Is Bernie Sanders Right About Glass Steagall?

By Roy C. Smith

Yesterday Sen. Bernie Sanders announced a seven-point plan to rein in Wall Street greed once and for all by “breaking up the big banks and re-establishing firewalls that separate risk-taking from traditional banking.” Sanders is a populist, so of course his plan has a populist ring to it; but, nevertheless the plan ought to be analyzed on the merits.

The key feature of the plan is to re-impose the 1933 Glass Steagall Act that separated traditional banking from the securities business, and which Congress repealed in 1999.  Much resisted by Wall Street when it was passed, the law changed the competitive environment of the US financial system, but led to fifty years of stability in banking and the development of robust capital markets that enabled companies to obtain large amounts of financing for longer term, riskier projects. By 1983, the US capital markets were the envy of the world and efforts to import US financial market technology and knowhow to Europe and Japan were well underway.

However, a global banking crisis began in 1984 with the Federal Reserve’s takeover of Continental Illinois Bank, which failed because of poor credit risk management and the consequent inability to roll over maturing deposits from large financial institutions. Other large banks had similar problems, so the crisis ultimately spread throughout the US, and then migrated to Europe and Japan, where, like the US, a Glass Steagall-type of law was also in place. Many banks had to be rescued by government funds during the fifteen years or so that the crisis endured. However, the suppression of bank lending imposed by government rescuers further shifted financial activity to capital markets, where corporate needs during the relatively high growth years of the 1980s and 1990s were fully met.

After the crisis, the banks realized that much of their business with large corporations had been disintermediated to capital markets where short term working capital could be raised more cheaply in commercial paper, medium tern notes and bond markets in the US and the Euromarket. The banks complained that their European competitors could participate fully in capital markets, but they were losing business because they could not. Bank loans, too, had become tradable in markets and had, partly through developments in derivatives technology and capacity, become integrated into fixed-income securities markets. Further, they argued, the Basel Accord that set a minimum requirement for risk-adjusted capital adequacy had been agreed, so another crisis was unlikely. It took several years to build support, but Glass Steagall was repealed in 1999.

After the crisis in 2008, governments around the world once again poured funds into large banks to prevent their failure and domino-like contagion of the problem throughout the global financial system.  The rescues involved several trillions of dollars (mainly expended by central banks through lender-of-last resort and market support activities) but stabilized the global financial system within a few months. 

Three observations of this history are worth making.

One – Glass Steagall did not prevent the banking crisis in the US and Japan in the 1980s and 1990s. Nor did the Basel Accord prevent the crisis of 2008.  Regulations don’t always accomplish what they intend.

Two – the crises involved many performance-oriented banks all around the world that were following similar business strategies in competition with each other (though under an extensive regulatory regime). These strategies focused on enabling companies and financial institutions to take on risk and projects necessary for growth. It was not just because of unlawful conduct, greed or incompetence that the crises occurred; it was much more a matter of systemic market failure. 

Three – government intervention was the only way that the financial system could be saved from total collapse with much more severe effects on the real economy than actually occurred. Too-Big-to-Fail policies were indeed necessary; the government was the only source of funds to act as a lender of last resort under such circumstances. Taxpayers actually made a considerable return on their investment in such programs as TARP and stabilization efforts by the Federal Reserve when these positions were unwound.

After the 2008 crisis when Congress was debating the Dodd-Frank Wall Street Reform and Consumer Protection Act (passed in 2010), a re-imposition of Glass Steagall was considered.  The arguments for it were that banks had become too big, clumsy and herd-like (and greedy) to manage market risk well enough to avoid the possibility of a future failure. The easiest way to reduce this risk would be to make banks give up capital market activities.  There was merit to the argument (that also applied in 1999) but banks strongly resisted a one-size-fits-all policy that would permanently bar banks from capital markets where three-fourths of the capital raised by large corporations occurred. They also objected to a policy that would affect them but not their foreign bank, or US non-bank, competitors.

Another argument was the extent to which bank lending had become integrated with securities markets, making activities difficult and expensive to separate, monitor, and enforce.

In the end, Dodd-Frank did not separate banking and securities businesses, or force banks to reduce themselves to smaller sized entities, but it did many other things that give much more power to regulators to control the financial system, and limit risk taking by banks. Dodd-Frank claims that it has eliminated Too-Big-to-Fail situations in the future, but it attempts to do so not by restricting their bigness (except in terms of a maximum market share of US bank deposits), but by restricting the amount of risk of failure than the banks can take on.

