Absent Management in Banking. How Banks Fail and Cause Financial Crisis - Christian Dinesen - 2020

Absent Management in Banking How Banks Fail and Cause Financial Crisis Christian Dinesen

Absent Management in Banking

Christian Dinesen

Absent Management in Banking How Banks Fail and Cause Financial Crisis

Christian Dinesen Dinesen Associates Ltd. London, UK

ISBN 978-3-030-35823-5 ISBN 978-3-030-35824-2 (eBook) https://doi.org/10.1007/978-3-030-35824-2 © The Editor(s) (if applicable) and The Author(s), under exclusive licence to Springer Nature Switzerland AG 2020 This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed.

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Acknowledgements

My sincere thanks and gratitude go to all those whose valuable material has formed the platform for this book, including historians, journalists and business school academics. The latter’s case studies provided both a rich and innovative source, that I highly recommend.

Dr. Tim Leunig was a constructive supervisor at the London School of Economics and Political Science (LSE). At the LSE Programme Manager Tracy Keefe guided me through the return to academia, Professor Albrecht Ritschl made valuable introductions and Dr. Peter Cirenza exemplified how to bridge investment banking and academia. Associate Professor Gianpiero Petriglieri, Organisational Behaviour, INSEAD encouraged me to write a book.

Niall Ferguson, senior fellow of the Hoover Institution, Stanford, and the Center for European Studies, Harvard, deserves special thanks for his suggestion to use business school case studies as a source for the history of management in banking, in addition to his own work on the Rothschilds and Siegmund Warburg. His invitation to Harvard Business School, where I read the first business school case studies and discussed initial findings, was both seminal and highly motivational. The staff at the Harvard Business School Library expertly and emphatically guided me.

Leif Höegh provided shelter and was an insightful sounding board, Charles Aldington gave encouragement, John Smith installed confidence and Torleif Hoppe shared his successful experiences of how and when to write.

Tula Weis and Lucy Kidwell of Palgrave Macmillan expertly and enthusiastically guided me through the publishing process.

Most importantly Dr. Emily Mayhew provided deep insight into writing, inspiration and loving support to make me as good as I can be. v

Contents

1 Introduction: Not Managed at All—How the Idea for This Book Occurred and What It Is About 1 2 The Medici and Renaissance Complexity: How the Challenges of Renaissance Banking Finally Defeated the First Multinational Bank 15 3 Rothschild, the Largest Bank in the World: How Multinational Family Ownership Overcame Nearly All Management Complexities When Others Failed 33 4 Less Regulation Means Greater Complexity: How Looser Bank Regulation Allowed Faster Growth, Greater Complexity and Contributed to Absent Management in Banking 51 5 Complexity from Growth: Territory and Size—How Absent Management Occurred Through Growth by State, Country and Sheer Size 75 6 Complexity from Growth in Lines of Business: How Absent Management Occurred When Different Types of Banking Were Merged 95

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7 The Absence of Incentives to Manage: How the Wrong Incentives Resulted in Absent Management 117 8 Producer Managers: How Continued Focus on Banking Resulted in Absent Management 133 9 Bank Failures Cause Crisis: How Absent Management in Banks Can Cause a Crisis 151 10 Bank Failure: Triggering Crisis—How Absent Management in Banks Triggered the 2008 Financial Crisis 177 11 Bank Failures Cause a Global Crisis: How the Complexities of United States Mortgage Securities Devastated Banks and Made the Banking Crises Global 201 12 The Cost of Financial Crisis: How Absent Management in Banking Became Costly 227 13 What Has Changed: How Little Has Changed in Terms of Complexity, Producer Managers and Absent Management in Banking 245 14 Conclusion 271 Index 287

CHAPTER 1

Introduction: Not Managed at All—How the Idea for This Book Occurred and What It Is About

The idea for this book came on the back of the losses incurred by large investment banks in 2008. One investment bank announced a quarterly loss of $14 billion as part of its full-year 2007 results. This was only one quarter of the $52 billion United States investment bank Merrill Lynch was to lose on United States mortgages. It seemed impossible to manage so badly as to incur a loss of this magnitude. Surely nobody would do this.

If nobody would manage that badly, this pointed to another possibility.

Some banks were simply not managed at all.

This book is about management in banking and particularly about absent management in banking. Bank customers, shareholders and regulators have assumed that banks are always managed. Banks have been assumed to be no different than other large commercial organisations, such as manufactures and retailers, in having a management that sets strategy, implements this and holds itself accountable to its owners and other stakeholders. Like other commercial organisations, some banks are assumed to be managed well, others badly, with the quality of management being subject to change over time.

But banks are different. They developed with a different approach to management historically, with banking being the top priority and much more important than management. For centuries banking was almost everything that was required. Only a few early banks grew complex enough to require management. Two of these are the subjects of the early chapters. Some banks developed by size and complexity and prospered, at least © The Author(s) 2020 C. Dinesen, Absent Management in Banking, https://doi.org/10.1007/978-3-030-35824-2_1

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for a time. When some banks grew very large and complex, they lacked the historical development of management of other commercial organisations, such as railways and car manufacturers. Some banks learned and borrowed management from other commercial organisations.

Banks are also different in that they found it difficult to develop and change incentives to reward management as much as banking was rewarded. After five centuries of banking, many bankers had a way of doing things. They found it difficult, sometimes impossible, to change even when the banks themselves changed enormously, in both size and complexity. And these changes in size and complexity transformed the need for management. At times, this transformation was ahead of the development of management and resulted in absent management.

When banks are not managed, this makes them much more likely to fail. Bank failure has serious consequences. If some banks are not managed, this has implications for customers who have their money deposited with the banks or who depend on future bank borrowing for their lives and businesses. A failing bank can also have serious consequences for other banks with whom it may do business including borrowing money. A bank failing can cause suspicion that other banks may also be in trouble and subject to failure. This is because banks base their business on trust. For customers to deposit money with a bank they must trust the bank to be able to pay these deposits back. If one bank fails, the trusts in the banking system may be undermined. A bank failing can have serious consequences for a government. If the bank is so large that its failure threatens the stability of a country’s financial system, the government may need to rescue the bank. Such a rescue can be extremely costly to the extent that it affects the government’s finances. One or several bank failures can require a government to raise additional funds, through increased borrowing and taxation or reduced expenditure or all three.

This book is about absent management in banking, but that is not meant to imply that there is no management in banking. There is currently little sympathy for banks amongst the rest of society. This is unsurprising given the devastation caused by the recent financial crisis where banks are seen as one or the main culprits. However, there always have been, and continues to be, many managers in many banks who ensure that the crucial function of banking makes its indispensable contribution to modern society. No banks are completely without any management. This book is about the partial absence of management in some of the most important banks as well as in some less important banks. Because banking is based on

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the trust of its customers and because banks are increasingly interconnected, any partial absent management that causes a bank to fail can have serious consequences for customers, other banks and governments. Any absent management in a bank can contribute to, and sometimes cause, a financial crisis.

Many questions have been asked regarding how banks failed and caused the most recent 2008 financial crisis. Few questions have been asked regarding why some banks did not fail and did not cause the crisis. There is only one difference between individual banks and that is the people who have managed them in the past and who manage them now. Individual banks succeed or fail because of the people who manage them. Individual banks are in the business lines they are in, the locations they are in, have the brands and culture they have and so on, because of the people who ran them in the past and who run them now. The managers and only the managers have made one bank different from another. External forces, including economic conditions and regulation, heavily influence the destiny of banks. At times, this influence is completely beyond the control of the banks. But it is the people, and particularly the most senior people in the bank, who decide to establish a bank in the first place and subsequently decide in which lines of business, in which countries and how the bank should operate. Unlike the British soldiers in the First World War who 100 years ago sang, “We’re here, because we’re here”, and often had little or no choice in the matter, banks are where they are because of their managers, past and present. In an interview with the Financial Times in Japan in 2007, just as problems in the United States mortgage market were beginning to cause a wider market crisis, the chief executive officer of Citi, one of the largest banks in the United States and in the world, said: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing” (Nakamoto and Wighton 2007). Dancing simply because the music is playing is not good or bad management. It is absent management.

So this book is about the banks that were not managed. It is less about the banks that were well run, did not fail and cause a crisis and did not need rescuing. These managed banks are, however, now enduring significantly increased regulation and much reduced reputations, due to their unmanaged competitors.

All bulls are dangerous; it is just that some bulls are more dangerous than others. So it is with banks. All banks are complex; it is just that some banks are more complex than others. And all banks are dangerous. Even a

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run on the deposits of a small bank, where depositors fear for the safety of their savings, has the potential to cause a wide panic and a banking crisis.

However, there are some banks that are significantly more dangerous than others. These very dangerous banks are now known as Systemically Important. They used to be known as ‘too big to fail’, but when they failed, the term was changed. They nearly all show some instances of absent management. By mid-2017, banks in the United States had paid fines of over $150 billion related to the 2008 financial crisis. And banks continue to commit acts today, resulting in large fines. If a bank continues to incur fines of hundreds of millions even billions of dollars, pounds, euros and so forth, it is sometimes not because the bank is badly managed, it is because it is not managed at all.

Management is one of those activities that is so well known that it is possibly not necessary to define it. Most of us have worked for or been subject to an organisation, public or private, with some level of management. Perhaps the first time we encountered management was when we first attended school and became aware of a headmistress or headmaster.

Most employees have a manager and so do most managers. The earliest use of the word appears to relate to the Latin manus or hand and the French main and coming to us through the French manège, which in English can mean an area where horses (and riders) are trained or handled.

In other languages, manège is now used to describe the performance circle in a circus. ‘I will handle this’ is close to ‘I will manage this’.

In this book, management involves deciding on objectives and a strategy, on how to achieve these including the risks involved, the strategy’s implementation and monitoring as well as accountability. Management requires thinking, planning and delegation. It is very much about handling or managing people. However, and most importantly, management is not about producing, and it is not lending, trading, analysing and all the many other production activities in a bank. This distinction is central to absent management in banking. It is often the doing, the lending, trading and so forth that people in banks want to do. Most bankers want to be producers, not managers. But when bankers are recognised internally as good, successful and profitable producers, they are often then promoted to managers. The cowboy who herds the most cattle becomes the head honcho; the best saleswoman becomes head of sales or sales manager.

However, bankers often remain producers while they manage and hardly any become full-time managers. This was how it was from the very first banks, which were simple, one location operations and just required

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a banker or two and no full-time, specialist managers. Most heads of large banks still meet clients. Some retain an active producing role, typically in retaining key clients and acquiring new ones. Buying or merging with other banks mostly involves top management because it is important. But it is really a type of production because it is nearly always about growth.

Due to the continuing producer role, and its associated skills, rewards and status, the banker has less time, energy or interest in management, and at times none at all.

Sometime in the last ten years, the term ‘management’ has been replaced by ‘leadership’, in business schools, academia, the media and banks. This is a dangerous, semantic fashion. Leaders lead, and we remember brave example of leadership as we have just commemorated the centenary anniversary of the brave officers and sergeants who lead their men over the top of the First World War trenches. The managers then were the most senior officers, the generals and the politicians, democratic or despotic. Much, but not all, of their management was terrible, ending in long stalemates with catastrophic casualties and suffering. There was some exceptional management in the First World War, such as the medical services and supply lines, but much of it was terrible. However, the management was not absent, and it was not just leadership, however brave. The tendency to talk about leadership rather than management is attractive to bankers, some of whom are military history buffs, but it does a disservice to management and to war. Only war is war, however much investment bankers and traders would like to see themselves as being in the trenches. And management needs thinking and planning and discussion, which can take a long time and be tedious. In banking, management rarely receives the rewards and status of a producer winning a battle for a client or a profitable trade.

During the last ten years, many books were written about the 2008 financial crisis. As this is a history book, there was no particular rush to write it. By waiting ten years the book would hopefully benefit from the extensive research being carried out immediately after the latest financial crisis and also enable more of a historical approach. If evidence could be found that banks are not managed, the approach would be to try and answer one of the basic historical questions of how we got to a situation of absent management in banking.

This book was not a management consultancy presentation in a former life. There will be no charts. Actually there will be one chart, as an ­exception to prove the rule that there will be no charts. But it is a really good chart.

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It is sadly not possible to write any book about banks without some figures. There were two figures in the first paragraph. However the figures have been kept to a minimum, and there are no tables of figures, not even one to prove the rule that there are no tables of figures.

What this book aims to do is to explain why complexity caused absent management. Without complexity in banking there is no need for management. So it is important to explain complexity. One of the approaches to explaining complexity will be to explain the jargon and abbreviations that hide complexity behind them. And it is important to avoid using multiple and endless abbreviations that make those not familiar with these abbreviations feel like uninformed outsiders.

The board of directors of some banks were guilty of absent management because they did not understand what their bank was doing. When they complained that it was impossible to foresee the events that caused their bank to fail, this was all too often a case of not understanding what the bank was doing in the first place. However there were nearly always other banks doing similar things whose management understood what the bank was doing, managed it and kept the bank from failing. Without understanding there is no management. So this book will aim to explain complexity. These explanations may be simplistic to some bankers but given that the complexities caused some banks to fail, explaining complexity is necessary.

This book takes several approaches to establishing absent management in banking, including economic history, management consultancy and working experience within banking. Economic history is helpful to establish how management in banks developed, and developed differently from other commercial organisations, and for some concepts such as path dependency. Management consultancy enables the use of business school case studies and consideration of some management concepts such as producer manager and tools such as incentives.

Practical experience is of limited value by itself. Enough war stories have been told about the recent financial crisis but they have not provided enough insight into how banks fail and cause crises. Practical experience is too subjective and limited to one person’s impressions and recollections.

Practical experience only adds value when combined with other approaches, in this book, with economic history and management consultancy. It is this combination of different approaches that gave rise to the idea of absent management. Working as a former management consultant in an investment bank, I should have been able to tell what was wrong with the

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management to cause this literally unbelievable level of losses. Determining what was wrong with the management and making suggestions for how to improve it was how I had made my living for ten years before joining an investment bank. The only possibility I could come up with for not being able to tell what was wrong with the management, apart from my own inadequacies as a management consultant, was that perhaps there was no management at all. Because the results were so bad that it was not possible to imagine that anyone would manage that badly.

Once the possibility of absent management occurred, the first question I wanted to answer was the historical question of how we got to this position of no management. Economic history had an answer, but not amongst its traditional sources. Business school case studies were suggested as a source by the eminent historian, Niall Ferguson. He believed I could use business school case studies for economic history because of my management consultancy background.

Combining different approaches carries the risk of not satisfying any of the three approaches. This book may not be academic enough for some economic historians and perhaps not practical enough for some management consultants. Some bankers will search in vain for the names of contemporary senior bankers who they may have worked with.

This book is about absent management, not the absence of managers.

The bankers have been referred to as the chief executive officer, senior manager or Board of this or that bank, not by their names, at least if they are still alive. The reason for this omission of names is that absent management was the historical result of how management developed in banks. This development, combined with the increased complexity of banks, caused instances of absent management. Absent management is an institutional failure. It is not about individual bankers, and their names are therefore not in the text. The names can be found in the sources for those interested. There are many biographies and media writings about these individuals. Some individual traders and investors are mentioned by name, but they are not bank managers.

The sources for this book are deliberately wide-ranging and hopefully somewhat innovative. Historical biographies on bankers and banks have interesting application for additional research on bank management.

Examples are an excellent, painstakingly researched book by Raymond de Roover on the Medici Bank, Niall Ferguson’s biographies of the Rothschilds and Siegmund Warburg, plus a multitude of others. Philip Auger has written insightfully, and entertainingly, about banking in the United Kingdom. Carmen Reinhart and Kenneth Rogoff remain the

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leaders on historical banking crises, with more recent additions particularly from Financial Times journalists.

The development of management in banks has received little focus by economic historians compared to the focus on management in industry. It is not clear what the reasons are. The economic history focus on management in the 1960s had waned by the 1980s when banks had grown into multidivisional and multinational organisations, and their management should have been of greater interest. So for this book there was a need to look elsewhere than traditional economic history for an answer to how we got here. The suggestion of using business school case studies as sources for this book will hopefully be seen as having proven useful.

The business school case studies were all produced for educational purposes and intended as the subjects of class discussions. The case studies describe a situation in a bank, supported by interviews, organisational charts and financial information. Many but not all were from Harvard Business School, the pioneer of the case study educational method. The authors are mainly business school academics, although some received assistance from management consultants and the banks themselves. Interviews were a central part of the preparation of many of the case studies. Case studies are specifically stated as not representing best practice. They are not intended to be either positive or negative in their approach, but to record a business situation. Consequently, and importantly, the cases used for this book were selected for their relevance and illustration of bank management and not for their support or contradiction of absent management in banking. Nowhere in the case studies was this term or concept found. This makes the case studies objective as far as this book is concerned.

Business school case studies were found to be both valid and powerful as historical sources. Case studies used in this way document a historical record beyond the educational uses for which they were originally produced. Of the 25,000+ available case studies from Harvard Business Publishing, 1700+ relate to banks, finance and insurance with the first describing a situation in 1970 (Harvard Business Publishing 2019); 68 case studies were used for this book based on their focus on banks’ management, including issues such as organisation, strategy, incentives and crises. For any readers of this book interested in further reading, business school case studies are highly recommended.

Once a historical approach is adopted business school case studies are a rich, even entertaining, and certainly highly informative source. One story that emerges is how banks became increasingly complex to manage.

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Reduced regulation since the 1970s, combined with increased globalisation and multiple mergers and acquisitions, resulted in banks of such vastly increased size and complexity that absent management of some of them, some of the time, becomes perhaps not inevitable but understandable.

If using business school case studies as a source for economic history involves a degree of novelty, the godfather of management history, Alfred Chandler, would have been comfortable with this approach when writing his own case studies on industry such as Du Pont and General Motors in 1962. Alfred Chandler stands out as the first leading thinker on the role of management in economic history terms. His approach to management was partly based on case studies in the United States in the interwar years.

However, his focus does not include financial companies. Chandler places managers, who he calls administrators,1 at the centre of his thinking:“While the enterprise may have a life of its own, its present health and future growth surely depend on the individuals who guide its activities….They coordinate, appraise and plan”. His argument is then developed by making the point that administration [management] becomes a specialist, full-time job. This is an important distinction from financial services where senior managers often retain a production capability, for example, as bank branch manager spending part of his or her time seeing customers, or as a trader of equities or bonds or an investment banker. In Chandler’s examples, the role of managers is solely management. Alfred Sloan of General Motors, Chandler’s outstanding example of the successful multidivisional manager, neither made nor sold General Motors cars (Chandler 1962).

Importantly, Chandler recognises the need for the manager to have two different time horizons. “At times he must be concerned with the long-run health of the company, at other times with its smooth and efficient day-to-day operation.”2 This is a valuable recognition of the role of the manager and differs from most others in the firm who are solely concerned with the day-to-day operation. Compared to a purely professional manager, it is likely to be particularly complex and challenging for a producer manager to carry out both these tasks and have two time horizons.

The leading, institutional economic historian and Nobel Laureate Douglass North determined a helpful link between the organisation and its purpose and role within society: “organisations as purposive entities designed by their creators to maximize wealth, income, or other objectives defined by the opportunities afforded by the institutional structure of the society” (North 1990). North’s point is particularly helpful in highlighting the relationship between financial firms and regulators, the latter setting

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the parameters of opportunities. According to North, organisations will do what regulations permit. Sometimes they will do more, as the billions of dollars of fines imposed on banks evidence.

North also addresses the design of organisations and links these to what their creators are aiming for. This would indicate that the organisation’s structure and development should reflect how management is incentivised. North provides an interesting definition of the tasks of management which-“are to devise and discover markets and techniques, to evaluate products and product techniques and to manage actively the activity of employees” (North 1990). The issue of a management time horizon different from the day-to-day, with management having a strategic role, appears to be missing from this definition. He does however also say “short-run efforts at profit maximisation may result in the pursuit of persistently in-­efficient activities” (North 1990). This would indicate a need for both a short- and longer-term view to ensure that short-termism does not result in longterm inefficiency.

Incentives are one of the concepts that will be addressed as part of explaining absent management. It will be addressed historically from the organisation of the Medici Branch network in the fifteenth to the present day. North is particularly succinct on incentives, of which he says that “Incentives are the underlying determinants of economic performance” (North 1990). There is a vast literature on incentives, but for bank management this definition serves well. It accurately reflects the ‘money culture’ mentioned in several of the case studies and which I experienced. It is somewhat simplistic but the conclusion from North’s definition, the case studies and my experience is that in banks people do what they are paid to do, more or less.

Path dependency is a concept mostly associated with technology. An earlier definition from some of the academic leaders in the field of technological path dependence is helpful:- “The claim for path dependence is that a minor or fleeting advantage or a seemingly inconsequential lead for some technology, product, or standard can have important and irreversible influences on the ultimate market allocation of resources, even in a world characterized by voluntary decisions and individually maximizing behaviour” (Liebowitz and Margolis 2000). The classic path-dependent product is the QWERTY keyboard. You may have one in your hand if you are r­ eading this on a mobile devise. However, evidencing path dependency in management behaviour is more challenging than in the more established area of technology hardware. The establishment of bonus schemes, designed

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to promote growth, and thereby an advantage, had important and irreversible consequences. The consequences were that the incentive schemes promoted growth but not risk management due to a lack of downside for the employees. The schemes became irreversible because banks found it impossible not to pay bonuses, due to the fear of impact on morale and talent retention. Evidence of behavioural path dependence is also evidence of an underdevelopment of management. If behaviour in an organisation, however well-intended initially, becomes detrimental to the objectives of the business, but is not changed, then management is not carrying out its functions and may even be absent.

The banks considered will primarily be United States, United Kingdom and European banks, partly because they play a dominant role in global finance, and partly because they were central to the recent financial crisis, epitomised by the collapse of Lehman Brothers in September 2008. Large, multinational or global banks will be central to this book for the same two reasons. The first two banks considered were both multinational but were originally based in Florence (the Medici) and Frankfurt (the Rothschilds).

This book is aimed at students of banking, finance, management and crisis. Hopefully, it will also be of interest to everyone who is or were customers, employees, shareholders or other stakeholders of banks, as well as those who have suffered the effects of financial crises. That is a very large group, and it is therefore ambitious to hope that individuals from such a large group will be interested in a book that may be categorised under the not universally appealing subject titles of banking, finance, management, crisis and economic history.

To achieve this ambition, this book will tell the history of absent management in banking to try and answer the question of how we got to such a position. This history will start with an early bank, that of the Medici in Renaissance Italy, and go on to look at the Rothschilds’ long tenure in the eighteenth, nineteenth and early twentieth centuries.

Regulation plays an important role in the history of banking from the early days, including for the Medici, then particularly after the Great Depression in the 1930s. Regulation was fairly unchanged until the early 1970s from when a loosening allowed banks to grow in size and ­complexity.

It is this increased size and complexity that makes greater demands on management. It is also where the first distinct evidence of a modern absent management emerges. So loosening regulation and the growth of banks are highly interdependent.

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Loosening regulation allowed banks to grow in two main ways, by territory and by line of business and sometimes both. This growth often took place through mergers and acquisitions, perhaps the most challenging and complex activity of any business, due to the unknowns involved in buying and the complexity of integrating another business. Whether by territory or line of business, growth made banks larger and more complex. And the more complex the banks became the greater the need for management.

And given that the speed of growth was explosive, it became hard and sometimes impossible for management to keep up with the increased complexity. Sometimes complexity increased at such a rate that the management was unable to keep up and this resulted in absent management.

The role and history of incentives and how we got to the much reviled bankers’ bonuses is important. Incentives were plentiful, sometimes so plentiful that the recipients became unmanageable because they had become so rich, so quickly that they were beyond both incentives and management. Neither the possibility of further riches nor discontinuing of employment had any effect, so these individuals became unmanageable.

Incentives were also often directed towards increased production rather than management including the associated risks. This created a dangerous imbalance that was difficult, sometimes impossible, to manage.

The dual producer manager role, where the most successful bankers often end up, supposedly, managing the bank, is central to why management in banks falls short. Many banks promote the biggest producers into management positions. However, they are rarely, if ever, either trained or remunerated for their management. This approach contributes to absent management.

Following regulation, growth, incentives and producer managers, the next part of the book then delves into the rich sources of business school case studies for examples of absent management. The growth of banks made them harder and sometimes impossible to manage. It also made them more dangerous. When large, complex banks had no management, not only could they fail, but they could also cause a crisis. Absent management was a central cause of many financial crises including the most recent one.

Once the 2008 financial crisis hit with full force, it was essential for banks to have management in place. Some did not, and this absent management caused more failures. There was a need for stronger banks to rescue weaker banks and for governments to rescue failing banks to stop the crisis.

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Once absent management has been, hopefully, accepted as a reality and a cause of bank failures and financial crisis, the resulting financial crisis is a history of the devastating, widespread and lasting costs and effects. If all bulls are dangerous, the most dangerous bulls are those very large, complex bulls that are not handled or managed.

The final chapter before the conclusion will summarise what has changed in the ten years since the most recent financial crisis. Perhaps more important will be to summarise the absence of change in the last ten years. History does not repeat itself. It is far too complicated for that.

But “Those who cannot remember the past are condemned to repeat it” (Santayana 1905).

In the conclusion, most ambitiously, an attempt will be made to suggest what needs to change for management of banks to become less absent.

This is a necessary development before banks can become less dangerous and before we can all be protected from unmanaged banks.

But this is a history book, and we will start at the beginning. And at the beginning was the Medici.

Notes 1. The “administrator” terminology has generally been abandoned except in the educational sphere, with an MBA being a Master of Business Administration.

2. Ibid.

References Chandler, Alfred D., Jr. 1962. Strategy and Structure: Chapters in the History of the Industrial Enterprise. Washington, DC: Beard Books.

Harvard Business Publishing. 2019. https://hbr.org/store/case-studies Liebowitz, S.J., and S.E. Margolis. 2000. Path Dependence, Lock-In, and History.

The Journal of Law, Economics and Organisation 11 (1): 205–226.

Nakamoto, Michiyo, and David Wighton. 2007. Citigroup Chief Stays Bullish on Buy-Outs. Financial Times, 9 July 2007.

North, Douglass C. 1990. Institutions-Institutional Change and Economic Performance. New York: Cambridge University Press.

Santayana, George. 1905. The Life of Reason.

CHAPTER 2

The Medici and Renaissance Complexity: How the Challenges of Renaissance Banking Finally Defeated the First Multinational Bank

“No man ever steps in the same river twice, for it’s not the same river and he’s not the same man,” as Heraclitus had it in the fifth century B.C. Banking and bankers in the fifteenth century and today are different. The purpose of taking a historical approach to absent management in banking is to understand how we got here, not to look for historical repetition. History is part of the explanation as to why there are examples of absent management in banking today. Some of the problems and challenges, for example, sovereign borrowing and multinational operations, and their resulting complexities are remarkably similar. Some of the approaches to managing banks, particularly senior bankers combining banking and management, have continued from the earliest banks to the present day. The continued complexities of managing a multiline, multinational bank combined with the lack of specialist and incentivised management resulted in absent management. So a historical approach illustrates the continuity with which banks have been managed, or not managed. There was absent management in banking in the fourteenth- and fifteenth-century Florence, including in the Medici Bank. They set the first example, and many bankers would later want to manage like the Medici had done, like famously wealthy Renaissance princes.

The fifteenth-century Medici Bank was not quite the beginning of bank management, but their slightly earlier Italian banking contemporaries probably were. One of the earliest banking crises was the collapse of three Florentine banks, the Bardi, Peruzzi and Acciaiuoli. Extending credit to © The Author(s) 2020 C. Dinesen, Absent Management in Banking, https://doi.org/10.1007/978-3-030-35824-2_2

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sovereign rulers, including Edward III of England,1 Robert of Naples2 and the Dukes of Milan and Savoy, required careful management in the fourteenth century.

The Bardi and Peruzzi banks collapsed in 1345 due to lending 900,000 and 600,000 florins, respectively, to Edward III. The English king defaulted on the loans that had financed unsuccessful wars. These early, multinationally active banks collapsed before the Medici rose to become the largest bank of the time. Their collapses were caused by the overextension of credit to domestic and foreign sovereigns.

It is difficult to determine whether these early banks’ failure were caused by poor commercial judgement in their sovereign lending, bad management or absent management, as there is insufficient information available. However, the complexities involved were so intricate that they may have been impossible to understand and overcome, and therefore caused absent management.

The Plague that killed over one-third and perhaps up to two-thirds of Europe’s population from 1348 onwards is one reason why there are few records and little evidence of the present or absent management in this early banking crisis. And that plague, known as the Black Death, Black Plague or simply the Plague, and the economic stagnation that followed, was a factor completely outside the control of even the most competent bank manager.

The founding of the Medici Bank in Florence can be dated to 1397 when Giovanni di Bicci de’ Medici decided to transfer his headquarters from Rome, where he had previously managed his own bank. The Medici Bank lasted for nearly a 100 years until 1494. The ownership remained in the family, passing from father to son, with Giovanni succeeded by Cosimo de Medici in 1429, Piero for five short years from 1465 to 1469, Lorenzo (the Magnificent) until 1492 and Piero for the last three years of the bank’s existence until 1494. It was an eventful 100 years during which the Medici Bank became the largest bank in Europe and possibly the world. It went from one to ten branches across Western Europe and amassed and lost a great fortune. It counted the leading sovereigns of the day, including dukes, kings and popes, amongst its clients. The wealth accumulated elevated the heads of the Medici family to the supreme position of de facto rulers of Florence. But with growth came complexity. And complexity caused an absence of the previous sophisticated and competent management that had been fundamental in achieving the initial growth of this first major, multinational bank.

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It is perfectly possible for a bank to fail by making poorly judged domestic loans. However, lending to foreigners adds complexity. This complexity can arise from the need to understand conditions in a country different from the banker’s own. If the foreign lending is done through a branch in the foreign country, complexity arises from managing a branch in that country. Both types of complexities can become so great that it may not be possible to manage them, leading to absent management. With two sets of complexities, sovereign lending and multinational operations, often combined, the need for capable bank management was important during the Renaissance.

Complexity arose from several factors and increased due to the combination of these factors. A diversity of lines of business, the need to service multinational clients, primarily the papacy, and an imbalanced North South European money market caused by the papacy made the fourteenth- and fifteenth-century banking complex. This was particularly so for an organisation as ambitious, fast growing and successful as the Medici Bank.

However, complexity did not arise from the banking products themselves, which were relatively simple, well-established and understood. The Medici Bank primarily transacted three types of banking. One was dealing in bills of exchange, a second type was lending to individuals of high standing in society and a third was deposit taking for wealthy individuals.

Bills of exchange related to and facilitated a commercial transaction or trade between two places and often across one or more national borders.

Funds were entrusted to the Medici branch in one location, evidenced by a bill of exchange issued by the bank to the owner of the funds. This bill could be converted into cash to settle a trade with the local Medici branch or its representative in another location, often in a different currency. The amount that would be repaid, in a different location and currency, was agreed at the outset based on publicly quoted prices. Typically, the time until the bill was payable was related to the time it would take to travel between two places, say five days between Florence and Venice, or 90 days between Florence and London. At the outset, the bill would be priced in the currency of origination as well as a price in a different currency in the location where the goods were to be paid for. The Medici Bank would earn a profit based on the difference between the two prices. In a well-­ functioning banking marketplace such as Renaissance Florence, rates for other locations, such as Venice or London, were regularly quoted.3 Because rates for other important cities were well known, as was the time of travel, the products were relatively simple for experienced bankers,

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although not without risk. A change in the exchange rates during the duration of the bill could increase profits of the banker or cause a loss. So the bank took a risk of currency exchange volatility. And this was a real risk, given the slowness of travel and the political volatility of the fifteenth century. Much could happen in the 90 days during which the bill of exchange was being transported between Florence and London.

Importantly, medieval banking had to be careful not to commit the religious sin of usury, the charging of interest for lending money for a period of time. Practising usury could lead to excommunication by the Catholic Church. This is one of the most severe Catholic punishments, involving exclusion from the Church’s sacraments, including burial, as long as the excommunication lasts. Usury was one of the earliest examples of banking regulation. Transgressions were closely monitored by the Catholic Church and political rulers. Bills of exchange overcame this important restraint because the profit made was based on the difference in place rather than in time. Making money purely on a difference in time would have been usury.

The second Medici Bank product was loans to people of high standing, high-net-worth individuals in today’s parlance, particularly sovereigns, kings, queens, popes, princes, dukes and so on. These loans were highly individual arrangements. The loans themselves were not complicated nor were the stipulations for repayment. However, the complexity increased because loans were subject to the religious ban on usury. The profit from a loan is normally in the form of interest, but this was illegal and had to be hidden. One example of how to overcome the ban on usury was to overcharge the sovereigns for the luxurious commodities often sold to them by bankers, including the Medici, and paid for with the loan extended to them. This is an early example of bankers finding a way to work around regulation, now called regulatory arbitrage.

Sovereign loans also became complex because they entailed significant risks of not being repaid, due to the sovereign having spent the money on unproductive wars and luxuries. Often, the only way to get a loan paid back was to make another. Security provided by the borrower to the banker for the loans was often difficult to sell due to few customers being available, for example, for highly valued jewellery.

There was obviously a significant problem of enforcing repayment.

Taking a sovereign to court in the fifteenth century may not have been a viable option, given the need to maintain good relations with the largest customer and the power of the sovereign.

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In addition, sovereigns presented a significant concentration of risk, being nearly always the largest borrower in a country. This provided limited opportunity for spreading the large risk of not being repaid by a sovereign borrower by lending to other smaller debtors. Other customers were mostly so small in comparison to the sovereign that they provided little diversification.

One important objective of lending to sovereigns was to provide them with the funds to purchase the luxury goods also produced by the bankers.

A second reason to lend to sovereigns was that it was often the only way to gain access to profitable commodity trades and exports of goods such as wool or alum. Sovereigns often controlled these monopolies. Finally, lending to a sovereign was done with the purpose of being appointed to the profitable positions of tax collectors, another monopoly controlled by the state and one of the most critical state functions.

The sale of luxury goods, such as the silk locally produced in Florence, was an attractive business for the Medici. However, it might be necessary to lend to sovereigns to provide them with the funds to buy the luxury goods. This is an early example of consumer finance. Car manufacturers today lend to their customers to enable then to buy the car. And car manufacturers have discovered that consumer finance requires sophisticated financial management and discipline. The profit can be made on the products, or the finance or perhaps both. However, if one of the transactions incurs losses, it is critical to ensure that these losses are covered by making additional profit on the other transaction.

