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Financial Crisis: A Leadership Crisis?

Great catastrophes seem to occur suddenly and without warning, but on closer examination, it becomes clear that they had been years in the making.

As an example, consider the collapse of UBS in the recent finical crisis. The company seemed to get into trouble, all at once, in the credit crisis of the early twenty-first century. But years before the crisis, the company had begun a systematic process of investing aggressively in high-risk securities that left the firm in a vulnerable, even precarious position. The external economic crisis was merely the spark to the tinder.

The cause of this crisis, at UBS and many other financial organizations, was a combination of strategic mistakes, reckless investment decisions, and nonexistent control systems. The problem was created by executives who were propelled by a desire to achieve short-term profits, and facilitated by board members who demanded financial results and were not at all curious about the cause of what appeared to be success.

While attention is focused on the firms that found themselves in similar position during the financial crisis, little attention is given to other firms that were largely unaffected: well-run firms that were capable of withstanding a downturn in the world economy - and the fact that some weathered the crisis far better than others is an indication that the cause of crisis is not entirely external.

The Changing Social Perception of Companies

The author reflects on the trend in the 1980's, when deregulation and privatization swept through the US and European markets. Many state-owned companies were privatized and regulations that exerted control over private enterprises were scaled back considerably, largely coinciding with the fall of communism and the establishment of free-market economies.

Roughly two decades later, the pendulum has swung back in the opposite direction: the global economy has become stagnant, corporate growth has disappeared, and many large financial institutions have gone bankrupt or collapsed, and the faith in free-market economy has fallen to the point where there is widespread demand for nationalization and regulation of the private sector.

Specifically, the boom of the 1990s created the emergence of the "charismatic CEO," a maverick who disregarded the rules and achieved phenomenal economic growth, and gained a level of celebrity that rivaled that of a star athlete or popular actor. These individuals weren't entrepreneurs in the traditional sense - they did not found new companies to topple the complacent giants of industry - and many emerged within existing organizations. Instead, they revitalized existing firms p and did so by abandoning sound financial management: investing in high-risk ventures, borrowing heavily to finance speculative ventures, and disregarding the principles, rules, and even laws.

Their board of directors exercised little control, satisfied to let their charismatic executives run their firms, so long as the profits continued to roll in. In that sense, the purpose of this book is to do what board members failed to do: to consider the role of senior executives and the way in which their behavior results in the deterioration of their firms.

The underlying thesis is that there is a problem with the current consideration of the firm as an economic entity whose purpose is to maximize short-term returns for shareholders - which is an oversimplification that has not only enabled, but encouraged executives to ignore the long-term purpose of their firms. It has also encouraged opportunism, self-interest, and a lack of integrity.

The author suggests that confidence in corporations can only return if we return to long-term thinking, considering what consumers and society expect from a firm, and instill the board members and senior leaders to be responsible stewards of their firms. It is conceivable that firms may survive the current crisis without doing so, but it will only be a matter of time before the next one.

A second thesis for the present book is that the role of senior leaders in corporations has a wider impact on society that merely their customers and shareholders. Over the past century, the corporation has become a significant social institution, more powerful than church and state, and that the reckless actions of CEOs result in crises that affect not only their firm, but markets and the global economy.

The survival of the corporation as a social institution likewise requires a consideration of the long-term function of the firm, the role of the senior management, and the expectations of shareholders, customers, and society at large should have of them.

"All in all, we have to transform management into a more respected profession whose appeal transcends the ability to make money."

The role of the board of directors also needs to be rethought, as senior management of a firm are beholden to the owners of that firm. While a governing body cannot participate in the management of a firm's particular operations, it provides, or should provide, guidance and direction to the executives it has employed to do so.

In effect, the board of directors is the internal governance of a firm, and it is only when it neglects this duty that external regulation is necessary to do what the board has failed to do. But the board must likewise reconsider the function of the firm as a long-term enterprise: to simply command executives to make money, as much and as quickly as possible, with no regard for anything by the next fiscal year, is not sufficient, or appropriate guidance. And while the actions of senior management may have caused the crisis, it is the board who has encouraged and empowered them to undertake those actions.