Dodd-Franks defines “systemically important” banks as those with assets greater than $50 billion (about 40 US banks), which are to be subject to much tighter regulations than non-systemic banks. It also empowers the government to designate “systemically important non-banks” (the so-called “shadow banks”) and to regulate these the same as the large banks (four non-banks have been designated as systemically important so far). 

Dodd-Frank has many other provisions, including annual stress tests necessary to pay dividends, regulation of proprietary trading (“speculation,” which Bernie wants to tax), derivatives markets, executive compensation, rating agencies (Bernie wants to force them to become non-profit organizations), and consumer protection.

The irony of all this is that the weight on the big banks of Dodd-Frank, Basel III (a tough upgrade of the original Basel Accord), and various new national banking rules around the world, has made it very difficult for banks to comply with all the new regulations and still make a return on investment greater than their cost of equity capital.  Almost all of the major banks have failed to produce a net positive return on equity since 2009, so all are required to alter their basic business models to enable improved returns.

Accordingly all banks have their eyes on one of their own, Well Fargo, which has sailed through the regulatory changes relatively unscathed.  Wells, essentially a retail and consumer bank, never had a very extensive capital markets activity beyond what was needed to service its mainly small and mid-sized corporate clientele. Today it is the world’s largest bank by market capitalization, trades at 1.7 times its book value (the rest trade at an average of about 1.0x), and generates 5% net return on equity (after subtracting the cost of equity).

For big US banks like JP Morgan Chase, Citigroup and Bank of America, the best approach to modifying their business models as a result of regulatory changes may be to spin off to shareholders their riskier and more capital intense investment banking units. Doing so would improve shareholder returns, make regulators happier and enable their investors to participate in two different, but separate, business models. Doing so would also, de facto, break up these banks as if Glass Steagall had been restored.

Bernie Sanders probably has the right idea about what would be good for the banks and everyone else. But, restoring Glass Steagall is not necessary because Dodd Frank imposes so much regulatory weight on them that their best way forward may be to break themselves up.

But, the banks haven’t done so yet, and don’t seem to be inclined to do so.

Maybe things will be different by the time of the election, or by 2017 when the new administration will be pulling its legislative agenda together. But, if Bernie should somehow pull off a win, then he still has to face a Republican House or Representatives (and maybe a Republican Senate to), which will make his financial reform package tough (probably impossible) to pass.

Happy New Year from Rosie

by Roy C. Smith

Yes, it has been an ugly year.

We’ve had Syria, terrorism, the refugees, a collapse in oil prices, a European sovereign debt crisis, trouble with China and Russia, and world economic growth slumping towards a pathetic 3%. And we have had Trump and the Republican wannabes that make Hillary look good, and a lot of other stuff that has taken the winds of confidence out of our sails.

Unemployment is down to the 5% level, but only 63% of the workforce has jobs, the lowest percentage since 1978.

US stocks are likely to end the year in the red for the first time since 2008, but investors are nervous about rising interest rates without seeing much to look forward to in the general economy.

So, I asked my old friend Rosie Scenario out for a holiday drink, to see if she could cheer me up.

“You’re too gloomy,” she said.

It is true that the US economy has had a rough fifteen years, with two financial crises, a Great Recession and a war in the Middle East that has cost $4-$6 trillion and still isn’t over.

But, she added, after a prolonged period of slow economic growth that has averaged barely 2% per year, things are settling down for a long-term recovery.

The Fed has decided that after eight years the economy is strong enough to leave to its own devices, so it has ceased its price-distorting QE interventions, and allowed rates to rise a little, at least symbolically. Both regulators and litigators have hammered the banks, but corporations have been able to get what they needed from a record level of new bond issues, and consumers and small business are getting a boost from “peer-to-peer” lending, “fintech” and from private equity funds.

The traditional economic “factors of production” – wages, resources, capital and enterprise – still at low costs, are ready for another round of expansion. Real estate activity is up about 10%, consumers have cleaned up their balance sheets and are active again. US GDP for 2016 is expected to be about 2.5%; not great but better than it has been, and building up momentum for a push in the right direction.

Rosie also sees the international situation also looks better than it did.

It has been bleak, she said, but the worst is over. The EU and the euro looked like it might be shaken apart by its sovereign debt crisis, but Angela Merkel and the ECB showed they had the clear head and courage to commit the resources needed to settle things down. The hodge-podge economic union of 28 states, with a common currency used by 19 of them, has survived its first serious existential crisis and is stronger for the experience.

A bigger set of problems now exists in the BRIC countries that are also facing existential issues. Brazil has been affected by collapsing commodity prices and high inflation, but its main problem, like Argentina’s, is political, and can be turned around by a new government.