Sovereign lending was often a loss-leader for a bank, using today’s parlance, because the bankers were unable to charge interest. The loans were made with awareness of significant risk and at no interest, but with the aim of making profit on other commercial opportunities arising from the sovereign loan. Once the first loans had been made, this could result in a vicious downward spiral. It might be necessary to extend more credit to achieve repayment of earlier loans, to finance more wars and luxury expenditure as well as to retain profitable trading rights or tax collection positions. The simple loan had become complex. Sometimes the complexities, related to repayment or the related lines of business or both, became so great that they were unmanageable. The complexities were beyond the banker’s ability to manage them and resulted in absent management.

These complexities and the possible related absent management may have contributed to the fall of the Bardi and Peruzzi banks in 1345.

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The third banking activity of the Medici was deposit taking. A few wealthy individuals with savings sought a return and deposited money with the Medici Bank. This provided the main source of funding for the Medici lending business. However, the ban on usury made it impossible to pay these depositors interest. Fortunately, it was not forbidden to make gifts in the form of discretionary payments to depositors, as long as this was not part of a contract. So a sophisticated but informal system developed whereby depositors were rewarded with discretionary payments, often taking close notice of what levels of payments competing banks were rewarding their depositors with. Importantly, the bank needed to ensure that the return on the lending was adequate to cover the discretionary payments. This was an early example of the need for bankers such as the Medici to manage both their assets, being the loans made, and their liabilities, being the need to repay deposits plus discretionary payments.

The Medici were primarily bankers but they were involved in other lines of business. They had two wool factories and one silk factory in Florence. They traded in alum and luxury goods as a way to profit from the ban on usury and the resulting nil interest loans made to sovereigns and others.

The Medici also operated as tax collectors and performed some of the functions of a ministry of taxation and finance. In the case of Milan, the local tolls and other taxes were paid directly to the Medici by the tax collectors. The Church taxes, however, were always collected by the Church itself.

The papacy was the largest Medici client in the bank’s history. The Depository of the Apostolic Chamber was an official responsible for receiving the Catholic Church’s revenues and was usually a banker, making this banker the fiscal agent for the papacy. During the fifteenth century, the depository was usually the manager of the Medici Rome Branch.

In the first 23 years of the bank’s existence, papal business amounted to almost half of the bank’s total profits. However, the frequent succession of popes, of which there were 15 in the fifteenth century, meant that other bankers were occasionally appointed. By 1471, the Depository office had become less attractive to the Medici because Pope Sixtus IV4 was living beyond his means. The Pope expected the banker appointed as Depository to finance the shortcoming. This deficit was eventually settled by the papacy transferring stocks of alum to the Medici. Interest on what were effectively loans to the papacy would obviously not be acceptable to the Catholic Church, the institution responsible for the ban on usury. So the Medici overcharged the papacy for silks and other luxury goods.

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None of these additional lines of business to traditional banking appear to have caused significant complexities or losses on their own. The complexity arose when these other lines of business were combined with banking, when lending was made to enable customers to buy the wool and silk or to obtain the concessions to trade them. An important example was that access to the English wool monopoly trade was in the gift of the king.

However, King Edward III and his successors generally required loans to allow them access to this trade. If the Medici wanted to trade the only English export available, they had to lend to the king. Wool was also the only available cargo to fill the Medici galleys that had brought alum from Italy to England. When no coin was available to pay for the alum, it could be bartered for wool. But only if the Medici had the wool licence. So these combinations of lines of business made traditional banking complex. With the benefit of the impressive and helpful research done (Roover 1966), and using modern terminology, it is now understood that macroeconomic conditions added significantly to this complexity. This is now called the North South European monetary imbalance.

The papacy was the only truly multinational client of the fifteenth century. Other sovereigns were, almost by definition, limited to their own countries. Many merchants traded across borders, but because they were not multinational, the Medici Bank serviced them with bills of exchange.

The papacy was consequently by far the largest mover of money across borders. The creation of a highly complex problem was because all the money, like all the roads, led to Rome. Catholic Europe paid the Church tithes, being a tenth of each person’s annual income. Vast sums had to be collected each year and sent to Rome. The papacy revenue flowed one way, from all corners of Europe, even from Scandinavia, Iceland and Greenland. It imbalanced European trade by making it more difficult for Northern Europe to settle other Southern European claims. Once the papacy had been paid, there was little money, little liquid coin, left to settle other Southern European claims or buy their goods. The Florentines were eager to sell to Northern Europe but were not willing to buy many Northern European goods. There were few goods from Northern Europe being sold in Southern Europe where those with money were mainly spending it on domestic or Eastern luxuries. This one-directional flow of money from Northern Europe to Rome caused a complex and structural imbalance in the money markets of Europe.

The exception to the lack of Northern goods attractive to Southern Europe was English wool. The wool trade could be both profitable and,

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additionally, provide a much needed reverse trade to the papal money flowing south. So the imbalanced money markets inadvertently created by the Church, and the need to make loans to sovereigns involving significant credit risk in order to be allowed involvement in the wool trade, resulted in a combination of complexities. And this combination of complexities significantly increased the demand for deep understanding, a highly developed strategy and execution by bank management and particularly by the leading Medici Bank.

There was one other activity, if not quite a line of business, that would eventually distract and conflict with the management of the Medici Bank and that was politics. At the end of the Medici Bank’s life, the head of the family, Lorenzo the Magnificent, was so involved, conflicted and distracted by politics that it contributed to the collapse of the bank, which he was then no longer managing.

The Medici managers may not have fully understood all the aspects and interdependencies of the complexity they were facing. From the correspondence and ledgers and the admirable research done on the Medici as bank managers (Roover 1966), there is ample evidence that they understood how to trade bills of exchange and the dangers of lending to sovereigns including to access other profitable trades. What they certainly understood was that the increased credit balances in the branches of Bruges and London and that the shortage of liquid coin in these centres made it difficult for these branches and their managers to remit promptly to other branches and to the Medici head office in Florence. However, understanding the unbalanced North South European trade and money markets would challenge capable bankers in more recent times. The fifteenth-­century data and communication were in its infancy and dependent on a few individuals. One possible conclusion is that the environment was simply too complex for anyone to understand, particularly given this lack of information. And complexity was so great that it led to absent management, simply because it was not possible to manage within such a complex environment.

Between 1422 and 1470, the number of international banks in Florence more than halved, from 72 to 33. This was a long, drawn out banking crises. It may have initially benefitted the larger banks but ended up ­causing them significant challenges as the difficult market conditions continued. By 1494, there were only a handful of banks left, and the banking sector in Florence collapsed. It recovered in the sixteenth century, but never to its former leading position in Western Europe.

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Banking in Florence in the fourteenth and fifteenth centuries was innovative. The invention of double bookkeeping is what Renaissance Italian merchants and bankers are most famous for today. It remains a central management tool today, although there is no proof that the Medici used it.

Whether international, multinational or global, managing commercial operations in more than one country is one of the greatest complexities for any commercial operation. This was also true for the Medici. Italian medieval bankers and merchants of the early fourteenth century invented the commercial partnership, as we know it today, when it is still an important management structure. Partnerships for each individual branch including those outside Florence and the Italian Peninsula were how the Medici structured their bank. At this time, Italy consisted of many smaller states, including the papacy, and city states such as Florence, Milan and Venice. When the Medici first changed from one set of partnership agreements to another, as was required when one of the partners died, it was an important, and negative, development for the management of the bank.

This was due to the changed incentives for the bank’s general manager. In the new partnership agreement, the new general manager’s partnerships were reduced from each and every one of the bank’s international branches to being a partner in only some of the branches.5 The Medici management included good managers in many aspects, better than most of their competitors, and particularly in the beginning.

Originally based in Rome, Giovanni di Bicci de Medici (1360–1429) set out to capture the papal business. He retained the Rome operation but moved his bank to Florence and was soon required to expand and open branches in Naples and Venice. The Medici Bank was a family bank, as was the norm at the time. After Giovanni di Bicci’s death, his son Cosimo (1389–1464) took over.

As most business owners and senior managers know, choosing the right person and putting him, and later her, in the right position is perhaps the greatest challenge of any senior manager. Cosimo was no different. He appears to have been highly talented in identifying the right person and placing him in the right place, both in banking and later in politics. His observed ability to read character was one of the capabilities that made him a great manager. Although Cosimo appears to have been a capable people manager, he did not try to manage everything. He set direction, strongly and decisively. He delegated extensively and trusted his managers. However, he expected complete adherence to his directions and would threaten to dissolve a partnership if these expectations were not met. He

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did not let politics become a distraction from his banking responsibilities.

However, he was highly dependent on his general manager, Giovanni d’Amengo Benci.

And Cosimo had the best and most important asset of any bank owner, a great general manager. With the right general manager, many things work. Benci was such a general manager, extremely capable, liked and trusted by Cosimo. Under Benci’s management, from 1435 to 1455, the Medici Bank had its greatest period of expansion and maximised its earning capacity.

Cosimo and his successors used the general manager extensively, both on major strategic decisions, such as the establishment or closure of a branch, and for most day-to-day management. Compared to the Medici themselves, the general manager only had a minor share in the capital of the holding company. However, this share, importantly, made him a partner in the individual partnership agreement with each branch and gave him an interest in each and every branch’s success. The general manager was responsible for most daily management decisions and did not need to consult the Medici family partners on these. This level of delegation made him very powerful and also made the Medici highly dependent on him.

The Medici had a developed approach to people management, with a particular aspect being how they sent young and talented people from Florence out to branches to get experience and then promoted them quickly. The Medici followed a consistent policy of promoting from the ranks. This was central to the success of managing different branches in several countries in the largest bank of its day.

The Medici understood incentives. They were not overly generous in remunerating their clerical staff, but they paid competitive wages and salaries. Most importantly, each branch manager was remunerated by participating in the profits of his branch as a partner, instead of receiving a salary.

The Medici holding company owned the majority of shares in each branch partnering with the local managers. New branches were established in Avignon and London in 1446.

Branch management was taken seriously by the Medici. One article in the partnership agreement for the Bruges Branch forbade the granting of credit to anyone who was not a reputable merchant. Loans to sovereigns were forbidden. Other parts of the agreement prohibited the branch manager from doing any business for himself, to gamble, keep women at his quarters, accept bribes or valuable gifts, underwrite insurance or break local laws. Without being historically flippant, sexist or crude, most of

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these rules have relevance today. While these rules may have limited the powers and personal freedom of the branch manager, he was incentivised to focus on the job of managing the branch well in order to do well himself. He would receive 20 per cent of the profits after provisions for possible defaults. The available records evidence that the Medici were greatly worried about lending without proper judgement and accumulation of losses through bad debts. Making provisions for bad debt was a consistent policy of the Medici.

In 1451, the Medici Bank was composed of the head office in Florence, three branches within Italy (Pisa, Rome and Venice), four branches outside Italy (Avignon, Bruges, Geneva and London) and three industrial establishments (two wool and one silk shop). In 1471, the Medici Bank employed 57 people.

Cosimo’s highly effective general manager Benci had been a signatory to each of the partnership agreements with the branches. Benci’s death in 1455 meant that the Medici Bank had reached its greatest point. After his death, the management of the Medici banking house changed considerably and negatively to result in eventual complete abandonment. Upon Benci’s death, all the agreements had to be renewed. There was then an additional critical change in the governance of the Medici Bank. The holding company was terminated, and new contracts were signed between members of the Medici family and local branch managers. We do not know what caused this significant change in the governance of the bank.

It radically and negatively changed the incentive structure that had served the bank so well since its inception.

A great strength of the former holding company structure was that it gave the general manager a personal, economic interest in each branch.

Benci’s interest in each of the branches may have contributed to him ensuring that there was limited competition and infighting between the branches. It is possible that Benci was more likely to ensure the success of all the branches when he was personally linked to each of their successes or failures. Francesco Sassetti, the second general manager, who held the position for most of the rest of the bank’s life, from 1458 to 1490, only had shares in the Avignon and Geneva branches. The absence of shares, and therefore incentives, for Sassetti in some of the branches may well have led to absent management by him of those branches. After Sassetti became general manager, conflicts between the branches increased to the extent that one branch was occasionally reluctant to settle the bills of exchange of another.

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The second half of the fourteenth century, following the Plague of 1348, had been a truly devastating period of economic deprivation, with the European population reduced by between one- and two-thirds. This had been one of the most challenging periods of all European history, including for bankers. The Medici Bank had been fortunate to exist in a period of relative economic prosperity from the beginning of the fifteenth century until the 1460s. However, in 1453, Constantinople, capital of the Byzantine Empire, fell to the Ottoman Turks. The greatest economic powers of the fifteenth-century Europe, the Serene Republic of Venice and the Ottoman Empire, then started a war in 1463 that was to last for 16 years. This war contributed to a shrinking of international trade and an economic depression for the last decades of the fifteenth century. The Medici’s banking business was closely related to trade, partly because of the reliance on bills of exchange, so any reduction in trade had a direct and negative effect on the bank. The War of the Roses between the Houses of York and Lancaster for the English crown lasted from 1455 to 1487. This made lending to the English kings increasingly risky because the loans were used for an unproductive and lengthy war.

The structural monetary imbalance between North and South Europe continued to make any international business difficult. Sometimes, it was impossible to conduct effective bills of exchange across borders because of the dominant one-way flow of money to Rome from the rest of Europe caused by the papacy and its collection of tithes and other income from across Europe.

The history of the Medici Milan branch provides a historical example of the cost of lending to sovereigns, the concentration risk and the requirement for management of this line of banking business in a single branch.

Cosimo had been an important supporter of the Duke of Milan, Francesco Sforza.6 The Milan branch serviced Sforza, selling him jewellery and luxuries and lending to him with security in future ducal revenues. Cosimo had previously avoided entanglement with sovereigns, but the relationship with Sforza showed that Cosimo was fallible. Based on a capital of Imperiali 43,000, of which the Medici had provided 40,000 and the branch manager 3000, the branch had liabilities of 589,000. So the branch’s capital buffer was less than one-tenth for any deterioration in loans not being paid back. Apart from the security for the Sforza loans provided by ducal revenues, and the branch’s capital, the rest of the money, almost eight-tenths, belonged to depositors in the Medici Bank. The discretionary payments made to depositors, even if not contractual, were 12 per cent. The Milan

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branch was lending money at 15 per cent. The branch had a high concentration risk, with the Duke and Duchess of Milan being responsible for one-third of all its loans.

In addition to trading in luxuries, the Milan branch also traded wool and cloth sent on consignment by the London and Bruges branches. By 1478, losses from the lack of repayment of ducal loans were so great that it caused Lorenzo to liquidate the Milan branch. So what Cosimo had ill-­advisedly begun was not managed or perhaps not manageable by his less able successors. The lack of an interest in the Milan branch by the general manager, since the death of Benci and the succession of Sassetti, may have been a contributing factor to this uncontrolled, unmanaged lending. Absent management arose because the complexities of lending to a sovereign made the branch overly dependent on this large customer. The reliance on alternative ways of profit and repayment of the lending, including future ducal revenues and overcharging for luxuries, was too complex to manage.

Banking in the Lyon branch was focused on the trade fairs established when Louis XI of France7 granted extensive privileges to attract merchants to Lyon and away from Geneva in 1463. In spite of Louis’ epithet of the Prudent, this was an early example of loosening of banking regulation. To attract banks and business to Lyon, everyone was free from the restrictions imposed by the ban on usury and free to lend money at an interest rate of up to 15 per cent. The Medici kept their branch in Geneva branch while opening an additional one in Lyon.

In the beginning, things went well in Lyon. In contrast to Milan, the Lyon branch had no major concentration on any one customer. The largest debtor of the Lyon branch in 1467, the Duke of Savoy, was responsible for only one-twentieth of the total loans. This was prudent management given that the branch operated with a capital buffer amounting to only one-fiftieth of its liabilities.

However, the Lyon branch manager, Lionetto Rossi,8 was allowed such freedom that it amounted to absent management from the Medici and the general manager. Rossi caused significant losses over a period of 15 years.

In 1485, the Medici Rome branch dishonoured a draft on a prominent customer of the Lyon branch, causing doubts about the solidity of the Medici in France. Rossi was coaxed to come to Florence by Lorenzo, where Rossi was arrested and put in a debtors’ prison for four months.

Two years later, he was rearrested accused of owing Lorenzo and his other former partners 30,000 florins. The losses incurred during Rossi’s tenure took years to overcome under a new partnership agreement. Stability was

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only achieved after General Manager Sassetti spent 17 months in Lyon, showing some of his abilities for holding the general manager position.

The Lyon branch never recovered its early profitability and was closed down with the rest of the bank.

The London branch had early success, but this evaporated once the War of the Roses broke out in 1455. The need to make loans to King Edward IV to obtain licences for wool exports increased with the need for greater funds to finance the war. The London branch manager appears to have been more interested in his personal standing with the king than with the profits of the branch. During the early 1460s, there was literal absent management of the London branch with the branch manager Simone Nori, who was branch manager from 1450, spending most of his time in Italy, possibly due to poor health. His assistant Gherardo Canigiani made a great effort to integrate himself with Edward IV, granting him successive loans. In Canigiani’s defence without these loans the wool licenses would have been withheld by the king. Loans and licences were closely aligned with the amount of loans being related to the number of sacks of wool. By 1465, Piero Medici, having taken over from his father Cosimo, refused to renew the London branch partnership agreement but agreed to a limited partnership with Canigiani.

The lending to Edward IV contributed to enabling him to finance the war, buy luxury goods such as silk and repay old loans. Piero sent the Bruges branch manager, Angelo Tani, to London to manage the liabilities. Perhaps the strict Bruges partnership agreement that forbade lending to sovereigns was the reason for choosing Tani. The king did acknowledge the large debts and attempted to repay them by further wool licences. However, renewed strife during the War of the Roses and Edward IV’s temporary replacement from 1470 to 1471 resulted in the London branch’s liabilities being taken over by the Bruges branch including a doubtful claim on the king. This in turn caused the collapse of the Bruges branch in 1478, when the London losses were finally written-off.

As a family owned entity, the bank was strongly tied to the capabilities and focus of successive generations. Cosimo’s family successors appear to have lacked his people management skills to further improve or even maintain the fortunes of the bank. Cosimo’s son Piero was not in an enviable position. Piero had been brought up to be a political leader but had not had much practical banking training. His focus on state politics meant that he had limited time for the bank and left this to Sassetti. After 1466, Piero continued to pursue the policy of retrenchment that he had adopted after his father’s death in 1464. He took steps to terminate the

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Venice branch, which was doing poorly, tried to end the involvement in London and ordered the Milan branch to cut down the loans to Duke Sforza. Piero died in 1469 and was succeeded by two youths, Lorenzo aged 21 and Giuliano aged 16.

Lorenzo9 would rise to great political fame and become the unofficial head of state of Florence. His great wealth and expenditure earned him the accolade of the Magnificent. There was a great deal to contrast Cosimo and his grandson Lorenzo. Cosimo was a banker with political involvement. He refused a state funeral, although he was designated ‘Father of the Country’ by the Florentine State. Lorenzo was an out and out politician, from a banking family but with little banking talent or interest, who ended up as a sovereign debtor of his own bank.

These management shortcomings might have been alleviated or even overcome by the appointment of a great general manager. However, Sassetti was no Giovanni Benci. In particular, he does not seem to have had the ability to rule the branch managers with the same level of discipline Benci had done. Benci had the support and active involvement of Cosimo, with both of them being financially involved in every branch through the old holding company. Lorenzo delegated much more extensively to Sassetti than Cosimo had done to Benci, and does not appear to have been as involved in the management of branch managers as Cosimo had been. Lorenzo as the overall owner was a partner of each branch, but Sassetti was not. Lorenzo’s focus on and involvement with politics may also have meant that Sassetti did not have the support that Benci had from Cosimo.

Under Sassetti’s general management, the bank incurred huge losses because of insubordinate and prevaricating branch managers. The top management failed to curb their activities and their conflicts with each other. The large losses in Milan, London, Brussels and Lyon were due to excessive lending to sovereigns and mismanagement. They might have been curbed had there been more active and involved management from Lorenzo and Sassetti. In the case of Lyon, Sassetti did go there for over a year and achieved stability after extensive losses, but profitability never recovered. The absent management and particularly management of the branches was a key factor in the decline and fall of the Medici Bank.

A major challenge for Lorenzo was both political and banking competition and envy amongst other powerful families in Florence. He was both the leading politician and banker in Florence, and others desired his downfall. The Pazzi conspiracy, led by the members of the second largest

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bank, caused the death of Lorenzo’s brother Giuliano (1453–78) and nearly cost Lorenzo his life. Pope Sixtus IV followed this failed plot up by sequestering all Medici property in Rome, repudiating papal debt to the bank and expelling its branch manager, Giovanni Tornabuini, from Rome.

Lorenzo had to mobilise all his forces to overcome these assaults, including using money owned by his minor wards Giovanni and Lorenzo. He also diverted public Florentine funds for his own use.

Expenditure was what earned Lorenzo the accolade the Magnificent.

Records show that the Medici family spent the huge amount of 663,755 florins on buildings, charities and taxes between 1434 and 1471. However, this in itself would not have caused the downfall of the Medici Bank had it been as well managed as in its first six decades and had economic conditions been more favourable. Whatever the shortcomings of Lorenzo the Magnificent and his General Manager Sassetti, it would be a one-sided point of view to attribute the downfall of the Medici Bank exclusively to errors in judgement or mistaken policies.

In 1494, the Medici were expelled from Florence, and their assets were seized and put into the hands of the receivers. An economic downturn in the last three decades had made conditions very challenging. The persistent imbalance in the European directional flow of money created a complexity for those financing trade that was probably too difficult to understand and therefore to manage.

Successive generations of Medici failed to continue the success of the first two generations. The absent management talent and focus meant that the economic conditions and complexities were too much of a challenge.

In terms of crisis, the absent management of the Medici Bank was partly caused by the political crisis in Florence, with Lorenzo being the effective ruler. So rather than a bank causing a crisis, the country contributed to the fall of the bank. And a major reason was that being preoccupied by his political line of business, Lorenzo the Magnificent had abandoned the management of his bank.

The Medici would return, but not as bankers. They became dukes, cardinals and popes. Lorenzo (1492–1519), son of Piero, the last Medici involved in banking, became Duke of Urbino. Catherine (1515–1589), granddaughter of Piero, married Francis II and became Queen of France.

Lorenzo the Magnificent’s nephew, Giulio (1478–1534), became pope and took the name Clement VII. Ironically, the descendants of bankers became the future sovereign clients that had been so complex for their predecessors to manage.

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The legacy of the Medici is primarily related to the expenditure and cultural sponsorships of Lorenzo and the political position of the family in the last years of the bank and later when the family was a purely political force and no longer bankers. But it was the extremely successful and profitable Medici Bank that enabled the family to rise to these preeminent positions, not least by providing the funds to sponsor artists and their works, and to gain political influence. In terms of bank management the achievements were impressive particularly when the combination of Cosimo, as the owner and senior partner, had his General Manager Benci and both of them owned parts of each branch. However, Cosimo did not leave banking to his general manager and branch managers and lost money when he lent too extensively to the Duke of Milan. Once Benci was dead, no combination of owner and general manager was able to manage the complexities of both the unbalanced European money flow and the multiline and multinational Medici Bank. Once Lorenzo had abandoned bank management for politics, this absent management made it impossible for his son to prevent the failure of the bank and the expulsion of the Medici family from Florence.

Five hundred years ago, managing banks was complex when it involved several lines of business and different countries. Sometimes, macroeconomic factors would significantly increase this complexity. The first banks were run by bankers without the development of specialist management, just as there was little or no specialist management in pre-industrialised industry. The Medici set an important early historical example that bankers managed banks. They delegated to both excellent and less able general managers who themselves were bankers first and managers second.

Incentives were understood to be an important part of effectively managing banks, particularly one with multinational branches. In the end, the owner was distracted by politics, the general manager was less able and incentives were not optimal. The combined complexities of banking and politics then resulted in absent management that caused the failure of the Medici Bank.

Notes 1. (1312–1377, and king from 1327).

2. (1275–1343, and king from 1309).

3. A more detailed explanation of the medieval banking market is available in Roover’s excellent book. Raymond de Roover – The Rise and Decline of the Medici Bank, 1397–1494 (1966).

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4. (1414–84, pope from 1471, and responsible for construction of the Sistine Chapel).

5. This section draws heavily on Roover’s wonderfully comprehensive book on the Medici bank management.

6. (1401–66, and duke from 1450).

7. (1423–1483, and king from 1461).

8. (1433–1495, and branch manager from 1470).

9. (1449–1492, and successor from 1469).

Reference Roover, Raymond de. 1966. The Rise and Decline of the Medici Bank, 1397–1494.

New York: The North Library.

CHAPTER 3

Rothschild, the Largest Bank in the World: How Multinational Family Ownership Overcame Nearly All Management Complexities When Others Failed

As the Medici Bank was the largest bank in the fifteenth century, the Rothschild Bank became the world’s largest bank in the nineteenth century and into twentieth century. Not only were the Rothschilds the largest bank, they had ten times the capital of Barings, the second largest bank, in 1825.

Having originally been a dealer in medals and coins, Mayer Amschel Rothschild (1744–1812) became a banker in Frankfurt, with the second son Nathan (1777–1836) based in England by 1798. This was the start of the Rothschilds becoming truly multinational when their competitors were only located in a single city in one country, principality or city state. The complexity of managing a multinational organisation was solved by keeping the management in the family. The fourth son Amschel (1803–74) continued the original business in Frankfurt, Nathan in London, the fifth and youngest James (1792–1868) in Paris, the eldest Salomon (1774–1855) in Vienna and the third Carl (1788–1855) in Naples by the late 1820s.

This unique, multinational bank provided a multiplicity of opportunity, including in terms of arbitrage between their locations, taking advantage of differences in prices and liquidity. More importantly, the multinational structure provided true diversification against crises, which contributed considerably to the bank’s remarkable longevity and long-term leadership.

The multinational structure enabled several of the brothers to come to the © The Author(s) 2020 C. Dinesen, Absent Management in Banking, https://doi.org/10.1007/978-3-030-35824-2_3

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rescue when one of them faced threats to his bank’s existence, threats that would have been insurmountable alone.

Financial crises do not strike simultaneously and with equal severity everywhere. This was also the case in Europe in the nineteenth century.

Britain suffered a severe financial crisis in 1825, and James in Paris was able to support Nathan in London. Conversely, Nathan saved James from the collapse suffered by Paris in 1830. London and Britain, unlike the other four Rothschild locations of Frankfurt, Paris, Vienna and Naples, did not experience a revolution in 1848. Solomon’s son Anselm (1803–74) in Vienna would not have survived 1848 without support from his family.

Family rather than outside ownership, size and success enabled the Rothschilds to avoid the need to expand at a continuous or even exponential rate. This ability to vary their growth strategy was another important reason for their longevity. The Rothschilds took significant risks both in the early years and later. However from the second half of the nineteenth century, they did not need to do so in order to maintain their position.

Unlike the chief executive officer of Citi, the United States bank in the early twenty-first century, the Rothschilds did not need to dance every dance when the music played. Perhaps Economics Nobel Laureate Theodore William Schultz and many bank chief executive officers are wrong. You can maintain your position as number one for a very long time, in the case of the Rothschilds for a hundred years, by selecting your opportunities rather than by simply growing. Many competitors who tried to catch the Rothschilds, such as Jacques Laffitte in 1831 in Paris or Barings in 1890 in London, came to grief from taking risks that were too large relative to their capital or for which they did not have the Rothschilds’ diversification when a crisis occurred.

One of the reasons the Rothschilds were able to modify their strategy and growth was that they were always a family firm, and one where there was complete commitment to keeping both ownership and management in the family. One important tool was endogamy or intermarriage. The Rothschilds preferred and practised endogamy to an even greater extent than the royal families of Europe where Christian VIII (1786–1848) of Denmark, the father-in-law of Europe, had daughters married to the English and Greek kings and the Russian tsar. There were 21 marriages between descendants of the Rothschild founder Mayer Amschel between 1824 and 1877. Marrying outside the Jewish faith in the early years led to ostracisation by the family, as in the case of Hannah Mayer, a daughter of Nathan who married Henry Fitzroy in 1839. As time passed, more female

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Rothschilds did marry outside the faith, with nine such marriages between 1849 and 1877, indicating a loosening of the Rothschild intermarriage strategy and tradition.

The Rothschilds were a truly multinational bank and much more unified than most multinational banks today. There was no question that one Rothschild bank would not support the other in a crisis, even if there were much internal discussion and mutual criticism. Equally, opportunities were there to be shared, as were costs, all of which were inscribed in the partnership agreement. This was a more united system than the individual partnerships between the centre and branches that steered the Medici Bank. Here, infighting between branches led to bills of exchange from one branch not being honoured by another. Furthermore, there was complete awareness amongst the Rothschilds, even if they disagreed at times, that their wealth and position was due to their unity and that this unity was based on family and religion.

Before turning to the complexities that faced the Rothschilds and the management with which they, mostly, overcame them, the success factors are important, as is the dispelling of some myths.

In addition to the family-based diversification, there were a number of other factors that contributed to the remarkable rise of the Rothschilds to financial pre-eminence. Firstly, they were the only multinational bank of their time. When founder Mayer Amschel sent out his sons to the capitals of Europe, it was to look for opportunity, but possibly also to provide diversification from the often precarious business environment in Frankfurt. The business here was subject to changing politics and even the moods of local rulers. And there was an absence of competition at a time when being multinational was becoming of greater value. This increasing value was due to financial markets becoming more international just as trade in goods and services had become so. During the nineteenth century, the increasing needs for capital, both for governments and later corporations, exceeded what was available from local banks and branches of foreign banks in most countries. Exceptions were the United Kingdom and France, and their developed financial markets in London and Paris.

Increasingly, these international financial centres were required to meet the capital requirements of many European governments. As industrial development spread across the world, the need for capital, for example from Latin America, was also met by European financials centres and particularly London.

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The Rothschilds had made their early money providing services to the highest in the land, and they understood the value of friends in high places.

Prince William of Hesse-Kassel had been their first highly placed client, and his senior financial official Carl Buderus was instrumental in Mayer Amschel being successful in buying some of the Prince’s English bills of exchange in 1796.

John Charles Herries as British commissary-in-chief or paymaster to the British Army in October 1811 was the Duke of Wellington’s financial right-hand man. Herries became Nathan Rothschild’s first friend in a high place. The Rothschilds’ cultivation and connections with the highest in each land, be it a minister, prime minister or an emperor, gave them an important competitive advantage to understand opportunities and threats as well as to be mandated to execute bond issues or the financial rescues of banks or states. Working through personal relationships was how business was done then, because it suited those in power and they were unlikely to be held accountable. In today’s parlance, such practices could be termed insider trading and would be illegal in well-regulated countries.

Another factor that contributed to the rise of the family was that the Rothschilds knew how to get things done. The Napoleonic Wars (1803–15) created an unprecedented requirement for transfer of bullion to support Britain’s continental European allies and to pay Wellington’s troops. As Nathan later said: “The East India Company had £800,000 worth of gold to sell. I bought it all. I knew the Duke of Wellington must have it. I had bought a great many of his bills at a discount. The Government sent for me and said they must have it. When they got it, they did not know how to get it to Portugal. I undertook all that and I sent it to France; and that was the best business I ever did.” Nathan’s great, great grandson, the third Lord Rothschild (1910–90) once said that “Banking consists essentially of facilitating the movement of money from Point A, where it is, to Point B where it is needed.” The Medici’s bills of exchange had facilitated this need 500 years earlier.

There was an early example of absent management in the history of the Rothschilds. The immediate aftermath of Wellington’s and the Prussian commander Blucker’s victory over Napoleon at Waterloo was not quite the extremely profitable, mythical coup of Nathan standing by his pillar in the City of London, profiting from early information on the outcome of the battle. The real money was made in getting gold bullion to Wellington to pay his troops, as already described. According to the diligently researched records (Ferguson 1989), the Rothschilds did not know how

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they had performed financially after Waterloo. Their accounting was not up to the task. They were unable to record, let alone manage their enormous, but also varied, financial positions in the highly turbulent 100 days from Napoleon’s return from Elba (20 March 1815) until his defeat at Waterloo (18 June) and Louis XVIII’s restoration (8 July). This absent management was due to their simplistic accounting. We have no proof that the Medici used double accounting in the fifteenth century, but we know that the Rothschilds did not use it in the early nineteenth century.

This absent management was partly caused by a lack of outside management in the family bank which had not changed its traditional approach as well as a strong belief in tradition.

Unlike the Medici, the Rothschilds did not have to lend to rulers and governments. This was partly because the needs of governments were now so large that they obtained financing by issuing bonds, rather than by borrowing directly from individual bankers. And bonds, unlike direct lending, were tradable. The government issued the bond, received the money and was liable to pay it back with interest. The ban on usury was no longer effective. The holder of the bond was free to sell it, if someone was willing to buy it and a price could be agreed upon. So government debt had become liquid, although there was not always a buyer for bonds issued by governments with payment problems. For the Medici, there had been no possibility of selling the loans they had made to sovereign rulers. The Rothschilds could decide whether or not to organise and participate in a bond issue. If they did participate, they could sell the bonds, assuming there was liquidity in the particular bond. And with enough friends in high places, in several important countries, the Rothschilds were uniquely well placed to know when to sell and at what price.

Simultaneously, the size of the Rothschild Bank meant that their participation in, and therefore support of, a government bond could secure its success. At times the lack of Rothschild support made it impossible for a government to raise funds. Going to war was expensive and the bond market was often the only source of funds for a government, given the large amounts required. If the Rothschilds refused to support the bond issue the government would, in some cases, effectively be unable to raise the funds and to go to war. The Rothschilds saw wars as against their interest, due to the economic destruction and disruption caused and the likely reduced ability of governments to pay back the bond. So they often refused to participate in bonds issued to fund wars.

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The Rothschilds were also able to refuse support for a bond issue because they were multinational. The Medici had been overly dependent on a few large sovereign rulers and the Pope for a majority of their business, such as the papacy for transfer of tithes, the Duke of Milan for luxury goods trade, the King of England for the wool trade and all of them for loans. In contrast the Rothschilds were so well diversified that they were independent of a single sovereign or a government and of having to keep dancing when the music played. The Rothschilds kept a safe distance from many of the numerous bond issues by the former Spanish colonies in Latin America. These were generating speculative enthusiasm in London from 1820s onwards, but also saw frequent defaults, partly due to political unrest including revolutions. Perhaps it was also an advantage of the Rothschilds being Jews, and therefore to some extent outsiders, which meant they could be selective and not feel forced to participate.

Finally, the Rothschilds could pick or refuse opportunities because they were a family firm. They were always on the lookout for profitable opportunities, but they could afford to say no. They did not have shareholders to satisfy with dividends like the joint stock or listed banks. They did not have depositors, like some of the Medici branches, who needed returns.