In sum, good leadership on the part of executives and good governance on the part of boards are essential to building a respected company. Having them does not guarantee success, but lacking them does seem to guarantee failure.

Corporate Crisis: Some Drivers

There author considers five key "dimensions" that can be observed in corporate crises. They are not necessarily causes, but they do highlight specific areas of concern:

He means to explore each dimension in detail.

The explosion of corporate scandals

The 1990s was seen as a decade of rapid growth, particularly for western economies, that was largely powered by information technology. The "so-called new" economy arose from a more efficient use of information and improved connectivity between businesses, partners, and customers.

This gave rise to two problems: first, that the rapid growth led to a fixation on growth at any price; and second, the notion this was something "new" was an excuse to disregard as "old" the basic principles to be abandoned with little concern to their applicability.

The author suggests that the problem arose from treating corporate CEOs as if they were Hollywood celebrities. Before the disaster struck and their behavior was exposed, executives at Enron, MCU, RBS, AIG, and similar companies were considered to be extremely talented business leaders, solely because of their ability to generate revenue.

The crisis was particularly pronounced in the finance industry, where the raid increase in corporate activity created a high level of liquidity in financial markets: Credit became easily available and interest rates plummeted. This financial context paved the way for a booming real estate industry, in which banks and other financial intermediaries encouraged people to buy homes by providing highly attractive conditions.

The ability to quickly securitized subprime mortgages enabled the practice to become widespread very quickly, so that a very large number of firms had bought into the debt by the time the crisis became apparent. The giants of investment banking industry, having consumed the debt, fell sick in large numbers and in relatively short order.

(EN: My understanding is a bit similar, but traces the origin to the political institution, particularly the sentiment that credit and home ownership were declared to be rights that every citizen should have, regardless of his ability to repay, and it was the US government that pressed banks to make credit readily available, using FNMA and FMCC as puppets to buy subprime mortgages they encouraged banks to underwrite. The author seems to have a less detailed understanding of the cause of the crisis, but I believe his take to be plausible: while government insisted, I'm unaware that banks did much to resist or object, and eagerly seized the opportunity for a fast profit. It was likely mindless imitation of apparent success and greed for a quick profit that drove many other firms, even outside US borders, to adopt the same practices.)

From this, the author leaps to a conclusion: the crisis was a failure of leadership. It was a "spectacular lack of professionalism" in decision-making, a disdain for shareholders and employees, an exclusive concern with stock price, and a complete absence of ethical concern.

The emergence of the charismatic CEO

Prior to the 1990s, it was rare for a corporate executive to receive much attention from the media and the public: like most professionals, they were generally anonymous and, while the profession had some degree of respect, it was much in the nature of the same respect given to a lawyer, a doctor, or an engineer. They were not "media darlings."

In was during this era, particularly, in the technology bubble, that the names of CEOs bubbled up in the media and became household words and their entrepreneurial exploits were chronicled with the same passion as those of professional athletes. Almost overnight, executives went from anonymity to celebrity.

The taste for stardom, which gratified the egos of executives, also bedazzled board members and financiers, who put an unreasonable level of faith in star power: celebrity CEOs could count of getting carte blanche from the board of directors, and obtaining virtually unlimited funding from external sources, to do as they wished, on the blind faith that whatever it was, it would make a lot of money for investors.

(EN: Moreover, if some of the phrases that were uttered by executives during that era, might have come from an astrologer or a mystic rather than a business professional: one wonders how they managed to get away with it, except that it seems to be what everyone expects and accepts: the admiration for success becomes a replacement for logic, and it's given that something bizarre and unconventional must be good simply because it is not fathomable.)

Boards and CEOs: in search of balance

The author considers the rate of CEO turnover in large companies, which has increased significantly in recent years. Previously, a CEO would hold tenure for a long period of time, and the initiatives he undertook had a similar long-term perspective of maintaining the firm and upon leaving office, of having created a legacy that left the firm stronger than when he was appointed.

This notion has long disappeared, and it is not the CEO who is sole to blame: a chief executive is answerable to a board of directors who represent investors, and as the board's interest shifts from sustainability to short-term profit, the CEO is guided in that direction. Perhaps "guided" is too gentle a word: if the executive fails to deliver on their demands, the board will fire him and seek a replacement who supports their short-term agenda.

