This post first appeared on July 8, 2009
John Kay comes perilously close to nailing a key issue in his current Financial Times comment, “Our banks are beyond the control of mere mortal” in that he very clearly articulates the problem very well but then draws the wrong conclusion:
At Oxford university, I often hear people say there is nothing wrong with the system: the problem is the vice-chancellor/master/bursar/ university officials. And, in a sense, they are right. If the vice-chancellor had the wisdom of Socrates, the political skills of Machiavelli and the leadership qualities of Winston Churchill, not to mention the patience of Job, he or she would be very likely to be able to fulfil the conflicting demands of the post. But such paragons are few and far between. In the meantime we must try to find structures that can be operated by ordinary mortals.
In the same way, the claim that the fault with the banking system lies not with the structure of banks but with the boards and executives that claimed to run them is both correct and absurd…if the failures are both as widespread and as persistent as it appears, the problem is in the job specification rather than with the incumbent. If you employ an alchemist who fails to turn base metal into gold, the alchemist is certainly a fool and a fraud but the greater fool is the patron.
The bank executives pilloried by the UK’s Treasury select committee of MPs were all exceptional people. The vilified Sir Fred Goodwin was an effective manager who had slashed through the National Westminster bureaucracy and revived a failing institution – a task that had defeated many able men before him. His chairman, Sir Tom McKillop, offered experience and ability that met every possible specification for such a role in a big international corporation. As chairman of HBOS, Lord Stevenson was Britain’s supreme networker. This skill is a particularly valuable attribute in an environment where the essence of banking is to extract very large sums of taxpayers’ money while giving as little as possible in return. His chief executive, Andy Hornby, was criticised for being a retailer. But Halifax, half of HBOS, needed retail expertise. The only thing it needed to know about complex securitised products was that there was no good reason to buy them.
Like Sir Fred, Sir Tom, Lord Stevenson and Mr Hornby, most of the people who sat on the boards of failed banks were individuals whose services other companies would have been delighted to attract…
The hapless four were criticised for their lack of banking expertise but it is, in fact, not clear what modern banking expertise is. The world of modern banking requires all the skills of these gentlemen, plus some others, and no one can expect to have all these attributes.
It has been said of Jamie Dimon (who does not have a banking qualification) that his dominance exists because at every meeting all the participants know that he could do each of their jobs better than they could. But the business world cannot operate at all if it can operate only with individuals of the calibre of Mr Dimon. Better, as so often, to follow an aphorism of Warren Buffett’s: invest only in businesses that an idiot can run, because sooner or later an idiot will.
Our banks were not run by idiots. They were run by able men who were out of their depth. If their aspirations were beyond their capacity it is because they were probably beyond anyone’s capacity. We could continue the search for Superman or Superwoman. But we would be wiser to look for a simpler world, more resilient to human error and the inevitable misjudgments. Great and enduringly successful organisations are not stages on which geniuses can strut. They are structures that make the most of the ordinary talents of ordinary people.
The problem is Kay is applying traditional managements structures to investment banking, Even though these entities may have substantial retail arms and bank charters, the area that poses the management challenge is the capital markets businesses. And he makes a dangerous, erroneous assumptions: that mere mortals, meaning generalists, can run these businesses. That is bogus.
What makes capital markets businesses different from any other form of enterprise I can think of is the amount of discretion given of necessity to non-managerial employees, meaning traders, salesmen, investment bankers, analysts. In pretty much any other large scale business, decisions that have a meaningful bottom line impact (pricing, new sales campaign, investment decision) are deliberate affairs, ultimately decided at a reasonably senior level. The discretion that customer-facing staff have in pretty much any business in limited. At what level does someone have the authority to negotiate a contract? And even then, how many degrees of freedom do they have?