So the very large, multinational and well-connected Rothschild Bank was in an enviable position and was much envied. They faced many complexities and managed to overcome many of them for a long time. But eventually an instance of absent management contributed to the Rothschilds’ long, gradual decline. The most challenging complexity faced by the Rothschilds in their history was perhaps the economic rise of the United States, described later.

Turbulent times were an ongoing complexity, but there will always be turbulent times when considering a European period of more than a century. Specifically for the bank that was the largest issuer, trader and investor in sovereign bonds, there were two complex factors that could make repayment less likely: political uncertainty and war. Another challenging complexity was new technology, with railways and the financing thereof being particularly important to corporate banking in the nineteenth century.

In a banking crisis the most important reason why not all banks fail is the management. When a banking crisis hit England in 1825, not only did the Rothschilds not fail, but they were also instrumental in rescuing the British banking system. Six London banks and 73 of 770 country banks failed. The Bank of England was close to suspending payments, as had happened in 1797. The Duke of Wellington said: “Had it not been for the

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most extraordinary exertions—above all on the part of old Rothschild—the Bank [of England] must have stopped payment.”

The 1825 crisis was caused by the bursting of a speculative bubble in bonds issued by former Spanish colonies and caused a dramatic outflow of gold from London. James in Paris supplied Nathan in London with gold to enable the Bank of England to continue payments. Only abstaining from the risky Latin American bond issues, combined with the multinational diversification of the Rothschilds, enabled them to come to the rescue. The rescue was ultimately done at a profit. It established the Rothschild Bank as the dominant force in the bullion market, just as it already was in the sovereign bond market.

The Rothschilds differed between themselves in their view of the technological revolution and investment opportunity represented by railways.

Nathan’s grandson Nathanial (Natty 1840–1915) was deeply suspicious of railways, partly because of the many early accidents. He was proven wrong in terms of the investment returns made by banks from railways.

His uncle James’ investments and capital gains from railway investments made the French Rothschild house larger than the English. Natty’s decision not to become a major financier of railways may have set the direction of not becoming a leader of corporate finance such as the London Rothschilds were of state finance in the United Kingdom. This strategy would later reduce the size of the English house relative to other British banks in the late nineteenth and early twentieth centuries, as corporate financing became increasingly important as a source of income for banks.

Effective multinational diversification had enabled the Rothschilds to come to the rescue of the English banking system in 1825. It was also decisive in the bank itself surviving the 1830 and 1848 years of revolutions. The failures of other banks may have strengthened the Rothschilds relative to their competitions. James would not have survived the French 1830 revolution without the support from his brothers including £779,000 in gold from Nathan.

Rothschild Frères in Paris was close to bankruptcy in the year of revolution 1848 due to the 170 million francs of a French government loan that James held. The political unrest caused this holding to halve in value, due to concerns about repayment. With the French government in a disastrous situation, the collapse of the largest French bank would have made things worse. The French government agreed to renegotiate the loan. This is another early example of a bank being too big to fail after the Bank of England in 1826. The French government had to renegotiate the 1847

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loan, because if the French Rothschild Bank had failed, it might have caused the collapse of the French financial system. So James and Rothschild Frères survived and recovered to become larger than the London Rothschild Bank. But relationships between Uncle James in Paris and the nephews in London were not quite as strong as before. Still James managed to retain strong enough relationships to have the partnership agreement renewed in 1852, without major alterations.

A more stable political environment after 1848 created a new challenging complexity in the agreement of governments to allow banks to be owned by shareholders and listed on the exchange. An important example was the French Crédit Mobilier. Predictably, the family-owned Rothschild Bank objected to the establishment of joint stock banks. The directors of a joint stock bank would, according to James, be “anonymous” and “irresponsible” and be able to dominate commerce and industry. The latter argument has an element of hypocrisy given the dominance of the Rothschild Bank in sovereign bonds and bullion markets. The multinational potential of Crédit Mobilier was a clear threat to the Rothschild’s monopoly by the joint stock type of organisation. James did his best to influence government policy against shareholder owned banks but was unsuccessful.

The Rothschild’s multinational organisation and family ownership meant that they did not have to lend to every government or issue or own their bonds. This was important because the 1860s was another turbulent time. Firstly, there was another banking crisis in London.

In 1866, Overend, Gurney and Company, the largest discount house in London, suffered a bank run. A discount house is a firm that trades in bills of exchange, promissory notes and government bonds. As such, it is a secondary market rather than a primary issuer of bonds. Overend Gurney operated as a broker, matching buyers and seller, and also bought and sold bills of exchange for its own account. The firm was three times larger than the other three major discount houses combined. Its turnover was similar to half the United Kingdom national debt (Sowerbutts et al. 2016). The Rothschild Bank also traded in discount paper but was not a specialist discount house.

Having operated for over 80 years as a specialist and successful discount house, in 1860, Overend Gurney expanded aggressively into foreign plantations, grain speculation, iron production, shipping and railways. These ventures show signs of absent management in the lack of understanding of the risks and from the high rate of growth. The third editor of The

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Economist, Walter Bagehot (1826–77), noted that “losses were made in a manner so reckless and so foolish, that one would think a child who had lent money in the City of London would have lent it better”. This description sounds like absent management in the name of growth rather than just poor management.

Conditions were difficult with concerns about further wars in Continental Europe, following the Schleswig Holstein War in 1864, a general stock market collapse, a fall in cotton prices at the end of the American Civil War in 1865 and prolonged high interest rates. These factors caused business failures and made liquidating or selling investments difficult (Sowerbutts et al. 2016).

By 1865, Overend Gurney was suffering considerable losses and was insolvent, although not publicly declared so. It was still able to convert into a joint stock company and raise £10 million of new capital. This was because investors were not told the whole story of the amount of past losses and believed the partners guaranteed these losses. When a court refused Overend Gurney the power to collect a debt from the Mid-Wales Railway Company on 9 May 1866, the firm applied for assistance from the Bank of England, still then a private bank. Assistance was refused the next day due to the seriousness of the losses. Overend Gurney failed on 11 May 1866. The bank run on Overend Gurney was so significant that it would not be repeated in Britain until 2007.

The Rothschilds refused to lend money to Austria in 1862, because James did not want to lend money for war. This was in spite of several Rothschild Houses holding large amounts of Austrian bonds. The stock markets had expected and got the second Schleswig Holstein War between Prussia and Denmark in 1864. Subsequently, Prussia went to war with Austria in 1866, and finally with France in 1870. The German Chancellor Bismarck achieved his German unification under Prussian leadership. The Rothschilds lost money in the volatility but less than others, such as Overend Gurney and Credit Mobilier.

The Rothschilds had mastered the management of a multinational organisation in five countries, being the Free City of Frankfurt, the United Kingdom, France, Austria and Naples. They were the dominant financial force in Belgium and highly influential in many other Continental European countries. However, not all expansion went well. The Rothschilds issued bonds for Spain and Portugal, but there were defaults due to political instability. This caused losses to the bank and investors and damage to the bank’s reputation.

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The expectation of the Rothschilds and many others for the United States was that the Bank of the United States would become another Bank of England. It was established in 1791, championed by United States founding father Alexander Hamilton and supported by President George Washington, but opposed by presidents Thomas Jefferson and James Madison because they saw it as strengthening federal power. In July 1832, President Andrew Jackson vetoed the bill to recharter the Second Bank of the United States. Barings had been the European agent of the Bank of United States, but this relationship foundered and the Rothschilds stepped in in 1838. The timing was singularly unfortunate as it was followed by a major United States banking crisis in the late 1830s. In all, 343 of 850 banks failed completely, while another 62 failed partially. Many states in the Union defaulted on their bonds, which angered foreign investors.

These losses and developments significantly discouraged the Rothschilds from establishing in the United States.

There was one decisive obstacle to expansion to the United States. No family member was willing to go there to set up a bank. This is an interesting and rare example of absent management. The Rothschilds were exclusively a family bank, the largest bank in the world. Nevertheless, no family member was willing to take on the expansion into what would become the most powerful economy in the world. The future spectacular growth of the United States may not have been seen as clearly in the 1830s and 1840s, particularly after a major banking crisis and some state bond defaults. It is still surprising that the spectacular entrepreneurship of the second generation of Rothschilds was so lacking in the third. L.F. Rothschild, the United States investment bank, was founded in 1899 by Louis Rothschild who was not related to the European Rothschilds.

In addition to the turbulence of the 1830s and 1840s, a crisis in July 1857 involved failure of N. H. Wolfe and Company, the oldest flour and grain company in New York City. In August 1857, Ohio Life Insurance and Trust Company failed due to management fraud. The latter failure focused attention on the poor financial state of the railroads, making the crises more widespread. This was followed by the devastating American Civil War. An additional deterrence for any family member was the American public’s suspicion of big banks in the United States, and especially of Jewish banks. Another deterrence may have been the small size of the Jewish community in the United States, estimated at only 50,000 in 1848. Still the absence of a Rothschild family manager in the United States

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was, with the benefit of hindsight, the single biggest strategic mistake in the history of the bank.

Most of what can be said of the management of the Rothschild Bank is anything but absent. The family-based multinational partnership was uniquely successful, became the largest bank in the world for over 100 years and made its owners fabulously rich. The family organisation allowed collaboration and mutual support that is hard to find in any shareholder owned, multinational bank and even in most partnerships. The sharing of opportunity, risk and costs was institutionalised and cemented by a partnership agreement. This multinational structure gave the Rothschilds several important advantages. Firstly, it enabled them to engage in arbitrage, exploiting price differences between, say, the London and Paris markets.

Secondly, their diversification meant that they could bail one another out in the event of liquidity or solvency problems.

Communication was essential, and a significant investment was made by the Rothschilds to establish an infrastructure to ensure that it was fast, reliable and secret, initially simply by having the best horses. Detailed, frequent letter writing was at the heart of this until more technologically advanced methods became available, but regular and detailed correspondence overcame the obstacle of geographical separation. It was not necessary to have news instantaneously, as long as the news was received before anybody else received it. What mattered was a competitive advantage. This could come from accuracy of the news, often dependent on how highly placed the source of the news was, timeliness and the ability to manipulate the transmission of news to other investors.

The Rothschilds elevated communication to a new level and competitive advantage by combining it with their ability to have friends in the very highest places. This was combined with the Rothschilds having invested in the best horses and carriages to have the fastest and most reliable communication system. James in Paris would meet with King Louis Philippe1 and hear his views and concerns. James would write to Salomon in Vienna who would meet with Prince Metternich.2 Salomon would obtain a reply; write back to James who, in turn, would reply to Louis Philippe. The two rulers would benefit from a remarkably fast, reliable and discreet communication. These advantages must have outweighed having the Rothschilds in the loop. The Rothschilds would have the most accurate news because it came from the highest level. They would have the fastest news, because even the recipient ruler did not have it before it had been through the

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Rothschilds communication chain. Perhaps most importantly, they had it exclusively and before any competitors and investors.

Correspondence was the main form of communication, and meetings within the family were much less frequent, with years passing between them. Family gatherings, such as for the frequent intermarriages, provided opportunities for discussing family business and affirming collaboration and support. There was a high degree of respect for the achievement of the elder generation, but also a willingness to be strongly critical of each other, as evidenced from the correspondence.

Tradition, staying involved in the business and direction set out by the elder generation, played an important part in the management of the Rothschild Bank. There was a reasonable strong management discipline, of the shoemaker sticking to his last, as according to Nathan, “If I were to listen to all the projects proposed to me, I should ruin myself very soon…stick to your brewery, and you may be the great brewer of London. Be a brewer, and a banker, and a merchant, and a manufacturer, and you will soon be in the Gazette” [i.e. having ones bankruptcy notified]. The expansion of Overend Gurney onto corporate lending after several decades as a discounting house was an example of a shoemaker not sticking to his last.

The story of the first Barings crisis provides telling insight into important aspects of the Rothschilds’ superior and highly present management.

The second and final Barings crisis in 1995 will be addressed later, providing an example of absent management in banking, and family banking at that. The Rothschilds’ most formidable competitors, Barings Brothers & Co of London, came close to financial collapse in 1890 because of bad loans to Argentina and Argentinian corporations. In 1890, a revolution triggered a fall in the value of Argentinian credit. Barings’ Argentinian loan exposure alone amounted to more than Barings’ total capital of £2.9 million. This was described as ‘haphazard management, certain to bring any firm to grief’ by the Governor of the Bank of England William Lidderdale.3 It was also an instant of absent management in the pursuit of bond issuing and trading profits, possibly based on complacency from the average 13 per cent profits Barings had earned in the decade from 1880 to 1890.

To compare with the Rothschilds, in a similar crisis in Brazil where the emperor was overthrown in a coup d’état in 1889 and the country descended into civil war, the total amount of Brazilian bonds was only 2.4 per cent of the total Rothschild London Bank’s assets. In addition Rothschild’s ratio of capital to liabilities, or capital buffer, never went

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below one-fifth. The Rothschild London house did lose a large amount, £740,000, between 1890 and 1893. With a capital of £6 million compared to Barings’ £3 million, Rothschild could manage the exposure and afford the losses. Rothschild had managed their risk and capital, Barings had not. The London Bank could afford the losses due to prudent management. More importantly, the London Bank could have called upon the other Rothschilds had things got much worse. The cousins would have been supportive, although they would have had something highly critical to say about it.

The Rothschild—Barings story of 1890 is a historical example of why not all banks fail in a crisis. The banks with management, particularly good management, have a good chance of survival even in turbulent times such as Argentina and Brazil in the early 1890s. The banks that exclusively pursue profit and abandon management have, to state the obvious, a very high risk of failure.

There is evidence that the Rothschilds had anticipated the Argentinian crisis two years early. When it broke, the Rothschilds argued that Barings had to be rescued to avoid the collapse of, in Natty’s words, “most of the great London houses”. This would have been a crisis for the City of London and for the country. The government took action and the Bank of England rescued Barings, paid for by the other London banks under the leadership of Curries & Co and Rothschild. They each offered guarantees of £500,000 with a total of £17 million raised from London Banks, of which only £10 million was required. It took until 1894 for the new, reconstituted, Barings to repay the guaranteeing banks, having sold many of its assets.

In 1905, the Rothschild partnership was not renewed, and the London, Paris and Vienna banks became distinct operations. The main reason was more focus on local opportunities than those in other family countries and reduced trust and communication between the fourth and fifth generations. Amschel had become a banker in Frankfurt in 1789, and the Rothschild name is still important in advisory investment banking today.

One of its alumni has recently been elected president of France. But it is the period of the multinational partnership and world leadership that matter for considering absent management. The Rothschild story is an unusual story of abdication of rather than absent management. They abandoned the management of what had been the world’s largest bank. The London Bank was only overtaken as the largest London bank, in terms of capital,

by Midland Bank in 1915.

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There were many reasons for this, somewhat orderly, decline. Perhaps it is right, after all, that if you do not grow you eventually decline, if not necessarily die. The single biggest explanation for the decline, at least on a relative basis, was the lack of expansion into the United States, the largest economy in the world, by the 1880s. And the main reason was a limitation to the most important management tool of the Rothschilds, the family. If no one in the family wanted to go to the United States to establish and manage a bank there, then this was a limitation the Rothschild multinational bank was unable to overcome in the longer term.

Another change and possible reason for the gradual decline was the reduced trust between London and Paris and between the second generation, James, and the third, exemplified by his nephew in London, Lionel (1808–79) and Lionel’s son Natty. The London Rothschilds started to select which letters they showed to their uncles after the 1848 crisis. This is a change that is difficult to evaluate, but considering that everything had been shared until then, and this had been a fundamental strength of the management of the multinational organisation, it must have been a reduction of this strength. Unfortunately, lost correspondence makes it impossible to access the extent of this reduced communication.

However large and important the Rothschilds were in their chosen fields of European government bond issuing and bond and bullion trading, the markets were becoming too large for one bank to dominate. The size of transactions meant that more banks were required to be involved and this probably diluted the Rothschild’s position as the nineteenth century progressed.

Money was also leaving the Rothschild banking business, with £41 million withdrawn from the partnership by family members between 1874 and 1905. The amount withdrawn would have capitalised the largest bank in the world. The total capital of all the Rothschild banks was still very large at £38 million in 1905. Family members were increasing in numbers but, more importantly, were not reinvesting in banking, but in property, art and other business interests.

Following the non-renewal of the partnership agreement in 1905, it became clear that internal communication had deteriorated significantly when London was not informed of a large Austrian loan issued in 1908. The Vienna Bank had been a weak link in the organisation for some time. But while the problems of Vienna may have been worse than elsewhere, the same problem was emerging in every Rothschild country. The problem was a combination of growth of local economies and the necessity to collaborate locally to be involved. The Rothschilds were no longer able to do local

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transactions on their own due to the increased size of these transactions in these larger, local economies. There was a need to share with other local banks, and these types of collaboration started to overtake the collaboration with the first and second Rothschild cousins in other countries.

Other private banks were important, but so was the rise of joint stock and listed banks with their easy access to capital, enabling them to grow faster and become important locally. The reason the Vienna house was a cause in the reduction of Rothschild collaboration was the Kreditanstalt.

Established in Vienna in 1855 as a joint stock company with Rothschild and partners owning 40 per cent, it became the most important financier of railways within the Hapsburg Empire. The Kreditanstalt had all the features feared by James of a joint stock company, including being able to dominate local finance. However, it was a case of the Vienna Rothschilds joining what they could not beat. Anselm in Vienna was accused by his Uncle James and cousins in London and elsewhere of putting local Austrian interests and that of the Kreditanstalt ahead of the family interest, with some justification. There will be a return to the Kreditanstalt’s role in the Great Depression in the next chapter.

Other examples of local collaboration were railway companies in which Rothschilds were important investors, except in London. One-sixth of James’ total assets were held in various railway companies in 1852, including the Chemins de Fer du Nord railway company, with railway traffic doubling between the 1850s and 1860s. However, James had to collaborate with other investors. Important local partners included Barings in London, the Pereires in Paris, one of the 20 to 30 private banks in Paris known as the Haute Banque and the Disconto-Gesellschaft in Germany.

For the London Bank, a particular development reduced the importance of the Continental European collaboration. This was the strong interest of the British economy away from Europe with the increasing importance of the British Empire, something that had increased in the latter part of the nineteenth century.

The importance of endogamy was also reducing, although the majority of Rothschilds still married other Jews.

By the time of the First World War there was a new player in town, J.P.Morgan. Unlike the Rothschilds, J.P.Morgan had been built on corporate rather than government finance. From a partnership in 1877, J.P.Morgan had been the primary financier of the United States railroads, United States Steel, General Electric and AT&T. The United States had become the lender to the First World War warring parties, lending £936 million to Britain and £736 million to France. The first of these loans,

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$500 million, was then the largest loan in history. The United Kingdom loan of $610 million to France mostly came from what had been borrowed from the United States.

The Rothschilds had not entered the United States but had additionally made the strategic mistake of not making a collaborator and perhaps even made an advisory of J.P.Morgan. The Rothschilds had refused J.P.Morgan a share of a South African loan in 1903. When James’ grandson Edouard (1868–1949) tried to raise $100 million for the French government in 1915 in the United States, he was rebuffed.

Other banks were gaining on and outperforming the Rothschilds in corporate lending, which was becoming more important as corporates grew and required finance to do so. This was one of the reasons for the Midland Bank overtaking the London Rothschild Bank in terms of capital in 1915, after Rothschild had held the number one position for more than 100 years. Capital in the London Bank reduced to £3.6 million in 1915, from £7.8 million in 1918, including the impact of devaluation to the pound and increased taxation. The Rothschilds were no longer the main channel for transferring money from Britain to Continental Europe, as had been the case during and after the Napoleonic Wars a century earlier, and not at all from the United States.

After the First World War, when the partnership agreement was no longer in force, the former collaboration was not resumed. By the time of the crash of 1929–31, the Rothschild London and Paris banks refused to bail out the Austrian bank and its involvement in the Kreditanstalt. This local joint stock bank had to be rescued by the Austrian government without help from the Rothschilds, in contrast with what had happened in the case of Barings in London in 1890.

The Rothschild banks carried on against tremendous challenges, including disastrous European sovereign bond markets in the 1920s and 1930s, the rise of anti-Semitism of which the Rothschilds were a prime target, confiscation of assets in Germany and France, active fighting by members of the family including in the French forces, flight to Britain and the United States and the ultimate horrors of the Holocaust.

Management of the London Bank finally admitted non-family members in 1960 and in 1970 the partnership was transformed into a limited company with an executive committee.

In terms of absent management and financial crises, the Rothschild story provides two important examples, although one is about Barings as much as Rothschilds. When James had held onto the large amount of the

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French government loan, he had abandoned the management of his investments. Years of traditional prudence and lecturing the rest of his family on prudency were temporarily suspended. It was a start of reduced communication with the London Rothschilds. Once James understood how precarious his position was, and that he might not be able to obtain enough support from his brothers and nephews as had happened in 1830, he regained his senses and persuaded the French government to save him by renegotiating the loan. In terms of crisis, the French government clearly believed that the fall of Rothschild Frères would add to the precarious position of the French financial system and might cause a collapse. This is the only plausible reason for them agreeing to renegotiate a loan on terms detrimental to the French state.

A second example of absent management leading to a crisis is the first Barings crisis in 1890. Again the government and, in this case, the other London banks believed that Barings had to be rescued to avoid the crisis bringing most of them down, and the London and United Kingdom financial system with them. This is the reason why the government guaranteed Barings’ liabilities and the other banks paid for them. Although the banks were compensated by the sale of Barings’ assets, this was unpredictable at the time the guarantees were made. Barings’ absent management of its Argentinian exposure, in pursuit of profit and possibly due to complacency after years of high returns, was close to bringing down the financial system of the second largest economy on the world. The managed banks lead by the Rothschilds prevented this.

Notes 1. (1773–1850, and King from 1830 to 1848).

2. (1773–1859, and Foreign Minister from 1809 and Chancellor 1821–48).

3. (1832–1902, and Governor of the Bank of England between 1889 and 1892).

References Ferguson, Niall. 1989. The House of Rothschild. This chapter is deeply indebted to this wonderful work.

Sowerbutts, Rhiannon, Marco Schneebalg, and Florence Hubert. 2016. The Demise of Overend Gurney. Bank of England Quarterly Bulletin 56 (2): 94–106.

CHAPTER 4

Less Regulation Means Greater Complexity: How Looser Bank Regulation Allowed Faster Growth, Greater Complexity and Contributed to Absent Management in Banking

Before the 1970s, banks were simple and mostly small, limited to one country or state, and generally one or two lines of business. Some banks became larger and more complicated when regulation allowed it. Had regulation remained more restrictive regarding banks’ number of activities and territories, it would, obviously, not have been possible for banks to grow so large and become so complicated. Eventually some banks became so complicated that they became impossible to manage. The reason is both simple and logical. It is possible for an organisation to grow so fast, by type of activity, geography or both, and therefore become so complex that it is unmanageable. Unmanageable results in absent management.

This chapter and the next are about how banks became so complex that they became unmanageable.

The second reason for absent management is the development of the capability to manage increased complexity. It is possible that the management can keep step with rapid growth and complexity. We generally and correctly assume that airline pilots are experts. They are exclusively focused on flying the aircraft safely with no distractions from the task of managing an airline, for example, by increasing the number of customers. However in the history of bank management, the managers themselves, the owners, any shareholders, customers and regulators have rarely asked if m ­ anagement © The Author(s) 2020 C. Dinesen, Absent Management in Banking, https://doi.org/10.1007/978-3-030-35824-2_4

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capability has kept step with increased complexity. Any questions were generally related to how much more money the larger and more complicated bank would make and sometimes if the bank had enough capital.

The faulty assumption that managers of banks have always developed the necessary specialist capabilities, and are exclusively focused on managing increased complexity, is the third significant reason for bank failure and absent management in banks. Firstly, loosening of regulation and, secondly, growth had made banks more complex. The faulty assumption that bank management could handle any level of complexity is a significant reason for bank failure. This absence of specialist and exclusively focused management in banks is the subject of a later chapter. This chapter is about how a combination of loosening of regulation and the growth of banks caused absent management of some banks.

Regulation of banks existed as early as the time of the Medici. One restriction, in this case religious, amounting to regulation of banking, was the Roman Catholic ban on charging interest or usury. This ban on usury illustrates how bankers from the very beginning found a way around regulation, not by directly breaking the law but by regulatory arbitrage. When the Medici made discretionary payments to their depositors, it was an early example of regulatory arbitrage. While depositors in the fifteenth-century Florence did not receive interest, they did receive a gift from the bank.

And the amount of this gift was competitive with what they might receive from other banks. It was based on the investment income the bank was able to make from money deposited by customers as well as from the bank’s capital and its owners’ money. All this money was then invested, by the bank and for the banks’ own account and risk, in a range of activities, from loans to sovereigns, to bills of exchange to trade in wool and luxuries.

Regulatory arbitrage, including finding the location with the most accommodating regulation, was also a feature of the fifteenth century. When King Louis of France abolished the regulation on charging usury for the trade fairs in Lyon, the Medici established a branch there and eventually closed the branch in Geneva. Bankers moved to locations, such as Lyon, where the King had lifted the ban on charging interest to promote trade.

Rulers understood even then that there was a strong relationship between regulation and what banking could do for the economy. If charging interest was allowed, bankers would lend more willingly to finance trade. Light or no regulation meant more trade. More trade meant more taxes. This was particularly important at a time when the vast majority of state tax revenue was sales, import or export taxes, rather than income, profit or wealth taxes.

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The history of banking regulation is only marginally longer than the history of regulatory arbitrage. Historically, banks have quickly found a way to work around regulation or at least mitigate its impact on the bank’s opportunities and to increase profits.

Most later regulations aimed at protecting a national banking system that the country was dependent on for its strength and prosperity, including to finance its armed defences and its wars. Eventually, regulation aimed at protecting bank customers. This only happened when the political incentive for protecting bank customers became stronger. This development occurred once the electoral franchise became more extensive and there was a high communality between bank customers and those who could vote for the politicians responsible for the regulation of banks.

At the time of the Rothschilds in the nineteenth century, the regulatory ban on joint stock companies benefitted this, the world’s only multinational, but also family-owned, bank. The Rothschilds, personified by James in Paris, did his best to persuade the regulators, in the shape of Napoleon III and his ministers, to maintain the ban on joint stock companies. This is an interesting historical example of a bank lobbying politicians and even more interesting that this lobbying is to maintain restrictive, and not loosening, regulation. The French government wanted more competition amongst banks and to the Rothschilds, so allowed banks to be established based on subscribed capital from many investors.

Other parts of the Rothschild family were content to become investors in joint stock banks. The most important was the investment by James’ nephew in Vienna, Anselm, as head of the Austrian Rothschild house, in the new joint stock bank, the Kreditanstalt, in 1855. This was partly controlled by the Rothschilds and became Austria’s largest bank until its collapse in 1933.

Joint stock banks were not allowed in France until 1852, when the Crédit Mobilier was founded, while they had been allowed in England already from 1826. Before then, English bank ownership was restricted to partnerships of no more than six people. The Bank of England was the only exception, having been a joint stock bank since 1697. With the Industrial Revolution having taken off in England in the eighteenth century, the need for larger banks was correspondent to this completely new, truly transformational economic development. The Industrial Revolution was an important reason for the development of banks. It was why the Rothschild founding father, Mayer Amschel, sent one of his sons, and perhaps the best, Nathan, to England, although he always focused more on government than on corporate finance. Without the development of

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banks and their ability to gather capital and offer it to industry, at a price, the Industrial Revolution could not have developed as fast as it did.

The United States finally got its Federal Reserve, central bank, lender of last resort and bank regulator all in one in 1913. It was supposed to deploy its lender of last resort facilities only to those bankers who exercised proper prudence and care in their financial operations (Moss and Bolton 2009). So presumably there would be no support for banks displaying absent management. Eventually, it would be the possible impact on the country’s economy from a bank’s failure, rather than the prudence of the bank’s management, that would determine if the bank would receive support from the government’s central bank.

The period of economic boom in the United States from 1921 to 1929, the decade just prior to the Great Depression, saw two brief and mild recessions and a sharp reduction in the number of banks from around 30,000 to below 25,000. Some of this reduction was due to mergers and acquisitions, but the majority was due to an extremely high failure rate amongst banks. Interestingly, this did not cause a banking or wider financial crisis.

During the 1920s, banks in the United States started to enter new and riskier lines of business. The demand for loans from business reduced, as many businesses were so profitable that they could finance their expansion themselves. Business loans as a proportion of total loans reduced from close to half in 1922, to only just over one-third in 1929. Conversely, there was significant growth in lending to individuals. Some commercial banks chose to provide margin lending to private individuals who wanted to invest in the rapidly expanding, and very profitable, securities market.

Margin lending meant that it was possible for an investor to borrow up to 80 per cent of the amount invested in the stock market.

In addition to this indirect exposure to the stock market, some commercial banks decided to start underwriting the issues of shares on the stock exchange. This had previously been an exclusive activity of specialist investment banks. Commercial banks were not prohibited by regulation from underwriting the issues of shares at this time. The underwriting process involves the bank guaranteeing the amount of capital raised from investors to the company issuing the shares. If the underwriting takes place when the stock market is volatile, the bank takes the risk of paying the issuing company more than is eventually raised from investors. The bank will own the issued shares, but if the stock market has fallen, the value of the shares may be less than what the bank has paid the company

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issuing the shares. Investment banks lost as much as a quarter of the market share of underwriting activity to commercial banks in the three years from 1927 to 1930. Importantly for the potential absent management in banking, entering into margin lending and share underwriting significantly added to the complexity of managing commercial banks (Moss and Bolton 2009).

These expansions in business activities did not happen automatically and not every bank diversified. Each bank had its own management, and they individually made the decision to enter new lines of business in search of profit. Other banks stuck to their last of simple commercial lending in one state. While competitive market pressures may have been hard to resist, nobody forced banks to expand. The commercial banks’ increased activities contributed to the economic boom of the 1920s, by adding capacity to margin lending and stock underwriting, but the banks cannot be solely blamed for the 1929 crash. The companies that decided to issue the shares and the individuals who borrowed up to 80 per cent to buy them took their own decisions as well and contributed to the crash. Given that the stock market had increased by one-fifth each year since 1922, investors’ continued buying of shares is understandable. But the managements of banks that entered these activities were each individually responsible for placing their banks and themselves in harm’s way. And when the crash came, many of these banks were completely unmanageable.

The Great Depression of 1929–33 was a catastrophically severe economic downturn and also a major banking crisis or possibly two major crises. During 1929, there had been a slowdown in industrial production and a reduction in share prices after their peak in September. On ‘Black’ Thursday, 24 October 1929, the New York stock market crashed. A combination of factors contributed, including an overheated economy, overvaluation of shares, easily available credit, including margin loans, an agricultural crisis and increased interest rates from five to 6 per cent in August 1929.

The collapse of the stock market caused the value of shares to almost halve in the three months from September to mid-­November 1929.

Banks experienced a drastic fall in the value of their stock holding and the loans made to their margin borrowing customers, as well as loan and mortgage defaults and withdrawal of deposits. In spite of this, the October 1929 crash was not immediately followed by a banking panic, but concerns about bank solvency and the safety of deposits culminated in bank runs in many states during October 1930. This resulted in over 600 banks being suspended in November and December 1930, including one of the

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thirtieth largest private commercial banks, the Bank of the United States.

This bank was the result of mergers with five other banks and was active in commercial lending, real estate loans and security investments. While two of its senior executives were sent to prison for fraudulent bookkeeping, there was probably also absent management of this large, complex bank.

Not all banks failed. In this crisis following a major stock market crash, over 19,000 banks did not fail. So the majority of banks did not fail. Many were small retail banks far away from the dangers of Wall Street. The difference between failure and survival was the individual management decisions of each bank, as to which line of business to be in and how much risk to have taken when the crash came. Bank management is not about being able to predict the future. That is, as the proverb has it, difficult. Bank management is, most importantly, about being in business tomorrow, about not failing. This is partly due to the trust of depositors and partly to the damage a single bank failing may do to a country’s banking system, and the whole country, as in the 1890 Baring crisis. So bank management should ensure that the bank can survive most situations imaginable, certainly a very severe economic downturn, although perhaps not the Plague of the fourteenth century.

As for the second bank crises and the deepening of the Great Depression, the failure of the largest Austria bank, the Kreditanstalt, was the proximate cause. The Kreditanstalt was the reason without which the second crisis might not have happened, or at least not happened then, according to a former head of the Federal Reserve and eminent economic historian (Bernanke 1995). The Kreditanstalt was the joint stock bank established and partly controlled by the Vienna part of the Rothschilds.

Many countries were on the gold standard in 1931, fixing the exchange rate of their currencies to gold, and consequently between other gold standard currencies. When depositors sought to withdraw funds from the Kreditanstalt, this caused worried foreign investors to convert the Austrian currency into gold. A run on the Kreditanstalt led to a run on the Austrian currency. The crisis spread to runs on banks in Germany, and British banks also came under pressure, due to their exposure to Austria. In spite of large loans from the United States and France, Britain had to abandon the gold standard and saw the value of its currency fall by a third. Twenty-five other countries followed Britain in abandoning the gold standard. This in turn caused many to convert dollar into gold. The European crises affected United States banks and in a second banking crises 720 United States

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banks closed their doors during the four months from June to September 1931 (Bernanke 1995).

The impact of the Great Depression was catastrophic in terms of economic and human loss, with particular severity and longevity in the United States and Western Europe. Many countries were affected due to the international loss of demand for exports and the slump in investments.

The United States gross domestic product or GDP, being the total value of goods produced and services provided in that country in one year, fell by close to one-third and unemployment exceeded one-fifth. The United States did not recover its previous long-term growth pattern for ten years until 1942.

Unsurprisingly the Great Depression caused a range of new banking and securities regulations to come into force, including the Securities Exchange Act of 1934, leading to the establishment of the Securities and Exchange Commission (Nanda et al. 2002), the regulator of investment banks. The most important banking regulatory effect of the Great Depression in the United States was the Glass-Steagall Act of 1933. This Act prevented banks accepting deposits from large-scale dealing in securities. Bank could either accept deposits and make loans, being commercial banking, or underwrite and deal in securities, investment banking, but could not do both. The primary driver of this separation was that the role of banks in both activities could create conflicts. Cases of fraud had come to light as part of Senate Committee hearings on stock exchange practices (Nanda et al. 2002). There is no indication that the complexity of managing these two different and potentially accumulating businesses was recognised or was a motivator of the Act. The Act had real teeth, forcing the leading bank in the United States and the World, J.P.Morgan, to sell its investment bank. This resulted in the establishment of the pure investment bank Morgan Stanley. This divestment was not regulatory arbitrage as the two banks were and have remained completely separate. The regulation caused the establishment of several new United States pure investment banks including First Boston Corporation, Lehman Brothers and Dillon Read. However, for business outside the United States, commercial banks were able to continue doing both commercial and investment banking business as the regulation did not apply abroad. Citi and Chase remained leaders of what is today called Eurobond underwriting for non-United States investors, being bonds issued by foreign corporations in United States dollars.