Celebrity status also contributes to this: an executive can no longer fail, or even fail to achieve a high level of success, in privacy. Every act he undertakes is subject to public scrutiny, and when he fails to achieve immediate success - whether it is a genuine blunder or merely following a slower and longer course - his reputation and that of his firm is publicly flogged, which creates a panic among investors who seek a fast solution to a public problem.

There is, at many firms, an imbalance of power between the board and the CEO that does not result in a meaningful discussion and consideration of the long-term success of the firm, but a demand for short-term solutions that may not be in the long-term interest of the firm. As the media feed on drama, disagreements are aggrandized, and there is little chance of achieving harmony while both sides are being encouraged to fight.

While the problem is often laid on maverick CEOs, they are a dying breed, and chief executives have become much weaker in recent years in comparison to the board of directions, who become increasingly involved in decision-making: not merely in guiding the firm, but controlling it on the operational level.

CEO compensation

The "remarkable growth" in executive compensation has been an embarrassment to failing firms, and is also a contributor to corporate irresponsibility: companies link executive compensation to specific financial targets on the assumption that this will reward executives for improving the performance of the firm. Where the firm does well under their leadership, the top executives personally profit.

The problem is: the measures to which compensation are tied are not linked to the health of the firm, but to short-term performance that can be boosted (to boost executive's personal income) without doing any actual good, and possibly by doing harm to a firm's long-term sustainability.

Unfortunately, public awareness of CEO compensation did little to curb the trend: rather than drawing consternation, the attitude of investors seemed to be that the compensation was well earned, as justified by the metrics on which it was based. (EN: There is great faith in numbers, often without any consideration of what the numbers mean, or if they are valid. This is a cause of much dysfunction, even on the operational level.)

For example, stock options were a very popular (and lucrative) component of executive compensation during the technology bubble, which coupled with irrational speculation in the stock markets, led to extremely high executive compensation, even to the point of seven-figure paychecks for executives of firms that never generated any income and had no signs of long-term viability. Fortunes were made in short order by CEOs who employed the trick of boosting enthusiasm without delivering any actual results, then making a hasty exit with their loot.

The lack of prudence and "deficient professional competence" displayed by boards in directors lack the capability to address the problem. But nevertheless, the author maintains that "governments should not intervene in these matters" but leave it to boards of directors to discover a solution that will be approved by those who have the most at stake - their shareholders.

One thing that the author proposes is the need for transparency, such that anyone can clearly understand the rationale for executive compensation, and question it where it seems unclear or ill-conceived. The example is given of Richard Russo, who was chairman of the US Securities and Exchange Commission, who was forced out of his post after details of his compensation deal were made public. If there were transparency in the first place, it's less likely that the compensation deal would have been so questionable, or even if it were unsound, it would have come as no surprise.

Another important factor is in tying executive compensation to factors that have a real impact on the long-term performance of the firm, rather than its short-term stock price. This would discourage executives from boosting the latter at the expense of the former, which is the source of the most damaging problems.

Institutional investors

It was first remarked in 1977 that capital markets were undergoing a change as a result of a greater number of individuals becoming passively involved in investments: specifically, mutual and investment funds were growing rapidly, each of which have many small investors who place their investments in the hands of professional fund managers.

The investors of such funds care little for the securities they hold, and many do not consider themselves to be investors. They monitor the performance of their investments but do not interfere in the work of their fund managers. Such investors care only about performance of their investment, and are indifferent to the identity of the firms in which they have invested.

This motivates the fund managers, who control their aggregated capital, to make investment decisions accordingly: that is, with an eye toward investment performance and an indifference as to how that performance is achieved by the companies in which they invest. Furthermore, because they invest in a broad range of firms, there could be conflicts of interest between the companies they managed or between the firms in their portfolio and that of a colleague who manages a different portfolio at the same firm. This increases their reluctance to take an active role in governing the firms in which they invest.