By contrast, think how many decisions traders and salesmen in capital market firms make in a day, and their potential bottom line impact (though experiment: how much damage could a truly vindictive trader do in a day or a week, if he decided to blow up his employer?) Investment bankers work over longer time frames, and like many normal businesses, have a lot of things routinized so as to make them more efficient, but it also limits their latitude (standard forms for many types of client agreements, standard pitch book formats, etc). However, unlike “normal” businesses, a frequent activity in investment banking is creating new products, often in a very ad-hoc way, with teams with relevant skills thrown together to try to push something through. The politics are often sharp-elbowed, but people are too pragmatic to let turf issues interfere with getting a new deal launched).
The approach for managing these businesses in the days of partnerships, when the owners were personally liable for losses, was to have small units with partners running them who knew the business and could oversee it properly. Effectively you had four layers: associate/analyst (the college kids, the analysts, did pretty much the same stuff the associates did, who usually had MBAs, except the MBAs got to go to client meetings more often), VPs, and partners, but some of the more senior partners were department heads in units that also had partners (who’d manage either people on their desks, if traders of salesmen, or if in investment banking, had accounts and various VPs and associate types working on each client). But those department heads had also grown up in the business, and were still active in it. Heads of significant departments in turn would be on an executive committee, a part-time role.
The problem with this model is it starts to come under strain when the partner group gets too large. And OTC markets have strong network effects, so having bigger market share confers a competitive advantage. And now there are high minimum scale requirements for being in the business. You need to be in all major times zones with a pretty broad product array. all kinds of back office support, all kinds of IT for risk management, communications, position management…
So the scale of operation required to be competitive is too large for it to be managed by player-coaches who had deep expertise, and like the Dimon example, were more expert than the people working for them. But the normal corporate/commercial banking management structure, with more managerial layers, and the top brass having broader spans of control, was devised in earlier stages of industrial organization, when you had factories or service business with a great deal of routinization of worker and middle manager tasks. Traditional commercial banks are on the same factory format. They handle large volumes of very simple, standard transactions with a high degree of control and oversight. That’s a big reason why it took commercial banks over 15 years to make meaningful headway against investment banks. Although regulations were an issue, the bigger barrier was the radical difference between the two management cultures. There was no regulatory barrier to commercial banks offering mergers & acquisitions, for instance, but they were lousy at that for a very long time.
So Kay is effectively asking for a traditional commercial banking model, businesses “that make the most of the ordinary talents of ordinary people”. There are businesses like that in banking, but they are mainly in retail banking and corporate lending. If you want that world, you need a far more radical change in the industry than anyone is contemplating now. You’d need to go to the world that Taleb advocates, From a list of his ten suggestions:
4. Do not let someone making an “incentive” bonus manage a nuclear plant – or your financial risks. Odds are he would cut every corner on safety to show “profits” while claiming to be “conservative”. Bonuses do not accommodate the hidden risks of blow-ups. It is the asymmetry of the bonus system that got us here. No incentives without disincentives: capitalism is about rewards and punishments, not just rewards.
5. Counter-balance complexity with simplicity. Complexity from globalisation and highly networked economic life needs to be countered by simplicity in financial products. The complex economy is already a form of leverage: the leverage of efficiency. Such systems survive thanks to slack and redundancy; adding debt produces wild and dangerous gyrations and leaves no room for error. Capitalism cannot avoid fads and bubbles: equity bubbles (as in 2000) have proved to be mild; debt bubbles are vicious.
6. Do not give children sticks of dynamite, even if they come with a warning . Complex derivatives need to be banned because nobody understands them and few are rational enough to know it. Citizens must be protected from themselves, from bankers selling them “hedging” products, and from gullible regulators who listen to economic theorists.
If we can’t shut down credit default swaps, which the more I dig, the more I see they had a very direct role in the meltdown CDS on subrprime mortgages started in 2004, and there is a longer form gloss as to how that played a major role, if not the key role, in the superheated demand for “product” particularly subprime, in the manic phase of the credit bubble), we will never get to a world like the one Kay wants to see, or at least not until we hopelessly break the one we have now.