other banks with a return well above the London interbank offered rate, it again looked like a free lunch. Banks all ove
w w w.im d.ch
N o . 18 2 F e b r u a r y 2 0 10
GOVERNANCE: WHAT MUST WE LEARN FROM THE CRISIS? What must board directors, executives
hidden risks and led to the financial
and academics learn as the high point
meltdown. The lesson is, when it
of the financial crisis recedes? Whatever
looks like a free lunch, buyer beware.
happens to the proposals for regulatory reform, recent IMD research shows how 1
the structure of big bank boards
and
the behavior of board directors must 2
change to prevent future crises . The
2. Bad growth is not the same as good growth.
following are 10 key lessons, which will be discussed during the 2010 High
Following the herd and imitating the Paul Strebel
Performance Boards program:
competition by, for example, investing Professor, Director of in collateralized debt obligations is IMD’s program for High
Sandoz Family Foundation
bad growth. It boosts the top-line, 1. There is indeed no such thing as a
but reduces profitability and builds up
free lunch.
hidden liabilities. Bad growth is not
Performance Boards
based on something distinctive and When
mortgages
cannot earn superior returns. It’s even
with no down payment and zero
banks
offered
worse when you do not understand
interest to retail customers with very
exactly what you are buying, as many
limited resources, it looked like a
second-tier banks discovered after
free lunch. When these mortgages
getting heavily involved in mortgage
were repackaged and insured to get
derivatives. The lesson is that bad
a triple-A rating and then resold to
growth, with returns less than the
other banks with a return well above
cost of capital, destroys value. Good Hongze Lu
the London interbank offered rate, it
growth, in contrast, is based on
again looked like a free lunch. Banks
superior capabilities that provide
all over the Western world joined the
differentiation from the competition
party. But, the models used to rate
and
and repackage these mortgages were
returns. Goldman Sachs is one of the
unreliable because they depended
few banks with real risk management
on data developed during the period
capabilities
of booming housing prices. With the
outperform.
hence,
sustainable
and
it
higher
continues
to
growth in sub prime originations, the average characteristics of borrowers changed and a significant drop in borrower quality was not captured
3. Financial leverage is indeed risky.
by the ratings. The cost of the lunch inevitably kicked in: Higher interest
Borrowing can provide the resources
charges afford on
that
customers
disrupted
derivative
the
products,
couldn’t
for huge ventures and high growth
payments
rates, as kings, oligarchs, speculators
exposed
and bankers have shown over the
IMD Research Fellow
centuries. When it is easy to get credit, more
management
process
for
common
sense
people find returns that are greater than the cost
questions such as: “How can assets that are as
of borrowing and growth can be spectacular.
risk-free as cash continue to earn so much more
When banking activity expanded dramatically, it
than cash?” Assessing how much financial risk a
fuelled the housing and construction booms in
business can incur requires informed judgment
the US, UK, Spain and the Middle East. But when
about how much debt can be serviced in bad
the bubble burst, ventures went sour, returns
times without endangering refinancing and
dropped and risks were suddenly apparent.
investment in good growth.
Leverage can cut brutally the other way as the lines of people outside bust mortgage banks like Northern Rock in the UK and the idle construction cranes in Dubai dramatically
6. Hubris kills judgment.
illustrate. The lesson is that driving growth with debt requires serious risk management.
Risk management at the top – asking tough questions about exposure to major risks – is ultimately the responsibility of key executives and the board of directors. A chairman or
4. When it matters the risk may be greater
CEO, who dominates a board agenda, stifles
than you think it is.
the debate and constructive criticism needed to recognize warning signals both inside and
The
financial
markets
indeed
are
truly
outside the frontlines of a business. In our
interconnected. When banks are flush, they can
research on the 30 largest Western banks,
move capital and lend to projects anywhere in
those with their CEO and Chairman in place
the world. But when the crisis hit and a large
for a longer period, on average had the greater
bank like Lehman Brothers ran into trouble, the
losses on mortgage derivatives between 2007
whole system was affected. Although this crisis
and 2008. During the critical period from mid-
had its unique features, it is not unusual for
2005 to mid -2007, when banks bulked up on
confidence in borrowers to decline rapidly when
mortgage derivatives, those with the biggest
the financial markets tighten. Banks refuse to
losses like Citigroup, Merrill Lynch and UBS
lend on the same terms. They need liquidity and
had entrenched, dominant executive chairmen,
withdraw it, even from healthy clients. The risks
who pushed their firms to take more risks with
in banking have never been normally distributed.
company capital and invest in the apparently low
This recession has shown once again that just
risk, high-yielding derivatives.
when more borrowers need more leeway, banks may not be in a position to provide it.
Stanley O’Neal, who made his reputation at Merrill Lynch after 9/11, is a typical example of how hubris kills judgment. According to the Wall Street Journal, “Merrill Chief Executive
5. Risk management requires judgment.
Stan O’Neal would grill his executives about why, for instance, Goldman Sachs was showing
UBS was reputed to have one of the best risk
faster growth in bond-trading profits. ‘It got
management tools: a sophisticated mathematical
to the point where you didn’t want to be in the
modeling system. It was a trap; UBS was
office on Goldman earnings days,’ one former
the European bank with the biggest losses
Merrill executive recalls.” For Merrill’s former
from US mortgage derivatives. The problem,
CFO, Jeffrey Edwards, risk management was
their new CEO reported, was not a failure to
not easy. “People close to Merrill say that even
appreciate complexity, but the opposite, a lack of
if Edwards saw the risk, contradicting O’Neal
simplicity and critical perspective. Everyone was
was a dangerous game. ‘Either you did what
brainwashed by the superiority of mathematical
he wanted or you were out,’ says a Merrill
modeling and there was little room in the risk-
employee.”