Simply stated, as long as everything is going well and the investment in the firm is making a profit, institutional investors tend to avoid interfering with, or every paying much attention to, the goings-on at the firms in which they invest. And in the instance where things are not going well and a company is struggling to make a profit, institutional investors switch their investment to another firm rather than using the voting rights of their holdings to encourage it in a positive direction.

The most significant consequence of this change is that private investors are more vigilant, and feel that ownership in a firm entails the responsibility to keep close watch over it and take decisive action - whereas institutional investors do not.

A common criticism of firms whose stock is consolidated in the hands of a few individuals is that their voting power overwhelms opposition: a few individuals who hold a majority interest can direct the firm to pursue their interest to the exclusion of the interests of minority stockholders or the company as a whole.

But the shift to a situation where most of the stock in a firm is held by institutional investors who are indifferent to the point of negligence is not better. When a firm is held mainly be institutional investors, the likelihood is that the majority of votes will be cast in favor of whatever plan the firm's executive officers propose. The net result is an even smaller number of individuals having control over the strategic direction of the firm.

Improved corporate governance is possible without government regulation - but it depends on the commitment of investors to govern their own firms. On the bright side, there are signs that this is happening: "The changes we have seen in recent years indicate that institutional investors are genuinely concerned," though there is the potential for the pendulum to swing back to the opposite extreme, where institutional investors become like the few private individuals who hold a majority interest in a firm.

The Role of Corporate Governance

The expectation of the different corporate stakeholders and society at large have dramatically changed in recent years, and the expectation placed on companies are often contradictory. For example, an individual who owns a mutual fund demands the best financial results; the mutual fund holds stock in the company that employs the very same individual and it is decided that the best way for the firm to increase profits is to eliminate his job.

Corporate executives are likewise subject to contradictory expectations: the board may demand that they take entrepreneurial initiative to pursue new growth opportunities, but if they undertake a new venture that is not immediately profitable, they may be punished in short order for failure to deliver financial results.

Retuning to the shrinking tenure of CEOs, it's clear that boards of directors have little patience an demand short-term results, and a CEO must maintain a short-term focus, to boost profits by means that may not serve the long-term interests of a firm, then make a hasty exit - to another position at another firm where he will do the very same thing.

The very nature of the arrangement in which there is separation of ownership (shareholders) and control (executives) creates a schism, but the author attests it is more significant now than ever before. This conflict of interests ultimately is detrimental to the ability of the company to prosper in the long run as well as preventing it from performing its societal function.

The author suggests that many of the shortcomings can be attributed to the system of corporate governance itself, which he means to explore in the present chapter.

Defining Corporate Governance

The author's definition: corporate government is the processes, rules, and institutions that determine how decision-making authority is exercised in a company. Its purpose is, or should be, to ensure the firm's long-term success and survival.

Governance is effected by the delegation of authority: the shareholders authorize a board, the board authorizes executives, executives authorize management, and management authorizes employees to undertake certain actions in support of corporate operations.

The mechanism of authorization is the decision-making power granted to individuals, which changes over time: an objective is defined, authority is granted, progress is monitored, and the objective/authority is revised if progress toward the objective is unsatisfactory.

A system of incentives and punishments is implemented to encourage or discourage desired behaviors, usually with the intention of providing a personal incentive to achieve the desired outcome.

All of this occurs within a corporation. When politicians speak of the concept of regulation, it is roughly the same - but it is imposing objectives upon a firm that it would not choose to pursue for itself, decrease the ability of the firm to achieve its desired outcomes, and generally insist on investment in activities that are contrary to the interests of the shareholders.

Much of the conflict we see in corporate governance, internal and external, arises over disagreement about the objectives a firm should pursue, or the manner in which the firm should act in order to achieve those objectives.

Regulation

When we speak of regulation, it is generally in regard to governmental authority, which is used to impose external governance on companies to compel them to undertake actions that are in conflict with their mission or the methods by which they would voluntarily choose to achieve it.

The author looks to the Sarbanes-Oxley act of 2002 that imposed formal and inflexible systems for cooperate governance that was in places unclear and self-contradictory - and which ultimately proved entirely useless in preventing the very kind of financial meltdown it was created to prevent, as became evident in the credit crisis that began just five years later. And given the amount of difficulty and cost undertaken by the private sector to comply with this regulation, it is an excellent example of bad governance, and bad government.

