The Regulation of Banks and Financial Markets: One Year Later

The papers and the news broadcasts over the last week have been filled with stories about the failure of Lehman Brothers and the need to re-regulate the financial system. The second-guessing has been enormous on the failure of the federal government to come to the aid of the troubled investment banking firm, especially when put into the context of the bailout of AIG and the help given to other investment banks and commercial banks.

Furthermore, the report card on the government’s effort to re-regulate the financial system seems to be hovering between D and F! The consensus review of what has happened over the past year is: nothing!

In terms of letting Lehman Brothers go, let me just say that the second-guessing is a fun game and provides a diversion for journalists and makes good reading but is not very productive. This is the problem with decision making under very stressful conditions with very little information on what the potential outcomes of actions might be.

For one thing, very few people in the summer of 2008 even considered that the financial might be on the verge of collapse. That is what makes situations risky, the lack of knowledge of what might happen in the future. Yes, we can talk about Black Swans and so forth, but the probability of a severe financial crises occurring is a very unlikely event and business is not conducted on a “what-if-the-worst-happens” scenario. Second, no one has “experience” in dealing with a very serious financial crisis. It is entirely different studying previous examples of financial crisis, but to have to deal with one face-to-face is an entirely different matter. Third, the biases and prejudices and world views of the individuals in charge of making these decisions play a role in how people respond to a crises and no one, before-the-fact, can make an adequate prediction of how leaders will perform in a “once-in-a-lifetime” situation.

The financial system is still functioning and the economy seems to be working its way out of a deep recession. Could things have been done better? Yes. Could things have turned out worse? Of course. But, we seem to have muddled through the real crisis period. Hopefully, we will not have a second shock wave that sends us back into another panic mode.

In terms of re-regulating the financial system, I have several opinions I would like to share. First, to try and re-regulate a financial system immediately after a financial crisis occurs is, in my mind, not the thing to do. For one thing, you don’t really know what happened or what caused the crisis and to rush to judgment is often to rush into folly. Furthermore, villains are usually identified that may or may not really be the “bad guys” that need punishment or controlling. Powerful politicians or government officials impose their own biases and prejudices into the discussion and they are not always the best forces to design a new regulatory system. Also, new regulatory systems that are quickly put into place following a debacle are often designed to “fight the last war” and are not really appropriate for the environment the world is moving into.

The problem with not moving to re-regulate relatively quickly is that the movement to re-regulate loses its urgency.

My second concern has to do with the causes of the financial crisis. Since the financial collapse has to do with financial institutions and financial instruments, people look first at the individuals running these organizations or dealing in these instruments for the culprits of the crisis. The problem I have with this is that the leaders and practitioners of finance are responding to the economic and financial environment that they work within. The macro-incentives that exist within an economy are oftentimes created by others with very little insight into the incentives that they are actually setting up. The “others” I am talking about are, of course, our governmental leaders. Who created the macro-environment that produced the incentives for individuals to act in the way they did? What about Mr. Greenspan and Mr. Bernanke and the credit inflation that they spawned in the early part of this decade? What about the Bush 43 administration that created the huge fiscal deficits that resulted in a more than 40% decline in the value of the dollar?

The federal government represents more than 25% of GDP in the United States and with this impact on economic activity as well as through the rules and regulations it creates, the government has a very pervasive influence on the incentives that individuals and businesses have to respond to and operate within. The leaders in the federal government go free of blame while the people that have to live within the environment these leaders created must bear the burden of shame and guilt for the financial crisis that resulted.

My concern here is that maybe the re-regulation of the financial system is not the entire problem. My concern here is that people do not really understand who created the environment in which a financial meltdown could occur. Maybe better government policy making is in order, but maybe that is too much to ask for.

Finally, I would like to argue that financial types, human beings, are going to continue to innovate in the future and there is ultimately very little that governments or regulators can do to prevent financial innovation from taking place. (Human beings, by their very nature are problem-solvers and innovators.) Financial innovation has existed throughout history. Finance, really, is nothing more than information. That is one reason why financial innovation was able to explode beginning in the 1990s with the advancements in computer technology. The computer just allowed people to “slice and dice” massive amounts of information flows more efficiently and more quickly. (Even one of the staunchest proponents of behavioral finance, Robert Shiller, proposes using computer assisted financial innovation to take contribute to the evolution of new financial markets and instruments: see his books “Macro Markets” and “The New Financial Order.”) The whole idea of “information markets” builds upon models of financial innovation and how these models can be extended to other markets using massive new data base systems and the advanced computing power that is available in the ever-evolving world of information technology.

There must be oversight of the financial system and this oversight must be accompanied by increases in the openness and transparency of financial transactions and financial reporting. The innovation, in my mind, cannot be controlled. Therefore, we (business leaders, investors, and regulators) must also have more and more information available to us on a more timely basis in order to try and understand what is happening and to react to it. This, to me, is the world of the future.

It is this world of the future that must be considered in any effort to re-regulate the financial system. Fighting the last war is not going to produce the regulatory system we need. Ignoring the incentives that government creates is not going to produce the regulatory system we need. Regulations to produce specific “results” will not work. To my mind, it is not all bad that the rush to re-regulate or to develop a new regulatory system has stalled or been put on the bad burner.

Good Management Never Goes Out Of Style!