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Importantly for the challenges of management, the Glass-Steagall Act made banks less complex. There was considerably less complexity in managing either a commercial or investment bank than in managing a combination of these two activities or lines of business.

The Second World War was followed by the Breton Woods regulation in 1944, which lasted until 1973. This was an international agreement on a new monetary system based on gold, which had the aim of guaranteeing exchange rate stability and full employment. The Bretton Woods system worked by fixing the United States dollar and gold at one ounce of gold equalling $35 and with the United States dollar being fully convertible into gold. Other currencies that were members of the system had fixed parity directly with the United States dollar and therefore indirectly with gold. The United States dollar became used as a reserve currency in addition to gold by the member countries. Bretton Woods had more exchange rate flexibility than the interwar gold standard because the International Monetary Fund (IMF), a new institution founded at the beginning of the Bretton Woods era, allowed adjustments to the fixed exchange rates between individual member currencies and the United States dollar.

Central to the activities of banks, and limiting the complexity of their operations, was the controls on international capital flows from 1944 until 1959. This restriction limited the international flow of money and reduced the activities and complexity of banks.

The Bretton Woods system was abandoned in 1973 after United States President Nixon suspended the gold convertibility of the United States dollar in August 1971, partly as a consequence of the cost of the Vietnam War. The abandonment of Bretton Woods was a significant loosening of regulation, principally of many of the major currencies, and was not strictly about banks. But abandoning Bretton Woods significantly increased the complexity of international currency exposures and the opportunities and associated risks for banks.

After Breton Woods, many countries looked to the Basel Committee on Banking Supervision at the Bank for International Settlements for a new regulatory framework. This is an international committee of national banking regulators, established in 1974 by the Group of Ten industrialised countries and consisting of 11 countries being Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States. The committee has no regulatory powers and its decisions need implementation in law by individual countries to become part of their regulatory systems. Its first document on ­recommended

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capital ratios was published in 1988, known as Basel I. This introduced minimum capital requirements for banks and was followed by Basel II in 2004. Basel II significantly developed the measurement of capital that banks should hold. External credit ratings on banks’ loans and investments suggested capital from a nil risk-weighting for the most secure AAA-rated assets, one-fifth for less but still secure A-rated government bonds and more than 100 per cent for some high-risk assets. With regulatory approval banks could be allowed to use their own rating system. Basel II also recommended regulatory evaluation of a bank’s capital to its risks to enable early regulatory intervention. Another recommendation was for greater transparency of bank assets and investments. Importantly, the Basel recommendations were primarily focused on capital as the primary tool of bank regulation. There were no recommendations on reducing complexity, and restricting banks’ operations by line of business or territory was left to individual countries (Blaylock and Conklin 2010).

In the United States, there was considerable difference in how commercial and investment banks were regulated, following the regulatory enforced split after the Great Depression. Commercial banks were regulated by the Federal Reserve, were prohibited from investing in real estate and commodities, had significant restrictions on leverage with a 10 per cent capital ratio being considered well capitalised and had federal insurance supporting deposits. Investment banks were regulated by the Securities and Exchange Commission, had no restrictions on activities or leverage and were not federally insured as they did not accept deposits (Stowell and Meagher 2008).

The most important loosening of bank regulation in the United States since the Glass-Steagall Act in 1933 was the Depository Institutions Deregulatory and Monetary Control Act of 1980. This act instituted a number of important reforms including a uniform reserving requirement on all deposit-taking institutions. All deposit-taking institutions were brought under the regulatory powers of the Federal Reserve. The Act removed the limit on interest banks could pay depositors. This limit had encouraged savers to deposit their money with unregulated entities because the limit on what banks could pay was unattractive, particularly during the years of double-digit inflation following the two oil crises of 1974 and 1979.

The Act increased insurance of deposits from $40,000 to $100,000 at federally insured banks, savings and loan associations, and credit unions. The Act also removed the legal limit on what interest rates could be charged for mortgages. This limit had effectively kept all mortgages as prime, meaning

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that only people with a good credit ability to pay back the mortgage were able to obtain one in the first place. Banks were not willing to lend to people with a weaker credit score at the legal limit of what interest they could charge for the mortgage. The removal of the limit opened the market for mortgages for people with lower credit scores, the sub-prime market, which will be described in much greater detail later (FDIC 1997).

During the 1980s, commercial banks became increasingly attracted by the higher margins of investment banking. Commercial banks knew these margins from paying them when they themselves increasingly used investment banks to issue bonds and to package commercial and mortgage loans to sell them on to investors. Conversely, investment banks needed capital to underwrite equity and bond issues and increasingly to trade for their own account, particularly in bonds.

Some investment banks preferred to stay independent from commercial banks, but their need for capital caused many to abandon their partnerships and list on the stock exchange. This fundamentally changed the incentive structures in the investment banks, reducing the long-term loyalty of senior employees who had been partners and owners. The new incentives typically lasted until the stocks awarded as part of bankers’ remuneration could be sold, rather than the much longer duration of a partnership incentive.

J.P.Morgan was the first commercial bank to be allowed to underwrite a commercial bond offering by the commercial regulator in 1989. The bank then rapidly built its investment banking capabilities to become one of the largest investment banks with a particular strength in corporate bond issuing where its very large corporate balance sheet, funded by deposits, gave it an important advantage.

The restrictions of the Glass-Steagall Act of 1933 were gradually eased in the 1990s, and finally removed in 1999, with the passage of the Financial Services Modernization Act of 1999, also known as the Gramm-Leach-­ Bliley Act. It was again allowed for banks to combine deposit taking and investment banking. Canada had been ahead of this development with the passing of the Bank Act in 1987.

Pure investment banks retained one key advantage over the larger universal banks with their bigger balance sheets and deposit financing.

Investment banks were not subject to the leverage rules applied to commercial banks and had no regulatory limitations on leverage. Just before the last 2008, financial crisis investment banks were successful in ­persuading their regulator, the Securities and Exchange Commission, to abolish the

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“net capital” rule in 2004. This had previously restricted the amount of debt the brokerage units of the investment banks had been allowed. There was a belief that market forces would limit the amount of leverage investment banks would be able to take on. It was believed that the market would simply not lend more than certain amounts, credit rating agencies would downgrade credit ratings of investment banks that became too leveraged and shareholders would not want to own shares in overly leveraged banks. This belief in the market as regulator was to prove completely misplaced.

The removal of the barriers between commercial and investment banking allowed extensive mergers and acquisitions by banks keen to offer the full range of services. The investment bank Morgan Stanley, de-merged from J.P.Morgan as a result of the Glass-Steagall Act 44 years earlier, merged with retail brokerage Dean Witter in 1997. Travellers Insurance Group had bought retail stock brokerage firm Smith Barney in 1988. The new combined group bought pure investment bank Salomon Brothers in a $9 billion deal in September 1997, after which Salomon and Smith Barney were merged. In 1998, Citicorp, the ultimate holding company for Citibank, merged with Travellers Insurance in a $70 billion deal to become the United States largest securities firm. Part of this merger was not permitted by the Glass-Steagall Act, and Citicorp obtained a temporary waiver for this infringement of the Act. As soon as the merger was in place, Citicorp and other major banks intensified the lobbying effort to have the Glass-Steagall regulation abolished. This lobbying effort was successful in 1999 under President Clinton. An important argument was to allow United States banks to compete on an equal footing with foreign universal banks, whose regulators allowed a combination of commercial and investment banks (FDIC 1997). In the following year, two of the largest commercial banks J.P.Morgan and Chase merged.

Foreign banks also bought into the United States, the largest financial market in the world. In one year, in 2000, the universal Swiss bank UBS, being both a commercial and investment bank, merged with United States retail brokerage Paine Webber. Another universal Swiss bank, Credit Suisse First Boston, merged with investment bank DLJ, and universal German bank Dresdner Kleinwort Benson merged with Wasserstein Perella.

Banks also had a desire to be more multinational, in order to participate in growing markets outside their own, be it the United States, Europe or Japan. In addition, it was important for banks to follow their increasingly international corporate clients outside their own country, for basic b ­ anking

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services such as currency and cross-border transactions, to the more complex financing of international mergers and acquisitions.

In the United Kingdom, the development was similar. The United Kingdom was a leading banking centre built on centuries of tradition, going back to the fourteenth century and earlier, including the involvement of such foreign banks as the Medici. Prior to 1986, and the loosening of regulation, known as the Big Bang, banking activities had been highly segregated. Commercial banks, known as clearing banks, took deposits and lent to private individuals or corporations. Merchant banks, which are roughly British for investment banks, advised their corporate clients and underwrote issues of shares and bonds to provide finance for these corporates. Even further segregation existed between stockbrokers acting for clients wanting to buy and sell securities and stock jobbers who acted between stockbrokers and were making market, that is, setting prices and buying and selling. All stockbrokers and jobbers were partnerships and members of the Stock Exchange. The Big Bang loosening of regulation in 1986 allowed stockbrokers and jobbers to be joint stock companies and to list on the stock exchange, to be owned by banks and to be owned by foreign banks.

Attracted by the high margins, commercial British banks went into these new and different investment banking lines of business, making these combined, universal banks much more complex to manage.

According to the insightful and astute former banker Philip Auger (Auger 2001), the brokers bought by the big banks proved “impossible to manage”, and this complexity, impossibility and consequent absent management was central to the failure of several British investment banks.

The largest commercial British banks—Barclays, NatWest, HSBC and Midland—as well the merchant/investment banks—S.G. Warburg’s, Schroders and Kleinwort Benson—bought stockbrokers and jobbers.

Stockbrokers had been simple organisations from a management perspective. They operated in a single line of business, in a single country and were either partnerships or family owned. The management complexity and corresponding requirements were limited. There was therefore little need to develop specialist management skills, and the top broker generally led these operations. The incentive structures were equally simple, with a high correlation between the attractive margins earned and the rewards bestowed on partners. To the extent that these entities had their own culture, it was different from their new owners, the commercial and investment banks.

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Part of the motivation for the change in regulation had been to enable British banks to compete with American and other foreign banks. However, one result was that these foreign banks now acquired British banks.

Foreign banks bought six of the top city institutions between 1995 and 1997, starting with the failed Barings in February 1995.

Further regulatory loosening was to take place in the United Kingdom to attract foreign banks to the City of London. Following Big Bang, regulation was promoted by the British government as being ‘light touch’ to attract foreign banks to London. More banks meant improved finance for business. It also meant more corporate taxes from banks as well as income taxes from the growing number of highly paid bankers. And the bankers contributed to consumer spending and increased real estate values, particularly in London.

The lighter regulation in London compared to New York contributed to London becoming the world centre for the highly complex over-the-­ counter derivatives. Too complex to be traded on an exchange, these products had to be traded on the telephone. Each product was slightly different and increasingly complex. The complexity of derivatives will be laid bare later. London came to dominate this explosively growing derivative business, and London’s global market share grew from a quarter in 1995, to close to half in 2004. By then, close to half meant $300 billion of derivatives being traded in London every day.

From 1998, the United Kingdom Financial Services Authority took over banking supervision from the Bank of England. In 2000, the Financial Services Authority took over the supervision of the Stock Exchange, then the mortgage sector in 2004 and general insurance in 2005. However the picture was not clear with the Bank of England retaining the responsibility for the stability of the financial system. The British Treasury retained responsibility for the institutional structure of financial regulation and was responsible to the British Parliament. The British system has since been substantially reorganised, having been found unfit for purpose following the 2008 financial crisis.

Regulation has, historically, not only limited the number of lines of business banks could transact but has also limited banks to the number of locations where they could do business, in terms of states and countries.

All countries require foreign banks to obtain a license to operate. In the last quarter of the twentieth century, some governments proactively sought to attack banks, such as in the case of the United Kingdom, but

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also offshore locations such as the Island of Jersey in the English Channel and Cayman Islands in the Caribbean.

Importantly, the United States 1927 McFadden Act and 1956 Bank Holding Company Act restricted United States banks territorially to interstate branch banking. This was reversed by the 1994 Riegle-Neal Interstate Banking and Branching Efficiency Act. The possibility of operating in more than one state was an important loosening of regulation and enabled state banks to become national banks. The increased complexity of managing banks in two or more states may not be as great as operating in more than one country, particularly as there are no currency complications. At times, different parts of the United States display different cultures, economic conditions and cycles. Operating in many states is more complex than a single-state bank, but several large banks have managed this successfully for long periods, particularly when remaining commercial banks and not also becoming investment banks.

The mergers of commercial and investment banks has been described already. In the United States, there was an explosive growth in bank mergers and acquisitions as multistate banking was allowed after 1999. However already from 1988 to 1990, the average annual value of bank equity acquired in acquisition, a measure of the mergers and acquisitions, had been $4.5 billion. In 1991, it was over three times as large at $15 billion and reached over five times at $25 billion in 1995. Both the number of transactions and their size increased as many banks continued to merge and the transactions became increasingly larger. Consequently, the number of banks reduced with the commercial banks in the United States reducing from over 15,000 in 1980, to less than 10,000 in 1995 (Gilson and Escalle 1998).

In Canada, banks had been allowed to operate in more than one state since the 1930s, resulting in five national players having a market share close to three-quarters of the total banking markets. These were Royal Bank of Canada, Canadian Imperial Bank of Commerce, Bank of Nova Scotia, Bank of Montreal and Toronto Dominion. Within six months of the passing of the Canadian Bank Act in 1987 that allowed a combination of commercial and investment banks, four of the five large national banks had partnered with an investment bank. Only Toronto Dominion decided to build its own investment banking capabilities (Raynor and Bower 1999).

The most important management aspect of this history of tightening and then loosening regulation and growth of banks is that management of banks used to be simple when regulation was tight. The simplicity of the

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operation was such that just doing the banking was enough. Being a banker, a producer, met nearly all the requirements of a successful bank, because it was simple.

During 1980s and 1990s, new markets developed and products became more complex and more difficult to manage and to regulate. Mortgages and other loans, which are assets for a bank which expects to be repaid with interest, were packaged and resold to investors, while maintaining a margin on the sale. This increased the banks’ ability to lend more due to the reduced risk from divesting mortgage risk by selling the packages.

Corporates with lower credit ratings, which had previously relied on borrowing from banks, were able to issue bonds as investors became willing to take more risk. These bonds were exposed to higher risk of default but offered a higher yield to investors. They are known as high-yield, non-­ investment grade or junk bonds.

Finally came derivatives. Strictly speaking, a share or bond is a derivative of the institution issuing it. However, that is probably too semantic.

Derivatives commonly mean a traded instrument that is not an asset, such as a share or a bond, but a synthetic instrument, deriving its characteristics from an underlying asset, such as a share or a bond. In time, derivatives of derivatives were developed and traded.

The price of a share or a bond is affected by a number of factors, of which three are the condition and performance of the issuer of the share or bond, the terms of the share or bond and how liquid the market for the share or bond is. Liquidity is how easily the share or bond can be bought and sold without significantly affecting its price. Analysing the issuer is part of understanding the value of the share or bond, as is analysing financial market conditions and their liquidity.

A derivative of a share or bond adds at least three new factors: the terms of the derivative, pricing conditions of the derivative markets and the liquidity of this derivative. Added to the three factors affecting the share or bond, this makes for at least six important factors affecting the price of a derivative. A derivative of a derivative adds an additional three more conditions and so forth. Recalling the increased complexity of a commercial bank entering investment banking or vice versa, and doing so in another or several countries, the complexity of managing a universal and global bank starts to become clear. Actually clear is not true at all. But hopefully, it is clear that managing a multinational bank involved in derivatives is extremely complex purely from a product perspective. At some stage, with enough lines of business and products, including derivatives,

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and operating in a multitude of countries, banking can become too complex to manage and some activities can evidence absent management.

Most products and services in a bank are not necessarily complex in themselves. The Medici understood bills of exchange and lending to high net worth individuals. Certainly the bank employees who concentrate solely on one product would claim, in most cases correctly, to understand their products and services. These employees’ managers are often former producers, so would have a similar, if slightly less current, day-to-day understanding of the products handled by the employees they manage.

But the bank may enter a second line of business that the manager will be responsible for. A second line of business he or she has not learned when being a producer themselves. For the fast-learning, ambitious manager this should be a challenge that can be overcome. However, when a commercial bank takes over an investment bank, this challenge becomes complex and substantial for the senior managers. As is clearly shown in the billions of dollars, and euros and pounds, and so forth, of fines imposed on banks since the 2008 financial crisis, the senior managers did not, and do not, understand or manage some parts of their operation. If they had they are unlikely to have been fined with the associated cost, embarrassment and damage to the bank’s reputation. It is dangerous to apply logic to the management as it is too much about human behaviour and humans do not always behave logically. However, it does seem logical that if you continue to add new products and services to the offerings of a bank, at some stage it will be too complex for the senior managers to understand every product the bank offers.

If the products are completely independent, this may provide real diversification. If one product incurs losses, other products are unaffected.

Other products may or may not be profitable, but they may not all make losses if they are truly independent of each other. Conversely if two complex products are affected by the same event, this adds a whole new layer of complexity. To illustrate this consider a different financial service, the insurance of catastrophes, which is often considered completely independent of traditional financial market products. However the Kobe earthquake in 1995 caused both a large insurance loss and a significant fall in the Japanese stock market. The latter was in turn the catalyst for the final collapse of Barings Bank caused by the derivative contracts the bank had entered into.

Black Monday was another example of how complexity caused bank failure, of banks that were unable to manage this increased complexity.

From Monday, 19 October 1987, to the end of that month, the United

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States and United Kingdom stock markets fell by around a quarter. Sixty United States investment banking firms, including E.F. Hutton and L.F. Rothschild (no relation to the European Rothschilds), failed. The Wall Street stock market had seen a rapid rise, when a sharp, one percentage rise in interest rates, from 8.75 per cent to 9.75 per cent, knocked it down. Fast intervention by the Federal Reserve and large strong corporations buying back their own shares prevented a total market collapse (Raynor and Bower 1999).

The stock market had performed strongly since 1982. During the following years, increasingly complex trading strategies were put in place. Investors that wanted to protect their recent years’ stock market gains invested in a strategy so that they would automatically sell a derivative once the market fell to a certain level. The increase in the value of this derivative would protect, or hedge, the value of institutions’ portfolios. These automatic derivative trading arrangements were known as programme trading.

Another investment strategy was to buy the stock of companies rumoured to be takeover targets and simultaneously sell the stock of those companies rumoured to be acquiring. This strategy expected gains on both these trades. A takeover target often sees its share price rise because the buyer needs to pay more than the market price to succeed in getting holders of the shares to sell. Conversely, the acquirer often experiences a fall in its share price, sometimes because it will issue additional shares to pay for the acquisition. When the United States House of Representatives introduced a bill that would have removed many tax advantages related to takeovers, this caused the stocks rumoured to be takeover targets to weaken, as the takeovers were perceived as less likely to happen. Selling of these stocks then affected the overall stock market negatively. One reason was that investors in these stocks could not find buyers, and therefore started to sell other stocks on Friday, 16 October. This was partly because the investors had to meet margin calls, having borrowed to make the stock purchase in the first place. This in turn caused extensive selling on many global stock markets when they opened before the United States market on Monday, 19 October.

Mutual investment funds then had to sell because investors wanted their money back. Finally the market fell to such levels that the institutions’ automatic programme trading strategies were triggered and the stock market crashed (CNBC 2017). And 60 securities firms were unable to manage the complexities. And this was before firms became part of much larger, much more complex organisations, after extensive loosening of regulation in the United States and United Kingdom in the late 1980s and early 1990s.

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When corporate and investment banking was again managed together, following Big Bang and the abolition of the Glass-Steagall Act, these combined entities sold products and services many times more complex than anything seen before the Great Depression. The transactions were also many times larger, adding enormous scale and resulting in unmanageable complexity and absent management. Adding to this was the enormous growth of the banks in terms of number of countries and employees, which will be described in detail in the next chapter.

There is a link between regulation and bank crisis. According to some of the leaders on the subject of financial crises, Reinhart and Rogoff, banking crises are characterised by-“bank runs that lead to a closure, merging or takeover by the public sector of one or more financial institutions” or “the closure, merging, takeover, or large scale government assistance of an important financial institution” (Reinhart and Rogoff 2009).

So here is the only chart in this book, being the exception that proves the rule that there would be no charts in this book. And it is here because it tells a compelling historical story of a link between bank regulation and crisis. The chart has been constructed from Reinhart and Rogoff’s data by simply counting the number of banking crises in European and North American countries. The chart shows that the number of banking crises continues to grow over the longer term. As Reinhard and Rogoff have said, “Periods of high international capital mobility have repeatedly produced international banking crises, not only famously, as they did in the 1990s, but historically” (Reinhart and Rogoff 2009) (Fig. 4.1).

Most importantly the chart shows that banking crises were absent from 1946 to 1971. This was the period of the Bretton Woods international exchange rate system where exchange rates were stable amongst the largest countries in the world and foreign currency transactions were restricted, particularly until 1959. It was also the period when the Glass-Steagall Act prevented United States banks from being both commercial and investment banks. United States banks were also only allowed to do business in one state. The Big Bang loosening of regulation had yet to happen in the United Kingdom. It was prior to extensive deregulation of Anglo American banks in the 1980s and 1990s.

The collapse of Bretton Woods and the introduction of flexible exchange rates in 1973 contributed to the banking industry growing beyond these limits. There was a re-emergence of a global financial market as seen before Second World War, but without the discipline of the gold standard fixed exchange rates. The floating of exchange rates and the reduced level of

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40 35 30 25 20 15 10 5 0

North America Europe

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3 1 2 3 6 Pre-Gold Standard 1850-1879 3

6

21

Classic Gold War and Inter Standard War 19151880-1914 1945 2 1

21 Europe

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29

29

0 Bretton Woods 1946-1971 0

Post Bretton Woods 1971-2008 3

0

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North America

Fig. 4.1 Number of banking crises

capital controls after the collapse of Bretton Woods increased bank risks.

It is unsurprising that banking crises re-emerged after this date. The chart paints a powerful picture and indicates a strong argument for an international exchange rate mechanism to limit banking crises.

If international capital mobility is restricted, that will probably reduce the risk of a banking crisis. What is more likely is that if international capital mobility is reduced this will reduce international trade. And limiting international trade will most probably reduce economic growth. So reverting to Bretton Woods may be both extremely difficult in an increasingly global world and probably undesirable given that free trade has historically been one of the most important drivers of economic growth.

Given how new economic powers have emerged in the twenty-first century, in particularly China, and how the former dominant powers have been weakened, partly due to the latest financial crises, a copy of Bretton Woods with one dominant country and currency seems unlikely. Even large monetary unions such as the Euro do not provide the stability inside or outside their area of influence.

High international capital mobility is an opportunity for banks in that lending, borrowing and principal investment can be done across borders.

If banks want to follow their international customers and prevent foreign banks capturing these clients’ foreign business, the banks have to expand abroad. However, international activity adds significantly to the complexity of managing bank risks. With limited capital controls, banks can engage in multinational risks without establishing operations outside their own

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country. Banks had done this at least since fourteenth century, as exemplified by the Medici. In the nineteenth century, the Rothschilds perfected, dominated and almost monopolised multinational banking, managed by strong family ties. After Bretton Woods, in the last quarter of the twentieth century, multinational banking organisations became an important feature of banking. With growth in multinational banks and increased numbers of lines of business and sophistication of products, this became another driver of greater complexity of bank management.

History has more to teach us about the regulation of banks. Another important finding by Reinhart and Rogoff is that “In the eighteen of twenty six banking crises studied since 1970, the financial sector had been liberalized within the preceding five years, usually less” (Reinhart and Rogoff 2009).

Another important observation made by the Reinhart and Rogoff is “Bank crises are often accompanied by other kind of crises, including exchange rate crises, domestic and foreign debt crises and inflation crises…thus one should be careful not to interpret this first pass at our long historical data set as definitive evidence of the causal effect of banking crises; there is a relatively new area in which much further work is yet to be done” (Reinhart and Rogoff 2009).

Reinhart and Rogoff find that banking crises often follow financial deregulation. Combined with the earlier conclusion that firms will do what regulations permits, it then seems critical that regulation should only allow banks to do what they are capable of managing. Banking crises have been seen as a result of deregulation. If that were so, then, logically, either all or no banks would be equally affected by a banking crisis. This is not the historical experience. Some banks manage their way through a crisis better than others, while some fall by the wayside or are rescued. Banks are controlled by their management, within a framework of market forces and regulation. The only possible and unsurprising explanation is that the management of individual banks matters for banking crises.

When loosening of regulation, and in particular loosening a combination of regulations, allow banks to expand by line of business, ­sophistication of products, territorially by state and country and by sheer size, the regulators must be convinced that management has the ability to manage this complexity. Relying on the market forces will not be enough as shall be demonstrated later.

As aircraft has increased in size, how far they can fly and in technological sophistication, regulation has served to maintain and increase a very high standard of safety. The track record of financial regulation is nowhere near as successful.

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The management of banks was ill-equipped to deal with the increased freedom after financial deregulation. Specialisation of the management did not develop in banking as it did in many other sectors. The absence of specialist banking management is so important that it requires a chapter to itself on producer managers.

It is inadequate to argue that increased capital mobility and less regulations cause banking crises. It is possible to tighten regulations so much that crisis are less able to happen. This is what the chart shows. But while regulation does not cause crises the looser regulation is the more it allows crisis to happen. This is because the looser the regulation the more it relies on the management.

The argument for what causes banking crisis is that those managing banks have a choice in terms of the risks they take and the efforts they make to manage their banks’ risks and overall operations. It is the reason why management matters and why not all banks go bankrupt in a crisis.

Some banks do better, or less badly, than others. Management, as the determining factor of a bank’s strategy and tactics, is the single largest differentiator. This accurately reflects the founder of the management history, Alfred D. Chandler, who wrote that “While the enterprise may have a life of its own, its present health and future growth surely depend on the individuals who guide its activities” (Chandler 1962). How capable bank management is in handling its greater freedom is consequently likely to be central to failure and causing banking crises.

Regulators have not historically been focused on the management of banks but on the banks themselves. In particular bank regulation has focused on the capital banks have. Simplistically regulation has believed that as long as banks have enough capital, they will be safe. Simplistically that is indisputable. And when banks are small and simple, in terms of what they do and where they do it, it is possible to analyse, understand and regulate the amount of risks a bank takes and the capital it requires to ensure it can survive when things go wrong. When banks undertake ­activities that the management does not understand, either because the products are too complicated or because they are affected by international complexities and sometimes because of both, regulators have no possible way to ensure that the bank has enough capital.

Regulators are focused on numbers. Numbers related to the amount of loans made, credit quality of the loans and so forth. They look at the bank’ risks, how much liquidity it has and how much capital. But if you are as good at analysing numbers as those working in the regulators are, it may

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be difficult to also be good at analysing management. Numbers can be put on spread sheets, calculated, compared, contrasted, modelled and so forth.

That is not possible with people because they are too complex. The management’s incentive structures can be analysed and regulated to encourage good behaviour and punish bad. But human beings are unpredictable.

They do stupid things; they do bad, even criminal, things. Most importantly for this book they keep doing things, even when they do not fully understand what they are doing. When you are in charge of a major financial institution, operating multiple lines of business and multinationally, you may simply not be able to understand everything the bank is doing.

And it only takes a small part of a big financial institution to be unmanaged to cause fatal damage to the whole organisation. This is particularly so with banks, because the mere suspicion that a bank is in trouble can be enough for its customers and other banks to doubt it. And doubt, a lack of trust, can be enough to cause a run on the bank, a loss of liquidity and failure.

So regulators could get better at understanding bank management, and they are. Recently the term ‘management stretch’ was raised as a concern by regulators in relation to the merger of two large financial institutions.

However, regulators may not become good enough at regulating management in time to prevent the next banking crisis. So the other options are to restrict what banks do to ensure that they are always managed and that there is never absent management. Or banks could make sure that they always have managers capable of managing the complexities of their business. This has two sides to it. Firstly, for banks to grow in size and complexity only according to what can be managed. Secondly, to develop management capability within banks to ensure that the management is always in place and never absent. The next two chapters look at how banks have grown in complexity and size, then a chapter looks at incentives and the one after that at the challenge of managing in organisations where everyone wants to be a producer.

References Auger, Philip. 2001. Reckless and the Death of Gentlemanly Capitalism.

London: Penguin.

Bernanke, Ben S. 1995. The Macroeconomics of the Great Depression: A Comparative Approach. Journal of Money, Credit and Banking 27 (1): 1–28.

Ohio State University Press.

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Blaylock, David, and David Conklin. 2010. Basel III: An Evaluation of New Banking Regulations. London: Richard Ivey School of Business Foundation, The University of Western Ontario.

Chandler, Alfred D., Jr. 1962. Strategy and Structure: Chapters in the History of the Industrial Enterprise. Washington, DC: Beard Books.

CNBC. 2017.

2017/10/16/cause-of-black-monday-in-1987-as-told-by-atrader-who-lived-through-it.html. Cnbc.com https://www.cnbc.com.

FDIC. 1997. An Examination of the Banking Crises of the 1980s and Early 1990s.

Washington, DC: Federal Deposit Insurance Corporation.

Gilson, Stuart C., and Cedric X. Escalle. 1998. Chase Manhattan Corporation: The Making of America’s Largest Bank. Boston: Harvard Business School.

Moss, David, and Cole Bolton. 2009. The Federal Reserve and the Banking Crisis of 1931. Boston: Harvard Business School.

Nanda, Ashish, Thomas Delong, and Lynn Villadolid Roy. 2002. History of Investment Banking. Boston: Harvard Business School.

Raynor, Michael E., and Joseph L. Bower. 1999. CIBC Corporate and Investment Banking (A): 1987–1992. Boston: Harvard Business School.

Reinhart, Carmen, and Kenneth Rogoff. 2009. This Time Is Different: Eight Centuries of Financial Folly. Princeton: Princeton University Press.

Stowell, David, and Evan Meagher. 2008. Investment Banking in 2008 (A): Rise and Fall of the Bear. Evanston: Kellogg School of Management, Northwestern University.

CHAPTER 5

Complexity from Growth: Territory and Size—How Absent Management Occurred Through Growth by State, Country and Sheer Size

Banks grow because their management wants them to grow, not automatically by themselves. Management seeks greater opportunity for expansion and profit. They fear that not to grow, to remain small and specialised, will leave them at a competitive disadvantage. It was partly deregulation that allowed banks to grow, organically and by mergers and acquisitions.

As banks grew by the number of lines of business, countries and by sheer size, they became more complex. At some level of increased complexity, they became challenging to manage. Eventually all banks, and particularly the very large, very complex banks, or at least parts of them, can become unmanageable. Growth is the main cause of how absent management comes about.

Nearly all banks used to operate locally, in one city. Some banks set up branches across a state or country. But very few banks were international, multinational or global such as the Medici and Rothschilds.

Most experienced managers would agree that making any operation multinational, be it primary production such as farming or mining, industrial production, manufacturing, retail or a service such as a bank, makes the management more complex. Furthermore, the increase in complexity is not just doubled by being in two countries, it is multiplied, even squared to be more mathematical. There are many reasons for this, but few people with experience of multinational operations would disagree.

© The Author(s) 2020 C. Dinesen, Absent Management in Banking, https://doi.org/10.1007/978-3-030-35824-2_5

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The land on two farms or two coal mines may not be that different or can differ as much within one country as between two different countries.

Natural resources tend to be disrespectful of national boundaries. The differences between countries as far as bank management is concerned are nearly all about people and what they have become used to and prefer.

While people are not that different at a more basic level, their traditions and cultures are very different.

When the Swedes embraced Internet banking ahead of most other countries, it may have had to do with the high average level of education, including technical education. But that is similar in Germany, which has taken much longer than the Swedes to adopt banking online. Sweden, with 22 people per square kilometre, is less than ten times as densely populated than Germany (231 people/km2), so the distance to a bank branch is much greater for many Swedes than for Germans. Adding a third factor of colder and longer winters in Sweden than in Germany, some possible comparative attractions of Internet banking to Swedes become clear. So managing a retail bank in either Sweden or Germany and wanting to expand into the other country, the three factors of education, population density and the weather may affect the strategy to roll out Internet banking. And that is before addressing many other differences in customer behaviour, regulation and so forth.

Staying with the Nordic example, Nordic financial institutions have made numerous attempts to expand beyond their limited home markets, but they have nearly all been unsuccessful. The end of this book will consider the recent and worst of these, the catastrophic operations of Danske Bank in Estonia. This lack of multinational success is in spite of many successful Nordic multinationals in industry, transport and non-financial retail, such as Carlsberg, Electrolux, Maersk, IKEA, Lego, Nokia, Norsk Hydro and others. The complexity of managing financial institutions and the role of customer behaviour are likely to be reasons for this difference in success between corporate and financial services sectors in their multinational expansion. Another difference may be the development of management as a specialist activity in primary and secondary sector corporations, such as industry and manufacturing, as well as retail. In financial services managers have often remained part producers resulting in less development and focus on specialist management. This may have made financial services less well-equipped to successfully overcome the multinational management challenge.

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Mergers can be complicated enough when they involve different lines of business, change of ownership structure and sheer increased scale.

When they also increase multinational presence, the growth in complexity becomes truly unfathomable. One such was the potential merger between the United States and United Kingdom securities houses Morgan Stanley and S.G. Warburg. This would have created a leading global bank ranking amongst the top five largest security firms in the world with capital of over $11 billion (Sebenius and Kotchen 1998). S.G. Warburg had been founded by Siegmund Warburg in 1946. In an excellent biography of the founder, the bank was described as being managed as a “Renaissance principality” (Ferguson 2010). In terms of the dominance and authority of the founder there is much similarity with how Cosimo de Medici had run his bank. Cosimo was said to have had great people skills and in particular the ability to read character. Siegmund Warburg was described as an artist in relationships. Understanding and choosing the right people were at the centre of both their management. Similarly, the undisputed leader of Banc One and United States Banker of the Year in 1993 noted that banking is all about people and that he spent around three-quarters of his time on personnel (Hart and Uyterhoeven 1993).

The description of a tension in the personal style of management between for example Warburg insisting on regular meetings and written records with a widespread fear in investment banking of bureaucracy because it limited individual initiative, was a constant theme in the business school case studies throughout the 1970s–1990s (Ferguson 2010).

