I was cleaning up my office a bit this afternoon and came across my copy of Andy Haldane‘s brilliant paper “Rethinking the Financial Network (April 2009). People (including me) like to complain about the lack of leadership and insight at the commanding heights of the financial system, but based on this paper alone, I’m not sure the UK could ask for a better Head of Financial Stability at the Bank of England. (He was appointed to that position in late 2008, once the horse had not only left the stable but the country…)
If you are interested in the workings and health of the financial system, you simply must read this paper if you haven’t already. I won’t attempt to summarize it here, it is worth reading in its entirety but will excerpt his conclusion:
Through history, there are many examples of human flight on an enormous scale to
avoid the effects of pestilence and plague. From yellow fever and cholera in the 19th
century to polio and influenza in the 20th. In these cases, human flight fed contagion
and contagion fed human catastrophe. The 21st century offered a different model.
During the SARS epidemic, human flight was prohibited and contagion contained.
In the present financial crisis the flight is of capital, not humans. Yet the scale and
contagious consequences may be no less damaging. This financial epidemic may
endure in the memories long after SARS has been forgotten. But in halting the spread
of future financial epidemics, it is important that the lessons from SARS and from
other non-financial networks are not forgotten.
I’m fairly certain he is not a reader so I can take no credit, but it is very rewarding to see someone in his position with such a firm grasp on the concepts I’ve been trying to articulate (much less completely and articulately) for some time now. (see The science of Financial Regulation (June 2009) and Averting (financial) ecological disasters (August 2008)) I hope his voice is listened to and his insight and intellect used to help us build a better, more resilient financial system for the future.
Every executive committee member of a large bank, exchange or insurance company should read Kirk Wylie’s latest post to understand why their cultures are broken and why they so regularly find their organisations blithely running off the edge of a cliff, comfortable in the knowledge that, “well, hey at least we’re all doing it so it must be ok” and safe in the knowledge that their is a big taxpayer airbag (or trampoline?) at the bottom protecting them from any nasty consequences. Of course they are unlikely to – except in the unlikely event that it gets published in one of the traditional echo chamber publications like the FT or the WSJ.*
I’ll resist the temptation to copy/paste the whole post here but please go read it as this excerpt doesn’t give it justice:
Independent, entrepreneurial techies can actually make the biggest impact in the organizations that fight against them the most: they’re the ones that need them the most. Use them as agents for change, challenging assumptions, challenging entrenched attitudes, challenging technical group-think. Otherwise, your worst employees (the ones who can’t really get a better job elsewhere) win, and you as an organization fail.
Kirk is speaking of technologists, but the same thing applies across the organization. But big organizations kill entrepreneurship, actually it’s in their DNA. It’s not news, tall poppies and all that. As I was leaving 16 years of working – mostly happily – in big organizations I spent a lot of time thinking about why this was (and also why I hadn’t noticed it earlier in my career.) The answer to the second question was really because of luck. For 90% of my investment banking career I had the good fortune to be right in the heart of building three new and transformational markets: first the Ecu/Euro market, then the European credit markets and finally the move to ‘electronic’ capital markets. Throughout this part of my career, innovation, entrepreneuralism and independence actually helped me succeed because there was no pre-existing status quo to upset. This only became apparent to me in hindsight.
The answer to the first question is now obvious to me, but it wasn’t always so and really only revealed itself when I left and was able to step back and look at the machine from the outside. The expression ‘well-oiled’ machine says it all. This is the ultimate compliment used to describe a successfully managed organization. So where does non-linear innovation, disruption, questioning fit in a well-oiled machine? It doesn’t. In fact the more ‘well-oiled’ the machine, the less tolerant it is of exceptions. (Which also explains why I operated happily for so long at DrKW!) Switching metaphors, entrepreneurship is seen as a virus in these companies and they produce potent ‘corporate antibodies’ to seek out and subdue any such viral outbreak and they do everything (pace Kirk) to innoculate themselves against them in the first place.
But what is a CEO to do? The ‘well-oiled’ bit is equally important. I am sympathetic to this. (I mean if I was in charge I wouldn’t want too many of me’s running around, that would be chaos.) It’s not an easy question to answer and is made even harder (especially if you are running a public company) by the fact that the visible benefits of the entrepreneurial genes are only realized over time – I’d guess at least 4-5 years at a minimum and sometimes it might take as long as a full business cycle. And yet the average leadership tenure in these organizations is at best at the short end of that, and the compensation and stock market cycles are much shorter. I’ll be frank and say up front, I don’t have an answer but I’ve got a couple ideas I think are worth trying.
The first is to set – from the top – a deliberate human resource policy of seeking to “doping” the organization with a limited and controlled number of people like Kirk. (Doping is the process of adding controlled impurities to a material – for instance a semiconductor, or metallic alloy – to improve it’s useful properties.) This needs to be managed very deliberately, like a program – put a senior HR person in charge of this and manage it: these people will likely have a higher turnover, complain more often, get into trouble, want to change projects and/or departments and so need their own career track. I’m not sure what the correct ratio is, but I would guess it’s on the order of 1-2% of total staff, not necessarily evenly distributed throughout the company. (I knew my Materials Science degree would come in handy one day!)