The author then considers the Cadbury Report which was compiled at the behest of the government of Britain: the purpose of this report was to consider the very nature and purpose of governance, and distinguish between governance and leadership, knowledge of which is essential to developing good legislation.

The report specifically considers the mechanisms by which governing bodies operate and establishes as a fundamental principle the limits to which government intrusion should be permissible: the core principle is "comply or explain," which enables companies to define their own practices and, where anything seems irrational, to have the opportunity to justify the deviation rather than comply with counterproductive and harmful legislation.

The Cadbury Report did not establish laws, but it provided a rational basis on which law should be based, as a method of mitigating the random, feckless, and even harmful sorts of legislation that occur when a governing body exercises authority in a moment of extreme panic, desperate to have the appearance of doing something, even if it happens to be the worst possible thing it might choose to do.

The author maintains that regulation is not the answer to the problem of corporate governance and, in many instances, the power to compel every firm to undertake the wrong course of action can exacerbate problems and hasten disaster by preventing those who are closest to the problem to do what is most obvious and effective.

Shareholders and Boards of Directors

The author suggests that "most shareholders would like to have more direct and stronger control over the board of directors" than they are presently given: they periodically elect a board, often merely to approve the reinstatement of existing board members or confirm the appointment of a new member selected by the existing board and are able to vote on very few decisions. He does concede that "other shareholders" do not wish to be actively involved.

Executives tend to prefer things as they are - and oppose giving more power to the shareholders, and cite a variety of reasons it would be undesirable: shareholders are not knowledgeable enough to make sound decisions, they cannot make decisions quickly enough, and they tend to issue directives that are unreasonable in that they tend to decrease the authority and resources necessary to accomplish an increasing number of responsibilities.

Ultimately, giving more power to shareholders and even boards prevents the firm from acting quickly, to pursue opportunities or counter threats where expediency is essential.

There is, however, no basic agreement for how to improve on this, and efforts have bees superficial: bringing independent nonexecutive directors to the board, protecting minority shareholders, ensuring the proper functioning of the meetings, and rooting out conflicts of interest. Such methods can be employed to address specific problems, but none of them address the more widespread problems that exist.

Governance and Ethics

Corporate performance is not the result of regulation, but is a result of the quality of leadership and management that governs a firm in setting a strategy and facilitating its implementation.

Consider law: a company that wishes to be respected as an institution must comply with regulators, but the regulators will not guide a firm to be successful and, more often than not, provides very little help in the way of guiding a firm to be successful or even viable. No company has ever excelled, or even achieved positive success, merely by obeying legal requirements.

Good leadership also requires ethics, though the author offers only a few scraps to suggest what ethics might be: personal integrity, service to the common good, respect for the dignity of the person, a notion of justice and duty.

More importantly, ethics cannot be imposed upon an individual by governance, internal or external: they can demand or forbid certain actions to be undertaken. The most sophisticated system of corporate ethics remains "little more than worthless papers" that do nothing to encourage ethics except to punish people in arrears, and often to punish those whose intentions were entirely ethical.

An important fact: many of the firms involved in scandals were in full compliance with legal requirements: that is, they found a method to behave unethically and remain within the letter of the law. That is, by legal standards, they were doing nothing wrong.

(EN: Another important consideration is the degree to which regulation that is arbitrary an ineffective causes ethics itself to be seen as counterproductive. That is, ethics are seen as not only dispensable in pursuit of success, but also obstructive of success itself. And it is often suggested that to be successful, one must bend or ignore the rules or work around the system of governance. And this is often true.)

Rethinking the Nature of the Firm: Reframing the Role of CEOs

The current crisis was not caused by the economy: the financial meltdown and the credit crunch are the results, rather than the cause, or the problem. The cause of the problem is that top managers at many firms chose to pursue goals and undertake actions that posed a threat to the long-term interests of their firms. The solution to the problem is not inventing new methods of governance, but reconsidering whether it was wise to have abandoned principles that have been disregarded.

The chief consideration is the firm's nature and purpose, which has not changed, and the roles and responsibilities of executives and board members as derivative of (or counter to) that purpose.

