Management and the financial crisis ('we have met the enemy and he is us ...').

• Author: Sahlman, William A.

The current model of corporate governance in the United States and abroad is badly broken and has been for many years. The financial crisis has revealed the degree to which there are problems. Neither managers nor boards of directors foresaw or prevented the massive value destruction that took place at companies like AIG, Bear Stearns, Fannie Mae, General Motors or General Electric. Nor did external private monitors like the media, securities analysts, credit analysts or ratings agencies raise sufficient warnings about building dangers. Certainly, public agencies like the Federal Reserve, FDIC and the Securities and Exchange Commission did little to preclude the financial conflagration.

The assertion that systemic failures of corporate governance caused the economic crisis is perhaps controversial. Some argue that lack of adequate regulation combined with excessive corporate greed was sufficient to cause the problems. If regulation had been more stringent, or executives less greedy, the crisis would have been averted.

Yet, I wonder what corporate manager would with hindsight have wanted what has happened to happen. Everyone, including those who behaved unethically and those who were consumed by greed (some overlap), ended up getting battered. Surely, independent of the existence of a strong and competent regulatory regime, sensible actors would have self-policed. Even greedy executives would not have wanted to see their companies disappear or their net worths vaporize.

Given the nearly universal harm inflicted by the crisis, one has to wonder why managers and boards of directors engaged in such risky behaviors and failed to protect themselves, their companies, and any other constituencies, from employees to communities. Even if their only stated objective was to "maximize shareholder wealth," they failed beyond all reasonable measures.

So, what went wrong? What should managers have done to protect their company (and the world)? What should boards of directors have done? What should regulators have done? What should investors have done? An interesting and parallel question is: What could they have done?

I believe that there are ways to improve how our global economic system operates but there are no magic bullets. Every aspect of the system needs change - from government accounting to corporate board roles and structure - and changes to any single element of the system will fail unless all elements are changed. The most important and most difficult changes are those required of corporate managers. Managers bear a disproportionate share of the responsibility for what transpired and therefore for what must change.

Sadly, there seem to be few new lessons from this crisis. What happened recently has happened before though perhaps not at the same scale. There were some unique contextual factors that created and sustained a larger and more pervasive than average financial bubble, but the underlying managerial failures were no different than in previous episodes of financial excess. Managers made dangerous and foolish decisions, consumers and investors engaged in risky behavior, and regulators were ineffective. Greed played a role but the bigger problem was incompetence.

The world is in the middle of a difficult period of adjustment and reflection. Most of the attention seems to be devoted to changing regulatory structures and rules that affect corporate governance and the financial markets. The changes that result will do little to decrease the likelihood or magnitude of the next bubble-panic cycle. The root causes of such cycles are deep and unlikely to be addressed through public policy or other external means.

I assert that most of the problems evidenced so prominently during this financial crisis can be traced to failures in five related managerial systems inside each major private and public actor in the financial markets:

* Incentives--how risk and reward are shared; how people behave if they act in their own perceived best interests given the structure of pecuniary and non-pecuniary payoffs

* Control & Information Technology--how limits are placed on behavior; how information is captured and shared; how risk and reward are measured and how those assessments affect tactics and strategy

* Accounting--how managers choose accounting policies; how managers measure economic profits & losses, as distinct from GAAP profits and losses

* Human Capital--the process by which people with certain characteristics (skill, experience, networks, character, and attitude) are attracted and managed or encouraged to leave any organization

* Culture--the values that guide individual and group decisions

Enduring, successful companies have outstanding people (high skill and integrity); sensible accounting policies that mirror economic reality; excellent information, risk measurement and management systems; and, sensible incentives that balance personal and corporate risk and reward. These companies have a culture of doing the right thing that protects all major constituencies even when doing so doesn't maximize personal payoffs. Companies at risk have some combination of the opposite.

To see how the systems work individually and together, consider a group of securities traders at a Wall Street firm. Typically, traders are given strong incentives to make profitable trades--they get a big payoff if they do well. If they don't do well, they don't have to repay losses though they might be fired. In the U.S., getting fired does not necessarily preclude getting another job in the same industry.

Everyone knows that traders engage in a practice called doubling down; for example, if they put a trade on that goes against them, they want to double their position to make back the money they have lost and more. Or, they want to bet big on trades in which they have conviction.

Managers in charge of trading operations know that they have to pay close attention to the integrity, judgment, and skill levels of traders. They need to watch out for traders who take positions that are too large and too risky for the firm as a whole. They develop systems that track exposures by traders as well as aggregating the positions of all traders at the firm.

Finally, managers need to pay close attention to three related issues. They need to make sure they understand all aspects of a set of related trades so that they know the true net economic position and don't confuse profitability in one side with losses in the other. They also need to make sure that the reported values of securities in a trade are true market prices, not wishful thinking (or subterfuge) on the part of the traders. And, they need to distinguish between economic profits and accounting profits, which sometime differ by wide margins, particularly with regard to time horizons and risk.

In the past 20 years or so, there have been some remarkable examples of serious financial problems caused in firms whose managers failed to manage traders effectively. Examples include Societe Generale and Jerome Kerviel (loss of $7.2 billion), (2) Baring Securities and Nick Leeson ($1.3 billion), (3) and Sumitomo and Yasuo Hamanaka ($2.6 billion). (4) In each case an individual or a small group of individuals engaged in trading behavior that resulted in massive losses to the parent company. Typically, the individual could have earned a big bonus--in the millions of dollars--while the company lost billions of dollars, and, in some cases, failed completely.

That is the essential challenge in trading operations--attract highly skilled, honest traders, give them a share of the upside, watch them like a hawk to guard against risky and/or self-interested behavior, measure their risks and rewards accurately and continuously, and nurture a culture that protects and guides the organization. If managers mess up any element of the system they risk ruin, as has been shown many times.

This basic managerial challenge extends beyond financial trading operations. In many organizations, to illustrate, the sales staff has strong incentives to meet quotas on a quarterly or yearly basis. Some salesmen cross over the legal and ethical boundary to meet or beat a quota, an activity that tends to occur in the last few days of the relevant period. They might get a customer to agree to buy a product while guaranteeing they can return it after the quarter. Or they promise future services that would disqualify the transaction as current revenue. Indeed, at the company level, senior managers have some of the same incentives as the sales force, given the pressure to meet earnings estimates at the end of the quarter and the high levels of management stock ownership that characterize many public firms.

That there are pressures to accelerate/overstate income or defer/ understate expenses is not a blinding insight or necessarily a problem. Issues arise, however, if a firm has no internal controls that anticipate and deter such behaviors. Or, even more dangerous, if a company has a weak (or worse) ethical culture and no clear guidelines for how decisions are made independent of formal controls, then the pressures can be exacerbated. Such cultures tend to attract people prone to ethical and even legal lapses.

In studying the financial crisis as it unfolded over the past couple of years, it seems clear that many organizations suffered from a lethal combination of powerful, sometimes misguided incentives; inadequate control and risk management systems; misleading accounting; and, low quality human capital in terms of integrity and/or competence, all wrapped in a culture that failed to provide a sensible guide for managerial behavior. This assessment refers to financial services firms like Countrywide, AIG and Bear Stearns: it also applies to other actors like regulatory agencies, politicians, ratings agencies and probably to individual consumers.

One doesn't need to look far to find evidence that my assessment of the problem has merit...