The second is to create – and then protect institutionally, not personally – a specific department dedicated to exploring ‘white space’. When I say protect institutionally, I mean frame it like a trust so it cannot be undone or hacked by successive waves of management and is insulated from the quarter on quarter, year on year vagaries of the economy and/or the companies results. If you don’t do this, you will inevitably fall victim to the problems Azeem enumerates in his great post on why corporate venture capital (almost always) doesn’t work. Before all the serious, “pragmatic” people out there roll your eyes all at once (if indeed any such types would consider wasting time reading a blog) this doesn’t and shouldn’t need to be a big ask. Again probably on the order of 1-2% (even less for the biggest companies), of resources. The best example in practice I can think of is Xerox PARC, although the irony there is that Xerox didn’t really figure out how to plug PARC’s non-linear thinking and brilliant innovation back into the company (or at least not very well.) But perhaps that is not a bad thing (in proving my point) because I would posit that all other things being equal, Xerox’s share price has been higher (than it otherwise would have been) because they owned this asset. This cheap, deep out-of-the-money call option on the future. As far I as can tell, this is also what BT is trying to do with BT Design led by my friend JP and it is heartening to see that – at least so far – he is being allowed to continue to pursue this vision despite (and hopefully even because of?) the very poor results of the past couple years. I don’t know of any truly analogous initiatives in big finance.
And indeed that is (one of the reasons) we decided to set up Nauiokas Park. Clearly we’re not the whole solution, but we think we can play a key role for big financial institutions: a way to have (some of) their cake and eat it too: by entrusting a relatively small amount of financial capital to us, we think we can create just such a verdant ‘garden of innovation’, allowing them to harvest the fruits of some of the most dynamic entrepreneurs active in their industry, while protecting and nuturing them, away from the noxious antibodies of the corporate organism. Indeed, taking a page out of John Seely Brown, I guess you could describe our mission as seeking to create a vibrant knowledge ecology for finance and markets, and help our stakeholders profit from it:
There’s a fundamental change from finding ways to innovate inside a corporation to leveraging the knowledge ecologies of many little companies in places like Silicon Valley. You find that the shift turns much of the classical R&D into A&D – that is, acquisition and development. Larger companies can buy the research they need and instantly acquire a diverse portfolio of research groups.
I’ll be honest though, it’s not an easy sell. Even for the corporate leaders who ‘get it’ the reflex instinct is to think (sometimes aloud) “makes sense, but we can do that ourselves”. Well, you can’t prove a negative, but we’ve spent a long time inside these same big financial institutions, and our many years of experience led us to conclude that it is bloody hard to do (for all the reasons above and more.) On the bright side, being challenged makes you think harder and forces you to refine and adapt your ideas, ultimately making them better. Hearts and minds. Hearts and minds. Wish us luck.
* Just to be clear, I have nothing against the FT or the WSJ per se, I read them regularly (well WSJ not so much) and think they are solid publications. I’m not suggesting they aren’t important sources of information and opinion – you’d be stupid not to read them if you are in finance – just that, and this is the wonderful thing about the world in 2009 – I think you need to read much more widely and in particular embrace at least a diversity of viewpoints, if not views.
Although I’m fairly easy to find on LinkedIn or twitter or just via Google. I guess the search committee doesn’t use these tools. Or perhaps I don’t fit the profile? Now to be absolutely frank I’m not sure I’d want the job, but part of me says that if called, I should serve. And that it is easy to complain about how the old order is failing utterly to even recognize – let alone take advantage of – the huge tectonic shifts currently shaking the economic and social order, but that it is harder to ‘do something about it.’
In creating Nauiokas Park, one of the motivations was to turn our vision and understanding into actionable change (by funding and advising entrepreneurs and companies who are adapted to the new order and so I would consider this as trying to ‘do something about it’. Perhaps this is doing enough, but (if offered the opportunity) maybe a barbell approach would be even better.
So what am I talking about? Well RBS is looking for a couple more new non-executives. And looking at the team in place, I think I’d bring a nice combination of banking experience and skills (without the constraints of being an establishment figure), and understanding of the importance and power of technology in shaping the financial landscape of the future. Most of all I would bring a diversifying voice to the table. Sure I would be by far the youngest Board member (average age of current team c. 58, only Stephen Hester is under 50) but I think having (at least) one Board member who has a credible claim on being a digital native (or at least a well-assimilated immigrant) is actually a very powerful point in my favor.
Head hunters, Boards, nomination committees, task forces, the government etc. all talk ad nausea about the need to broaden and diversify the pool of non-executive talent in the FTSE100 boardrooms, but then go fishing using the same bait in the same pond. I am more than happy to acknowledge that there are many other equally or better qualified potential candidates (and for example, RBS might do well to add at least one, or better yet two or more women to their Board…perhaps they should talk to Amy…) but I hope for their sake and the sake of the UK economy – like it or not RBS is bloody important – that they don’t pick yet another couple 50 or 60 something white male FTSE100 insiders…
Bankers like to talk about channels – branches, call centers, internet, mobile. Sell the same products via multiple channels: adapt to individual customer preferences. Horses for courses. In wealthy developed economies, this way of thinking is mostly correct; or more precisely the resolution of the market renders the fallacies (of this way of thinking) invisible. To see the fundamental differences, to understand why – at sufficiently high resolution – these channels cease to be simply distribution mechanisms and become integral to the service being offered, one needs a better economic lens.