The management of S.G. Warburg was about personal leadership, which could not be upscaled once the organisation grew significantly. It was highly effective for an organisation of 150 people in the 1940s, 50s and 60s, but not for S.G. Warburg’s 5800 employees in the 1990s. This was particularly so because the 1990s’ chairman had been personally selected by the 1940s’ founder. This selection provided continuity, but there had not been enough transformation in the approach to management from a small, single country partnership, however well respected, to a global, financial giant. From 1950s Siegmund Warburg was concerned that the firm was growing unmanageably large. This is a rare, early reference to what can be termed a concern about absent management, from one of the most respected bankers in history (Ferguson 2010).

The continuity of this management approach is one of the most important reasons why analysing history to understanding management of banks, and the absence thereof, is valuable. If S.G. Warburg had been so

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successful under the management of its founder, for many bankers there was no reason to change this approach to management.

Merging Morgan Stanley and S.G. Warburg would have been a complex challenge because of the different cultures of the United States and the United Kingdom as well as the additional multiple locations. However they were both investment banks and asset managers, so would have understood each other’s business lines.

Established in 1934, S.G. Warburg still had only 150 people in the early 1960s. It then grew slowly to 777 in 1982. As soon as British regulation was loosened by Big Bang in 1986, S.G. Warburg bought jobber Akroyd & Smithers and government broker Mullens & Co., thereby adding complexity. S.G. Warburg now grew exponentially to 2500 people in 1985, and 6500 in 1993 (Ferguson 2010). S.G. Warburg was the United Kingdom’s largest combined investment bank and asset manager and one of the few remaining United Kingdom–owned securities firms after Big Bang in 1986. It was observed that the culture had remained unchanged from Siegmund Warburg’s death ten years earlier in 1982 (Ferguson 2010). A profit warning from S.G. Warburg in 1993 caused by a sharp reduction in earnings from the investment bank disrupted the merger discussions. When the discussions became public, Morgan Stanley decided not to proceed. The fall in profits and the public knowledge of the collapsed merger was followed by the resignation of the S.G. Warburg chairman, who had been in charge of negotiating the merger. The complexities of the exponentially grown and complex bank had overcome the capabilities of the management, and a degree of absent management had occurred.

The management culture established by Siegmund Warburg had not been scalable. In April 1995, S.G. Warburg was taken over by Swiss Banking Corporation, later part of UBS, the detailed description of which will follow later.

Hostile takeovers are rare in financial services, partly because of the inability to perform detailed due diligence of the target by the acquirer.

There is also a higher risk of loss of valuable senior staff that can be detrimental to the subsequent integration and future success. This risk is particularly grave if these senior staff have important customer relationships as is often the case in investment banks. Furthermore the increased complexity of operating in more than one state can contribute to a merger becoming a failure. Expanding a highly successful single state bank into more states could be much more of a challenge than may be imagined, given that this expansion is still within one country.

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The Riegle-Neal Interstate Banking and Branching Efficiency Act in the United States allowed interstate banking from 1995. The number of large interstate mergers and acquisitions increased immediately and significantly. The hostile takeover of First Interstate Bank by Wells Fargo in 1996 was a failure and was described as a “debacle” (Chang et al. 2004).

The purely California-based Wells Fargo did not have the management capability to manage banks in the 13 states where First Interstate Bank operated. The hostile nature of the takeover had caused the loss of threequarters of First Interstate’s top 500 employees, who took advantage of the attractive severance package offered. The first annual report after the merger described the growth and change of Wells Fargo: “By the end of 1996, we were a very different-looking company than we had been at the beginning of the year. Our assets had more than doubled, from $50.3 billion in January to $108.9 billion in December; we operated our retail business in 10 states instead of one; staff numbered 36,900 at year end, up from 19,250 twelve months earlier; we had 1,950 retail locations throughout the West, instead of 975 only in California; and we had a network of 4,300 Wells Fargo ATMs throughout the West instead of 2,400 only in California.” The hostile bid had not allowed due diligence. Combined with the loss of the majority of the top First Interstate employees, this resulted in delay in integration and serious loss in service delivery to customers, high stress levels and loss of morale amongst staff (Chang et al. 2004).

Much larger mergers soon followed. In 2000 J.P.Morgan and Chase merged in a deal worth $30 billion. In 2004 there were two further very large transactions, firstly, Bank of America merging with FleetBoston amounting to a value of $47 billion and involving 29 states. Secondly, newly merged JPMorgan Chase merged with Banc One amounting to $58 billion and 17 states. However, no single bank was close to being present in all 50 states (Ghemawat et al. 2006).

Increased complexity from growth by territory was not just a United States banking phenomenon. The concentration of retail banking in Europe varied significantly with Belgium having the highest concentration. The assets of the five largest Belgian banks were over half the market in 1997 and four-fifths in 2003. France increased from two-fifths to close to half over this period, and the Nordic countries were all over half and some at three-quarters share for the top five banks, showing similarly high degrees of concentration. The United Kingdom was far less concentrated, with corresponding figures of a quarter in 1997, and a third by 2003, for the five largest banks. Germany was highly fragmented, with the five larg-

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est banks having less than a fifth market share in 1997, and only just over that in 2003, mainly due to the large number of small savings banks (Sparkassen) and cooperatives (Volks- und Raiffeisenbanken).

Cross-border retail banking in mature European economies was generally seen as not offering the economies of scale available to other industry and service sectors. This was partly because customers had grown up with different traditions regarding banking. The advent of technology and particularly Internet banking was expected to change this.

The fall of the Soviet Union in 1989 enabled foreign banks to become involved in local Eastern European. Here, foreign ownership increased to over half in 1999, from close to nil ten years earlier. During the same decade, foreign bank ownership in Latin America increased from just over one-tenth to close to half. This significant increase in foreign investment in the banks of many countries added to the complexity of managing these increasingly multinational banking organisations. It also made mergers between them much more complicated, because they were likely to be involved in many more countries than before.

Just like the Medici and the Rothschilds had been the only multinational banks in their eras, Citi was the only truly global bank as late as the 1990s. In 1994 Citi had 3136 offices in 93 countries, of which 1947 were outside the United States. This was an enormous expansion from Citi’s 70 foreign offices in 1960. Two-thirds of Citi’s earning was from outside the United States (Malnight and Yoshino 1994). Other United States banks, and particularly investment banks, followed their multinational clients abroad and entered international business in foreign centres, particularly London, but also Frankfurt, Paris, Hong Kong and Tokyo. European banks had offices in dozens of foreign countries, but by the mid-1990s none earned significant proportions of more than one-third of their income outside their own country.

As in any multinational organisation, the management of banks operating in more than one country proved highly challenging. Citi rarely developed local banking franchises in most of its locations and primarily did international rather than local banking. Citi’s ‘Investment Bank’ initiative in 1982 created a parallel organisation in many countries, duplicating some of the commercial bank’s activities and expenses. The aim was to separate trading in the capital markets from the existing corporate lending to larger customers. The organisation into investment and corporate banking in each country was in response to increased complexity from rapid expansion. Once in place, each of the two parts in each country needed to grow.

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This in turn created a significantly higher demand on top m ­ anagement than had been the case historically. There was absent management in some cases that led to increased risk-taking and exposure to crises. Many restructuring projects were carried out with product lines, countries and regions, increasing or reducing in dominance. These changes involved significant increases in number of employees and expenses followed often only a few years later by drastic cuts in both. Conflicts between global client relationships, products and local operations were frequent and made significant demands on bankers and their management capabilities. Significant friction developed in some local Citi organisations, including competition for the same business from the same clients (Malnight and Yoshino 1994).

Citi’s significantly increased complexity severely tested management at the time of the 1987 Black Monday stock market crash. One reason was that the new investment bank units in some countries lacked local relationships upon which to build their business. This resulted in some of them focusing on trading for Citi’s own account. When the market crashed in 1987, many of these positions resulted in significant losses. The losses exceeded expectations because of the complexity of understanding the aggregate exposure (Malnight and Yoshino 1994).

These losses were the cause of a global reorganisation in Citi in 1990, which merged the institutional and investment banks and split corporate banking activities into developed and developing markets. The reorganisation occurred because it became apparent that there was a need for a more thorough understanding of what was happening in each activity and country. The several layers and duplication of management in the two activities hampered this understanding (Malnight and Yoshino 1994). It is not surprising that such an increase in complexity resulted in a development of concurrently complex management structures, nor that they would need reorganisation to achieve efficiency. It indicates that absent management can occur if the organisation is too complex and the corresponding management structure is similarly too complex. This is a problem more often seen in corporate than in professional services firms, with Citi being a rarity in its global reach. As other banks increased their geographical reach, many of them would experience similar challenges from the increased complexity.

The acquisition of Abbey National in the United Kingdom by Santander of Spain in 2004, was one of the first major retail banking acquisition between European countries for some years, amounting to €12 billion.

Santander was already present in Portugal and in 11 Latin American

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c­ ountries, with consumer finance operations in Germany, Italy, Netherlands, Norway and Poland, making it Spain’s largest bank and the world’s fifteenth largest. The acquisition was supposed to increase Santander’s earnings starting in 2007. The acquisition of Abbey National would create the tenth largest bank in the world in terms of market capitalisation, and the fourth largest in Europe. In terms of complexity, however, the combined entity would remain primarily a retail bank, with retail revenues amounting to four-fifths. The geographic split of earnings would be close to half from the Eurozone, about one-fifth from the United Kingdom and the rest from Latin America. So the increased complexity from managing retail operations in close to 20 countries would not to be further increased by significant wholesale and investment banking businesses, at least initially (Ghemawat et al. 2006).

In the 1990s, there was a sense that there would soon only be a handful of truly large, multiline, multinational or universal banks. This was a factor in Morgan Stanley and S.G. Warburg exploring a merger. Being one of the largest would be important in itself as some believed that only those banks with all the capabilities, present in all relevant countries and with enormous capital, would be able to compete for the most attractive investment banking business and asset management mandates. No one, or at least no one I have been able to find, ever asked if anyone would be able to manage such, almost fantastically, large and complex banks.

Management challenges do not appear to have been raised as a major issue in the Chase Manhattan and Chemical Bank 1995 merger. This merger created the largest bank in the United States and the fourth largest in the world. The argument made by the chief executive officer of Chemical Bank, when previously merging with Manufacturers Hanover Bank in 1991, was that “If it’s important for the United States to have large, globally competitive automobile companies, globally competitive chemical companies, globally competitive computer companies, it’s important to have large globally competitive banks as well” (Gilson and Escalle 1998).

The key objectives for the merger of Chemical Bank with Chase Manhattan were cost savings of up to $1.5 billion from a reduction in the workforce of 12,000 employees, important product and market leadership positions resulting in significantly higher revenue growth, easier entry into new markets and development of new products, improved satisfaction of complex needs of large corporate customers and to better afford large-­scale technology investments (Gilson and Escalle 1998). There appears to have been little consideration of the increased complexity and

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corresponding management requirements. No doubt, the management understood that successfully achieving these objectives would present complex challenges and require skilled management and a lot of hard work. However externally the impression is that the senior management simply assumed that they would be able to perform this significant management feat. And other stakeholders, such as customers, employees, regulators and shareholders, appear to have assumed the same. Employees would obviously have felt significant uncertainty about the high level of cuts in their numbers to achieve the objectives.

Perhaps this management challenge was simply not considered a problem given that both parties were already multiline and multinational. Both had been through mergers before, so presumably had experience of the merger execution risk. This is widely believed to be the most challenging process any large organisation goes through. Deregulation had permitted the growth of multidivisional, multistate and multinational banks. Much discussion has taken place of whether it is right for investment banks to be allowed to merge with commercial banks. Very little discussion has taken place of whether anyone would be capable of managing these complex giants.

It is puzzling why the management challenge of rapid growth and particularly mergers and acquisitions of financial institutions is not given more prominence in business school case studies and literature. In particular, no mention has been found of any instance where the management challenge of a merger or acquisition and the subsequent complexity of the resulting organisation is such that this should be considered a reason for not proceeding. It appears to be taken for granted that it is possible to manage any integration and resulting complexity. This is in spite of the extensive historical track record, which will be considered in further detail here, that if the growth is fast and diverse enough and results in significant complexity, absent management is a possible, even likely, result.

And sometimes, it seems that rapid growth and increased complexity are well managed. That is until something happens, such as a financial crisis.

And that is when Warren Buffett, who will enter the scene shortly as an actor, is relevant with his often repeated quote:-“Only when the tide goes out do you discover who’s been swimming naked”(FCIC 2011). Swimming naked is an excellent metaphor for absent management in banking. When the tide is high, nobody notices. When Salomon, in whom Buffett was a major shareholder, submitted unauthorised Treasury bond bids that was an occurrence of complete absent management. More on this in the next chapter.

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Growth creates a need for management. In a single location and for a single line of business, leadership is sufficient. The most senior person, often the owner, sets the example and takes the decisions. When the bank grows larger, leadership, by however great a personality, is not enough.

The ‘renaissance principality’ rule of Siegmund Warburg worked extremely well for 100 people. It could not be upscaled to when S.G. Warburg reached 5000 people, particularly when the top people remained bankers and princes, rather than specialist managers. The faster the growth, the more the complexity and greater the need for management.

In industry, in non-financial services, specialist management developed from the time of the Industrial Revolution onwards. In the United States, the railways’ and automobile industries’ rapid growth involved extensive mergers and acquisitions and resulted in multilocations. These companies were managed in the modern sense of the word by specialist managers, not by train drivers and car salesmen.

Management developed much later in banks than in industry. The main reason was the relatively simple organisational structures of most banks before the 1970s, with regulation limiting banks from operating in more than one state or country and in more than one banking segment. Larger banks were organised as multidivisional by the 1970s just like industrials had been from the 1920s. However management knowledge and skill, by the admission of at least one senior banker (Seeger et al. 1974), described in detail later, did not then exist in the largest United States banks. This led to a requirement to transfer management and knowledge from industry to banks in the 1970s.

By the 1980s, examples emerge of management in banks that would have been recognisable by the leading United States’ industrials in the 1920s, including management information and control systems. By 1994, management information was seen as a competitive advantage by some banks.

The increased growth and resulting complexity of banking organisations and its demands on management are evidenced by the significant differences in management requirements of commercial banks, for retail or commercial customers or both on the one hand and investment banks on the other. These differences became particularly apparent by the mid-­ 1990s, when these different types of banks were allowed to start merging after the Citi merger with Travellers that included the investment bank Salomon. The management requirements for banks before then were limited to either commercial or investment banks as combined entities had

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yet to emerge, mainly due to regulation. In particular, there are significant differences between investment banks, with their limited formal organisation, in contrast to the much more structured organisation of commercial banks. These differences persisted and made the management complex when some of the investment banks became part of commercial banks.

By 1995, retail banks were embracing developed management techniques. These banks now saw themselves as both product and service providers. This added to the complexity of the organisation and to the demands on its management. However, this level of management thinking was often not accepted and implemented across all types of banks, particularly not by those more focused on larger transactions such as the commercial banks servicing larger corporate clients and investment banks. By 1993, Banc One had acquired 137 banks in 74 different transactions in the 25 years since its first acquisition (Hart and Uyterhoeven 1993). By 1999, even this leading light in terms of commercial bank management was finding increased complexity to be a management challenge.

One particular complexity was that deregulation had permitted investment banks to diversify extensively by line of business. The United States investment banks also increasingly undertook transactions where they invested substantial amounts of their own money.

The absence of the development of specialist managers in financial services contributed to absent management in banking. Growth, complexities and the corresponding management challenges of the multinational banks become evident during the 1990s. This was as a result of the most remarkable geographical diversification growth with the leader, Citi, increasing from 70 foreign offices in 1960 to 1947 by 1994. By 1999 the risks of operating in multiple banking segments, like in the largest Swiss banks, were described in the financial press as involving high risks and poor odds of overcoming them. This development deserves a chapter to itself, so for now we will return to banks and bankers making deals for merging and growing banks.

By 2004, Citizens Bank in the United States had made 25 acquisitions, which had made it the eighth largest commercial bank in the United States. The latest and largest acquisition of Ohio-based Charter One had resulted in a combined bank with $131 billion of assets and 24,000 employees. When the chief executive officer had joined 12 years earlier, it had $3.5 billion of assets and 1300 employees (Lal and Han 2005). As part of its early culture, the chief executive officer would write directly to individuals who deserved special recognition. This was no longer p ­ ossible

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due to the 20 times greater number of employees. The chief executive officer reflected that he could remember to call 1000 people by their first name, but that this now was one in 20, and no longer most employees.

“You can’t manage based on personality alone.” This is a critical recognition that personal leadership is not enough and that specialist management is required. Adding Charter One significantly hindered the chief executive officer’s ability to reach out to his front-line colleagues. Video conferencing replaced weekly face-to-face meetings. Management involving a high level of personal touch was diluted by the very much larger number of locations, distances and time zones between them. The chief executive officer saw his job as now being “less operational and more motivational”.

Motivation is important for any organisation, but it is only one part of management. When the chief executive officer recognises that his job is less operational than when the bank was one-tenth of its current size, his reduced operational or management activity needs to be replaced by other layers of management.

The chief executive officer needs to become a manager of managers, which is a different job than being the most senior banker, the leader who is able to be on first-name terms with half the employees. If he or she does not become a very proficient, specialist manager of managers there will be gaps resulting in absent management. This will be caused by the combination of rapid growth and the lack of development of specialist management.

In 1990 Credit Suisse became the first foreign owner of a major Wall Street investment bank with a controlling 60 per cent stake in Credit Suisse First Boston (Nanda and Morrell 2006). First Boston had been one of the investment banks to be divested by a commercial bank, First National Bank of Boston, following the Glass-Steagall Act in 1933. It had grown to be one of the most profitable investment banks in the United States by 1986, based on its leading mergers and acquisitions department, bond trading and mortgage securities as well as its part ownership of a London-based joint venture with Credit Suisse called Credit Suisse First Boston or CSFB. In the late 1980s, First Boston incurred trading losses in mortgage securities, bonds and equities, including from the equity crash of 1987.

Being involved in so many rapidly growing trading areas was complex. In such difficult times as the late 1980s were for financial markets, there was an accumulation of losses rather than diversification of earnings.

CSFB was originally a joint venture based in London. However, the complexities of managing the relationship between the two parents, First Boston and Credit Suisse, had led to a merger between the majority owning

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parent First Boston and the joint venture CSFB, also called CSFB. The other parent Credit Suisse now owned 44.5 per cent of the United States’ regulated investment bank. Credit Suisse was restricted by the Glass-­Steagall Act from being a majority owner of a United States investment bank as Credit Suisse was a universal, including a commercial bank. In 1990, losses in CSFB meant that regulators allowed an exceptional loosening of regulation, and Credit Suisse’s 44.5 per cent stake was allowed to increase to 60 per cent. The reason United States regulators allowed the universal bank Credit Suisse to become a majority owner of an investment bank was the significant losses suffered by CSFB when the junk bond market collapsed.

The leading junk bond market bank Drexel Burnham Lambert had already collapsed in February 1990. The United States regulators were concerned by the possibilities of a second bank failure with CSFB. So after the Citi Travellers Salomon’s temporary exemption, this was another important chink in the armour of the Glass-Steagall Act. This was an armour that had kept investment banks and commercial banks separate for nearly six decades. The Act had kept the management of banks less complex than it would otherwise have been, and there had therefore probably been less incidents of absent management. The Act had probably prevented or at least mitigated financial crises in the same long period, the longest period without a financial crisis in modern times.

Following a reorganisation in 1996, Credit Suisse was now a truly multiline, multinational universal bank operating in four business units, being, firstly, a Swiss commercial banking unit serving corporate and personal customers. Three global units were, firstly, private banking for wealthy private clients, secondly, corporate, trading and investment banking and, thirdly, asset management.

In 1997, a fifth unit was added when the second largest Swiss insurer Winterthur was bought for over $9 billion. This was the first example of bancassurance, the combination of banking and insurance, in Switzerland.

Although several banks, including Credit Suisse since 1990, had owned life insurance subsidiaries, Winterthur was a large, multinational, life and property casualty insurer. The lack of expected synergies, and possibly the complexities of managing such different lines of business, caused Winterthur to be sold to the large insurer Axa of France after only six years.

The Credit Suisse experience with insurance is remarkably similar to that of Citicorp, which merged with the Travelers Insurance Group to form Citigroup in 1998. As in the case of Credit Suisse, lack of the expected synergies, and possibly management complexities, caused

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Travelers Property and Casualty to be divested in 2002, with the Travelers Life Insurance company being sold three years later to MetLife. The only remaining insurance remnant was the red umbrella that remains Citi’s logo today. It would provide very little cover from the deluge of the financial crises a few years later.

The period 1995–2002 was an intense merger and acquisition period for the investment banking industry, with 19 deals valued above $1 billion, amounting to a total value of just over $90 billion. The largest were Swiss UBS’ acquisition of Payne Webber of the United States at $17 billion, CSFB’s of Donaldson Lufkin & Jenrette at $14 billion and Dean Witter’s of Morgan Stanley at $11 billion. However, the truly large transactions were between the universal banks. In 1996 Union Bank of Switzerland rejected Credit Suisse’s $47 billion merger proposal. The Union Bank of Switzerland and the Swiss Banking Corporation, Credit Suisse’s two main rivals, then merged in 1997 to create the second biggest bank in the world and the largest asset manager.

With this intensity of mergers and level of growth, primarily by mergers and acquisitions, it is understandable that many banks felt pressurised to participate. There was a strong sense that the future would belong to universal banks and that those who remained in fewer lines of business or who were not present in all the major financial centres would become irrelevant. However it is difficult to find references to the question of whether it would be possible to manage these newly merged, very large, very complex businesses. Perhaps the architects of this phenomenal growth had complete, blind faith in their own management ability. Perhaps they were so consumed by getting the deals of the mergers done that managing the resulting complexity was not given much thought. The latter point is somewhat supported by the succession of deals undertaken by some of the top leaders. Perhaps they saw their job as continually doing deals rather than managing what they had accumulated. The two examples of insurance expansion, Winterthur and Travelers, indicate that it was possible to grow beyond where synergies were possible and perhaps also take complexity too far, and that this was recognised in the relatively swift reversals of these accumulations within a few years.

When banks developed in size and complexity, management did not develop with adequate speed and capabilities. However, when banks grew rapidly but in a less complex way within one banking segment and one country, management was able to develop adequately, such as in the case of Banc One. At least until its merger with JPMorgan Chase.

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It was the historical development of a combination of growth in size and complexity that the corresponding management development was unable to match. One example was the securities house Henderson Crostwaithe which was acquired by the historically famous, and infamous, Barings Brothers and Co in 1984. The name of the securities house was changed to Baring Securities Ltd., which then grew from 18 to 2000 people in eight years and with offices around the globe. This increased the demand on management exponentially. The lack of management oversight resulted in the failure of the bank in 1995, having been founded 232 years earlier. The second Baring crises story will be told in the next chapter.

Some of the early growth of Citi had been to achieve diversification.

There was a strong belief that if a bank was diverse enough, this would reduce the amount of capital required because its risks were diversified. By 1989, Citi had overtaken Bank of America and Chase to become the largest bank in the United States and the ninth largest in the world (Wulf and Mckown 2012).

Diversity had worked well for the Rothschilds. When one brother or uncle was in trouble, the other brothers and nephews, who each ran their own operations, could and did come to the rescue over most of the nineteenth century. However well it is possible to diversify risk, so that it is unlikely that everything goes wrong at the same time, it comes with a high price. That price is complexity. The more diverse, the more lines of business and the greater the number of states and countries a bank operates in, the more complex it is to manage. Given the risks that can be taken in individual lines of business, it is essential that each line of business is understood and managed. The absent management of one activity can result in significant losses, with resulting embarrassment, loss of reputation, questions from analysts about similar problems elsewhere, loss of customers, although hopefully not a full bank run, and fines if regulation has been breached.

Importantly, this complexity eventually makes it not just more difficult to manage but also more difficult to understand if the risks are still being diversified. In a truly complex organisation what appears to be highly diversified risks, may be actually accumulating risks that will deteriorate due to the same event or crises. Investment bank originating, packaging, distributing and investing in United States subprime mortgages would provide devastating examples of this unmanageable complexity in the 2008 financial crisis.

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The largest and most complex of all banks, Citi, experienced significant internal friction, sometimes from competition for the same clients. Once a bank is very large and diverse, it is highly complex to understand everything a bank is doing for a client, particularly if this client is also involved in several lines of business and in many countries. So several parts of the bank will each be seeking to do business with one part of the client. In many cases top management has no clarity over what each part of the bank is doing with each part of the client. To the outsider this may sound surprising. However as a management consultant I have often asked a large financial institution for its total income or exposure to a single client, only to be told that this information is not available. And that was not because they did not want to tell me, but because they did not have the information. With this lack of understanding of the whole involvement with a client, it is difficult to maximise the benefits of this type of relationship. Of greater concern is that the cumulative exposure to this client can be difficult to understand and manage. The already described 1982 Investment Bank initiative in Citibank is a good example (Malnight and Yoshino 1994). Often growth and diversification were so rapid that the management of an overall client relationship could not keep pace.

There are not many examples of admitted failure by management in banking. The case of the merged ABN AMRO is one. Merged in 1991, the combined ABN and AMRO bank group had assets of €987 billion, more than 4500 branches in 53 countries and more than 105,000 employees by 2006. It was diversified by territory being top three in the Netherlands and in Brazil’s private sector and was a top 10 European and top 15 worldwide bank based on total assets. ABN AMRO was diversified by product, offering both retail and commercial products to a diverse client base. However the strategy failed. The group did not achieve a top five position in terms of total return to shareholders in its selected 20 banks peer group. The chief executive officer publicly said that the challenges had been greater than anticipated, the impact of a restructuring programme had been underestimated and the targets had been too ambitious (Keuleneer and Cossin 2010). This is a somewhat refreshing honesty, even humility. However, the next chapter in the ABN AMRO saga would show little of these two qualities.

Having decided it could not achieve its ambitions on its own, ABN AMRO sought a partner, settling on Barclays. As ABN AMRO’s global transaction banking, the services that facilitate trade for corporate customers including global collection and payment, foreign currency, payroll,

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reporting and liquidity management, was one of the largest in the world, merging with Barclays would create the world’s largest transaction bank.

However a consortium consisting of Royal Bank of Scotland (RBS), Fortis of the Netherlands and Belgium and Santander made an offer of €71 billion, over one-tenth above ABN AMRO’s share price, in June 2007.

Their intention was to break up ABN AMRO between them and sell the remaining bits. One could assume that breaking up a bank would be easier than integrating the whole thing. However, the size and complexity of ABN AMRO meant that the transaction, in addition to its very substantial size, was also extremely complex. Firstly, ABN AMRO had agreed to sell La Salle of the United States to the Bank of America in April 2007. The RBS had explicitly stated that there would be no deal without La Salle. As part of its defence against the consortium, ABN AMRO got a court order to proceed with the sale for €15 billion in July 2007. Surprisingly the consortium did not revise the size of its bid when it resubmitted its bid a few days later. Santander then immediately sold one of its parts of the spoils, the Italian Bank Antonveneta to another Italian bank Monte Paschi for €9 billion, before the ABN AMRO takeover was even completed.

No one is bigger than the market (Schonberger 1967). By August 2007, there was a storm underway in the market that was to prove bigger than any one and any bank. The advent of the largest financial crises since the Great Depression caused bank share prices to plummet and the bad assets within ABN AMRO and many other banks to deteriorate. Even more than the size and the complexity of the ABN AMRO deal, it was the additional complexity of the timing of market conditions that caused this transaction to contribute to the fall of the RBS and Fortis, both of whom required government takeovers. Santander weathered this storm, partly due to the expedient and successful sale of Bank Antonveneta. Another important reason was that Spanish regulators had prohibited banks, including Santander, from investing in the securitised assets that were causing many other banks such large losses. We will revisit the ABN AMRO debacle when considering RBS during the 2008 financial crisis.

When very large organisations are merged, the complexities are also large. It may be that the complexities are not just correspondingly large but exponentially large. It is not easy and perhaps impossible to measure complexities of management in numbers or units. However, a simplistic calculation illustrates what managing the integration of two multiline, multinational banks may amount to. If two banks, operating in two lines of business in the same ten countries, are merged, perhaps the resulting

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complexity of integration should be one for merging the two lines of business and ten for merging each bank in ten countries, thus resulting in 11 complexities. Another possibility is that it should be one complexity for merging each country, that is, ten, and another complexity for merging the two lines in each country, that is, another 10, or 20 in total. Add to this the possibility that the merger of two financial institutions involves introducing new lines of business and countries. Then the benefits of the merger will, in the majority of cases, involve extracting synergies by reducing costs and enabling cross-selling. Reducing costs will often require improving operations by combining them, perhaps selecting the best practice from one of them, training those not familiar with this practice and then performing better, but with a reduced number of people to provide the cost savings. Cross-selling will involve training to enable staff in one segment selling the products and services of another segment, making staff multiline operators.

Add to this the complexity of integrating technology systems. The 2006 merger of the Bank of New York and Mellon Financial created the largest securities services and asset management firm in the world and the eleventh largest United States financial institution with $17 trillion in asset under custody (Taliaferro et al. 2010). Nearly a quarter of the combined revenue would come from 36 foreign countries. BNY Mellon expected $700 million in annual cost savings, equal to close to one-tenth of expenses, and nearly one-tenth, or 3900, of the combined employees of 40,000 would be laid off. There was a high degree of awareness of the complexity involved, with one senior executive comparing the system integration to brain surgery. Seven months after the announcement, and two weeks after closing the merger, the technology plan that would contribute to achieving the cost savings was deemed too risky in terms of preserving customer service, and was abandoned. The revised plan did work in terms of no loss of customers, but the technology cost reductions could not be achieved. This was because not enough old systems could be retired within the planned time frame.

As the dependence on technology continues to increase, the complexities of integrating legacy technology systems are now such that they can be the single largest challenge of a financial services merger. In spite of, and partly because of, remarkable technological advances, the integration of legacy systems remains a major complexity challenge. Some financial groups that have executed many mergers end up with literally hundreds of legacy systems that are difficult to retire. Large financial groups have prob-

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ably now reached a level of technological dependence where system integration in a large merger is unmanageable, and long-term retirement of systems is the only option.

As seen in the previous chapter, regulation allowed banks to grow larger. And some did. Some grew very large, mainly through acquisition to operate in more states, more countries and more lines of business. The growth resulted in much greater complexity for management. When the tide went out in 1987 as stock markets crashed, banks suffered losses due to their complexity and absent management. Banks also grew by types of activity and lines of business, and the next chapter will show the resulting complexity and incidents of absent management.

References Chang, Victoria, Charles O’Reilly, and Jeffrey Pfeffer. 2004. Wells Fargo and Norwest: “Merger of Equals”. Stanford: Stanford Graduate School of Business.

Ferguson, Niall. 2010. High Financier, The Lives and Time of Siegmund Warburg.

London: Penguin.

Financial Crisis Inquiry Commission. 2011. The Financial Crisis Inquiry Report.

National Archives and Records Administration.

Ghemawat, Pankaj, Eduardo Ballarin, and Jose Manuel Campa. 2006. Santander’s Acquisition of Abbey: Banking Across Borders. Boston: Harvard Business School.

Gilson, Stuart C., and Cedric X. Escalle. 1998. Chase Manhattan Corporation: The Making of America’s Largest Bank. Boston: Harvard Business School.

Hart, Myra M., and Hugo Uyterhoeven. 1993. Banc One. Boston: Harvard Business School.

Keuleneer, Luc, and Didier Cossin. 2010. Deal Making in Troubled Waters: The ABN AMRO Takeover. Lausanne: International Institute for Management Development, Lausanne.

Lal, Rajiv, and Arar Han. 2005. Citizens Bank. Boston: Harvard Business School.

Malnight, Thomas W., and Michael Y. Yoshino. 1994. Citibank: European Strategy and Organization. Boston: Harvard Business School.

Nanda, Ashish, and Kelley Morrell. 2006. The Credit Suisse Group (A). Boston: Harvard Business School.

Schonberger, Ernest A. 1967. The World Sugar Market: For Many Investors, It Leaves Bitter Taste. Los Angeles Times.

Sebenius, James K., and David T. Kotchen. 1998. Morgan Stanley and S.G. Warburg: Investment Bank of the Future (A). Boston: Harvard Business School.

Seeger, John A., Jay W. Lorsch, and Cyrus F. Gibson. 1974. First National City Bank Operating Group (A). Boston: Harvard Business School.

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Taliaferro, Ryan, Clayton Rose, and David Lane. 2010. Merger of Equals: The Integration of Mellon Financial and The Bank of New York (A, B & C). Boston: Harvard Business School.

Wulf, Julies M., and Ian Mckown Cornell. 2012. Citibank: Weathering the Commercial Real Estate Crisis of the Early 1990s. Boston: Harvard Business School.

CHAPTER 6

Complexity from Growth in Lines of Business: How Absent Management Occurred When Different Types of Banking Were Merged

In both retail and corporate commercial banking, profit is generated from the difference between the interest rate charged to borrowers and the interest paid to depositors. Some fee income is also generated, ranging from charges for simple bank services, such as bank accounts for retail customers and overdrafts, to more sophisticated services for commercial customers. There is a cost related to attracting new customers, sales and marketing, so there is value in retaining customers, particular higher-net-­ worth individuals and larger corporate customers. Many small transactions, cost efficiency and long-term client retention are all important for profitability in commercial banking (Raynor and Bower 1999). Banks also sell other services on behalf of other companies, for example, insurance, and receive a commission for doing so.

Investment banking makes profit from a much wider range of services and activities, including fees for advice on corporate financing and raising of equity and debt capital, sometimes related to mergers and acquisitions.

Many investment banks also trade capital market instruments on behalf of investors and for the bank’s own book using the bank’s own capital. By 1980s, underwriting clients’ capital raising, which involved the bank guaranteeing the success of the share or bond issue and taking the associated risk, had made investment banks much more large deal-driven than commercial banks doing corporate lending. For investment banks, generating

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ideas, their track record, how they ranked in league tables, their distribution networks to reach investors including globally and their capital strength, all became important factors for being awarded equity and debt raising mandates. Investment bankers were often incentivised by deal-­ related performance bonuses and trading profits (Raynor and Bower 1999).

The United States investment banks in particular increasingly undertook transactions where they invested substantial amounts of the bank’s own money. One important type of transaction was underwriting of share issues where the firms began to guarantee the share price for the issuer before selling the shares on to investors, in what became known as the ‘bought deal’. In the bought deal, the investment bank effectively owned all the newly issued shares at the guaranteed price. This was attractive to the company issuing the shares because it was guaranteed to raise a certain amount of equity capital at a certain price. This compared to the traditional approach of book building, where investors were lined up to participate prior to the transaction. The bought deal provided significantly higher margins for investment banks, because the issuing company paid for the guarantee, but required much greater trading capabilities and significantly higher capital.