Russia’s GDP will be down 3.6% this year, mainly due to oil prices, but Putin’s machismo behavior that drew sanctions over his Ukrainian actions has added to his difficulties, and sent him a message – his fifteen years of domination of Russian politics has been enabled by a robust growth in per capital GDP, but because of the recession and the collapse of the ruble, GDP per capita (in terms of current prices) will be 40% less in 2015 than in 2013.

Putin knows that strong, authoritarian leaders in Kiev, Cairo and Tripoli have been brought down by public protests, and seems to realize now that further confrontations with the US and the EU will only make his economic problems worse. After all Europe is Russia’s biggest customer for its oil and gas, and increasingly there are alternative sources of supply available to it. All in all, Putin is likely to end up more helpful than we expected in Syria and Iran, and start to make nice again to get back into the good graces of the EU. Maybe the UN’s agreement to secure a cease-fire in Syria, in which Russia played an important part, is an example. 

China, too, faces big issues in the next few years – it has to be able to deliver economic growth sufficient to satisfy the billion or so Chinese who are not yet among the middle class but aspire to be there. Growth has fallen from 12% in 2010 to 7% in 2015, with government expectations of 6.5% in 2016 (and others looking for less). Efforts to confront falling growth rates resulted in a stock market bubble that burst last summer. Serious government efforts to stabilize markets were not very successful, showing the limits to its power.

Indeed, China’s growing influence in the world has been a result of its extraordinary growth over the last thirty years. A slowdown in growth rates to a more normal level brings many challenges to the Chinese government -- domestically to avoid pressures for the level of political freedom that rival Taiwan has achieved; in South East Asia, where Chinese bellicosity has been fueled by its rising economic power; and in the broader world where China has been accepted as a superpower, but without showing it has the capacity to remain one.  It is hard to see how China’s Communist Party can remain in power without a transition to a more open and democratic state in the future. Slowing growth rates may accelerate this process, which would be good for China, its neighbors and trading partners.

Terrorism is still a big issue, Rosie says, but nowhere near as big as we (and our political candidates) make it out to be. Radical Islam has been most dangerous to other Muslims in the Middle East. It has been less dangerous in Europe, but of course its profile there now is very high (and likely to get the attention it needs). In the US since 9-11, terrorism has been less dangerous than school shootings; so far consisting only of radicalized individuals or small groups operating on their own.

In the US and the EU, terrorism is largely a police issue and the more incidents there are, the more cooperative police become with each other in developing their abilities to prevent attacks. In the Middle East, military force will be needed to contend with ISIS, but it will have to be supplied by Middle Easterners.

Finally, Rosie thinks our wild and awkward political process is likely to produce the best of all possible results.

The drama of primary elections is necessary in a country of 330 million people, who have different things to say about issues and want to vent about them. Sure, candidates say and do whatever they can to attract votes, but in the end, it winnows down to two (or possibly three) viable candidates, who stimulate the economy with billions of dollars of spending on advertising and other expenses. After the election, we either have a “divided government,” i.e., one in which the Presidency and the Congress are not controlled by the same party, or we don’t. If we don’t, then the party in control can enact whatever platform it can get by a 60-vote hurdle in the Senate. That condition doesn't occur very often, and is unlikely this time.

If it doesn't happen, the country will muddle along somehow, with minimal changes in major political or economic positions. When no one gets what he or she wants, not much actually happens. We can live with that, especially if it keeps stuff we really don’t like from being enacted.

The President, of course, can start wars or other military engagements that are hard to get out of.  After a year or more of listening to the candidates, we will know which are more warlike than others. Whatever it thinks of any candidate at any particular time, however, the American electorate has very little enthusiasm for wars in the Middle East or anywhere else.

Meanwhile, after a tumultuous year, the new Speaker, Paul Ryan, managed to get the House Republicans (and the others) to pass a $1 trillion government-spending bill, rather than shut down the government.

So, all in all, Rosie says, things are also messy, but the US will continue to be the strongest economy in the free world, positioning itself through market actions for a return to higher growth rates. The rest of the world is sorting itself out for the best, and our politics aren’t as bad as they look.   

Well, Rosie has always been able to cheer me up (at least for a few weeks), and maybe she will cheer you up too.

Happy New Year from us both.

Did the Fed Really Curb its Emergency Lending Powers?

By Roy C. Smith

Last week the Federal Reserve announced that it would adopt restrictions imposed by Dodd Frank to limit its emergency lending powers under Section 13(3) of the Federal Reserve Act, but it now has even more room to act in the next crisis.