Developing and emerging economies provide just that: a high resolution lens on economic activity: in a developing (ie relatively poor and resource constrained) economy, the concept of a ’rounding error’ is ridiculous: micro-everything matters: pricing, transaction costs, payment media, etc. ‘Newtonian’ economics and finance is insufficient to understand how these economies work; you need to look at “quantum” effects. You need high resolution. Why do I find these markets so fascinating and important? Yes, there are many investment opportunities and this is exciting; but we are not yet in a position to really explore these and take advantage and so that’s not the main reason. Yes, it is clearly rewarding to encourage and marvel at human ingenuity that so often leads to success in what are often enormously challenging conditions. But that’s not it either. The main reason I think these markets – especially ‘frontier’ markets – are important, is that by observing the world through the lens of these economies and markets, one cannot help but gain a deeper, more granular, fundamental understanding of how markets work (or don’t work.) The fundamental forces – the risk quarks – that are invisible to the naked western eye are revealed by the tunneling electron microscope of emerging frontier economies.
Nowhere is this effect more obvious than in the cambrian explosion of innovation in markets and services built on the substrate of mobile networks in emerging markets. From the point of view of someone concerned with envisioning and understanding the future of financial services, one of the most pertinent and exciting laboratories is the explosion of mobile trading, payments and banking systems in Africa and other poor, developing economies. I first wrote about this a few years ago, and since then, many of my expectations have been borne out and the potential for disruption – both at home and abroad (ie in the West) – if anything has grown. Indeed one company I wish I had invested in – Obopay – was founded by Carol Realini (who I would love to meet one day) after having spent some time in Africa where she saw first hand how powerful a mobile approach to payments could be.
Of course, although I may have been among the first, I’m by no means alone in seeing mobile financial services as an enormous opportunity, or in seeing the developing world as a key driver of innovation. This is great news as hopefully it will encourage people and institutions with more capital than I to look seriously at investing in developing innovative business models in this space. A few weeks ago CGAP (a very interesting organization, check them out) published a report predicting that:
The market of mobile financial services to poor people in emerging markets will surge from nothing to $5 billion in 2012.
There are about one billion people in emerging markets who have cellphones, but no bank accounts. CGAP expects that number to rise to 1.7 billion to 2012, with around one in five of them picking up mobile money — and creating the $5 billion market.
Most optimistic researchers expect more than a billion people in emerging markets to start using mobile money within a few years, while some are more cautious than CGAP.
Now a billion potential customers – even if they are relatively poor – is a market opportunity even the most jaded venture capitalist should be able to get excited about. But it gets better. I figure if you can figure out how to profitably provide basic payment and banking services to this billion, you probably have a pretty decent business model with which to take on the billion or so people who already consume banking services in more developed countries (and who by the way all have a mobile phone…) These potential customers in the developing world are a dream come true in the sense that if you solve their problems, you’ve solved everyone’s problems (via Reuters:)
“The Grameenbank model works, but the scalability is limited,” said Hannes van Rensburg, chief executive of mobile financial services provider Fundamo said on Wednesday.
“The problem is about the inertia of money. It’s very difficult to move very small amounts of money fast,” he said in an interview with Reuters at the GSMA’s Mobile Money summit in Barcelona.
Access to financial services could not only remove the need for long, costly and risky journeys to move money around, but also reduce the burden of constant, active money management endured by those living on tiny amounts and in constant danger of financial crisis.
“Poor people are doing a tremendous amount of financial transactions just to survive,” says Stephen Rasmussen, who runs a mobile banking program for CGAP, an association of non-profit organizations under the auspices of the World Bank that seeks to help to increase financial access for the poor.
“People at the very bottom spend far more energy and mental time on managing these systems than we do,” Rasmussen told Reuters.
Mobile money deployments have huge momentum, with the number expected to double to 120 by the end of the year, according to the GSMA.
The more cynical amongst you might say: “..yeah, ok. But so what? The big telecom and financial services providers are just going to carve this up and so where’s the opportunity?” I don’t have all the answers but I am fairly certain that most – especially western – large incumbent industry players (from both sides) are structurally and evolutionarily poorly adapted to harness this opportunity. They already have, and I suspect they will continue to frame this opportunity through the low resolution historical lens of their existing business models and approach. Phrases like “We are a bank. We do ‘x’.” or “We are a telecom operator. We do ‘y’.” will continue to be all too prevalent. And so while the giants sit around haggling amongst themselves as to how they can and will divide this market, there will be ample room for the nimble, energetic and open-minded entrepreneur to make her mark.
According to the June 22 letter, the review identified “valuation concerns” where “appraisal documentation is missing or incomplete,” or where property-assessment methods were “insufficient/lacking.”
Other missing information included employment confirmations, phone numbers, credit reports and rent verification, the letter said. The review also found “income calculation errors.”