Specifically: firms exist to offer goods and services that customers voluntarily purchase. As social institutions, companies must be profitable and efficient, but short-term profits are not their sole objective. By adoption a long-term view, and considering themselves as a functional element in society, firms can be reasonably profitable and can also be effective drivers of progress within society.

Turning to external regulation (government) has become a widespread demand, but it is incapable of having a positive effect: it can proscribe actions that have been witnessed to have had negative effects, but inhibiting harmful behavior, even if it could be done effectively does not equate to encouraging positive behavior.

Governance can be improved by good practices and formal mechanisms, but the excessive emphasis on governance itself tends to overwhelm the purpose of a firm. A company is a group of people whose activity is organized to produce goods and services, generating economic value in the process, and it is driven by effectiveness, innovation, passion and leadership. Its purpose is not to follow procedures comply with policies, and its goals are not achieved merely by doing so.

Moreover, it is often the case that those who are in a position to place governance upon an organization are not motivated by the purpose of the firm, but are responding to ulterior motives: investors are more interested in achieving personal financial returns, politicians in making a positive impression on the voting public, than in improving upon the functional performance of a firm or tending to its long-term success.

Good leadership and governance are critical to the development of a successful firm, but it must be more than regulation and control: it must encourage the organization in a positive direction, one in which its purpose an long-term success are the primary consideration. It also requires leaders and regulators to work cooperatively, toward the same goal. The author suggests the board and management of a firm are analogous to a person's lungs: he can survive, but not prosper, if one has shut down and the other is barely functional.

In order to be effective, and in order for their firms to be effective, leaders and regulators should begin with a clear goal: to contribute to the firm's long-term success. This will by necessity include economic goals, but it must recognize that economic measures are merely metrics that gauge the success of the firm's strategy and the manner in which it executes upon that strategy. That is, a firm generates a profit as a result of providing a good or service customers purchase - if it puts profit first, without consideration of its function, it can do so, but at the expense of its reputation and long-term sustainability.

Not only does a firm need to put out a good product to be successful in the long run, it must also:

A good manager or regulator must integrate these objectives, and prioritize where contradictions and conflicts arise. Ultimately, the firm that is able to set long-term goals and achieve them will enjoy stability and financial success.

Pursuing the same things will also transform the firm into a more respected institution. A corporate brand is not respected in and of itself, but follows the respect people have for the organization on account of its behavior. Largely, this is dependent on the quality of the firm's product, but it also derives from the experiences that people have interacting with the firm outside their role as a consumer.

This can readily be witnessed in proactive: observe that the most respected firms are those whose chief concern is not generating short-term returns for shareholders, but long-term benefit to customers, employers, investors, and the public. Financial success is the result, not the objective, f good governance and management.

Some Final Thoughts

In this chapter, the author has identified a key cause of the corporate crisis and the erosion of corporate reputation: the focus on short-term financial results to the detriment of long-term functional success. There are a number of strategies that can be taken to weather and emerge from the present crisis:

First, and worst, is to undertake short-term actions meant to alleviate the symptoms of the economic downturn - to wait and hope for external conditions to improve and then, once the economy has recovered, go back to doing the same thing as it had done before ... until the next crisis inevitably occurs.

Second is to rely on government intervention. The author remarks that there is a trend in western nations to be more accepting of "big government" and to be passively compliant, and even among the public, otherwise-intelligent people seem to be in favor of the nationalization of certain industries, such as banking. The author has already described how ambitious government reforms failed to prevent a recurring crisis and the ways in which regulation is seldom the path to meaningful and lasting success.

The third option is to remember the nature and purpose of the firm and its role in society, and to assess its operations in light of that purpose. Economic efficiency and financial profitability are to be seen as the result of successful operations, but not their drivers. Best case, they should be considered in a historical context, assessing the effectiveness of the organization's past activities, and where they are lacking, to be considered as symptoms that require attention and investigation.

To achieve sustainable and long-term success, leadership and regulators must recall that a corporation is an organization of people, many of whom know and recognize the proper course of action to achieve success, and that leaders encourage and guide them in doing so.

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