Now trading as principals, rather than merely as agents, investment banks placed their own capital at risk to invest in assets ranging from stocks and bonds to commodities and derivatives (Raynor and Bower 1999). The bought deal increased the complexity of investment banks. Significant amounts of capital were required to finance the purchases of blocks of securities from issuers. Effective distribution capabilities were required to place the new issues with investors before a possible fall in price.

Underwriting a new issue came to resemble trading. Those firms who were leaders in trading, including Goldman Sachs and Lehman Brothers, benefitted from this development. The bought deal is an example of how new banking activities came to require more capital. This in turn motivated investment banks to issue shares and list on the stock exchange themselves. They were also motivated to merge to become larger with more capital and to have all the required capabilities. All of this resulted in more complexity for those managing the investment banks.

Investment banking was transformed in the late 1970s to mid-1980s, with traditional underwriting margins declining and a wide range of other activities becoming more important for their income. Security trading and mergers and acquisitions advice, often supported by equity and debt issue underwriting and asset management, were perceived as desirable and even

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necessary for any investment bank that wanted to be in the first rank. In terms of real risk for the firms themselves, trading for their own account, including bought deals, was where the greatest risks and profits were and where the best management was required. For the United States investment banks, this was a transformation. From earning almost all their revenue from traditional underwriting in the 1970s, this represented less than half by the mid-1980s (Raynor and Bower 1999).

From a complexity point of view, the difference between underwriting an issue and guaranteeing a bought deal, where the bank owns the new shares until they are sold, may not seem significant. But the risk is completely different. And so is the cost of failure. If the traditional underwriting fails, the shares may not be sold and the issuer will not be able to raise the capital. The bank’s reputation will be negatively affected, and the client may be lost. In the bought deal, and in all trading where the bank is a principal, failure reduces the bank’s capital. If the failure exceeds the banks’ available capital, the bank has not only failed the client but has failed itself and is insolvent.

The top-ranked Canadian securities dealer Wood Grundy was the lead underwriter on the Canadian tranche of the privatisation of British Petroleum in 1987. The firm guaranteed a price for the shares well above what they could eventually be sold for. The fall in price was unrelated to the specific deal and was caused by the Black Monday stock market crash in October 1987. This cost Wood Grundy C$55 million in losses. Wood Grundy had been in discussions of a takeover by Royal Bank of Canada, which were broken off in June 1987. A few days later, First Chicago announced the acquisition of a third of Wood Gundy for C$270 million, equal to five times book value, being the total assets of the bank less its outstanding liabilities. Two months after the British Petroleum losses, First Chicago abandoned the transaction. In January 1988, Canadian Imperial Bank of Commerce (CIBC) bought two-thirds of Wood Grundy for C$190 million or just over two times book value. The loss to Wood Grundy shareholders was equivalent to three times book value. The managers of Wood Grundy had abandoned management by entering a bought deal that bet more than half the value of the firm (Raynor and Bower 1999).

Conversely, asset management is a much less risky business, where retail and institutional customers invested their money with the asset managers, many of which were owned by investment banks. Asset managers invest their clients’ money on the clients’ behalf. The asset managers needed to operate diligently with a need for good IT systems. However, the asset

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managers were not taking investment risk themselves and neither were their investment bank owners. Because asset managers were not taking risk, the margins were substantially lower and were received as fees rather than trading profits. And fees provided diversification from the trading profits for the investment banks’ revenues. However, fees were not completely diversified from financial market movements that could also affect trading. This was because the fees charged for asset management were a proportion of the value of the assets under management. When markets went down, so did the fees, and this could coincide with trading losses elsewhere in the investment bank.

When investment banks extended their activities to asset management, this created an additional complexity related to the fundamental issue of trust, always critical for banks. If an investment bank was to incur problems in its non-asset management activities, this might raise concerns amongst its asset management clients. This concern might be completely without substance as the funds in the asset management would be completely separate and highly unlikely to be affected by any issues in, for example, the firm’s trading book. However, the asset management clients might decide that they would rather have their assets managed by an organisation not exposed to investment bank risks, such as an insurer or an independent asset manager. Such perceived contagion risk would cause outflows from asset managers that were owned by investment banks, or were part of universal banks, during the 2008 financial crisis.

Investment banks became as much traders as underwriters and sometimes much more so. All types of bonds, as well as derivatives and commodities, were traded with investors, other investment banks and on exchanges, but, importantly, often for the firms’ own accounts. To some extent, this was no different from what banks had done historically, including the Medici and the Rothschilds. What was different was the complexity of the assets and products traded, the number of countries involved and the very large size of the firms, some of which were no longer just investment banks but were part of very large commercial banks such as JPMorgan Chase, Citigroup and UBS. What appears not to have changed as fast as the complexity was management. The exponential growth in complexity was such that management could not keep up, leading to gaps and resulting in absent management.

In the United Kingdom, before the Big Bang in regulation in 1986, banks operating in the capital markets, also called securities firms, were permitted to perform only one of three functions. Firstly, investment

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banks, called merchant banks in the United Kingdom, were traditional corporate finance advisers, who underwrote the issuing of equity and debt securities. Secondly, stockbroking firms bought and sold securities on behalf of investors. Thirdly, jobbing firms made market, set prices and traded securities on the London Stock Exchange, executing orders for stockbrokers (Raynor and Bower 1999). However, Big Bang resulted in a frenzy of consolidation among British investment banks, stockbrokers and jobbers (Raynor and Bower 1999). Each had their own specialist capabilities, but became part of more diverse but also more complex groups— groups that were significantly more complex to manage than the individual units had been before Big Bang. A prime example of this consolidation and increased complexity was S.G. Warburg, as previously described.

The need for capital amongst investment banks fuelled consolidation.

This resulted in more complex organisations, with greater demands on management. It also changed ownership structures from partnerships to listed companies (Sebenius and Kotchen 1998).

Increased complexity and the need for capital went hand in hand. A change in ownership and therefore incentives was the result for many banks. This was a new world for investment banks. To compete in the new investment banking world, which was fast moving from international to multinational to global, investment banks required both abundant capital and international networks. Obtaining more capital was what the investment banks were best at, and they now took their own medicine. American and British investment banks, which traditionally had been structured as partnerships, began listing on stock exchanges and selling shares to the public (Raynor and Bower 1999).

The large bulge bracket or universal banks, Citibank and Chase Manhattan as well as Barclays and Deutsche Bank, which combined many types of banking, were already listed before the 1970s (Sebenius and Kotchen 1998). Merrill Lynch had listed early in 1971. The list of investment banks selling shares to the public included Bear Stearns, Morgan Stanley and Salomon in the 1980s, and Lehman Brothers in 1994. In the United Kingdom, Morgan Grenfell did an initial public offering in 1986, Kleinwort Benson in 1987 and Schroders in 1993.

There is an interesting, somewhat semantic, change in job titles following the abandonment of partnerships and the stock market listing of banks.

The title of partner was no longer appropriate once shareholders owned the bank. Former partners became known as managing directors (Sebenius and Kotchen 1998). This new title should not be mistaken for the new

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managing directors having management capabilities. There were now hundreds of newly titled managing directors, but they were not necessarily able to manage these significantly more complex and geographically diverse banks. Management skills remained in short supply.

So while there were no longer partners, only a few of the newly titled managing directors could be said to be experienced managers. They were capable advisors, traders or investment bankers focused on their clients and markets rather than on managing increasingly large, diverse and complex organisation. The board of directors, the most senior level of the firm, was composed of a similar mixture of backgrounds. The boards were said to often find it difficult to take a managerial perspective on running the firm (Sebenius and Kotchen 1998). This is a surprising and worrying observation, given that the board has the ultimate responsibility for managing the firm. The observation points towards absent management at the highest level.

In spite of fewer people spending time in bank branches these days, preferring to do their banking online, you have probably met your branch manager at some stage. You may or may not have met an investment banker. But even if you have not, you are probably well aware of some difference between investment bankers and your local bank branch employee.

Managing the two of them and all the other types of employees in a banking conglomerate is complex, very complex. For one, they have different incentives, to which we will return later.

First Chicago Corporation was a large commercial bank expanding into investment banking in 1986. Rather than buying an investment bank, it developed organically by establishing the so-called Global Corporate Bank as a distinct business entity. It hired investment bankers, many of whom were based on Wall Street in New York rather than in Chicago. This organic growth exemplifies the complexity of management introduced by differences between commercial banks, which had retail and corporate customers on the one hand, and investment banks working exclusively with sophisticated corporate clients on the other.

Commercial banks have their own complexity, including managing large number of employees often in numerous locations. Investment banks’ complexity stems partly from their highly complex and often diverse activities and products, from advising on corporate finance to trading derivatives.

One management challenge in combined investment and commercial banks is that investment bankers tend to be short-term focused, often on obtaining mandates for and completing large transactions. Trading in the capital markets can have a very short-term focus, down to a week or even

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a day. Being appointed to taking a company public by listing it on the stock exchange is a once-in-a-lifetime event of that client opportunity.

Commercial banking success tends to be based on many smaller transactions, deposits and loans, and longer-term client relationships.

There were several challenges for the top management of the organically growing First Chicago Corporation, arising from managing a combined commercial and investment bank. One challenge was that investment bankers tend to come from companies that had little formal organisation.

Another was the contrasting management complexities of large numbers of employees in commercial banks.

The hiring of investment bankers by the commercial bank meant that the new hires did not provide the management skills and experience expected by the senior commercial bankers (Friedman 1990). Contrast in size and particularly in the number of employees between commercial and investment banks had shaped the top managers of each type of banks.

Managing these different types of senior bankers proved highly challenging for top management of combined entities.

But it was not just size that differentiated the two types of banks. They were also significantly different in the compensation of their people, at both senior and junior levels. Commercial banks entered into investment banking attracted by the higher margins. The investment bankers who produced these higher margins were paid significantly better than their new commercial banking colleagues. The compensation in investment banks was multiple times higher than in commercial banks. In 1986, Wall Street investment banks were typically paying business school graduates $100,000, increasing to $300,000 with three years’ experience. Managing directors were paid base salaries of $150,000 and could be paid bonuses of $850,000 or more. Commercial bankers might start at $30,000, or less than a third of investment bankers, and were still earning around half of their investment banking colleagues several years later. Commercial bankers rarely had the opportunity to make the bonuses that could take investment bankers’ total remuneration into seven figures (Friedman 1990).

There was also difference in the hours worked. Investment bankers, at all levels, were often working long hours and weekends to secure large transactions. Most, but not all, commercial bankers would work closer to the parameters of a working week. There was difference in backgrounds, with more investment bankers recruited from the more expensive schools and universities. The two types of bankers even differed in appearance, with investment bankers having more money to spend on suits and dresses, watches and cars.

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All of these differences made collaboration between the new colleagues more difficult for top management to achieve. When commercial and investment banks merged, there was much talk of synergies, for example, bringing investment banking capabilities to commercial banking clients. This was a key objective for First Chicago. For this to work, commercial and investment bankers would have to collaborate. Achieving this collaboration and the related synergies was a complex challenge for top management.

Another distinction between commercial and investment banking was, and is, that the different size of transactions and time horizons created different incentive structures. Investment banking focus is on individual, large, highly profitable deals. In contrast, commercial bankers mostly work on much lower margins from many smaller corporate loans, so require longer-term continuity with their clients. Investment banks are more likely to be short term while commercial banks have longer-term concerns. This different time horizon in turn resulted in significant challenges for creating incentive structured to reward and retain the two different types of bankers. Investment bankers had very high expectations of being rewarded quickly and often directly related to the most recent deals. Commercial bankers were used to incentive structures rewarding longer-term service and with the rewards being sustainable over longer time periods.

In First Chicago, several structures were tried, starting with a relationship manager from the commercial banking side. When the relationship manager introduced investment bankers to a client, they would often discuss with the client’s most senior executives due to the importance of the transaction involved, leaving the relationship manager out of his or her debt. Similarly, it was difficult for the relationship manager to contribute further given the product expertise of the investment banker. In the First Chicago case, there was also a contrast between the investment banker overpromising to win the mandate, while the relationship manager would only promise what could be delivered to protect the long-term relationship. Finally, the relationship manager would never receive the level of remuneration of the investment banker if a deal was successfully executed (Friedman 1990).

With regulation only recently allowing combined commercial and investment banking, the management capabilities in banks in the late 1980s and early 1990s were limited to either commercial or investment banks. The managers of combined commercial and investment banking entities, such as J.P.Morgan before the Glass-Steagall Act in 1933 made divest its investment bank, were long gone.

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Until 1997, Banc One had been a pure United States retail banking group. The unusual spelling of its name was because the holding company, Banc One, was not itself a regulated bank. As such it could not have ‘bank’ in its name. Banc One had been a major beneficiary of the loosening of regulations allowing banks to operate in more than one state. Between 1993 and 1998 Banc One had taken over 22 banks in 14 states with a total value of $33 billion. By 1998 even the successful and well-managed Banc One was finding increased complexity to be a management challenge.

Until 1995 Banc One had been managed under a principle called the ‘The Uncommon Partnership’, which had mixed central control with local authority. Thereafter, greater standardisation and centralisation were introduced (Friedman 1990).

In 1998 Banc One decided to merge with the previously mentioned First Chicago NBD which had a dominant presence in Michigan, Indiana, Florida and Illinois, and international offices in Argentina, Australia, Canada, China, England, Germany, Japan, Mexico, South Korea, Singapore and Taiwan (Phillips and Greyser 2001). This meant that Bank One, until then a pure United States commercial retail bank, was now also a multinational, commercial, corporate and investment bank. Banc One was now dealing with companies as well as individual customers and in 12 countries rather than one, significantly adding to the complexity of management.

These included agreeing on a branding strategy, either one brand, multi brands or an endorsed branding strategy. The decision was to launch a new brand with First Chicago NBD, a Bank One Company. The ‘k’ in bank was allowed as First Chicago NBD was a regulated bank, unlike the Banc One Corporation holding company. A small but visible complexity was that Banc One allowed casual dress for its employees dealing with retail customers. First Chicago NBD required formal dress for its employees dealing with corporate customers. This may seem a relatively small issue, but it is illustrative of the increased complexity of merging different lines of business and their associated cultures.

When a new chief executive officer arrived at Banc One in 2000, problems partly arising from complexity and the resulting absent management persisted. The integration of some of the many mergers was incomplete.

There were significant internal conflicts, partly due to the culture clashes, expense control was poor and morale amongst the now 83,000 employees was low. The quality of the loan book, very important for a commercial bank, was weak, and the credit card business had lost millions of customers. Finally, information technology was not providing adequate customer

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service. The incompleteness of the First Chicago NBD merger was evidenced by the unfavourable views those commercial bank directors had of Banc One directors as too slow moving. The reverse view was that Banc One directors saw their First Chicago NBD colleagues as ‘a bunch of cowboys’. This latter view was in spite of another contrast namely that First Chicago NBD had been tightly controlled while Banc One had been famously decentralised (Marshall and Thedinga 2012). Banc One had expanded beyond the capabilities of the top managers, making it so complex that they were unable to manage it and certainly to manage it well. A series of cuts in expenses, senior bonuses and dividends to shareholders were key measures of the subsequent turnaround. The new chief executive officer talked about the previous high dividends paid to shareholders as being an abdication of a decision around capital. This is close to absent capital management. The dividend cut reinstated management of capital.

In Canada four of the five commercial largest banks bought investment banks, within six months of the 1987 Bank Act allowing this. One of these was CIBC’s purchase of Wood Grundy mentioned earlier. The initial approach was not to integrate the acquisitions and leave two separate providers to large corporate clients. This meant two separate, highly different organisations, with some investment bankers with five years’ experience earning five to ten times more than corporate bankers with 20 years’ experience (Raynor and Bower 1999). One reason for this was that large clients were used to dealing separately with commercial and investment banks. It was a concern that these clients might not like to interact with only one provider for everything. However not integrating the two operations, perhaps because of the complexities involved, indicates an occurrence of absent management. In the case of CIBC’s acquisition of Wood Grundy in 1988, it took ten years to integrate the commercial and investment banking. That meant ten years to determine how to deal with the largest clients and how to remunerate both investment and corporate commercial bankers. In terms of client relationships the effort to establish a relationship management function was abandoned after several attempts and eight years, due to the complexity involved. The successful solution adopted was to let those bankers who had the historical client relationship handle those clients and bring colleagues from the bank to that relationship. Those bankers with the relationship sat outside the management structure, with no direct reports.

This is another interesting reflection on exactly how complex senior client relationship management is in terms of delivering a wide range of

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banking services. In terms of remuneration, a common bonus pool was established for those involved with large corporate clients, but the wide disparity between who was paid what remained. This simple approach appears to have overcome some of the previous problems (Raynor and Bower 1999).

As banks started developing different lines of business, it became clear that coordination between these activities would require more capable management. Initially, each line of business did its own thing, served its own customers and contributed to the overall profit of the bank. Each line was established because of an opportunity for profit. Because each line of business did its own thing, there was little opportunity for collaboration and synergies. There was also little if any understanding of what risks might affect two lines simultaneously. This tradition of independence of business lines would make the management of risks extremely complex and at times completely absent, as each line of business and the banks containing them grew significantly larger.

As early as 1983 Chemical Bank became aware of absent management between two of its divisions. By then Chemical Bank was the sixth largest bank in the United States, with 20,000 employees and $47 billion in assets. It was organised into three profit centres, which, in turn, were organised into divisions that were also evaluated as profit centres (Bitetti and Marchant 1983). A profitable product for the bank was Due Bills.

This product acknowledged that customers had purchased United States government bonds, called Treasury Bills. The customer received payment of the principal bill upon expiry plus a special rate of interest. The bank could firstly make a profit from investing the Due Bill assets at a higher rate of interest than was paid to the customer. These investments could include assets with a higher yield and a different maturity than Treasury Bills but with a correspondingly higher risk. The bank could also make a trading profit from buying and selling the proportion of Treasury Bills that were held as security for the Due Bills as required by regulation.

Finally, the bank could charge the customer a fee for each original buying or selling transaction (Bitetti and Marchant 1983).

The Central Bank Metro Division selling the Treasury Bill received no profit for this sale. All the profit went to the Treasury Division. Treasury was unwilling to increase the fee charged to customers for competitive reasons or to share the fee with the Metro Division. This situation was further complicated by a fall in interest rates, which reduced the margin earned on investing the Due Bill funds. Finally, regulation was loosened to

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allow interest bearing money market accounts to corporate customers.

The Metro Division could now sell the interest bearing money market account product in competition with Due Bills and retain the profit.

However, this sale of money market accounts by the Metro Division could eat into funds customers might invest in Treasury Bills where the profit went to the Treasury Division (Bitetti and Marchant 1983).

The divisions did not communicate with each other, were incentivised to earn their own profit rather than considering the overall profitability of the bank or the best outcome for the customer and there were no established management process to address the conflict. After two years, it was left to a senior person in the Finance Division, responsible for strategy and corporate planning, to adjudicate and decide amongst the competing divisions (Bitetti and Marchant 1983).

Chemical Bank was an early example of a rapidly growing bank battling with absent management. As it developed a multidivisional structure, requirements for additional management to coordinate the activities of the various divisions, both for maximisation of profit and to avoid excessive internal competition, were developed. Each of the divisions operated much like a specialist bank. There was limited tolerance for additional layers of management or bureaucracy, particularly if this limited activities or reduced profit for the Division. The days of management through a partnership between heads of various activities, who could see the overall best picture for the bank, were past. Chemical Bank was to become a major player in the consolidation of the 1980s and 1990s. It merged with Chase Manhattan in 1995 and in turn with J.P.Morgan in 2000 and with Banc One in 2004. The combined entity became the second largest bank in the United States after Citi. With 160,000 employees, it was now eight times larger than Chemical Bank had been in 1983, 20 years earlier. The divisional management problem would become ever more demanding, by line of business, geographically and sometimes both simultaneously.

Salomon was a leading United States investment bank for most of the twentieth century. It was founded as a partnership in 1910, and had gone public in the 1980s. Salomon expanded rapidly in the 1980s almost trebling in seven years, from 2300 people in 1981 to 6800 by 1987 (Sharp Paine and Santoro 2004). Salomon was particularly noted for its innovation in bond trading. Warren Buffett, one of the world’s most successful and largest investors in recent times, was a shareholder and non-executive director on the board.

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Salomon became an example of absent management when it emerged that its government bond trading desk had submitted unauthorised bids in the name of Salomon’s clients in a government bond auction in December 1990 and February 1991.

When the United States government borrows it does so by issuing bonds. Salomon was one of the 39 primary dealers the government had authorised to bid for new bonds. This meant that Salomon could bid for bonds for clients as well as for its own account and could do so without making a deposit to guarantee the bid. One of the rules was that no firm should bid for or be awarded more than just less than a third of the total bond issue. This rule had been recently established in July 1990, in response to the size of Salomon’s government bond bids. It was named the Mozer-Basham rule, a reference to Michael Basham, a Treasury official, and Paul Mozer, head of Salomon’s government trading desk (Sharp Paine and Santoro 2004). Making the unauthorised bids on behalf of clients had enabled Salomon to circumvent this new rule.

There were two parts to the absent management. One was the two incidents of submitting unauthorised bids. The other was that top management was aware of the February 1991 unauthorised bid from April 1991 but had failed to report it to the government. Salomon issued its press releases in August 1991, five months after having become aware of the unauthorised bid. The government then informed Salomon that its position as a primary dealer was under threat. The Salomon chief executive officer, chairman of the board, president and the vice chairman in charge of the government bond trading desk all resigned. It was observed that the chief executive officer and chairman and the president had “lost the ability to lead” (Sharp Paine and Santoro 2004), a succinct description of absent management.

In terms of the first part, the unauthorised bids, the absent management included mistakes and even failures, and these will happen from time to time in small and big organisations. Warren Buffett, who had taken over as Interim Chairman in response to the crisis in Salomon in August 1991, admitted as much. If an organisation almost trebles its number of employees in six years, such mistakes and failures become more likely. Absent management occurs because management cannot keep up with the growth and complexity and because most managers remain producer managers rather than specialist, exclusively focused managers. We will return to the producer manager approach in a following chapter.

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Weaknesses in how to assess the performances of various business units and individuals had been identified within Salomon during the rapid growth of the 1980s. A number of management improvement processes were still under way by 1991, but had not been implemented.

One of the delays was the suspicion of increased bureaucracy and how this might restrict Salomon’s strong entrepreneurial culture (Sharp Paine and Santoro 2004).

The second instance of absent management is more difficult to understand. The resignation of the top executives strongly indicates that they had not managed the situation and they were observed to have lost the ability to lead. If they had attempted to conceal their early knowledge of the unauthorised bids, this points more to mismanagement than absent management.

In contrast, the management implemented under Buffett was present, impressive and probably prevented the Salomon story from ending there and then. Salomon was able to sell its safe and liquid government bonds and find alternative sources of finance. This contrasted with Drexel Burnham Lambert, which was liquidated in February 1990 after admitting securities fraud. Drexel’s assets included a large proportion of less liquid, non-investment grade or junk bonds that could not be easily sold to support the firm because buyers could not be found.

Buffett‘s open internal and external communication about the previous management failure helped to restore confidence in the new leadership.

Although a number of regulators carried out investigations, little additional was discovered to what had been communicated under Buffett’s direction.

Salomon retained its primary dealer status after being suspended for two months. No criminal charges were brought against Salomon, although it was fined $290 million. The settlement was considered a victory for Buffett and the new management.

The larger and more complex a bank, the more complex the ramifications of absent management. Salomon lost a number of important clients because of their concern about the bank’s actions and lack of action. In other countries where Salomon was also a primary dealer for government bonds, significant efforts had to be made to persuade these governments to allow Salomon to retain this valuable status. Those in the corporate advisory part of the investment bank of Salomon had difficult conversations with their clients. This is an example of how absent management in one part of a complex organisation can affect other parts, although these

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­ ivisions and their managers have had no involvement or influence on d what has not been managed. This is a particularly serious problem in banks because the trust of clients is such an integral part of the services and products offered by banks.

Buffett resigned as chairman in the summer of 1992 after the settlement. The new chief executive officer of the holding company became the only Wall Street chief executive officer who was independent of a business unit. The way he described his job is noteworthy as involving guiding and overseeing strategy, governance, capital allocation, risk and the firm’s ethical standards (Sharp Paine and Santoro 2004). Salomon subsequently became part of Travellers Insurance Group and then of Citi, trading under the name of Salomon Smith Barney, with the Salomon name being dropped in 2003.

Culture is a very difficult concept to analyse. One possible definition is that culture in a business is how things are done as opposed to what is done. A chief executive officer in another large and complex bank believed culture is how people behave when no one is watching (BBC News 2012).

Possibly, there was a culture of arrogance that came home to roost, when clients and other trading houses decided to stop dealing with Salomon.

Determining an occurrence of absent management might be seen as considering culture or a lack of culture, but that is not the intention here.

Absent management is specifically about whether there is management activity or not. The approach adopted here is not about how management was done, well or badly, but whether it was done at all. When Salomon submitted its unauthorised bids, there was complete absent management.

When the top management did not report transgressions they were aware of, this was another incident of absent management. If they choose not to report the transgression that would not be absent management, but mismanagement as well as very poor culture of how things were done.

Moving to the United Kingdom and Asia, the second and last Baring crisis shows how traditional bank management did not keep pace with the increased complexity of banking activities. This lack of management development resulted in absent management. The 1986 liberalisation of financial services in the United Kingdom allowed banks to become involved in a number of different lines of business including stockbroking. Competitive pressures meant that there was a scramble to buy stockbrokers. One hundred and five years after the first Barings crisis, a rogue trader, Nick Leeson, working in a Barings-acquired stockbroker in Singapore, ran up £843 million of losses in unauthorised derivative trading. In contrast to the first

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Barings crisis in 1890, other British banks were unwilling to support Barings (Bernard et al. 1995), and the rescue attempt by the Bank of England failed. The Dutch Bank ING bought the assets and liabilities of Barings for £1 one week later.

The regulatory loosening allowing British banks to buy stockbrokers resulted in a clash of cultures, similar to that seen in First Chicago, between commercial and investment banks. The traditional investment bank Barings Brothers & Co obtained business through relationships and was not an aggressive risk-taker with the bank’s own capital. Perhaps the memory of the first Baring crises still lingered. When the Japanese stockbroker firm Henderson Crosthwaite (Far East) was acquired for £6 million in 1984 and renamed Baring Securities, this was a significant contrast with the old Baring. This stockbroker was described as freewheeling and entrepreneurial in complete contrast to its new owner (Bernard et al. 1995).

There was also a contrast in time horizons, as had been the case in First Chicago between commercial and investment banks. The traditional Barings’ approach to corporate finance was focused on longer-term client relationships, while the newly acquired stockbroker’s time horizon was much shorter, today and tomorrow (Bernard et al. 1995). The recruitment in the two parts of the business also differed. The stockbroker hired people who had strong, confident, driven personalities and were ambitious to make money. In contrast, Baring had traditionally looked for education, experience and management skills, often recruiting amongst English public schools and Oxford- and Cambridge-educated candidates (Bernard et al. 1995).

Incentive schemes and exponential growth in the new acquisition included generous bonus schemes of up to half of the stockbroker’s profits, and the growth was phenomenal. Barings Securities grew from 18 people in 1984 to 2000 in 1992, with offices around the globe (Bernard et al. 1995). However, the approach to management was unsophisticated as was typical of stockbrokers. The head of Barings Securities was described as a consummate salesman who ran the company as a one-man band, with second-rate management capability and little concept of risk. This approach was well suited to growth in good times, but less so in more challenging times (Bernard et al. 1995). The stockbroker culture of revering the top producer was prevalent. In Baring Securities, this was Nick Leeson who as a star performer was not to be upset (Bernard et al. 1995).

Neither the top management nor the regulator should be fully blamed for not detecting the fraud. However strong the risk control functions it

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will never be possible to prevent a clever employee from defrauding a bank to some extent and for a period of time. But there was absent management in the lack of understanding of how derivatives worked, the significant profits being generated and how this led to absent management of the profit generator Nick Leeson. This absent management in turn allowed the fraud to become so large that it led to the end of 233 years of Barings Bank.

What Leeson did was complex. He traded derivatives rather than equities, bonds or currency. And he traded derivatives of all three—equities, bonds and currency—and on three different exchanges. Some of the trades were taking advantage of the differences between the exchanges.

Any of these activities was complex. In combination, they were probably unmanageable. Leeson then, fraudulently, hid losses in a secret account and took risk on market movements, when he was only authorised to trade on behalf of clients and not on behalf of the bank itself and its capital. In 1994, Leeson generated supposed profits of £30 million, received a bonus of £400,000, but had hidden losses of £200 million. Although Leeson did receive a large bonus, there is little evidence that the fraud was to enrich himself.

The moment the tide went out for Leeson and Barings was the Kobe earthquake in 1995. It tragically killed more than 6000 people and injured more than 30,000. It also resulted in significant movements in the Japanese equity and bonds markets, resulting in a loss to Barings of £638 million.

The absent management that allowed the rogue trader room to operate owes something to the increased complexity of the new activity of stockbroking. This had been acquired rather than grown organically over time and contrasted significantly with Barings’ traditional business. Increased complexity of the operations was beyond the capabilities of the existing top management of the still family-owned investment bank. However the management does not appear to have been alone in its limitation. The regulator, in this case the Bank of England, relied heavily, perhaps almost entirely, on the Barings management for information, but does not appear to have had better understanding of the issues (Bernard et al. 1995). The Barings failure is one clear example of absent management resulting from complexity.

The leading French bank Société Générale, or SocGen, was established in 1864 to promote the development of commerce and industry in France.

It had a turbulent history including surviving the Great Depression through income from work on French government loans and those of its colonies. SocGen was nationalised after Second World War. So were the

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35 other large French banks nationalised, including the French Rothschild Bank, as state ownership expanded in France during the 1960s. Subsequent deregulation enabled the bank to expand by activity into investment banking and trading in capital markets. When France moved to the right politically in 1986, SocGen was privatised and listed on the stock exchange, partly to symbolise how the new government viewed the economy. The French government remained an important shareholder, directly and indirectly, which prevented a hostile takeover in 1988 (Hunter and Craig Smith 2011). SocGen found itself too small in 1999 when it failed to win the amicable takeover of Paribas, another of the top three French banks.

Paribas was instead taken over by the largest French bank BNP. SocGen only just stayed independent when BNP bid for both Paribas and SocGen, but only succeeded in acquiring the former (Hunter and Craig Smith 2011).

SocGen decided to grow by developing its trading activities instead of by takeovers. This strategy was very successful. SocGen became a pioneer in the development of sophisticated equity derivatives (Walker 2013). The operations involved with issuing debt for large corporate clients were combined with the financing division, including loans, bonds, interest rates, currency hedging and structured finance products. These operations had different cultures, but the combination successfully improved SocGen’s ranking for issuing bonds. The bank also took more risk for its own account, partly based on its strong intellectual tradition and ability to innovate financial structures and their valuation. SocGen had a top traditional retail and corporate banking franchise in France and other countries. The profits generated by these were €1.8 billion in 2006, about a third of the total profits. SocGen’s Corporate and Investment Banking Division contributed profits of €2.3 billion or around two-fifths of total.

Additionally, €577 million was made from the bank trading for its own account, amounting to just over one-tenth of total profits.

The new division was successful, profitable and very complex. The level of complexity made SocGen partly unmanageable. The complexity meant that it was possible for a single trader to expose the banks to such risks that it seriously threatened SocGen’s survival. The complexity also meant that it was possible to disguise this activity from management. The governance and risk management system were inadequate.

A trader manager reprimanded one of his traders for unauthorised positions but did not investigate further in 2005. The IT risk management system missed at least 947 occasions when this particular trader eliminated traces of the risk resulting from trades, with no hedges or protection. The

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system also missed at least 115 times when this trader recorded a purchase and a sale for the same asset at different prices. Two managers noticed the trader’s reluctance to go on holiday, but did nothing about it. Auditors questioned 39 separate discrepancies on his trades, with no investigation.

The various controllers changed frequently and did not coordinate adequately enough to cause an investigation. Nonetheless, at 13 different times, someone called the trader for an explanation. On the two occasions when his explanations was incoherent, and his manager was notified of this, the manager took no action. The trader showed very significant profits—€43 million in 2007, more than six times the €7 million he had made in 2006. Of this €27 million was made from trades on the bank’s own account. No one questioned how such profits were possible, given the strict limits in place for the section in which the trader worked.

When an employee of SocGen’s Accounting and Financial Affairs Department investigated in January 2008, the trader gave answers the employee could not understand. This was not unusual as these employees often lacked market knowledge comparable to traders. This lack of understanding was one reason why matters might not have been taken further.

Another might be that traders making a great deal of money should not be unduly bothered. The earlier example of Barings in 1995 and their star trader Nick Leeson was similar.

In the case of SocGen the investigating employee persisted and was instrumental in exposing the fraudulent trades. On 20 January 2008, it was discovered that the trader, Jérôme Kerviel, had built up an un-hedged, unprotected position of €49 billion. This was close to double SocGen group’s total capital of €27 billion. If the position had not been discovered at this time, and the positions had had to be sold down while markets kept falling, SocGen would most likely have ceased to exist.

SocGen was allowed three days to manage the situation by the French regulator. This primarily required selling down the massive position accumulated incurring significant losses.

At the same time, SocGen suffered losses related to United States subprime lending of €2 billion. SocGen had been a leading innovator of the financial structuring that enabled subprime lenders to package and resell the loans to investors. Including the losses from selling the rogue traders’ position, SocGen’s total loss for 2008 was €5 billion.

J.P.Morgan and Morgan Stanley organised a share issue of €6 billion in new capital. and SocGen was able to continue operating. The Group chief executive officer stepped down, although he remained chairman of the

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Board. The head of the corporate and investment banking division moved to become responsible for asset management. The manager of the trader was dismissed. The trader was jailed for three years with an additional two years of suspension. On appeal, he was not required to repay €5 billion.

It will always be possible for a single individual, operating alone, to defraud an organisation. Any organisation taking risk in markets where prices can move is exposed to a possible loss. The case of SocGen is one of absent management. An operation grew so complex that the management was unable to manage it. Fraud is one of those risks any organisation is exposed to. If the complexity of the organisation is so great that the management is incapable of limiting fraud to ensure the survival of the bank, that is absent management. It is not bad management because no one would manage that badly. It was not that SocGen was managed badly. In terms of its fraud risk, it was not managed at all.