Another fine example of six sigma in banking. Imagine if Dow and Dupont ran their chemical plants like this. Holy crap. Or Boeing built planes this way. Yikes. But then again, in those industries lives are at stake. Banking. [shrug] Just money. Ok a few billion hundred billion. But still, it’s not like anyone died. Sheesh.
Hmmm. In 2002 – yes 2002, seven years ago(!) – I wrote:
In a recent speech, Jack Welch, the former chairman of General Electric, made exactly this point: “…[if] you put six sigma in an investment bank, they would all gag!” In case you think he was just engaging in some gratuitous banker bashing, consider this: six sigma quality means havingfewer than 3.4 defects or errors per million operations in a service process. That is 99.99966% perfection.
Contrast this benchmark with the assurance once made to me — by a senior syndicate manager of one of the largest and most respected global bond underwriters — that it was perfectly normal and necessary to expect and reserve for 5%-10% errors in the allocation of a jumbo multi-tranche bond deal! Assuming an average of 200 individual orders (including splits) on a typical new issue, to reach six sigma quality levels you would need to have fewer than four errors over 5000 issues!
…And therein lies the next major opportunity for capital markets bankers over the next decade: to use technology not only as an enabler of innovation (as has been the case over the past 15 years) but as a driver of industrial efficiencies.
The guys in IT thought it was an interesting take on things (with $ signs in their eyes) but the ‘business’ side, well, let’s just say it didn’t strike a chord. Banks were special. Bankers were (even more) special. All that re-engineering and total quality management and painful restructuring and shifting centres of power…all good for manufacturing and you know, “other” industries. The ones they advised and financed and funded LBOs of… but not banking. Banking is “different.” You wouldn’t understand…What. A load. Of. Crap.
Well now they are paying for it. We all are paying for it. Rivers didn’t catch on fire but the financial system was well and truly polluted. But there is a bright side. The bright side is that there has never been a better time to come in and build businesses in banking and financial services that have an engineering DNA, businesses that are natively adapted to an industrialized and digital way of doing business. Indeed some of the pioneers in this mold have already enjoyed tremendous success (Markit Group comes to mind.) Others are emerging. And the incumbents have never looked less frightening (even if, especially because, they are now too big to fail.)
In the spring of 2005 I wrote the “screenplay” for AmazonBay and we launched DrKW Revolution on July 1 2005 – I still have the t-shirt to prove it. So I must admit I had to laugh when my old colleague Stu pointed me to the Morgan Stanley Matrix I nearly fell off my chair laughing: it was deja vu all over again…
Don’t get me wrong, it looks pretty useful and I completely endorse the vision. In fact I sort of have to given that it is exactly in line with the vision we had for Digital Markets at DrKW over 5 years ago! (Although not quite as comprehensive as far as I can tell…) But what I love most is that in terms of look and feel – the hexagons, the music, the video (but I can re-assure you I didn’t wear a tie or speak from a teleprompter!) – it is Son of Revolution. Amazing. Actually feel quite proud that we at least left an impact, even if it didn’t happen to be at Dresdner Kleinwort.
I just spent a few minutes digging around on the wayback machine but unfortunately couldn’t find any good links. Really too bad because the Flash intro page was very cool and would have loved to be able to look at it side-by-side with MS Matrix. (Any current Dresdner folks would be great if you could dig this code out of the archives if it still exists!) Fortunately, I did have an old marketing card brochure hanging around:
I’d be lying if I didn’t admit that I can’t help but feel a little proud seeing some of my vision start to come to life, especially at such a blue chip conservative firm like Morgan Stanley, but I would also be lying if I said I didn’t feel like screaming ‘I told you so’ to all the senior executives at DrKW who refused to stick their necks out and support what I was trying to do. Let’s just say I’m not surprised at how it all ultimately turned out there. Karma. The good thing is that this bad feeling is way more than offset by remembering all the truly exceptional people I got to work with while I was at DrKW and the support I received from so many of them especially since it wasn’t necessarily politically correct to do so. It meant and still means a lot to me. Anyhow, it would be cool if Hishaam Mufti-Bey, the guy behind MS Matrix would add us as a little historical footnote on his About Us page, as I imagine it won’t be long until all the old DrKW links have disappeared; it’s important to remember!
Just one final point though. What the hell is it with traders and black Bloomberg-looking web design??? Every bloody website I see focused on institutional capital markets customers seems to use this look. Get over it! It was fantastic for Mike (and rooted in a real engineering problem by the way) but when other people copy them, well… it just makes you all look dumb. Hire a designer. Do something original. Your content and you customers deserve it.
“The future is already here – it is just unevenly distributed.”
- William Gibson, Author
Update: Thanks to Martina for finding a slide version of the website stills / product look and feel…as you can see MS Matrix looks even more like DrKW Revolution than I remembered!
John Kay is one of the most lucid, accessible economic thinkers out there: pragmatic, insightful, skeptical and perhaps most importantly not prone to hyperbole. If you don’t already read his weekly FT columns (also archived and published here), I highly recommend them. (Perhaps one day I’ll get the opportunity to meet him, and be able to convince him to join our advisory board.) His column yesterday, “Why ‘too big too fail’ is too much for us to take” was particularly articulate and on target:
Commercial success and democratic election are the only sources of legitimate authority in a society that no longer relies on spiritual leadership nor respects hereditary titles. An organisation exempt from either of these disciplines represents an unaccountable concentration of power. As we have today at Citigroup, Barclays and Deutsche Bank.