Section 13(3) provisions allow the Fed to lend funds to any entity outside the banking system if circumstances are deemed to be “urgent and exigent.”

In 2010, a Congress angered by federal “bailouts” of banks and other financial institutions passed the Dodd Frank Act, including in it an amendment to the Federal Reserve Act of 1913 to limit 13(3) programs that enabled loans to Bear Stearns and AIG during the financial crisis. The amendment requires such programs be limited to those with a “broad base” of eligibility (now interpreted to mean involving at least five different participants) that are also approved by the US Treasury Secretary.  The idea is to limit 13(3) to only being able to provide liquidity to multiple, solvent financial institutions in times of crisis.

It took the Fed five years to come up with these new rules to implement the amendment, despite its being spurred by Senator Elizabeth Warren, Representative David Vitter and others in Congress from both parties who seek to limit the Fed’s powers.

The Fed’s action, according to Congressman Vitter, “is the first real acknowledgment from the Fed that it needed to do more to curtail its own bailout authority.” 

The new rules will prevent the Fed from lending money to prop up a single failing firm, said Fed Chairman Janet Yellen. Both the Bear Stearns and AIG rescue operations were considered crucial to the 2008 effort to stabilize the financial system by both Ben Bernanke, then Fed Chairman, and Hank Paulson, Treasury Secretary at the time.

But a lot has changed since 2008 that makes the one-off emergency lending powers of Section 13(3) less important to maintaining stability.

First, there are no longer any potential too-big-to-fail financial institutions that are outside the orbit of regulatory control established by Dodd Frank for “systemically important” financial firms.

Of the five large, independent US investment banks existing in September 2008, only two have survived and both are now bank holding companies regulated by the Fed. And, four of the largest other US nonbank financial firms have been designated as systemically important by the Dodd Frank authorized Financial Stability Oversight Council, thus requiring them to be regulated by the Fed and subject to enhanced capital controls, intervention and other constraints that should reduce systemic risk, and thus the need for a future 13(3) loan.

Other large nonbanks (e.g., Fidelity, BlackRock, and some hedge fund groups) have successfully argued that as managers of other people’s money through hundreds of different investment vehicles, they should not be considered as a single entity whose failure would have systemic effects.  So far the Fed has bought (or has been forced by political pressures to buy) into these arguments, so presumably it would have no reason to assist them in a crisis.

So, the lost power to intervene in individual cases of systemic risk is now a power no longer needed. However, since September 2008, other powers available to the Fed to avert and manage crises have been greatly increased.

Dodd Frank conferred additional authority and influence on managing systemic risk to the Fed. It now conducts annual qualitative stress tests on large banks and can deny those who fail the ability to pay dividends or do other things. The Fed also sets capital adequacy levels, leverage limits, and the requirement for “total loss absorbing capital” (in which bond holders participate in losses). It monitors banks closely and has the power, and apparently the will, to force them to remain in safe waters.

The banks have complied with the Fed’s post-crisis requirements, so are safer. But this has meant that much of the financial risk the banks used to carry on their balance sheets has migrated into capital markets and the nonbank sector.

This sector is a multitude of nonsystematic firms that operate in financial markets, but it is not directly subject to Fed regulatory control.

But, don’t worry, the Fed has found important ways to assert de-facto control over the nonbanking sector too.

This is done through market intervention programs, in which the Fed, through asset purchases, can inject large amounts of capital to preserve market functionality and alleviate liquidity panics. After September 2008, the Fed began an unprecedented effort to stabilize financial markets across the board, ultimately expanding its balance sheet to $4 trillion from less than $1 trillion.

Indeed, as early as March 2008, after Bear Stearns was rescued by JP Morgan (with Fed assistance), the two-dozen or so authorized market makers in Treasury securities were struggling to maintain their funding arrangements. As a result, the Fed established a temporary Primary Dealers Credit Facility and Term Securities Lending Facility to assist them. This was the first time in the history of the Fed that it had provided funding for nonbank broker-dealers in its efforts to maintain market stability.

These programs usually are ended after stability returns, but the Fed seems comfortable in starting them up whenever they seem to be needed.

Today, as a result of capital and other constraints, many banks have reduced their exposure to the repo markets, and nonbank money market funds and other participants have increased theirs. Consequently, in 2013 the Fed offered a $300 billion Reverse Repo Facility to assist dealers in this important market.

If a problem in the nonbank sector should require it, the Fed can intervene more precisely by declaring a 13(3) lending condition after designating five or more intended recipients in order to stabilize their broad based ability to roll over maturing liabilities of their own or of funds they manage. This would be within the scope of the new rules, even if only one firm (targeted for assistance) actually used the facility.