Long-Term Capital Management (LTCM) was an extreme example of complexity resulting in absent management. However LTCM was an investment fund, not a bank, so will only have a brief mention here. A former senior Salomon trader gathered a group of experts, two of whom later won the Nobel Prize, and raised $1 billion in 1994. LTCM then traded differences in prices or arbitrage, based on an extremely complex model, initially successfully increasing its equity to close to $5 billion. The margins of most of the trades were so small that the fund was significantly leveraged up through borrowing to make attractive returns. This resulted in $125 billion in borrowings on assets of more than $129 billion. As competitors entered LTCM’s main areas and this reduced margins, LTCM expanded into riskier areas with higher margins including emerging markets and junk bonds (Stowell and Meagher 2008). LTCM’s important counter party, Salomon Brothers, then departed the arbitrage market, and Russia defaulted on its sovereign debt in 1997. The Federal Reserve had to step in to avoid LTCM defaulting on massive amounts of derivative contracts that could have caused a wider collapse of financial markets. The Federal Reserve convinced 15 major investment banks to contribute $4 billion to a bailout that preserved market liquidity. The fund itself was completely unmanaged. The reason for this example of absent m ­ anagement in an investment fund rather than a bank is that it shows how complexity causes absent management. However clever the producers and supposed managers were, they still succeeded in constructing something so complex that it resulted in absent management.

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By 1989, Citi was the largest bank in the United States, the ninth largest in the world and employed 89,000 people in 90 countries. The number of problems or challenges in this highly complex organisation was correspondingly long. The new chief executive officer struggled to manage the large, diverse and decentralised bank. From 1985 to 1990, the investment bank operations cost the bank $400 million. In 1986, a new computer system cost $900 million, but did not deliver as expected. Citi had an exposure to less-developed country loans of $12 billion of which close to a quarter was not being repaid. From late 1990, United States government regulators began a two-year project overseeing Citi operations. The overexpansion and complexity was remedied with cuts of 17,000 people and expensive capital raising of $1.2 billion. In the third quarter of 1991, Citi did not pay a dividend, the first time since its predecessor was founded in 1813 (Wulf and Mckown 2012).

Complexity grew as banks expanded into different lines of business.

The management challenges of understanding lines of business the manager had not grown up in were challenging to overcome for even the most senior managers. Managing the people in different types of banking shows the complexity of the management challenge and how difficult it was to overcome. This was in addition to the complexities of achieving the collaboration and synergies that had been arguments for the growth and particularly the mergers undertaken to achieve the growth. The instances of inability of senior managers to understand, monitor and manage their increasingly complex organisations were to expose these organisations to significant risk of failures. These absent management instances caused by complexity was to leave many banks exposed to the largest financial crisis for over 70 years and was to continue to expose banks to risk of loss and failure to the present day and beyond.

References BBC News. http://news.bbc.co.uk/today/hi/today/newsid_9630000/9630673. stm. 12 June 2012.

Bernard, Alicia, Stewart Hamilton, and Donald A. Marchand. 1995. The Barings Collapse (A) Breakdowns in Organisational Culture and Management.

Lausanne: IMD. Bitetti, Carolyn M., and Kenneth A. Marchant. 1983. Chemical Bank–Allocation of Profits. Boston: Harvard Business School.

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Friedman, Raymond A. 1990. First Chicago Corporation: Global Corporate Bank (A). Boston: Harvard Business School.

Hunter, Mark, and N. Craig Smith. 2011. Société Générale: The Rogue Trader.

Fountainbleu: INSEAD. Marshall, Paul W., and Todd Thedinga. 2012. Jamie Dimon and Bank One (A).

Boston: Harvard Business School.

Phillips, Peter L., and Stephen A. Greyser. 2001. Bank One: “The Uncommon Partnership”. Boston: The Design Management Institute/Harvard Business School.

Raynor, Michael E., and Joseph L. Bower. 1999. CIBC Corporate and Investment Banking (A): 1987–1992. Boston: Harvard Business School.

Sebenius, James K., and David T. Kotchen. 1998. Morgan Stanley and S.G. Warburg: Investment Bank of the Future (A). Boston: Harvard Business School.

Sharp Paine, Lynn, and Michael A. Santoro. 2004. Forging the New Salomon.

Boston: Harvard Business School.

Stowell, David, and Evan Meagher. 2008. Investment Banking in 2008 (A): Rise and Fall of the Bear. Evanston: Kellogg School of Management, Northwestern University.

Walker, Russell. 2013. Scandal at Société Générale: Rogue Trader or Willing Accomplice? Evanston: Kellogg School of Management. Northwestern University.

Wulf, Julies M., and Ian Mckown Cornell. 2012. Citibank: Weathering the Commercial Real Estate Crisis of the Early 1990s. Boston: Harvard Business School.

CHAPTER 7

The Absence of Incentives to Manage: How the Wrong Incentives Resulted in Absent Management

Complexity caused absent management in banks. But why did management in banks not develop so as to overcome this challenge? Non-financial organisations also became complex, but many developed specialist management to ensure the presence of strategy, its implementation and monitoring. Had specialist management developed in banking as it did in non-financial organisations, it might have contributed to ensuring management was always present, even in the face of great complexity. Absent management happens when complexity is too great to manage. This is more likely if there are no specialist managers to manage this complexity.

The reasons for a lack of development of ever-present management, good or bad but not absent, were a lack of development of management as a specialist activity in banks and an absence of incentives to stimulate this development.

This chapter will look at the historical development of incentives. In particular, it will consider the absence of historical development of incentives to manage. The next chapter will turn to the absence of development of specialist management in banks.

The importance of the financial sector in the United States economy grew impressively once banks’ regulation loosened. With an increase in the proportion of corporate profits from the financial sector from around one-seventh between 1973 and 1985, it reached one-fifth by 1986, approached one-third by the 1990s and amounted two-fifths in the first decade of the twenty-first century. Average compensation for the finan© The Author(s) 2020 C. Dinesen, Absent Management in Banking, https://doi.org/10.1007/978-3-030-35824-2_7

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cial sector from 1948 to 1982 was no more than one-tenth higher than the average for all domestic private industries. Thereafter, it increased very significantly to four-fifth or nearly double the average by 2007 (Johnson 2009).

The incentives for the highest paid levels of finance increased with reduced regulation and increased profits. In 1970, about one in twenty graduates from some of the top United States universities went into Wall Street finance. The growth of incentives contributed to the proportion increasing sevenfold, to between a third and two-fifths by 2006 (Johnson 2010).

It is perhaps surprising that any book about bank management would focus on an absence of incentives. Too many and particularly too large incentives have been a major and even the major focus of the criticism of the 2008 financial crisis. Bankers’ bonuses have become synonymous with irresponsible greed. When banks failed, they caused misery for customers and shareholders and many other stakeholders, but mostly for citizens who had to suffer government austerity in countries where the banks had to be bailed out. These bonus incentives have been the easiest, but also justified targets of commentators and the media when criticising the behaviour of the main protagonists of the crises.

And bankers’ bonuses were wrong. In particular, they were so short term that bankers were able to cash them out too early. Some bonus recipients were able to leave to join another bank, or even retire, before the impact of the transactions to which the bonuses had been related were fully felt and understood by the banks, governments and citizens who had to bear the cost.

The bankers’ bonuses were wrong for another, catastrophic, reason.

The bonuses were not related to management. Bonuses were typically paid for banking, lending, trading and deal making, rather than the management of banks. It is easy to see this. If the incentives had been related to management rather than to banks, they would have been much longer term than was the case—so long term that they would have taken account of the downside of the business that was supposed to be managed. But they were primarily related to banking and particularly deals and therefore short term. This incentive structure contributed to an absence of incentives to management and an absence of the development of specialist management in banking. Along with the growth in complexity, this absence of development of specialist management in banking was one of the determining causes of the latest and many past banking crises.

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It is easy to conclude that people do what they are paid to do. That is supposedly a key trait of capitalism and the free market. What is missing from this simplistic conclusion is that people tend not to do what they are not paid to do, with apologies for the double negative. And this is particularly so when there is another activity, within the same organisation where you are paid very well, sometimes, literally, unbelievably well, to do something else. But what you are not paid to do is to manage.

In addition, it is too simplistic to conclude that the payment of money is the only incentive. People are incentivised by many other types of rewards as well as by the concern or even fear of a negative outcome.

People are incentivised by status, for example, by a more senior title, and not just because this title, in turn, may lead to higher payments. It is both a standing joke and a truth in banking, and particularly in investment banking, that if we promote him or her to managing director this year we do not need to pay them a higher bonus. Incentives are also the subject of an important psychological field of study, which is beyond the scope of this book. Here the topic of incentives is limited to the combination of economic history, banker biographies, business school case studies and personal experience, which provides insight into incentives as they have worked and failed in banking.

Interestingly increased management responsibility can be an incentive in that it increases the influence, even power and status, of the promoted manager. It has been used as such in banking. However given that increased wealth is generally the strongest incentive in banks, particularly in investment banking, increased management responsibility without correspondingly increased earnings can lose its power to incentivise.

Long-term job security is an incentive in banks and particularly in commercial banks with their longer-term focus and objectives of client retention. Conversely one of the major failures of incentives in investment banks has been that the incentives were so large and so short term that they relatively quickly provided lifelong financial security and independence. As such incentives significantly reduced or eradicated future positive or negative incentives for this individual, who might no longer desire additional reward or fear a lack of bonus or even dismissal.

The feeling of doing a good job is a strong incentive for many people.

In some parts of banking, this quickly becomes closely aligned with being well and better paid. So a good job is making more money. Doing a good job is often not enough, at least not in banking.

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One exception to this rule may have been Siegmund Warburg. An aspect that puzzled those who have studied him was that he believed that wealth was a by-product of high-class work. It was this high-class work which was the aim. Money-making for his own sake and in particular for his own wealth was not his primary aim. In this he seems to have been an exception but not more so than he admitted that he did like making money for his firm and himself, even if it was not his primary aim (Ferguson 2010).

If doing a good job is not enough, altruism does also not have much role in banking. I was often told in my early years in banking that “We are not here for the common good”. But banks play an indispensable role in modern society and to that extent they exist for the good of all. Ensuring that employees understand and even feel incentivised by this role might improve the behaviour of banks and particularly of the most senior management.

Incentives were part of the story of the Medici and a reason for both their success and decline. At all times the Medici ensured that each local branch managers were correctly incentivised. This was not done by being paid excessive salaries, but by having a share in the fortunes of their branch.

The original partnership agreements gave both the Medici and their first and best general manager, Benci, a share and interest in the success of each and every branch. The Medici continued to be successful as long as this incentive structure was in place. The change in incentive structure was caused by the need to renew all the partnership agreements when one of the partners, in this case Benci, died in 1455. His successor Sassetti only had partnership interests in two of the branches. It is not possible to conclude that it was solely the change in incentive structure and not also the reduced capabilities of the general manager that initiated the slow decline of the Medici Bank from 1455 onwards. The disastrous losses of some branches, in which the new general manager had no interest, increased conflicts between branches and was an important reason for the Medici Bank’s decline. These losses and conflicts would probably have been less likely if the original incentive structure of the general manager of having a share in each and every branch had been maintained (Roover 1966).

For the Rothschilds, incentives were perhaps best described as keeping it in the family and supporting family members in distress with the expectation of themselves receiving support when required. Another incentive was to become fabulously wealthy. The partnership agreement between the brothers, cousins and cousins-once-removed provided a strong

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i­ncentive structure to keep non-family members out of management. This was reinforced by intermarriages. The incentive of reciprocal support was critical for the long-term success and survival of the multinational Rothschild Bank.

The keeping it in the family incentive structure was also a weakness due to the absence of an incentive for a family member to take up the challenge of establishing in the United States. This was perhaps the greatest strategic mistake in the history of the multinational Rothschild Bank. Assumptions are necessary to suggest why there was an absence of incentives for one of the younger generation to show the same entrepreneurship in the mid- to late nineteenth century as their uncles had when leaving Frankfurt in the late eighteenth century and establishing in London, Paris, Vienna and Naples. Possibly all of the younger Rothschilds already had a lot to lose, both in terms of wealth and position, by leaving any of the established Rothschild houses in Europe. Certainly any new enterprise would have been subject to the constant and intense criticism that the uncles and nephews in the established houses handed out to each other. There were perhaps no identifiable, additional gains to be made from leaving the family’s well-established banks in Europe to take on a significant commercial risk under the critical eyes of uncles and cousins, on a different continent, with only a very small community of co-religionists. This absence of incentives for a family member to establish in the United States was the main reason for the largest strategic mistake of not establishing and thereby, eventually, being superseded by other banks starting with J.P.Morgan.

Incentive schemes were part of early management of non-financial industries. In the 1920s, the Chief Executive Officer of General Motors, Alfred P. Sloan, believed that managers should be frankly told that a business opportunity involved both profit and risk (Holden 2005). The original General Motors incentive schemes were characterised by the company lending money to managers so that they could purchase company stock at market prices. Managers paid market interest rates on such loans, and in the General Motors incentives plans, managers were also required to gradually repay the principal. The stock incentive plans of the 1920s were seven to ten years in length, a much longer term than most modern stock option plans (Holden 2005). The early 1920s plans, including General Motors’, may have been better designed than the stock option management incentive plans that became popular in the 1990s (Holden 2005).

One reason was that the incentive plans aligned the managers’ interests with the medium- to long-term interests of the firm. Another important

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reason was that the early plans had downside risk as well as upside reward.

If share prices went down, the loans to buy them still had to be paid back.

Once you start doing something, it can be difficult to change or stop.

This is true for institutions as for individuals. One description of this behaviour is path dependency, a concept mostly associated with technology. The best known example of path dependency is the QWERTY keyboard. Although more efficient and ergonomic keyboards have been developed, the overwhelming use of the QWERTY keyboard persists. This is partly because of the enormous investment already made by individuals and institutions in hardware and training in the use of this particular keyboard layout.

The original payment of bonuses was to incentivise certain behaviour and effort and gain an advantage at a certain time and in certain market conditions. Introducing these incentives may have led to important future expectations that were difficult to reverse. This may even be the case in a situation where the behaviour is voluntary and supposedly under the control of management (Liebowitz and Margolis 2000). No bank is forced to pay bonuses, at least not variable bonuses. However, the concept of path dependency indicates that what has been done before influences behaviour today and tomorrow. History matters. Of course it does. If not, there would be no point to this book, which hopefully there is.

The establishment of bonus schemes, designed to promote growth, and thereby an advantage, had important and difficult to reverse consequences. One consequence was that some schemes promoted growth but not risk management due to a lack of downside risk for the beneficiaries of the schemes. The bonus schemes became difficult to reverse because banks found it almost impossible not to pay bonuses, due to the fear of impact on morale and retention of important employees.

Path dependence is absent management. If behaviour in an organisation, however well intended initially, becomes detrimental to the objectives of the business but is not changed, then management is not carrying out its function. Path dependency is absent management unless doing nothing, carrying on with the status quo, is a chosen management option.

The lack of improvement in the management of incentive schemes in banks evidences path dependency. Incentive schemes were certainly present in banks by the mid-1970s, and probably earlier. Bonus schemes were initially implemented to improve profitability by encouraging a performance-­ driven culture. In 1975, problems of not paying bonuses were identified when times were less favourable due to the first Oil Crises in 1973. The

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embargo on export of oil to the United States by the Oil Producing and Exporting Countries, or OPEC, caused an economic downturn there and generally in the developed world due to the sharp increase in oil prices.

Management of banks were concerned with the impact on morale from not paying bonuses for this macroeconomic reason. This indicates path dependency. A system was initially instituted to improve efficiency by incentivising productivity. The system then showed the flaw that not paying bonuses could damage morale. Finally, the system could not be abandoned for the same reason. This situation was present in banks in the early 1970s as well as in the late 1990s, which will be described later.

The short-term approach of some banks’ incentive schemes, particularly investment banks focused on the next deal or trade rather than on the long-term customer relationship, can encourage path dependency. The pursuit of short-term profits can result in persistently inefficient activities (Liebowitz and Margolis 2000). The contrasting time horizons of commercial and investment banks have been shown to be based on different earnings models. The short-term investment banking horizon was chasing large deals or trades. The longer-term horizon in commercial banks was looking for smaller, more frequent transactions based on longer-term client relationships. One of the essential requirements of efficient management is to have both shorter- and longer-term views, to be both tactical and strategic. One of the reasons for the need to have both these views is to ensure that a short-term horizon does not result in path dependency.

Importantly, this is true in both pure investment banks and even more so in banks combining investment and commercial banking.

Incentive schemes and their problems in time of crises were present in financial institutions by the mid-1970s. They indicate path dependency in the behaviour of management to pay bonuses even when results are poor.

There was a lack of long-term thinking by management.

First Federal Savings was an Arizona-based Savings & Loan Association that expanded rapidly in the 1970s and 1980s. The incentive scheme in First Federal Savings in 1975 (Doyle and Lorsch 1975) was different to a company with shares and listed on a stock exchange. First Federal paid cash bonuses to employees who achieved their sales and expense targets when the Savings & Loans Association made increased profits. It became a key problem that no bonus might be paid in 1975. This was due to the withdrawal of savings by depositors under economic pressure caused by the 1973 Oil Crises. Withdrawal of savings limited the Savings & Loan Association’s ability to lend mortgages. Management was concerned with

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the impact on morale from not paying bonuses for macroeconomic reasons, and in spite of the efforts and flexibility shown by staff during a difficult year (Doyle and Lorsch 1975). The First Federal incentive scheme had only upside and, as an unlisted entity, was paid in cash rather than stock. The binary upside and downside in the original incentive schemes of General Motors were not present. The First Federal scheme (Doyle and Lorsch 1975) provided incentives for growth but with the only downside being the absence of a bonus. This type of incentive stimulates growth but does not encourage risk awareness.

At First Federal, it was clear that the expectation level regarding bonuses had become pervasive and inclined management towards path dependency in terms of paying bonuses. Employees were starting to wonder why they had worked so hard if they were to receive only a small or no bonus at all.

A no-bonus year was expected to cause a tremendous morale problem amongst managers (Doyle and Lorsch 1975). If a bank was driven to paying bonuses to avoid demotivation, but those bonuses did not correlate to performance, this would induce limited management of risk and provide too much focus on growth.

A later look at First Federal includes an interesting observation as part of what the bank had learned from its 1970s bonus experience. The bonus programme was seen as causing too much of a short-run outlook, disregarding long-range implications for immediate benefits. First Federal’s financial difficulties of 1975–1977 were seen as a result of this short-term outlook caused by the incentive scheme. And the difficulties were seen as much more severe for First Federal than for its competitors (Doyle and Lorsch 1975). There was an increased awareness of the absence of long-­ term considerations in that short-run concerns were not balanced with concerns in the long run. This was in sharp contrast to the early General Motors’ incentive plans.

Path dependence had become an integral part of the bonus approach in Citi by the late 1990s. An original objective of aligning the incentives of employees with the profitability of the organisation was overridden to ensure motivation, retention or both. Citi was by then a very large and diversified organisation, the largest bank in the world by number of worldwide locations and possibly the most complex. Importantly, Citi experienced the same incentive-related problems as the much simpler, less-diversified First Federal Savings & Loans Association had experienced 20 years earlier. By 1997 the annual people assessment in Citi had become sophisticated, but the historical problems of not paying bonuses persisted.

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In Citi, a performance scorecard used for the annual assessment was built around six different types of measures: financial, strategy implementation, customer satisfaction, control, people and standards. The rating system was based on a scale of below par, par or above par. A below par rating in any category resulted in no bonus being received. A par rating meant a bonus of up to 15 per cent of base salary. An above par rating meant up to 30 per cent. For a manager to be rated above par overall, he or she would need at least a par rating in all the components of the scorecard. This assessment structure meant that a manager achieving, say, the financial standards but not the non-financial standards, for example, around people, could not receive a significant bonus. Following the rules would be active and present management. Ignoring the management rules and paying a high bonus anyway, to reward only financial goals and retain an individual capable of achieving just these, would show absent management (Dávila and Simons 1997). Whether for the reasons of a bad year or one weak measure, it was a problem for banks not to pay bonuses.

In the 1990s Credit Suisse was Europe’s fourth and Switzerland’s second-­ largest financial services group, employing 62,000 people worldwide of which 28,000 were in Switzerland. It provided one-stop-shopping for banking and insurance products and operated on every continent and in all major financial centres. The bank’s operations included retail banking in Switzerland and for individual customers in 120 countries, private banking for high-net-worth individuals, global investment banking, global asset management and insurance (Fulmer 2000). The long-term problem of bonus payments in bad years was that Credit Suisse did not have a strong performance-based culture. Although employment contracts said that an employee’s bonus could be zero, such outcomes were extremely rare (Fulmer 2000).

The multidivisional strategy was described by a newspaper as a high-risk strategy. The two big Swiss banks, UBS and Credit Suisse, unlike most of their European competitors, were described as committed to remaining global leaders not only in investment banking but also in asset gathering.

The odds of long-term success were said to be stacked against them (Fulmer 2000).

By 1999, Credit Suisse showed strong signs of incentive path dependency as well management challenges and risks associated with complexity resulting from rapid growth. By then employees were rarely paid nil bonus.

A particular problem for Credit Suisse, and its main Swiss competitor UBS, was the combination of investment banking and asset management.

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Negative publicity in the investment bank had the potential to cause outflow from the asset management, should the investors of the managed assets lose confidence in the overall organisation. The different time horizons between the bank segments appear to make bonus schemes particularly hard to manage. Investment bankers in Credit Suisse were successfully chasing large deals and trades and were remunerated for achieving these successes soon thereafter. In asset management incentives were related to growing the assets under management, including keeping them for the longer term. So these differences emerged from the bankers who are highly transaction-driven versus those that value long-term relationships.

There is little evidence of bonus schemes with any downside. An absence of downside might encourage risk taking rather than prudence. In the case of Credit Suisse, the lack of downside in the incentive scheme for investment bankers resulted in little encouragement of risk awareness. When the 2008 financial crisis hit with problems in the investment bank, the customers of the asset management side became concerned, and some withdrew money and placed it with asset managers less exposed to investment banking. This made bonuses and particularly not paying them to the asset management side extremely challenging, as the lower assets and corresponding fees could be blamed on the investment bankers in the group. It was complexities like these, combined with path dependency and absent management, that resulted in banks continuing to pay bonuses even when their earnings had been replaced with large losses.

The desire for rapid growth in types of activity and geography, as well as the increased investment of the banks’ own money in trading, not only increased complexity but also the need for capital. This need for capital was mostly met from publicly listing on stock exchanges, causing a change in ownership from private to public. A need for capital and the change in ownership consequently changed incentives. This was particularly for senior people who had previously been partners but had now become employees. The change in ownership structure often preceded the dramatic growth of the company. The combination of these changes increased the requirements on management, partly from the impact a change in ownership had on incentives. It is challenging to manage within a ‘money culture’ (Sharp Paine and Santoro 2004). There were not many other incentives than money available such as, for example, titles or sustainability of employment. The existence of path dependency is part of a lack of development of management. Management had the choice of changing behaviour that was not beneficial to the organisation. This was not done

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to an extent that showed overcoming path dependency. This story of absent management was written on a QWERTY keyboard.

Incentives played a different role in commercial and investment banks.

In commercial banks with their longer-term focus, the main problem related to not paying bonuses in a poor year because of the loss of motivation and possible loss of staff. However, in commercial banks bonuses were typically a proportion of the fixed salary. So not receiving a bonus was a concern for those working for commercial banks as seen in the First Federal case. However being employed next year with the hope of conditions being better also mattered. This was different in investment banks where bonuses could be a multiple of salaries. Once some investment bankers got used to receiving bonuses of one or several times their salary, they often adopted lifestyles that could not be financed by their base salary. So not receiving a high bonus meant a change in lifestyle and loss of status. This increased the pressure for paying top investment bankers high bonuses and contributed to path dependency.

As seen in the previous chapter on managing commercial and investment bankers within the same bank, compensation was a significant complexity for top management. Commercial bankers could be dis-incentivised by suspecting that their investment banking colleagues were paid several times more. Investment bankers had concerns that their bonuses might be diluted by having to pay commercial bankers from the same bonus pool.

Incentives were different depending on the types of ownership. A family-­owned bank could have an incentive structure aimed at keeping it in the family. In particular, a family-owned bank or partnership would be incentivised to keep the bank safe in the long term, to survive and be there tomorrow. For a banking family, or a group of partners, not only their future earnings but also their standing, even identity, would be associated with the continuation of the bank. So family ownership and partnerships are not only incentivised to preserve the bank, they are also highly incentivised to prevent the bank failing. This worked well for the Rothschilds for decades, but not for Barings once the complexities overcame the capabilities of the management.

The change from a partnership to a listed company fundamentally changes this incentive. Once the bank is listed, any manager can sell the shares awarded as an incentive, when the incentive scheme allows this. As long as the bank is still in existence and the share price high, the manager has no financial incentive to keep the bank from failing beyond the date when his or her shares are sold.

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An unlisted partnership or association would be restricted from rewarding with shares that could both increase but also reduce in value. Growth through mergers and acquisitions would often change the type of ownership for the acquired entity, leading to additional management complexity.

This also had transformational effects of the incentives experiencing a change of ownership structure, typically from a private partnership to an entity listed on the stock exchange.

Salomon had been a partnership from 1910 until 1981, when it was sold to a publicly listed commodity dealer. Following this acquisition, Salomon’s employees grew from 2300 employees to 6800 in only four years, with the bank earning a record $557 million in 1985. The very rapid growth was mainly through bond trading during a period when corporate and government debt grew extremely rapidly. Salomon was a leading innovator in the mortgage-backed securities business. This was a new asset class whereby mortgages were issued to retail customers, and these mortgages were then packaged together and sold on to investors. Much more on explaining this asset class and its importance will follow later.

Selling these loans provided a new source of capital for mortgage lending, enabling rapid growth in this activity. The new asset class also provided a lucrative source of fees for investment banks that were structuring and distributing this new asset class. Salomon grew to become one of the world’s pre-eminent financial institutions. It was an expert and one of the leaders in underwriting, distributing and trading the United States government securities, corporate bonds and equities, and mortgage-backed securities (Sharp Paine and Santoro 2004).

The case of Salomon shows management challenges in an extremely rapidly growing organisation, particularly in terms of risk management and path-dependent incentives. The time horizon of employees was affected by both a change in ownership, which now had little interest in long-term earnings, and the sheer size of annual remuneration in investment banks.

Salomon publicly disclosed that it had uncovered irregularities and rule violations in connection with its bids in three the United States Treasury Security Auctions in 1990. An internal Salomon observation prior to 1991 evidences the attitude to management. Many bankers were concerned that the use of management tools and controls to facilitate resource allocation, planning and accountability would undermine the firm’s entrepreneurial ­culture. This attitude showed a reluctance to accept, let alone embrace, management. When the Treasury auction crisis occurred in 1990, many of

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the proposed management processes were still under development or not yet implemented (Sharp Paine and Santoro 2004).

The change in ownership structure had preceded the dramatic growth of the company. Both these changes affected the requirements on management. The challenge of managing within a short-term money culture was encapsulated by the then co-head of investment banking at Salomon.

He observed that some people only joined the firm for a few years to make a lot of money. The money culture was explained by the view that the person who earns $10 million for the firm is more valued than the person who makes $1 million, and the person who earns $100 million is a god. A real problem was that if someone were paid $10 million for three years in a row, the manager would have no authority over this employee who had, by then, achieved financial independence. The person would not have to listen to moral persuasion (Sharp Paine and Santoro 2004).

The bonus culture had moved from being difficult to manage to unmanageable in Salomon, caused by the growth of the organisation and the changes in ownerships. If an employee was able to become financially independent within only a few years, any medium let alone long-term incentive scheme would have little effect. In one special case, the 31-year-­ old head of the bond arbitrage group, which made $400 million in profits, took home $23 million in one year (Sharp Paine and Santoro 2004).

The short- and long-term complexity is also less relevant for an organisation creating multimillionaires within just part of one business cycle. In a partnership, partners would be incentivised to sustain the firm’s earning power and to continue in existence. Avoiding failure was possibly the single most important objective for a partner. An employee in a listed company would be focused on individual deals and annual remuneration, particularly if the remuneration was so substantial as to overcome any loss of longer-term earning power.

By this stage, the bonus culture had moved from being difficult to manage, as in the United States savings bank First Federal in 1975, to unmanageable in Salomon in 1990. If an employee was able to become economically independent within only a few years, any medium, let alone long-term, incentive scheme, such as the early incarnations in General Motors, would have little effect. Even when the annual assessment process for employees had become sophisticated, as in Citi by 1997, the historical problems of not paying bonuses persisted.

Action was taken by Warren Buffett in Salomon on the time horizon and scale of compensation. Buffett was critical of the old-fashioned

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method of compensation where bonuses were paid in cash. This was inappropriate for a company based on shareholder capital, which was no longer owned by partners but by shareholders, of which Buffett was one of the more substantial. Short-term cash payment of bonuses was more appropriate to a partnership that Salomon had been. The continuation of paying bonuses in cash after Solomon had been listed is a good example of path dependency. The firm continued a practice from the period of partnership that was no longer appropriate for a period of public ownership.

Buffett approved of the management decision in 1991 to pay bonuses in the form of shares, which the recipient would be unable to sell for five years. This was still only half the time of the original incentive plans in General Motors. This would mean that the bonus recipient would have a risk of the value of the restricted shares going down as well as up without being able to sell them. Buffett’s intention was that wealth creation by employees should be the result of themselves owning part of the business, with both risks and rewards. Wealth creation for employees should not only involve upside, when shareholders had the risk of both upside and downside (Sharp Paine and Santoro 2004).

Goldman Sachs was another investment bank that went public, in 1999, to obtain capital to increase its global activities and to take more risk for its own account. Interestingly, titles were changed from partners to managing directors before then, in 1996. This was specifically done as an incentive. Some who were not partners, but had made exceptional contributions, were made managing directors as recognition of their contribution, often at a young age. One of the aims was to provide the incentive of a managing director title to stop competitors from hiring Goldman Sachs talent with the promise of a managing director title (Nanda et al. 2006). The managing part of the title did not imply a management function.

Going public provided a positive impetus for management in banks.

The need to report to shareholders, particularly when listed on the demanding New York and London stock exchanges, created a significantly increased requirement for disclosure, reporting and accountability. The banks that remained in partnerships or family ownership were sometimes left behind. One example was Lazard Frères who had been a leading investment bank during the twentieth century. It had been a top ten ­mergers and acquisitions advisor, but had slipped to twelfth by 2001. A new head of the New York office in 1992 realised that pay reviews were

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the only driver of the banks’ authority. Partnership meetings were said to be infrequent and achieving little. Performance reviews were said to amount to grunts, incomparably simplistic in contrast to listed peers such as Citi (Subramanian and Sherman 2008).

In the major investment banks, the compensation process had become extremely sophisticated, complex and laborious by the early 2000s. The approach was relatively similar amongst them, reflecting the intense competition for the best and highest paid talent. Key features included the size of the bonus pool, the mix of cash and equity and the dates at which the equity could be sold. Many factors were involved in determining the allocation to each division and individual.

By 2007, internal observations in Lehman Brothers indicated that including risks in the incentive plans to determine individual incentives had been discussed for as long as a decade but had not yet been implemented. A particular problem in those activities was the ability of traders to value their own positions. A high or low value could affect the expected profit, and consequently the trader’s compensation. Another important problem was that many activities would not see their final outcome for several years. Compensation was often based on net revenue. This in turn reflected what an investment or trading position could be sold at (Maedler and van Etten 2013). If the value of the position was to deteriorate later, the compensation would already have been paid when this occurred. This approach provided no incentive for traders to think longer term for the benefit of the bank, particularly if they left after their compensation had been received.

The music stopped in 2008. Wall Street bonuses amounted to an astonishing $35 billion in 2006, and only fell a little to $33 billion in 2007.

With losses in New York’s traditional broker/dealer operations estimated at over $10 billion in 2007, and over $35 billion in 2008, bonuses fell significantly but only to a still very large $18 billion in 2008. This was still the sixth largest bonus pool on record and amounted to an average $112,000 per employee (Zeisberger et al. 2009). In spite of extremely large losses, it was difficult not to pay bonuses. When the investment banking industry was surveyed at the end of 2008, all but 2 per cent said that compensation was a factor in the 2008 financial crises. This did not prevent the payment of the 2008 bonuses. The money and bonus culture had become truly path dependent and management of incentives was truly absent.

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References Dávila, Antonio, and Robert Simons. 1997. Citibank: Performance Evaluation.

Boston: Harvard Business School.

Doyle, Stephen X., and Jay W. Lorsch. 1975. First Federal Savings (A). Boston: Harvard Business School.

Ferguson, Niall. 2010. High Financier. The Lives and Times of Siegmund Warburg.

London: Penguin.

Fulmer, William E. 2000. Credit Suisse (A). Boston: Harvard Business School.

Holden, R.T. 2005. The Original Management Incentive Schemes. The Journal of Economic Perspectives 19 (4): 135–144.

Johnson, Simon. 2009. The Quiet Coup. The Atlantic, May 2009.

———. 2010. The Next Financial Crisis. Boston: Forum for the Future of Higher Education.

Liebowitz, S.J., and S.E. Margolis. 2000. Path Dependence, Lock-In, and History.

The Journal of Law, Economics and Organisation 11 (1): 205–226.

Maedler, Markus, and Scott van Etten. 2013. Risk Management at Lehman Brothers, 2007–2008. Madrid: IESE Business School of Navarre.

Nanda, Ashish, Malcolm Salter, Boris Groysberg, and Sarah Matthews. 2006. The Goldman Sachs. Boston: Harvard Business School.

Roover, Raymond de. 1966. The Rise and Decline of the Medici Bank, 1397–1494.

The North Library.

Sharp Paine, Lynn, and Michael A. Santoro. 2004. Forging the New Salomon.

Boston: Harvard Business School.

Subramanian, Guyana, and Eliot Sherman. 2008. Lazard LLC. Boston: Harvard Business School.

Zeisberger, Claudia, Na Boon Chong, and Grace Wu. 2009. Bank United States: The Challenge of Compensation After the 2008 Financial Crisis.

Fountainbleu: INSEAD.

CHAPTER 8

Producer Managers: How Continued Focus on Banking Resulted in Absent Management

The heads of large banks are both clever and energetic. The competition for the top jobs is so intense that it is impossible to achieve such a position without at least a good brain and the willingness to work hard. Other qualities, such as single mindedness and emotional intelligence, are helpful, but intelligence and hard work are indispensable. The days when the top positions were inherited have almost completely gone, at least amongst the large, complex banks. As soon as a bank is listed on a stock exchange and becomes owned by shareholders, merit rather than genes becomes the overriding selection criteria. Inherited wealth and nepotism as well as a top education are, of course, still helpful in the competition for the top spots.