If “too big to fail” is incompatible with democracy, it also destroys the dynamism that is the central achievement of the market economy. In principle, there is no reason why disruptive innovations and radically new business models should not come from large, established, dominant companies. In practice, the bureaucratic culture of these organisations is such that this rarely happens. Revolutions in business generally come from new entrants. That is why so many of today’s market leaders – Microsoft and Google, Vodafone and Easyjet – are companies that did not exist a generation ago. These companies could not have succeeded if governments had been committed to the continued leadership of IBM and AOL, AT&T and British Airways.
If there is one single learning we as democratic capitalist societies need to take away and apply in earnest from the Crash of ’08 it is to put in place mechanisms, policies, regulations, norms – whatever is needed, to ensure that no private or public commercial entity is ‘too big to fail.’ The externalities on society are too important (and the mis-pricing of these is probably the largest contributing factor to the excessive rents that accrue to such entities in times of stability.) The wonderful thing is that with the technology and economic infrastructure of the 21st century, it is entirely possible to implement a market-based pricing of intangible externalities if – and sadly this is far from a given – sensible, good faith laws and rules are put in place. The markets in pollution permits is an obvious example, although as has been seen in the carbon markets, all too often we see the entrenched power of incumbents forcing a distortion of the rules to dilute their effectiveness (think free allocation of CO2 permits vs. auctioning.)
(One of) the analogs in finance you could imagine would be a market in Central Bank liquidity rights: the right for a bank to borrow say 12mo funds from the Central Bank at a set rate or margin. Banks would have to hedge the committed lines of credit they extend with these liquidity rights. Designed correctly (tricky no doubt but doable), these could trade in a free market, with the Central Bank auctioning off and participating in secondary market operations to manage their supply and demand. With these you could actually price liquidity (perhaps not perfectly but still) and if they had existed, I suspect that banks would have been much more cautious before writing trillions of dollars worth of committed back-stop facilities to structured finance vehicles (SIVs, etc.) and corporates at derisory pricing.
For those of you that aren’t bankers – for years these kind of facilities were written even for weak credits with tiny commitment fees, most between 5-15 basis points (ie 0.05-0.15%.) They were never ‘expected’ to be drawn, and so were often treated as free money when in effect they were just out-of-the-money options sold without regard to the tail risk. Another ‘picking up nickels in front of a steamroller’ strategy that failed catastrophically. Of course everyone knew that these facilities were underpriced, and for most banks (but some of the dumb money smaller banks) they were notionally acknowledged as loss leaders to win other business. This in itself is not a problem per se. The problem arose because these ‘loss leaders’ actually made revenues and accounting profits (of course while storing up enormous contingent risks but these were invisible and seen as so unlikely as to be irrelevant, just like for super-senior CDO tranches) and so it was only too easy to keep selling more and more of them. A loss leader than makes you money: what’s not to like about that?
John Kay finishes his argument with a succinct recommendation:
“Too big to fail” – whether the claimant is a bank or an auto company – is not a status we can live with. It is both better politics and better economics to deal with the problem by facilitating failure than by subsidising it.
There has been much noise (on both sides of the Atlantic) on the appropriate role of government with respect to giving a financial boost to new ventures and entrepreneurs, especially given the vast sums that have been targeted towards failed giants. This is a debate for another time, but I suspect the single most effective thing governments could do to help entrepreneurship, innovation and economic renewal sustainably, over the long term and with the least risk of unintended consequences, would be to heed Mr. Kay’s call and ensure that henceforth no company in any sector is ever again too big to fail.
I hesitate to wade into this debate with my observations or suggestions: it is complex, has been studied at length by many academics and professionals much more qualified than I, and almost certainly does not lend itself to simple, mechanistic solutions. (Which is why I am highly skeptical when any politician suggests that more detailed laws or rules are the answer.) However I’m extremely frustrated with the lack of ‘outside the box’ thinking in this debate – not because it is necessarily where the answers will be found – but because unless one steps out of the frame of conventional wisdom you are almost certainly condemning yourself to come up with sub-optimal solutions. Especially since some of the fundamental tenants that are taken as gospel might be wrong. So with the disclaimer that I don’t pretend that the following suggestions are not without their own problems, I think they are worth considering, if for no other reason than to change the frame of the debate. Indeed I first thought of writing this post 3-4 years ago but it always seemed kind of pointless as at that time, there was absolutely zero appetite for considering any other compensation paradigm in the industry. I mean why would you, right? It was all good. Happy days.
I would suggest that most investment bankers (and MPs) are not paid enough. Enough base salary that is. But wait a second I hear you saying (well perhaps not today but certainly a couple years ago), the strength of the system is you can make a lot of money sure, but only if you perform. Who could argue with that? Well I will. For two main reasons. And I think if my suggested approach had been the norm in the industry, we would not have seen the same degree of egregious and venal behavior and may even have avoided some of the worst excesses.