Though there are many in Congress who would like to clip the wings of the Fed further, the Fed is more powerful than ever. "We're perfectly happy now that there are alternative ways to deal with a failing firm,” said Ben Bernanke recently, “the Fed doesn't have to intervene in [individual cases] the way we did in 2008."

And, he might have added, what we have learned from our various intervention efforts has increased our confidence that when another crisis comes we will have the tools needed to meet it.

Building the European Champion

By Brad Hintz and Roy C. Smith

Barclays, Deutsche Bank and Credit Suisse have all announced plans to cut back capital market activity under new CEOs brought in to revise the business models.  What to do with the investment banking remnants is the difficult part, but an imaginative solution is available.

The three European universal banks have used investment banking as a way to supplement slow growing domestic banking and subscale asset management businesses. Over many years, going back to Big Bang, they have poured their dreams and capital into acquisitions of businesses and talent that they hoped would enable them to occupy the high ground of global capital markets, only to encounter wave after wave of pain and suffering. Finally they appear to be bowing to the inevitable – cutting back investment banking to the bare minimum needed to sustain and protect their basic banking businesses, and, one way or another, jettisoning the rest.  

What makes this difficult to do is that investment banking represents 20-40% of these banks net revenue, and over half of their balance sheet. What makes it good to do is that at least 70% of their troubles come from this culturally alien business that they have all had to engage mostly American hired guns to manage. 

The lost income and the prestige will be missed, but the impaired balance sheets and the debilitating exposure to regulatory constraints and litigation will not. Getting rid of the troublesome investment banks leaves the parents with much diminished scale and more limited aspirations, but the rebooted banks would be able to concentrate on their commercial and retail businesses and have a chance to improve their stock prices considerably, as UBS has done, while greatly easing the minds of their regulators.

But transitioning out of investment banking is not easy. A simple solution might be to transfer some portion of the unwanted assets to the non-core pile and liquidate them over time. Doing this might release required capital of 10% or so held against risk-weighted-assets (RWA), but the liquidation itself is likely to require haircuts that would consume most of it.

We looked into Barclays Chairman John McFarlane’s suggestion that a “European champion” capable of competing with the Americans might be put together from among the parts of the European players.  We studied a combination of Barclays Capital and Deutsche Bank’s investment bank, two of the strongest, to test the feasibility of the idea. 

In terms of market share, the idea is compelling. With over $28 billion in revenues this new European champion would command a number two market share in fixed income trading, number three in institutional equity trading, and in investment banking it would hold the leading market share in both debt and equity underwriting and would be number two behind Goldman Sachs in mergers and acquisition advisory. Even if one were to assume a 10% client defection this new combination would remain a top three investment bank with powerful positions in Europe, the USA and Asia.

The regulatory capital position of the new entity looks reasonable with an equity capital to RWA ratio of 12.9% compared to a 13% ratio for the Goldman units. On a pro forma basis the new entity would generate an 8.2% ROE in 2014 versus Goldman Sachs estimated ROE of 9.4% in its investment banking and trading businesses. This performance remains below the cost of capital for a standalone investment bank but the potential for some merger synergies, balance sheet rationalization and a shift in the mix of the product portfolio makes a 10% ROE a reasonable near-term goal.

But there were some problems.  The combined balance sheet of the new firm is 50% larger than Goldman’s balance sheet due to the new firm’s heavy reliance on fixed income sales and trading and therefore the pro forma leverage ratio is too high. It's RWA to asset ratio also is suspiciously low which may imply challenging regulatory discussions in the future.  All this will require further surgery and adjusting to shrink the trading units to a more reasonable size with a balance sheet able to secure a BBB debt rating.

For such a combination to work it will require new some new entrepreneurial energy, capital and resourcefulness beyond what’s available at the parent banks. This could be obtained by pairing up with one or more private equity investors to build a new, viable business outside the EU banking regulatory regime, though the firm most likely would be considered a SIFI and subject to Basel and some other rules. The new investors would assemble a high-grade, well-incentivized management team from the best in the business that would pull together such other assets and talents it needed.

The new firm could be funded in part by offering cash, some debt, Buffett-like preferred stock, or equity to banks selling the RWA, and by selling LP interests to institutional and other investors. Ultimately the new firm would present itself as an independent privately owned investment bank, with managers and employees owning significant stakes. It would hope to have an advantage over the banks in attracting both top talent and capital.