I recently asked a group I was speaking to what was the difference between responding to incentives and “greed”. “Greed” is, of course, one of those loaded words that can immediately draw a visceral reaction when mentioned. The basic answer of the group was that greed was like pornography…greed is what an individual sees it to be. Responding to incentives is how the world goes about its daily living and for the response to incentives to become greed is just a matter of degree…it is an “excessive” response to incentives.

A concept like greed, to me, is like the concept of ego. All successful people have an ego…and that ego can be quite large for people who are very, very successful. But, it is not the fact that successful people can have extremely large egos that gets to me…it is how those people with extremely large egos use their egos. Let me give you three people with extremely large egos whose egos do not both me: Tiger Woods, Michael Jordon, and Bill Russell. (Yes, these are all sports figures, but they serve my purpose in this post.) Yes, these individuals have very large egos but…these people tend to make other people around them at least as good, if not better, than they would be otherwise. That is, they raise other people to levels they would not be able to achieve individually and this produces teams that win and win and win!

The point I am trying to make is that responding to incentives, in and of itself, is not “bad” but how this response is applied that makes all the difference in the world. “Greed” in building a management team and creating an exceptional company is definitely good and a benefit to the society and culture in which it resides while “greed” aims at self glory tends to be destructive and short-lived.

The difference to me is focus, with an emphasis on the longer term, on sustainability. To me, this is what ultimately defines “good management” and it is something that one should look for because good management, even in the face of fads and frenzies, never goes out of style. “Good management” builds winners…sustainable winners. “Good management” is what one should look for to invest in at all times.

Good management must first create an organization that has some kind of competitive advantage, something that differentiates it from other organizations, within the marketplace. This competitive advantage is generally built upon something the firm has, some core competencies that others don’t possess. And, these core competencies are enhanced by the team that management builds to enhance and sustain these core competencies.

In judging a company, I have gotten away from just looking at the head of the organization, the top dog. What has become crucial in my appraisal of any organization is the people the head person brings in to support and enhance the firm. If a leader surrounds him- or her-self with very talented people, people that will challenge and question the leader, people that will push others, including the leader, to do their very best, then I believe that such a company will have a fair chance to build up a competitive advantage over other companies and sustain that competitive advantage over time. A “leader” that cannot stand to have other “stars” around his heavenly presence may be able to create a competitive advantage for his company to start with, but generally he will not be able to sustain that competitive advantage over time.

A company in which the leader facilitates the very capable people around them is better able to “keep focus” on what is important much better than the leader that must generate all the ideas himself. It is important in the modern environment to constantly be bringing new or better products to market on a regular basis, but someone must keep the focus of the company. “Good management” encourages, supports, and promotes the team to keep up this “time pacing” of new products and services while, at the same time, maintaining focus on what created the competitive advantage of the company and what factors will sustain this competitive advantage.

Alternatively, a leader that does not build a strong team to surround him finds that the competitive advantage that the company initially boasted slips away over time. This is because creating a competitive advantage produces exceptional returns. (In the book “Competition Demystified” by Bruce Greenwald and Judd Kahn, exceptional returns are defined as a 15% to 25 % return on capital after taxes.) However, here is where the longer run is important. Others see this exceptional return and capital is drawn into this space to attempt to get some of the action. This additional competition works to break down the competitive advantage and reduce the returns that are earned by those in this specific industry.

One should note that the competitive advantage may come about only because the firm happens to be in the right spot at the right time; it has nothing to do with talent. Being in the right place at the start of a “bubble”, for example, can make someone look like a genius when there is nothing to back up the performance. (See Taleb’s first book “Fooled by Randomness” for a discussion of this phenomenon.)

In either case, as returns are being threatened by greater competition, the “leader” that has little talented support staff and limited new ideas begins to lose focus on what got them the initial competitive advantage and starts to focus on other factors that can enhance returns and have nothing to do with core competencies. Financial engineering is one such diversion that can bring continued returns. Increased leverage and mismatching maturities, as we have seen, are two such types of financial engineering that bring positive results…at least in the short run.

Less than stellar management, therefore, tends to lose focus on what initially brought them attention and eventually puts greater and greater reliance on other factors, like financial engineering, to keep attention. As is often the case, however, one cannot always tell the wheat from the chaff as the economy experiences “good times.” Only with the bust do we really find out who the good managers/leaders are.

Or are their clues we can observe earlier on that can give us some insight into which companies have “good management”? I, of course, believe that you can identify good managements early on. I have emphasized the word “sustainable”…which of course has to do with long term performance. Greenwald and Kahn argue that good managements are able to sustain the 15% to 25% returns for an extended period of time while still focusing on core competencies. Sustainable competitive advantage is also connected with relatively stable market shares within the core industry of the company.

Sustainable competitive advantage is connected with “how” the firm is able to achieve the high returns and the stable market share. Where do the earnings come from? Have they come from the core competencies of the company? Does the company attract and build up the talent that continually enhances these core competencies? Or, does the company have to go outside these core competencies to keep up performance? Or, do these companies rely upon financial leverage or strategies connected with mismatching durations to maintain performance?

Good management does not go out of style! I don’t believe that one has to argue for “conservative” management practices across the board. I do believe, however, that one should insist that the management of a company keep its focus on what it is strong in and build from that foundation and not depend upon extraordinary means to “puff up” its performance. In this, I believe that good management will build a good team and act “conservatively” because it doesn’t need to rely solely on its “super star leader” or “gimmicks” to create a winner…a team that continues to win over time. Therefore, I would argue that the concept of “Greed” is connected with FORCED performance…not with true achievement!