First is the problem of credibility and the fit-for-purposeness of the bonus. In a system when even average employees in average years get half or more of their total compensation in bonus payments, and top producers in top years get most of their total compensation in bonuses, the idea that bonuses are entirely discretionary and variable is delusional. Paying out zero bonuses – even in poor years – is a nuclear option – the credibility of the bonus as a completely variable element of compensation is significantly if not completely undermined. So in effect the variability (both to the upside and the downside) is in reality highly damped. ie It starts to look like mostly fixed costs; and yet crucially for the employee it is not and so you have the worst of both worlds: the employee does not benefit from the security of a larger fixed remuneration, but the company effectively is committed to paying a high quasi-fixed cost. It’s worth taking an example: imagine a banker with a base salary of £100,000 per year who over the past 5 years has received bonuses ranging from £90,000 in a really poor year for the firm and his activity to £250,000 in a great year. On average his bonus’ have been £160,000 over this time. I would suggest this is a dumb way to pay this professional. Rather his salary should be around £200,000 and his bonus should have been beetween 0 and £40,000 every year except for the stellar year when perhaps it should have been £100-200,000. ie The norm should be c. 0-20% of salary. By taking this approach – given that the employee will value the greater certainty of the second construct, the company will be able to pay this banker less on average and yet have a more satisfied and aligned employee. As long as the first question asked when considering the bonus of an employee continues to be “what did he/she get paid last year?”, the robustness of the bonus process will be somewhat of a farce.
Which brings me to the second point. I can already hear some of you screaming out that this would just encourage a bunch of freeriders and goes against the core tenants of paying for performance. Well no and no. First of all if your employees are being paid these kinds of salaries and choose to freeride, they should be sacked and then you should be sacked for hiring the wrong people. Without exception, the very best professionals I have met, at all levels of the organization, do not work more or less hard because of the money: they work hard because they want to succeed, because they are passionate about their work. And they expect that if they are successful that the money will come. Any of you who have ever worked on a trading floor, do this thought experiment. To the best of your knowledge, what was the correlation between those that worked the hardest, put in the most effort, and those that were paid the most? Clearly, and especially in big companies, there will always be people ‘along for the ride’, trying to live off the efforts of others; often knowing they probably won’t get paid the most but they will certainly work the least. Worse, if push came to shove most people in most organizations can easily identify most people like this. By paying salaries that accurately reflect the value of the opportunity and the median pay for people with the skills to capture the value of the opportunity – I would guess that you would actually have fewer freeriders. The company couldn’t afford to tolerate them. They would have to remove them.
Adjusting the compensation paradigm towards a higher fixed component and a more sensitive and truly variable component (including averaging payouts over 4-7 years, including the possibility of down – ie malus – years) would also go a long way in improving risk management by going with the grain of human nature rather against it. Behavioral Finance 101 applied to human resource decisions. Again I suspect that had banks (a) had proper internal transfer pricing of cost of capital and liquidity and (b) a more salary-based compensation policy perhaps we could have avoided the most toxic behavior that developed in the structured credit market. A lot of the original ‘mark-to-market’ profits that were generated out of thin air (upon which very real bonuses were paid out) essentially were nothing more that arbitraging long term risk against overnight funding and the inability of the bank to charge appropriately for the capital used to allow these trades. Indeed the extreme complexity of many of these structures was imo just plain old misdirection – like a magician’s illusion. It made the profits seem plausible – after all it was really clever stuff – and created an illusion in management’s eyes as to the real source of the profits and the associated risks. Plus these very clever – and increasingly rich – people also, like most of us, liked to show off a bit and so – like musical virtuoso’s – competed to produce the most elegant and complicated embellishments, just to prove what could be done. If the average MD in this business had had a salary of say £500,000 with an expected bonus of £0-750,000; rather than a salary of £125,000 and an expected bonus of £500,000-2,000,000 you would have produced a very different, more healthy, set of behaviors I believe.
To conclude, I’d like to reiterate that I am not suggesting that this is a perfect solution – it clearly has its own problems – but rather I am suggesting that it is a much better system than the existing one, and would produce better and more balanced economic outcomes over time for all stakeholders (employees, shareholders, taxpayers.) So as a roadmap to the great and good who are currently tasked with revisiting pay in banking I would leave them with these three suggestions:
encourage smaller organizations (in particular for high risk/reward activities) where it is much easier to align and monitor the interests of all stakeholders
Morgan Stanley is changing its compensation scheme by de-emphasising the year-end bonus and increasing executive salaries as the Obama administration prepares to introduce a set of broad reforms aimed at changing Wall Street’s pay incentives.
The firm’s board of directors approved an increase in the base salaries of several of its top executives, while at the same time reducing the end-of-year bonus, according to a regulatory filing. Other banks, including UBS and Credit Suisse, have moved in a similar direction.
Wow. Watch them all fall in line now. It’s all about not being different than your competitors. Great to see this idea being put into practice (even if it did take a Level 5 financial storm to do it…) When I first suggested this idea to my peers and bosses 5+ years ago it’s not an exaggeration to say they looked at me like I had horns growing out of my forehead…
Obviously, Citigroup has continued to be much in the news of late, first becoming a penny stock and then enjoying a nice bounce this week because, well…(short covering?) For better or worse, I try to focus mainly on the tremendous opportunities that exist in the context of inventing the future of such a vital yet stale industry that is finance. So why, I asked myself, so many posts about Citi?
