which need a strong magic to lay them. The people who have shown the best understanding of Fascism are either those who have suffered under it or those who have a Fascist streak in themselves. A crude book like "The Iron Heel,' written nearly thirty years ago, is a truer prophecy of the future than either "Brave New World" or "The Shape of Things to Come." If one had to choose among Well's own contemporaries a writer who could stand towards him as a corrective, one might choose Kipling, who was not deaf to the evil voices of power and military "glory."

    –George Orwell, "Wells, Hitler and the World State"

  5. Anonymous Jones

    To synthesize the comments of both DownSouth and Siggy, non-financial incentives are crucial to much of the world, just not to those who run it.

    Another problem with management beyond the Peter Principle is the self-selection bias. It is exactly those who seek the levels of upper management of the large companies, especially the position of CEO, who are the most likely to exhibit antisocial personality disorder. It is rare that a non-sociopath will have a competitive advantage over a sociopath in rising up the corporate ranks to the top. To wit…

    "Profile of the Sociopath

    * Grandiose Sense of Self
    Feels entitled to certain things as "their right." Extreme narcissism. Can create, and get caught up in, a complex belief about their own powers and abilities. Believe they are all-knowing, entitled to every wish. May state readily that their goal is to be a mogul, rule the world.

    * Need for Stimulation
    Living on the edge. Promiscuity and gambling are common.

    * Incapacity for Love
    Ultimate goal is the creation of a willing victim; incapable of real human attachment to another

    * Superficial Charm and conventional appearance
    Does not perceive that anything is wrong with them; only rarely in difficulty with the law, but seeks out situations where their tyrannical behavior will be tolerated, condoned, or admired

    * Manipulative and Conning
    They never recognize the rights of others and see their self-serving behaviors as permissible. They appear to be charming, yet are covertly hostile and domineering, seeing their victim as merely an instrument to be used. They may dominate and humiliate their victims.

    * Seeks Affirmation to Create Lack of Remorse, Shame or Guilt
    Has an emotional need to justify their crimes and therefore needs their victim's affirmation (respect, gratitude and love); Does not see others around them as people, but only as targets and opportunities. Instead of friends, they have victims and accomplices who end up as victims.

    * Irresponsibility/Unreliability
    Not concerned about wrecking others' lives and dreams. Oblivious or indifferent to the devastation they cause. Does not accept blame themselves, but blames others, even for acts they obviously committed."

  6. DownSouth

    Anonymous Jones,

    I had a psychologist friend who believed the same as you, that those with anti-social personality disorder are disproportionately drawn to and well-suited to positions of power. But he insisted upon one caveat, and that is that human behavioral types are distributed along continua and not in discrete categories. Probably nowhere is this better demonstrated than in the findings of Kinsey, Pomeroy and Martin, who developed a seven-point scale (0-6) to indicate degrees of homosexuality-heterosexuality.

    We could do the same with type of behavior you describe. A person with the characteristics you enumerate we could define as a 0, and a person, let's say, who is kind, generous, compassionate and caring we could call a 6. I think it goes without saying that a 4, 5 or 6 would be totally inappropriate as a modern corporate executive. But when we get 0's in positions of power, we have a problem.

    As to your comment that "non-financial incentives are crucial to much of the world, just not to those who run it," I have to disagree. Being an engineer by training and a reformed "pragmatic jewell," as an art-dealer friend of mine used to call me, I once believed the same as you do.

    However, if those who "run the world" do not respond to non-financial incentives, then how do you explain this?:

    "Mexican splashes out record $140m for Jackson Pollock's drops of genius
    1948 work by American master becomes world's most expensive painting"

    As the article explains, that's the most expensive painting ever sold, $4 million per square foot for some paint dribbled (and litterally "dribbled" if you're familiar with the work of Jackson Pollock) on a canvas.

    I could write quite a bit about this, as it's common knowledge amongst those who study ancient civilizations that powerful men have always coveted exclusive objects that convey a sense of prestige, status and rank upon their owners, and that much human behavior throughout history has been dedicated to acquiring these objects. This behavior can hardly be described as "rational," and has no place within the classical economic paradigm. And yet there it is.

  7. Anonymous Jones

    DownSouth —

    I agree with your instinct that most everything is a continuum. I actually believe what people perceive as "bright lines" are usually much more fuzzy upon closer inspection. You can play this game with anything, even acts as repugnant as murder and rape. Start pushing anyone with tough fact sets and their "bright lines" quickly blur.

    The reason most humans accept a belief in any certain bright line is for economy of thought. It is just a natural heuristic technique. However, once one accepts that almost everything is a continuum, the world becomes much more interesting. What is the shape of the continuum? Is it a barbell with little in the middle? Or is it a ball with sticks on the sides? Or is it evenly distributed across? Or is it irregularly shaped?

    But these questions are useless for most of humanity. People become attached to their heuristic methods and often react in anger when it is suggested that the lines they have drawn could possibly be masking a more complex and subtle world. So we should probably keep this to ourselves before everyone gets their knives out.

    FWIW, I didn't actually promote the "synthesis" as my belief. I was just being "clever" (sarcasm intended). I think it would be very difficult for anyone to care about nothing but money. In fact, the "0" sociopath would usually see money as a means, not an end. The end is probably better defined as power, to which money is a very good means. As you note, lifetimes could be spent writing about this.

  8. donna

    I don't believe in the Peter principle. I think companies just promote the managers who suck up best, and then find out they are only good at sucking up.

  9. gatopeich

    Well said, donna.

    Trapped by the interesting post and superb comments, thinking about reading more of J. London, and at the same time realizing that we are talking the talk while they walk… Away with our money!

  10. moslof

    Belonging to clubs like the Augusta National and landing the corporate jet there a couple hours after a break in the February weather doesn't require much money because the Master's tournament pays the bills tax free and you can meet with all your CEO buddies and strategize with no gossipy women around. These are the non$ perks that any and all bankers will bow down to their bosses for, just to keep the hope alive….

  11. Francois

    "The boredom factor is important. Much of traditional banking is quite boring. The desire to find new challenges is an admirable human trait. It is, however, very expensive for shareholders to allow their chief executives to indulge it."

    AMBAC comes to mind as a case example. Here was the corporation who had the most net profit per employee on the PLANET. But the business was a bore; mix that with the side effects of a testosterone-based culture and danger signals should've started to flash all over the place.

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