GOVERNANCE: WHAT MUST WE LEARN FROM THE CRISIS?
7.
Judgment
requires
strong
sparring
partners with relevant industry experience.
8. Board members cannot be true sparring partners if the CEO and Chair roles are combined.
Asking the right questions about exposure to major risks is the responsibility of top
For board members to be true sparring partners,
management and the board of directors. The
our research shows that the chairman has to
board should know key company executives
act as a facilitator – capable of encouraging
and develop a succession pipeline; middle
alternative views, leveraging the contributions of
managers should be rotated between different
diverse individuals, keeping an open discussion
departments
well
on track and bridging gaps when people are
versed in using their own judgment as well as
challenging one another. An effective chairman
mathematical models to assess risk and prevent
reconciles opposing points of view and cuts to
dominance by the top team.
the heart of issues without bruising egos. The
and
functions
and
be
CEO, who has to lead the company and not act Goldman Sachs rotates staff between the
as a facilitator, is a weak candidate to chair the
control and the revenue-generating sides of its
board.
business. When announcing Goldman Sachs as the Bank Risk Manager of the Year in January
Recent research by The Corporate Library
2008, Risk magazine cited the career path of
supports this view. Companies whose CEOs
Robert Berry, head of quantitative risk modeling
also serve as board chair are “…more likely to
in the risk-management department, as an
have certain troubling corporate governance
example of management rotation. Berry started
characteristics than companies where the
as a fixed-income trader and then spent three
roles are separated.”
years improving interest rate derivative models
are “…associated with board entrenchment
in the dealer’s front office before working in
or lessened oversight of management,” and
risk management and control. As a result of
include relatively long CEO tenures; fewer board
rotation, Goldman Sachs’ top executives are not
meetings per year; classified board structure;
only deeply versed in risk management, but can
and “…the presence of executive committees
substitute for each other.
typically given the power to act on behalf of
3
These characteristics
the entire board, potentially allowing for a Board directors must have relevant industry
concentration of power.”
expertise in order to challenge management about the major issues facing a firm and the appropriate degree of risk to take. No matter how eminent they are in their field, board members lacking financial industry expertise cannot raise
9. Shareholders, not consultants, should be
the red flag on collateralized debt obligation risk
brought in as additional sparring partners.
with a triple-A rating. In our research on the 30 largest Western banks, those with the greater
It’s impossible for even the most prestigious
losses on mortgage derivatives between 2007
consultants to be objective because their fees
and 2008 had almost no one on their boards
depend on keeping the client happy. This is
apart from the CEO/chairman with financial
especially obvious in the case of compensation
markets expertise. Those banks with the biggest
consultants, who are under implicit pressure
write-downs – Citigroup, Merrill Lynch and UBS
to recommend higher pay. In December 2007,
– had no independent non-executive director
the US House Committee on Oversight and
with the industry expertise needed to credibly
Government Reform found that “…in 2006, the
challenge their CEO/chairman. The same is true
median CEO salary of the Fortune 250 companies
for almost all the institutions acquired by their
that hired compensation consultants with the
government or another bank. Those with more
largest conflicts of interests was 67% higher
limited write-downs typically had much more
than the median CEO salary of the companies
financial expertise on their board.
that did not use conflicted consultants.”
4
Rather than paid advisors, executive teams and
happened, or are they just talking in their self-
their boards should bring in the owners. It’s
interest? No matter. The important thing looking
the shareholders’ money that is on the table.
forward is to stop listening to financiers about
If anyone is going to act as effective sparring
financial reform.”
partners to prevent the next crisis, it’s the
unlikely to be as civil in his reaction to bankers
5
6
The man in the street is
shareholders. And if they get it wrong, at least
and business. To restore the confidence of
part of the fall-out will be their responsibility,
customers, investors and the public, real
which is how it should be since they are the
change must occur in governance behavior in
ultimate risk-takers.
the executive suite and the boardroom.
10. Without real change, social legitimacy and reputation will be badly damaged. It’s one thing to admit the need for change; it’s another to actually bring it about. Bankers continue
to
award
themselves
massive
bonuses, despite the fact that recent profits are largely due to cheap government funding. As the economist Paul Krugman put it after Congressional hearings in early January 2010: “Do the bankers really not understand what
2
3
4
5
6
Strebel, Paul and Hongze Lu. “Risk Management at theTop. Business Strategy Review. Spring 2010, forthcoming. Manzoni, Jean-Francois, Paul Strebel, and Jean-Louis Barsoux. “Leveraging Boardroom Diversity.” Business Insight. Sloan Management Review/Wall Street Journal, 25 January 2010. Barret, Annalisa .“Companies with Combined CEO and Chair of the Board Positions,” The Corporate Library. 25 March 2009. House Oversight Committee Majority Staff. Executive Pay: Conflicts of Interest Among Compensation Consultants. December 2007. Strebel, Paul. “Checks and Balance in Corporate Governance.” Swedish Corporate Governance Society Annual Report. 2009. Krugman, Paul. “Bankers without a clue.” International Herald Tribune. 14 January 2010.
Chemin de Bellerive 23 P.O. Box 915, CH-1001 Lausanne Switzerland IMD is ranked first in executive education outside the US and second worldwide (Financial Times, 2009). IMD’s MBA is ranked number two worldwide (The Economist, 2009) No part of this publication may be reproduced without written authorization © IMD, February 2010
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