Such a solution is complicated, but doable. The large discounts from book value at which Barclays and Deutsche Bank stocks currently trade leave room for negotiations that incentivize new investors and still recover shareholder value for the banks.

Barclays has selected Jes Staley, an American investment banker, to become its next CEO. Although this suggested to some that Barclays was committed to retaining its commitment to investment banking, a different message seems more likely. As McFarlane surely knows, and Staley will soon find out, the future of Barclays Capital after ringfencing in 2019 is bleak. The two thus will be forced to look for alternatives to simply continuing as before. What exactly they or the other banks will do we will have to wait to see, but Barclay’s choice for its next CEO, with long experience in asset management, and more recently with hedge funds, understands the private equity terrain very well and would know how to explore a solution from that direction.

 eFinancial News, 9 Nov. 2015

Preventing the Next Existential Moment

By Roy C. Smith

VW is facing an existential moment, one like BP’s after the Deepwater Horizon oil spill that cost its shareholders $70 billion in market value. Surely, someone on VW’s Supervisory Board must have asked “what could we have done to prevent this from happening?”

The same question must have been asked by the Boards of Directors of the dozen of so major banks who between them have paid out approximately $200 billion to settle lawsuits brought by the US Department of Justice, the Federal Housing Authority, the SEC, the CFTC, State Banking Regulators, and British and European regulators since 2008. 

These various and numerous regulatory offenses leave the impression that today’s Big Business firms ignore or deliberately flaunt laws and regulations intended to contain their power and influence.  Observers must wonder whether anyone has ever asked the question of any large corporate board members.

There is, alas, little evidence that anyone has.

Boards are the bodies charged under the law with looking after the interests of the shareholders of private corporations.  They are required to appoint CEOs, but otherwise their duties are unclear, having to do with “monitoring” things, making sure takeover offers are handled fairly, looking after social responsibilities, and, of course, avoiding the existential moments.

How to prevent those moments from occurring is of utmost importance to their shareholders, so boards need to consider some different approaches to doing so. Here are four ideas:

Challenge Strategies

Boards not only appoint CEOs, the CEOs establish business strategies that boards must approve and fund. This may include VW’s strategic initiative to use its diesel engine performance to rise to the top of the auto industry.  If people independent of management had challenged this idea rigorously then the plan’s Achilles heel (they can’t do it without violating emissions standards) might have been revealed.  But it wasn’t.

After the merger of Citicorp into Travellers to form Citigroup, there were dozens of other mergers of big banks.  None were seriously challenged by their boards, all of whom seemed to go along with the idea that being bigger was always better, even when it plunged them into a realm of new businesses and risky activities they knew little about.  Almost all of the litigation settled by the major banks is the result of missteps in trading, underwriting, mortgages, or other activities the banks were not in a decade before.  More pushback from the independent board members (supported by their own experts and advisors as needed) might have made a difference. At least they could have focused attention on the difficult implementation of the strategy that proved to be their Achilles heels.

Rethink Middle Management

Goldman Sachs became a public company in 1999 after 130 years as a partnership.  It wanted to preserve some of the uniform cultural and managerial aspects of the partnership, so it devised a different kind of management structure from other banks, one that put a lot of emphasis on middle management to enforce professional standards for the whole firm.  Today, Goldman Sachs has about 34,000 employees, of whom 2,100 or so are Managing Directors, the firm’s principle culture carriers.  Of these, approximately 20% are Partner-Managing Directors, a senior position that is entitled to partner-like compensation based on a share of the whole firm’s annual income. Managing Directors are selected based on their performance as middle and upper mangers responsible for revenues, risks, costs and legal exposures.  The units they supervise are under constant surveillance to maintain high standards, and to detect and prevent any form of misconduct or wrongdoing. Things fall through the cracks sometimes, but with 2,100 of these guys continuously roaming the halls, there are fewer accidents than might occur otherwise.

Learn from Mistakes

Every legal or regulatory settlement that occurs can be a teaching moment. There is something to learn from a thorough discussion of the events that ended in lawsuits, especially by the standards-enforcing middle and upper managers of a firm. The need to know what motivated the troublesome events, why they went undetected and what the outcome of the litigation was, but can only do so if someone prepares the information (from the extensive legal proceedings) on the cases and enables a full discussion of them by the entire middle management cohort group, however large, though the discussions must be held in small groups overseen by someone in touch with top management.

Few firms do this – they don’t want to highlight their own settlements, or take the time necessary to send everyone to school periodically on such matters.  They should. It would improve everyone’s understanding of what happened, what was wrong with it, and to clarify for everyone’s benefit how such things should be handled at their own firm should they crop up.