I guess it is impossible to write a blog like the Park Paradigm without posting relatively frequently about Citigroup; every hero need a nemesis right? So I guess in this context they’re the Joker (and I’m, um…Batman???)
Clearly much of the price appreciation is due to a vicious short-covering rally that Messrs. Pandit and Lewis kicked off. But the fact is, what do they have to lose? If they can fool us long enough, credit spreads will come in and recovery will become a self-fulfilling prophecy. Otherwise, Congress (read: the US taxpayer) will bail them out once again. Citi, B of A and AIG have each had multiple bites of the bailout apple, so what’s another bite among friends? They are inclined to do this because their reputations are already severly damaged; in essence, short of outright fraud, they can’t get any worse. Therefore, they are motivated to throw caution to the wind, be super-positive and hope for the best. If new management with fresh reputations were on the scene, the would be much less inclined to release bullish statements without empirical data to back it up. This is a major flaw of TARP: letting incumbent managements stay around. It has created perverse motives that serve neither the troubled institutions nor its shareholders very well.
So with this in mind, I’ve been curious to see how the whole (non-executive) Boardroom shake-up that has been hinted at would play out. Well today Reuters reported that Citi would be adding (at least) three new outside directors, and confirming that – due to mandatory retirement at age 72 (not gross negligence and/or insanity) – 2 current directors would be leaving. Speculation was that the new directors would be:
Wow. That will really shake things up. I mean these new guys, they bring a completely new perspective to the existing Board, right? A real diversity of experience and knowledge. Two plus two equals five stuff…
I don’t know much/anything about Messrs. Grundhofer, O’Neill or Thompson, but I’m pretty sure they are all very talented, experienced managers with great track records; and there is no reason to believe they won’t be an improvement on whomever they replace (admittedly a fairly low hurdle…) But c’mon! Where are the new Board members who will challenge the industry (not just the corporate) status quo? Who have a vision of what finance might/should be in the 21st century? Where is the new Board member with a firm grasp of the latest trends (and implications thereof) in information and communications technology and how they will shift the societal and cultural framework in which Citi operates over the coming years? Where is the independent Director who isn’t a paid-up member of the Fortune500 great-and-good (and so will be more likely to bring a different perspective to the table, and less baggage)? Where are the Board members that manage their own email inbox (or at least read and respond directly themselves), that have a Facebook or a Twitter account, that write and/or read blogs? That have bought at least one iPhone app and feel more panic when they don’t have access to broadband/the web than when they don’t have a mobile/voice signal?
Every successful team I’ve ever seen or been a part of has one common denominator: diversity. Diversity of experience. Culture. Expertise. Seniority. Temperament. Gender. And even better if there were one or more ‘independent thinkers’ amongst the group. And just to be clear, I’m not talking about box-ticking compliance driven ‘diversity’ (although by accident rather than by design, this can sometimes help at the margins, by at least avoiding the ten 60-something white guys out of central casting…) but diversity that creates intersections. Of ideas, world views and aspirations. Because that’s where interesting things happen. (You can bet that my bank‘s Board will have this principal as its foundation.)
I’d be curious to know which headhunter(s) worked/are working on this mandate and what was their brief (and who wrote it?) I would have hoped (on behalf of US taxpayers) that the Obama administration had much input into the search criteria and that they would be looking for Directors that would focus primarily on ensuring the future success of Citigroup without regard to worrying about legacies and sunk costs (real and psychological.)
As an aside, take a couple minutes and wade through the mangroves of Citi’s corporate governance. No wonder it’s gone so horribly wrong! (I wish I had looked at this a couple of years ago, even without hindsight, it just screams sell…) They have 49 people on their Senior Leadership Committee. FORTY-NINE!!! I assume they at least have a wiki to manage committee business…
The debate du jour around the world’s capitals and financial centers is of course “How do we save the banking system?” Good banks. Bad banks. Private banks. State banks. Capital injections. Credit insurance. Etcetera. But in this Dr. Seuss world of solutions, and despite thousands upon thousands of articles, blog posts and editorials, I have been very surprised to see that one crucial element seems to be missing from all the solutions being discussed: innovation and entrepreneurialism.
Governments should invest (at least) a small amount of the billions and billions they are ploughing into the financial system into new banks. That’s right – start-ups. But not carbon copies of the banks we have today. 21st century banks. Banks that aren’t built on foundations of obsolete business models and technologies. Banks that are “digital natives”. Banks that by design answer the question: “If you had a blank sheet of paper, how would you build a platform and and organization to provide banking services in today’s (and tomorrow’s) world?” Banks that not only understand the importance of Moore’s (and Kryder’s) and Metcalfe’s and Linus’ and Amara’s laws but also their ramifications for a business that is intrinsically and structurally about managing digital information flows in a connected society and economy. Banks without (literally and psychologically) the corrosive burden of legacy costs and structures. Banks who apply Coase’s theories in the context of transacting in a networked world. Banks who embrace the lessons of Dunbar and Kahneman and Thaler (and Sunstein) when designing their management and compensation policies. Banks that strive to live up to Einstein’s suggestion that “things should be made as simple as possible, but not any simpler” and have an instinctive bias against complexity and a copy of Maeda‘s The Laws of Simplicity in the Board room. Banks that recognize that when you boil it all down, the product they are ultimately selling is trust.