Pay and Promote Differently

Increasingly, it seems necessary to replace “you-eat-what-you-kill,” pay-for-performance compensation programs with ones that are more holistic and take into account defensive and preventive measures taken by managers. If the word gets out at the mid-manager level that performance is to be judged by several factors, not just profits contributed, including how well one’s unit performs over time and what managers have done to prevent harm, things will change quickly. Boards should be willing to pay well for good managers that do these things well. They are scarcer than good engineers or traders.

Pay, of course, also needs to be increasingly in company shares as managers rise in the firm, and always subject to “clawback” provisions, including in cases in which a subordinate is charged with wrongdoing. The firm should also make it clear that individuals charged by regulators may not be reimbursed for legal expenses, and the firms will cooperate with prosecutors in their prosecution of the individual.

Existential events are not often fatal, but few companies escape the years of lackluster performance that follow the thumping that the events engender. Boards of Big Business companies need to wake up and recognize that they can lower the probability of such events in the future by reshaping the cultures and middle management cadres that have enabled them.

Whatever Happened at VW?

 

by Ingo Walter

With the resignation of CEO Martin Winterkorn and his replacement by Porsche’s CEO, the firing of three key R&D bosses, the herds of prosecutors and tort lawyers hoping for years of litigation, and the ominous clouds overhead from the media, among regulators and customers – and not least investors who have lost up to 42% of the value of their shares - the VW scandal raises lots or questions that go way beyond the world’s largest car manufacturer itself. They concern corporate governance, management decision processes and individual accountability, the regulatory environment, as well as industry competitive structure and performance. A true learning moment.

As the proud owner of a VW Toureg turbodiesel, it also hits close to home. Happily for now, VW V6 diesels like mine have not been named in the fraud allegations. But that may just be because of the expensive urea-based technology to cut nitrogen oxide (NOx) emissions found in large diesels was what VW was trying to avoid using in small ones by relying a “magic” approach that nobody could replicate and that turned out to be fraudulent. Now pundits have proclaimed the “death of diesel,” probably prematurely and unfairly.

What next for VW? Examples from the banking industry suggest that "rogue" behavior in one firm often turns out to be "industry practice." Examples include manipulation of foreign exchange and Libor benchmarks, hedge fund “late trading” in mutual fund shares, mis-selling of “payment protection insurance to ordinary retail customers,” insurance broker kickbacks from underwriters, falsification of international payment transactions, aiding and abetting tax evasion, and the list goes on.

One firm gets tagged and the others run for the hills and take a very low profile until the posse rounds them up. That could be the case here also, with MB, BMW, Renault, Peugeot, etc. Some are saved (for the moment) because they focus on big or expensive cars able to support urea-based approach. Others focus on mass-market, cheaper diesels and may have encountered engineering problems similar to VW’s. They say they have not, that VW is unique. If not they will step up very soon. Last guy in is a reputationally rotten egg. So we’ll soon see whether the VW problem is in fact firm-specific or industry-wide.

Certainly the nitrogen oxide emissions remain an issue with the US and especially California most aggressive in putting on the regulatory pressure. The European approach seems to have been more retarded and haphazard by comparison, with heavy lobbing from the important car manufacturers and their governments. Travelers can tell you that the air pollution problem is pretty bad in parts of Europe. On a dozen or so days a year the speed limit in the Paris region is cut to 90 km/hr because of the health effects of NOx and particulates – in an air-shed where well over half the cars and almost all trucks are diesels. This is not a matter of engineering fraud but rather one of deficient emissions standards, but now that the VW cat’s out of the bag it points to things to come for the automakers.

To the outside observer it seems that what happened here is that the VW engineers got seriously squeezed between the marketing pitch for modern European common-rail diesels (fuel economy, durability, torque and environmental friendliness – much of it true) and the tightening noose of US environmental standards. This eventually made the two simply incompatible.

The engineers no doubt signaled the problem internally (how high up we don't precisely know) and senior management told them to fix it or else. So they were trapped. Pressed to the wall, the engineers came up with a workaround. Whether in the whole process anyone raised the full range of potential consequences including the possibility of individual criminal charges we also don't know. Anyway, decisions got made somewhere. Under German law such matters tend to move quickly into the criminal domain where unlike in the US firms cannot be charged in civil proceedings (and allow a range of punitive options, possibly including criminal pleas by firms themselves) but rather are targeted on the individual.

So the otherwise walk-on-water CEO has walked the plank instead and may be personally charged (famously, this has rarely happened in banking).

Some Europeans have blamed the US regulatory approach and litigiousness for triggering the brouhaha. In Europe it would have been taken care of in a sensible way by corporate specialists talking to regulatory specialists, eventually arriving at a mutually acceptable solution. Maybe so. But they said the same thing in the FIFA mess.

Two Questions Raised by the VW Case

by Roy C. Smith

The VW case will raise two questions for sure: is someone going to jail?, and what should be expected of boards of directors in preventing corporate misconduct?

Last month Volkswagen’s Supervisory Board asked for the resignation of CEO Martin Winterkorn and said it was investigating the company’s engineering staff to pin down responsibility for the installation of the “defeat devices” used for seven years to disable emission controls on 11 million diesel engine cars sold in the US and Europe. The devices were installed to boost performance standards for the cars that VW emphasized in its advertising. Prosecutors in Germany, the US and Sweden and other countries are investigating the situation for possible criminal violations.

Meanwhile, market analysis have estimated VW’s potential all-in costs of fines and legal settlements to be in the $18 to $20 billion range, roughly equal to the loss of about $25 billion, or a third of the company’s market capitalization since the admission was made to the US Environment Protection Agency on September 18th. VW has taken an initial $7.5 billion charge to its legal reserves to cover the exposure.

This is likely to be the biggest self-inflicted corporate disaster since BP’s 2010 Deepwater Horizon oil spill in the Gulf of Mexico that has cost it $28 billion so far. BP’s market capitalization is about $70 billion less (35%) than what it was in 2010.

Going to Jail

Senior corporate executives do go to jail for their actions. The former CEOs (and other executives) of Enron, WorldCom, and several other companies from the 2001-2003 era are either still in prison or have only recently been released. Financial figures like Bernie Madoff and Allen Stanford are too, though the top executives of global banking firms are not, despite a certain amount of public support for locking them up.

The simple truth is that under legal systems in most developed countries, to be convicted of a criminal offense requires proving that an individual intended on breaking the law, and then did so or compelled others to.

Corporations make a lot of mistakes, and sometimes engage in activities that offend the ethical sensitivities of others, or fail to comply fully with the voluminous regulations to which they are subject. Most corporations exist to make profits in competitive businesses that require them to develop what edges they can. Sometimes they overdo it. When they do, they have to face the consequences in civil courts where a payment of money is thought to be the best way to settle claims against them. If their conduct is considered to be especially objectionable, public opinion becomes a factor that can amplify the consequences.

VW’s admission that it knowingly installed 11 million devices to thwart emission regulations appears to be a case of criminal wrongdoing for which there will be a paper trail of responsibility. We shall see where it leads, but somebody had to approve the plan to install the devices, and probably a range of senior officials knew about it.  German prosecutors have shown themselves to be completely indifferent to the status of individuals they regard to be responsible, and the publicity surrounding the VW incident (reminiscent of Enron) only makes its executives more vulnerable to being charged with a criminal violation.

Duty of Boards

The question of whether boards can be expected to prevent corporate misconduct is one with a long history of unsatisfactory answers. There seems always to be a regular flow of corporate scandals in which boards are shown to have failed to monitor executives adequately. Despite a fair amount of post-VW introspective huffing and puffing, this is not likely to change in the future.

The most important thing that boards do is to appoint the company’s chief executive.  That means choosing someone to be responsible for the company’s financial performance and for safeguarding its reputation. Most boards emphasize the former and take the later for granted. Some think it is a zero-sum game, in which aggressive growth policies come at the cost of increasing reputation risk.

In reality, however, most large company boards are unable to monitor CEOs carefully enough to prevent unforeseen events. This is because of the complexity of corporate operations, the sociology of boards and the limited time any one board member has to delve into details, especially if these are being concealed. Nor is there evidence that splitting the Chairman and CEO roles, or emphasizing long-term results in compensation arrangements makes much difference.

Some economists think that markets are more skeptical of corporate results and explanations, and accordingly are better monitors of CEO performance than a group of loyal and supportive board members, but there is not much evidence of this either.

It just may be that boards are not much good at preventing trouble. What they have to be good at, however, is cleaning up after the trouble – replacing CEOs as soon as evidence of trouble arises, conducting thorough, honest investigations to get to the bottom of things quickly, and then doing what they can to rebuild the company after the trouble.

There is some evidence that this is improving. CEO turnover, according to a 2011 Bloomberg study, was at an all-time high for the world’s largest companies. Certainly this is so for the global banking industry that has turned over the CEOs at nine of the top twelve firms since 2008, some more than once. Even so, the larger the enterprise, the longer it seems to take for boards to step in with a cleanup.

VW, however, has been quick off the mark.