(adapted from Wikipedia) A bank is a financial institution whose primary activity is to act as a payment agent for customers and to borrow and lend money. It is an institution for receiving, keeping, and lending [and investing] money.
Obviously in order to build such a bank you need a team of leaders who not only understand banking and finance but understand intuitively the social and technological landscape of the 21st century. Bankers who refuse to trivialize novel tools and modes of communication and interaction simply because they are unfamiliar. Bankers who are as comfortable on Facebook or Twitter as they are on a trading floor or in a branch. Bankers who collect and collate their daily information via RSS readers and wikis and blogs and not just from the FT or CNBC or Bloomberg. Bankers who have accepted that the value they can create no longer comes from arbitraging information scarcity and building black boxes that hide complexity but from embracing abundance and building tools to help people navigate this complexity as partners. Bankers who would be equally comfortable discussing the future of finance with the founders of Google as they would be with the governor of a Central Bank. Bankers who are passionate yet sober. Bankers who are focused on the future and on providing a service that doesn’t rely on coercion or inertia or lack of alternatives to keep their customers satisfied. Bankers who realize what a tremendous opportunity exists to start afresh and be part of creating a new paradigm in financial services.
These individuals exist. Many are readers of this blog. I am one of them. So is Amy. We are connected to many more via our networks. I suspect that many of them would jump at the chance to participate in a venture (or ventures) like this. And not just because the financial opportunity cost of doing so has plummeted (although that clearly helps, everyone has bills to pay…) but because it’s exciting. Because it would be challenging. Because it’s the right thing to do.
So why not just do it? Why the government? Why a billion dollars? Because building a bank by bootstrapping from nothing is exceedingly difficult, perhaps impossible. There are many reasons, importantly:
The fundamental nature of the business – selling trust-based products and services in a highly regulated environment – means that the minimum level of operating costs and capital required to be credible is substantial.
Perceptions are important, especially in these turbulent economic times; no matter how abusive the relationship (with their existing bankers), people and companies are going to be initially very cautious about giving their custom to a new bank, especially one that is obviously not too big to fail (indeed the implicit endorsement of the government in this context is probably even more important than the capital itself.)
Much can be achieved within the existing legal and regulatory framework, but many of the most interesting opportunities rely on this “institutional framework” evolving to “catch up” to the technological and economic reality; having the government as a partner would facilitate the dialog and help to counter the inevitable resistance from incumbents who have a vested interest in maintaining the (old) environment to which they have adapted.
Because as a taxpayer if I am forced to invest in the old (to mitigate catastrophic systemic risk), I want to also invest at least a part of my money in the future (to help build and profit from the reinvention of banking): remove the cancer yes, but start working on the cure.
As for the billion dollars, this was just a nice round back-of-the-envelope (somewhat informed) guess (plus it fit with the song!); this would be sufficient equity to build an operation with credibility and critical mass, and would support a sufficiently large but conservatively leveraged asset base to produce enough operating income to sustain growth and profitability (and pay back the government in full over a 5-15 year horizon without jeopardizing the business.) The right (minimum) amount needed could well be less, is unlikely to be more and would not need to come 100% from government coffers – indeed private co-investment would be desirable – and further the bulk of the capital would likely be called over a period of 1-3 years as the balance sheet is built up.
I’m deadly serious but to be frank, I’m not sure where to go with this. Although I have a pretty interesting and diverse network that includes a number of even better connected people, I don’t think I’d have much success cold calling Mr. Brown or Mr. Darling and getting a chance to pitch this over a latte at the local Costa… Even less Mr. Obama or Mr. Geithner… But perhaps if nothing else, I can catalyze the conversation and bring this option – earmarking at least a small portion of the various btrillions of rescue funds to seeding a new generation of 21st century banks – to the attention of the politicians and the public.
I know there is a risk that this proposal sounds like just one more in a never ending line of petitioners going to the government for a handout. I hope that (at least, especially regular) readers will not doubt my integrity when I assure you that this is not my intent, and I genuinely believe that this is an idea worthy of serious consideration. And most importantly that – in this context - the government’s money is actually more valuable than anyone else’s. To get started. Essentially I’m suggesting the government(s) have a unique competitive advantage that makes them the ideal incubators for a new generation of banks (and that they would realize excess financial returns by exercising this advantage.)
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When I read this story on 
pops into my head…
Well now they are paying for it. We all are paying for it. ![Reblog this post [with Zemanta]](http://img.zemanta.com/reblog_c.png?x-id=5a146aa2-03b8-4e06-8804-34b683c960f2)
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and despite thousands upon thousands of articles, blog posts and editorials, I have been very surprised to see that one crucial element seems to be missing from all the solutions being discussed: innovation and entrepreneurialism. 
in the Board room. Banks that recognize that when you boil it all down, the product they are ultimately selling is trust.![Reblog this post [with Zemanta]](http://img.zemanta.com/reblog_c.png?x-id=fa42bf9d-8ac6-4c1b-9352-1646d9d5134a)