Nevertheless at some stage banks will be involved in so many different lines of business and products, in so many countries and have become so very large that no single individual can understand, let alone control, it all.

When that happens will depend on the level of complexity in the organisation and the capabilities of the individual, but it is inevitable if complexity continues to grow. When something becomes increasingly complex, in order to manage it you can become increasingly expert. However, if the bank becomes increasingly complex in several different lines of business, products and countries, no one person can be an expert in all these complexities. So the only possibility is to manage through other people who are expert in their areas. And to do this you have to be an expert manager.

And given how demanding it will be to manage so many complex activities you have to be a really, really good manager and have really good ­managers © The Author(s) 2020 C. Dinesen, Absent Management in Banking, https://doi.org/10.1007/978-3-030-35824-2_8

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working for you and so on. And this does not often happen in banks, because nearly everyone wants to be a producer, a proper banker and not a manager.

In the beginning, when banks were small and simple, there was no need for specialist management. The most senior banker, often also the owner or a partner, was also the manager. Sometimes the bank was managed by a partnership with a committee of partners appointing and working with the most senior partner, who ran the bank on a day-to-day basis. If the bank was one branch, operating in one line of business and one country or state, this adequately met the management needs of the operation. The approach was the same whether the bank was a commercial or investment bank. In some cases the owner was someone who did other things than banking. In such a case the owner or owners might appoint a manager.

This manager was himself, and in those days it was nearly always a he, a banker who also managed.

For the first 650 years of western banking, say from the beginning of the fourteenth century in Florence until the middle of the twentieth century, this was how nearly all banks were managed. The Medici, Rothschild and Warburg banks were all managed by producer managers. They would never have thought of themselves as such. They were bankers. Being a banker involved not just carrying out banking business but also the required leadership, including setting direction, executing and setting a great personal example as a leader (DeLong et al. 2007).

In Goldman Sachs the greatest producers often ended up as the chief executive officer of the firm. Sydney Weinberg, who took Ford Motor Company public and was the best known businessman in America, was chairman of Goldman Sachs from 1930 to 1969. He was succeeded by Gus Levy, Goldman Sachs’ second highest producer after Weinberg (Nanda et al. 2006). A later chief executive officer described the leadership of Goldman Sachs by the senior partners as producer managers, who execute and meet clients, even as they lead their businesses. They are not administrators who order their subordinates to do the real work (Nanda et al. 2006).

In the largest bank for much of the twentieth century and some early parts of the twenty-first century, J.P.Morgan, the chief executive officer is still a producer manager. When the United States pharmaceutical giant Pfizer lost one of its lenders in the $68 billion acquisition of Wyeth in 2008, the chief executive officer of J.P.Morgan supposedly stepped in saying “I got your back come hell or high water”. This chief executive officer of

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the largest and extremely complicated bank insists that he is “part of the army that supports” the investment bankers who he describes as the bank’s “Navy Seals”, the United States Navy’s special forces. Some believe this approach helps explain why J.P.Morgan survived the financial crisis better than any other United States bank. What it shows is that even this chief executive officer remains a producer manager rather than a full-time manager. However it is also “a terrifically run operation” according to Warren Buffett (Weber 2018). But as we shall see later J.P.Morgan also and still suffers from incidents of absent management.

It took management academics to develop a term for this type of leadership or management in banks and other professional services firms. This first and important term was in Lorsch and Mathias’ seminal 1987 article When Professionals Have to Manage (Lorsch and Mathias 1987) where they used the term ‘producing manager’. Others have referred to ‘player managers’ referencing sports including such great soccer players as Kenny Dalglish at Liverpool and Gianluca Vialli at Chelsea. At the end of their playing careers they simultaneously played and managed their teams. In Goldman Sachs and Merrill Lynch the term ‘producer manager’ was occasionally used and that is my preferred term because the two words are equal. Not producing manager or managing player, but ‘producer manager’. At least in the terminology the two activities are equal. As the focus here is absent management, the result was, and often is, that there was absent management because being a producer, a banker, took precedence over being a manager.

Industrial corporates was where management was developed as a specialist skill and in a remarkably different way from banks and other professional services firms. The Industrial Revolution in Britain in the eighteenth and nineteenth centuries saw the emergence of very large corporations starting with mining and textile factories. These employed first hundreds and then thousands of people and their sheer size meant that the enterprises required organising to function effectively. Different skills were required to organise the work from those who did the work, mined the coal and iron or worked the looms when they moved from home industry to factories. The managers were not just foremen or leading workers, they were something entirely different. They had authority to decide who did what, under what conditions and for how long. They worked in an office rather than a mine or factory and dressed differently. Sometimes they were not only managers but also owners.

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Most importantly managers in industry were just that, managers. They were specialist at management. They did not also pick up a pickaxe and start digging or thread a loom. In fact many of them would not have known how to do so as they lacked the skill. They were managers, and their skill was management, not production.

Possibly the management of a large industrial corporation had similarities with the historical management of a large agricultural estate. On large farms with hundreds of labourers, such as existed for example in England when the Industrial Revolution began, there was similar complete separation in activity skills and status between farm workers and the owner managers. Uniquely in England there was a large concentration of land ownership when aristocrats had bought church land from King Henry VIII as he completed the dissolution of the monasteries by 1540. In addition English landowners did not have the additional powers over the peasants working the land of their Continental European counterparties.

English landowners therefore needed to encourage, and sometimes compel, but certainly to manage, those working the land to increase productivity (Meiksins Wood 1998). Some of these large estate owner managers became large industrialists because coal or iron was found on their land, and they had the money to exploit it. Some of them also had the specialist management skills to manage large enterprises or to find professional managers with those skills.

The Industrial Revolution also brought another new management challenge. It required specialist management skills to manage enterprises in more than one location and none more so than, obviously, the railways.

Everywhere the railway went, specialist management was required, completely separate from the activities of driving the trains and operating individual stations. The railway managers used the trains as passengers, but there was no question of them driving the trains.

Banks, of course, were a crucial and completely necessary part of the development of the Industrial Revolution. The highly developed banking sector in the City of London was one of several reasons why the United Kingdom saw the birth of the Industrial Revolution. Other countries such as France, Germany and the United States also saw rapid developments of their banking systems to support the financing of their industrial revolutions.

Amongst the earliest available business school case studies addressing bank management are several on the First National Bank. This was a predecessor of today’s Citi, which was to become one of the largest, most geographically diverse and most complex banks in the world. These cases

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consider the development of management in response to a multidivisional structure and of the attitude to management in 1970. A managerial role within the bank was seen as a poor career choice for any ambitious employee. Management was administration and operational but not a leadership function. Management skills were then not available in Citi and had to be imported from the automobile industry.

Citi’s predecessor in 1970 was an early and rare example of a multidivisional structure in a financial institution. The structure in 1970 reflects the multidivisional structure of the large chemical company Du Pont and automobile manufacturer General Motors in the 1920s. The management historian Alfred Chandler described this in 1962. Chandler identified the role of General Motor’s Advisory and Financial Staff as helping to coordinate, appraise and plan policy. This interdivisional committee’s most important functions were to make recommendations to the Executive Committee and to propose new policies and procedure. The Executive Committee in turn remained the governing body at General Motors (Chandler 1962).

While the multidivisional structure was present in Citi by 1970, the roles of the professional managers were different to Chandler’s observations in General Motors. Where professional managers proposed new policies to the top of General Motors, the Citi Operating Group appears as an administrative function. The Operating Group was less powerful than the professional managers in Du Pont and General Motors, the non-financial, industrial examples. The head of the Operating Group had concerns that his group was still seen by the rest of the bank as a necessary evil and was only just tolerated by its more intelligent brethren (Seeger et al. 1974).

The low regard in which this function was held is seen from the description of the newly appointed head of the Operating Group. He was described as an immensely perceptive, sophisticated investment banker (Seeger et al. 1975), who cried for 30 days when he was assigned to head up the Operating Group. This was in spite of understanding that the back office was a point of vulnerability.

Banks’ complexity increased with the demand for corporate finance.

Whether to lend to or invest in railways, with their new types of risk and often poor safety record, was a major discussion point and bone of contention amongst the Rothschild houses. However, corporate finance remained a specialist banking activity. There were only a small number of banks involved. The growth in corporate finance for different sectors and in ­various countries caused increased complexity in banking products. But at

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least the banks nearly always operated from a single location, limiting their operational geographical complexity.

The development of management in industry and transportation got all the attention from historians and later management academics. It was a remarkable and interesting development, management as a specialist activity. The focus of such important historians as Chandler on the development of management in such industries as General Motors and Dupont in the 1920s is understandable.

No such specialist development took place in banking and other professional services. And less attention was paid by historians or academics.

Although banks had existed for at least six centuries, there was an absence of a history of management in banking, until very recently. And until Lorsch and Mathias’ 1987 article When Professionals Have to Manage, very little attention was given to those entities such as banks where specialist management did not develop.

The transfer of professional managers and management knowledge from industry to banks was clear in the early Citi case. Citi was aware of current management practices in industry in 1970. The head of the Operating Group, the crying banker, set out to hire a right hand man. He acknowledged that the Operating Group was a factory and that the principles of production management had to be continually applied to make that factory operate more efficiently (Seeger et al. 1974). The pure retail side of banking was learning from industry in terms on how to manage.

The head of the Operating Group was fully aware that Citi could not provide what he required. “The plain fact is that the language and values we need for success are not derived from banking” (Seeger et al. 1974). His eventual recruit as his right hand man had worked for Ford Motor Company for six years and had a Master of Business Administration (MBA) degree from Massachusetts Institute of Technology. This recruit in turn made a remarkable observation at a speech at the American Bankers Association in 1974. “The fact is that, traditionally, banking operations are not really managed at all” (Seeger et al. 1974). Finding this observation in an early management case study, sitting in the Library of Harvard Business School, was one of the first encouragements for pursuing the possibility of establishing Absent Management in Banking. If a senior executive of a major bank could make this statement in the early 1970s, there must have been a time when there was absent management in ­banking, at least management as understood by a corporate executive with an MBA.

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Professional management in Citi in the 1970s was an administrative and not a leadership function. Citi bank’s top management attention was directed outwards and towards the market (Seeger et al. 1974). Tradition held that the career path to the top in banking led through line assignments in the market-oriented divisions (Seeger et al. 1974). The new recruit from Ford did not see himself as a banker in the traditional sense, partly because he had an MBA and because he had grown up in industry (Seeger et al. 1974).

By the 1970s professional management in financial services was considered administration and was side lined as such both operationally and as a career path. However awareness of professional management practices, including multidivisional structures, was present within financial institutions. The knowledge of these practices and that they were not to be found in banking were the reasons for the recruitment from non-financial, industrial corporations such as Ford.

There is significant variation in the importance of the producer manager approach in different types of banks. For pure retail banks whose success is related to carrying out millions of small transactions and providing banking services such as deposit taking, payments, personal loans and so on to private customers, the approach to management looks more like that found in other retail sectors. Many retail banks have learnt a great deal from retail and service businesses such as supermarkets or car rentals.

When Banc One designed ‘The Bank of the Future’ in the 1980s it was modelled on retail. The first branches included an interactive video centre and a sales boutique environment that offered such services as insurance, real estate, brokerage services and travel and was open seven days a week (Phillips and Greyser 2001).

The more a bank, such as a corporate commercial or investment bank, is focused on larger clients, the more prevalent the producer manager approach is. However the producer manager approach and related culture have also become important for retail banks because many of them are part of universal banks with retail, commercial and investment banking activities. In a number of mergers to create universal banks, the person becoming chief executive officer was from a commercial or investment banking background. He was likely to continue operating as a producer manager.

Those chief executive officers with a retail banking background often found themselves becoming producer managers once they were chief executive officers of universal banks. Reasons that will be considered in

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more detail shortly included the need to lead corporate commercial and investment bankers by example. These chief executive officers also found that large corporate commercial and investment banking clients expected to meet the top man or woman, because that was a sign of the client’s importance.

Where there are pure specialist managers at the very top of large universal banks, they nearly all have some client involvement. In addition they rely on producer managers in many if not all parts of the bank so the producer manager approach is relevant for commercial and investment banks, although less for pure commercial retail banks.

By 1990s larger banks had started using some professional managers for such support services as operations, finance, IT and Human Resources (Auger and Palmer 2003). These were specialist managers supporting the producer managers in their dual roles, particularly with their management responsibilities.

One of the important features of the producer manager approach is that the very top people still do client or production work. In banks with large clients, the chief executive officer is still expected to have a relationship with the largest clients. A similar approach is seen in non-banking professional firms such as the large accountants, lawyers, management consultants and so on. The importance and influence of the producer manager approach in universal banks can be seen from chief executive officer with a retail bank, who has not met a customer for decades or possibly ever, suddenly having to spend time with large clients of the newly acquired commercial or investment bank.

There are plenty of books about banking, including about individual banks. The more famous the banks, the more books. Many of them are interesting, even enjoyable. They are particularly focused on the famous bankers, the vast majority of whom must have been producer managers.

However nearly all these books do not consider management and concentrate on banking, understandably enough. The great deals, the sometimes explosive growth and the competitive triumphs are covered, often with great insight and based on interviews with those senior individual still alive. More recently, and particularly since the 2008 financial crises, many books have focused, sometimes even more entertainingly, on the monumental failures of some banks. But still little focus has been given to ­management. As far as the books about failures are concerned, this is surprising. There are plenty of anecdotes about what chief executive officers were doing, including their golf and bridge playing habits, but little about

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how the banks were managed. Some of the best known and biggest selling books on banks have not a single listing on ‘management’ or ‘leadership’ in their indices.

It would be superficial to conclude that there was absent management in banking because those writing about them have not addressed the topic. But management has not been of great interest to the writers and, presumably, their readers. It is possible that the management part of bankers’ producer manager roles was the least interesting, to the writers, their readers and possibly to the bankers themselves.

Before considering how the producer manager approach to management contributes to absent management, its advantages should be given their due. Many professional services organisations consist of fairly small teams with one of more senior people being both top producers as well as managers of their teams. This provides a fairly flat structure and relatively little bureaucracy. Bureaucracy is seen a big negative by high producing bankers, particularly those involved with large clients. It is seen to both stifle creativity and getting in the way of doing business. Small teams unencumbered by bureaucracy are well suited to the intense, highly competitive world of large client banking and capital markets.

One of the real benefits of the producer manager approach is that most managers are close to the business, due to their production responsibilities. This enables them to take decisions that are well informed about the needs of the business including the clients. In contrast, a specialist full time manager in an industrial corporation will need to make significant efforts to be in close communication with those fully focused on producing and selling the goods produced.

This closeness to the business makes the producer managers credible to their peers and subordinates. One of the arguments why the producer manager model has persisted for so long is that in professional services firms full time producers would not respect and follow the leadership of managers who are not also producers. It is a determining characteristic of a professional services firm that what the senior producers do sets the standards of the firm and provides the example for their juniors. Bankers are doers, and the greatest bankers become legends such as Cosimo de Medici, Nathan Rothschild, John Pierpont Morgan and Siegmund Warburg. The contrast with famous corporate business giants, Henry Ford, John D. Rockefeller and Bill Gates, is that bankers are famous for what they did, not for what they built. What both have in common are the large amounts of money they made.

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In corporate and investment banks, juniors compete extremely hard to work with the top producers. These top producers can conversely have their pick of the most talented younger bankers. For a successful banking career, it is often seen as crucial to have a senior producing patron. One of the worst examples of this almost cultish adoration of top producers is when they move from one bank to another. If the top producer does not move with a team, the first management action of the newly arrived top producer manager is often to dismiss all the direct reports of his or her predecessor. These posts are then filled by recruiting the direct reports and colleagues from the previous bank of the new boss. This is often done with no consideration for what talent may be lost or the delay in completing the new team, due to the often long, up to six months’ notice periods of these previous colleagues. This is not sophisticated, modern management. It is about the strength of the personality of top producers. It also indicates that they are recruited almost exclusively for their production and not for their people management. It finally says something about the confidence of the new top producer manager in his or her management skills. The idea that none of the exiting direct reports can add anything to the future setup is simplistic and illogical. But the new producer manager is primarily a producer who wants tried and trusted producers from his or her past.

Spending the time assessing and managing the existing talent, who is in place and ready, is not an attractive management task for this new producer manager.

Management as a skill and discipline is regarded as a necessary evil, something that has to be tolerated for reporting and compliance reasons.

The ‘real’ bankers often do not see management as a skill or function that creates value in the organisation.

Corporate clients expect the best talent available to work for them. This is one of the reasons why the producer manager approach persists. As producer managers become more senior, clients still expect them to be involved in the client’s business even if the actual work is largely delegated.

Clients will often view their key, long-standing contact to be ultimately responsible for the service provided.

Another important advantage of the producer manager approach is that it allows bankers to achieve a high degree of personal satisfaction. People often join banks to be bankers and not to be managers, except perhaps in the case of pure retail banks. The sense of achievement is often linked to successful banking, capturing a new client, being mandated to issue a bond, completing a highly profitable trade, improving in a league table

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and, significantly, to making a lot of money. For bankers it is less easy to find the same personal satisfaction from longer-term achievements, for example, the development of junior subordinates from interns to fully fledged, highly producing bankers.

Incentives have been considered in the previous chapter, but it is worth emphasising how they can influence the producer manager approach. It is easier to link the returns on the production of a producer manager to the bank’s financial results than the results of her management. The production tends to be related to clients and markets, to increasing revenue and profit. It tends to be short term and often within the year being considered in terms of a bonus. Sometimes the true consequences of a trade can take longer to be understood, as was described in the last chapter. Mostly it is possible, when assessing the annual performance, to determine with some accuracy what the individual banker has produced and estimate what this has contributed to the bottom line.

It is more difficult to assess the financial result of the management of the producer manager. If she has a high performing team and she has kept her team stable, this has an important financial impact. There has been no gap between losing a strong performer, finding a replacement and getting him up to the same level as his predecessor. There has been no spending on executive search firms that can cost a third of the annual remuneration of a new hire. There has been no need to offer a high guaranteed bonus, in addition to the fixed salary to attract the right level of talent. The producer manager’s and her senior peoples’ time has not been taken up by interviewing a series of candidates. The stability of the team is unlikely to have been achieved without the producer manager having devoted time and energy to lead her team, including frequent group and one-to-one communication and feedback, as well as development of her existing talented team members. The team’s stability would be unlikely without her management time effort.

At the producer manager’s annual assessment, where the basis for her bonus, or often more accurately her share of the bonus pool, is determined, it is unlikely that her production and management will be equally recognised and rewarded. In a year where she has excelled as a producer, as a banker and also managed to lead her team to excel, she may not be equally rewarded for both producing and managing. Her production will count most. When her boss, a more senior producer manager, has to explain the apportionment of his bonus pool amongst his direct reports, it is much easier to explain why some are rewarded more than others. This is

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particularly so if some of her production success that year is already known at this higher level. And both her boss and his boss probably achieved their elevated positions due to their production rather than their management.

This is path dependency. If those deciding on the proportion of reward for production versus management reward production more because that is how they were rewarded, they are following a path. And nothing will change. And management will be less likely and sometimes absent.

Scorecards for annual assessment were introduced into banks decades ago. Examples in the previous chapter showed how difficult it can be not to pay a bonus in a poor year, for fear of losing a talented person or demotivating everyone. However path dependency can also play a role in terms of which part of the production or management is rewarded most. If a producer manager is responsible for capturing an important new client, it will be difficult not to recognise this in the annual assessment and bonus.

If this person’s management has been poor, it will be difficult to reduce the bonus given the excellent production. Conversely, if the person has also managed to have an excellent year as a manager, that will probably not be equally highly regarded and rewarded as the production. After all the bonus pool is only ever so large, so that is unlikely too.

There is also a job security aspect of the producer manager role that favours the production. In bad times when cost cuttings reduce employee numbers, those making a contribution to production are less vulnerable than those more exclusively focused on management. If the bad times are likely to result in a crisis, the survival instinct of a producer manager is likely to make her focus on production. This is exactly the time when management is most important. And this is when management may be absent due to the producer manager focusing on production.

For the producer manager, who joined the bank to be a banker, her enjoyment is more likely to come from her production. Equally she is more likely to be rewarded more for her production than for her management, even in years where she excels at both. She may continue to excel as a manager as well as a producer, but when she needs to prioritise, the incentives of achievement and reward are likely to drive her to produce.

To repeat, people who join banks do so for many reasons, but many of them do so to be bankers rather than managers. The modern retail bank, where management looks more like other retailers than professional ­services firms, is an exception. Merrill Lynch became the world’s largest stockbroker and had global operations involving investment banking and advisory services, wealth management, asset management,

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capital market services, insurance, banking and related products. It was common for Merrill Lynch’s chief executive officer to have risen through the stockbroker practice. An exception was the chief executive officer from 2003 to 2007, who had a background at General Motors (Thomas and Kanji 2005). But even this former industrialist and MBA, once at Merrill Lynch, wanted to be a producer. He was reluctant to accept a staff job, even that of chief financial officer, although he eventually agreed (Thomas and Kanji 2005).

Morgan Stanley in 1999 provided an example of the development of investment banking management. Morgan Stanley had developed from a small partnership to a top multidivisional and multinational, publicly listed financial institution. The senior employees had changed titles from Partner to managing director. Management continued to be seen as potentially detrimental to banking by 2000. Management was still not seen as an attractive career path. Many observers, both inside and outside of the firm, wondered whether Morgan Stanley’s then new chief executive officer could successfully change the way the firm worked and implement new management systems. And whether he could do this without tainting the entrepreneurial culture and creativity that had been the foundation of the firm’s success (Burton et al. 1999).

Morgan Stanley had experienced phenomenal growth during the period from the 1970s to 1990s. In 1970, its 230 employees focused almost exclusively on traditional corporate finance. By 1992, its 7000 employees, a 30 times multiple growth in 22 years, operated in ten divisions and five North American, seven European and six Asian locations. The ten divisions were investment banking, equity, fixed income, merchant banking, asset management, foreign exchange, commodities, research, services and finance, administration and operations (Burton et al. 1999).

The firm was growing, diversifying and globalising which strained all of the internal systems and placed significant demands on managers (Burton et al. 1999). The lack of management capability was also noted: “Most people grow up trying to be great professionals, great traders, great salespeople, great bankers, not managers or leaders” (Burton et al. 1999).

By 1999 management had been embraced by retail banking for years.

However it was a common joke that for investment banks, the term ‘Wall Street management’ was an oxymoron (Burton et al. 1999). There was a problem of the big producers. The new Morgan Stanley chief executive officer had identified the problem and was focused on changing it. “Wall Street has historically had a culture where the biggest producers have always

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made the most money despite the fact that they are destroyers of culture and destroyers of people. You have to have the courage to stand up and fire those destructive forces” (Burton et al. 1999). From his 1999 statement: “We have not done a good job in pushing down the importance of management and explaining what we expect from you once you become a principal on a desk or a managing director. What is required of you? Well, you have not finished. You have further responsibilities. You have a job to do. And your job, other than making money, or building the systems that you’re building, is to teach the people below you” (Burton et al. 1999).

In addition to incentives outlined in the previous chapter, there are a number of disadvantages of the producer manager approach, which can contribute to absent management. The first is related to time.

When earlier comparing commercial and investment banking, it was noted that commercial bankers often have the longer time horizon. Their business is based on smaller individual transactions and retaining the commercial clients, as well as high net worth individuals, for a longer period of time in order to be able to make a profit. This is even more the case for retail bankers whose business is about a very high number of small transactions requiring long-term client retention to be profitable.

There is similarly a difference in time for production and management, but in this case, the conflict between the two is contained in one person.

An effective producer manager must be able to handle two time horizons simultaneously. The production is generally the more short term, related to clients and markets. For the commercial producer manager, there may be less of a conflict. Servicing commercial clients successfully will require retaining them for more than one year. Successful management similarly requires a multiyear time horizon. For those serving larger clients, including investment bankers, the time conflict becomes more acute. For these clients, successful production is about a single or a few large transactions.

And these transactions are extremely time sensitive. This is a key reason why these bankers often work long hours and why their juniors, including their summer interns, sometimes have no evenings or weekends off.

The time pressure is further intensified by competition. Many larger deals are competitively bid, so winning can become all time consuming.

Once a deal has been successfully won it often involves more than one bank. This means that each bank is highly incentivised to drive the deal and deliver on time. Similar time pressure applies to nearly all trading, where market hours require complete concentration, as does handling investor clients particularly those with a high net worth.

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It is a characteristic of many producer managers that they never seem to have enough time. The enormity and variety of tasks facing producer managers can be overwhelming. They have their position because they are very good at their job, certainly at the production side. So they are much in demand, internally and externally. They never have enough time. And if they do not have enough time, they have to prioritise, consciously or unconsciously. And production gets priority because that is where the money is, for the bank and the banker. The bankers leading the large deals are generally producer managers, responsible for managing anything from their own small teams to large divisions and even country operations.

The time conflict within each producer manager strongly favours the production, and it is common that management is done last, if at all. Any requirements from clients have an immediacy that management requirements often lack. The short-term timing requirements can be so overwhelming that even the toughest investment banker finds it hard to also carry out the medium-term, significantly less time-sensitive management tasks. If a banker does not win a deal, the bank’s top executives will hear about it and react. If the annual assessment of the banker’s team is late, human resources is likely to chase. There is no comparison in the seriousness of these two reactions for the producer manager.

The internal conflicts on how to prioritise time become particularly acute in times of crisis, when clients’ needs are likely to be at their most intense. This is also when the management requirements are at their most demanding, such as leadership and setting an example for younger, less experienced people, let alone taking strategic decisions for the bank. So while a producer manager is the only type of manager that is credible to other professionals, this is of little value if the production responsibilities prevent the very best management in times of crises. This is where the producer manager approach can cause absent management at the most critical moment.

The need to pay attention to short-term client and market production issues also means that medium- and long-term strategy may not get the attention required. The discussion within Salomon, for close to a decade, to improve the incentive plans to take account of risk, had never been implemented. The low priority for this complicated management task was probably a reason for this lack of implementation.

Another reason production tends to win the most attention from the producer manager is client focus. The importance of client focus is often paramount in all types of professional management service firms, and

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banks are no exception. The client is the source of revenue and profit, of rewards in terms of both bonuses and promotion. Banks compete fiercely for clients. In some cases the relationship a banker has with a particular client is considered the most important value the banker brings to the bank. Some clients are so loyal to a particular banker that they will move their business with her, should she move to another bank. If such a valuable client needs attention, the producer is likely to abandon all other tasks to ensure the client has her full attention. Management responsibilities are likely to come a poor second.

Client focus has become a mantra for many banks. The promulgation of client focus as a key value of the bank further emphasises its importance and the outranking of management responsibilities in the producer manager’s agenda.

Conversely management is seen as diluting production. At the very least the management responsibilities are likely to be a distraction for the producer manager. With production on its own often being demanding enough, the outstanding management responsibilities can easily become an irritant. This development is unlikely to add to the motivation to complete these management responsibilities when the producer manager does get around to them, perhaps at the end of the day or at the weekend.

Another problem with the producer manager approach is that these people are very rarely equally skilled at both functions. Nearly all producer managers learn production first, from the day they join the bank. Once they have proven themselves successful as producers, they typically become leaders of small teams, the first step on the producer manager ladder.

In non-financial corporate organisations, where technical skills are highly rated, somebody who is given management responsibilities often stops producing. But even where this is not the case they are often then trained as managers. Management is after all just another technical skill that can be learnt. The idea that someone is a natural leader may have had application in simple organisations but is outdated given the complexities of the management responsibilities of a modern bank.

In banks the new manager keeps producing. Even in a retail branch, the newly promoted manager is likely to still see clients, although at some stage she may become a full-time specialist manager with an approach more like a retailer than a professional services firm.

In commercial and investment banks the newly promoted manager will continue to produce. But management training is rarely offered. In one case when three valuable producers were promoted to team leaders and

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producer managers, human resources were requested to provide them with management training. No internal training for managers, or a list of external providers of such training, was available in the bank, which employed 3600 people in 2006.

As for the corporate approach of sending a newly appointed manager back to school, perhaps for an advanced management programme at a business school, this almost never happens in investment banks. The newly promoted producer manager is supposed to get on with the additional management responsibilities, while at no stage reducing her production.

Finally, there has been a significant change in complexity of production and management. For a bank in a single line of business, operating in a single state or country, neither producing nor managing is particularly complex. The senior person in such an entity can successfully carry out both production and manager responsibilities.

Both functions have grown significantly in complexity as evidenced by corresponding growth in complexity of banks. However, many bankers welcome a growth in complexity of their production. New products with complex features provide opportunities to serve clients better and beat the competition.

However, complexity of banks has grown so much that they have arguably become unmanageable. Consider the Morgan Stanley example with 30 times the number of employees in 20 years. That can be unmanageable by the best specialist managers available, doing nothing else than managing highly complex entities.

But most of those managing such banks are producer managers, with production priorities that are often greater than the management priorities. These production priorities provide greater achievements for the managers and, in the shorter term, probably account for a larger proportion of any bonus, and fit the skills of the producer managers much better than their management priorities.

Management of banks developed much later than in industry. It developed during a period of rapidly increasing complexity, both in terms of types of activities and geographically, with the additional pressure of significant growth of many banks both organically and by mergers and acquisition. The Baring example of the 1990s shows that this increased complexity developed ahead of management’s capabilities to understand and control the associated risks. The attitude to management changed in banks from the 1970s to the 1990s and, positively, became seen as a competitive advantage in retail banks. However the attitude to management as

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a discipline remained negative in spite of the evident requirements for management of large, fast growing and complex organisations. This attitude, which was particularly evidenced in investment banks, is likely to have hindered management control and therefore made banking crises more likely. Not only the attitude to but also the capability for management had not developed adequately by the 1990s. There is little evidence that professional management had developed the ability and status within banks comparable to that in industry decades earlier.

Historically, the management approach of producer managers has remained unchanged while the complexity of many banks has increased enormously. This lack of development of management in banks is a major contribution to absent management.

References Auger, Philip, and Joy Palmer. 2003. The Rise of the Player Manager.

London: Penguin.

Burton, Diane, Katherine Lawrence, and Thomas J. DeLong. 1999. Morgan Stanley: Becoming a “One-Firm Firm”. Boston: Harvard Business School.

Chandler, Alfred D., Jr. 1962. Strategy and Structure: Chapters in the History of the Industrial Enterprise. Washington, DC: Beard Books.

DeLong, Thomas J., John J. Gabarro, and Robert J. Lees. 2007. When Professionals Have to Lead. Boston: Harvard Business School Press.

Lorsch, Jay W., and Peter F. Mathias. 1987. When Professionals Have to Manage.

Harvard Business Review (July–August).

Meiksins Wood, Ellen. 1998. The Agrarian Origins of Capitalism. Monthly Review 50, July 1998.

Nanda, Ashish, Malcolm Salter, Boris Groysberg, and Sarah Matthews. 2006. The Goldman Sachs. Boston: Harvard Business School.

Phillips, Peter L., and Stephen A. Greyser. 2001. Bank One: “The Uncommon Partnership”. Boston: The Design Management Institute/Harvard Business School.

Seeger, John A., Jay W. Lorsch, and Cyrus F. Gibson. 1974. First National City Bank Operating Group (A). Boston: Harvard Business School.

———. 1975. First National City Bank Operating Group (B). Boston: Harvard Business School.

Thomas, David A., and Ayesha Kanji. 2005. Stanley O’Neal at Merrill Lynch.

Boston: Harvard Business School.

Weber, Alex. 2018. J.P.Morgan – Defying Attempts to End Too Big to Fail.

Financial Times, 18 September 2018.

CHAPTER 9

Bank Failures Cause Crisis: How Absent Management in Banks Can Cause a Crisis

Absent management is particularly dangerous in times of financial crises.

It is then even more likely to be the cause of the failure of a bank. The reason absent management rather than the financial crisis is the cause of the failure of the bank is that it is very rare for all banks to fail in a crisis.

Management makes a difference, and absent management is likely to cause the failure of a bank when a financial crisis hits.

The possible reverse causation is even more serious. Absent management in banks can cause a financial crisis. Absent management in banks was a cause of the 2008 financial crisis.

A modern, systemic banking crisis can be defined as an episode where there are bank runs, a significant share of non-performing assets such as loans that are not repaid, bank liquidations and large-scale policy intervention to support banks (Calomiris and Gorton 1991). The 2008 financial crisis saw all of these. A banking crisis has the potential to cause a wider financial, national and international economic crisis. A key link in this causation is when sovereigns have to support banks. This can in turn lead to sovereign currency, debt or a combined currency and debt crisis. Another link is where a banking crisis causes a wider credit crisis that negatively affects sovereign debt. The further cause of an economic downturn, such as when the 2008 financial crisis caused the Great Recession, will be considered later. In this chapter the focus is on the link between absent management, bank failure and a wider banking crisis.

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Just like all banks do not fail in a crisis, so do all bank failures not result in a crisis. The two Barings crises are historical examples of this. In the second Barings crisis in 1995, caused by a rogue trader in Singapore and absent management above him, the bank was allowed to fail by its prime regulator, the Bank of England. It was assumed, correctly as it turned out, that the failure of Barings would not cause a wider banking and financial crisis. Barings and its problems were so unique that they were not considered to apply to other banks. Additionally while other banks were involved with Barings in 1995 and its failure caused these banks losses, their survival was not threatened. As such the failure of Barings was not judged likely to cause a wider, sometimes called systemic banking crisis, let alone a wider financial and possibly sovereign crisis.

The first Barings crisis was completely different. A failure of Barings in 1890 was considered a threat to the standing of the London banking system with negative implications for the United Kingdom economy. A rescue was arranged by the other London banks, not for the love of Barings, but as a matter of self-preservation and to protect London and the United Kingdom.

Banks cause crises in several ways. Most importantly any bank that fails will raise questions about the security of other banks. This is because many banks do similar kinds of business and many banks work closely with other banks.

Firstly, because banks do similar kinds of business, should there be a run on one bank, caused by depositors concern about the safety of their money, other depositors will question if their money is safe in their respective banks. So the loss of trust in one bank may cause the loss of trust in other banks, and the run of one bank is contagious and causes runs on other banks. This was seen in the banking crisis in the United States and many other countries during the Great Depression in 1929–1931.

Secondly, the interaction of banks has become increasingly deep and complex, for example through the use of financial instruments such as hedges and derivatives. If one bank is trading a hedge or other financial instrument on an established exchange, the main exposure is price volatility. The financial security of the exchange is unlikely to be a major concern and is often backed by all the exchange members. But not all financial instruments are traded on exchanges. A credit default swap is a financial instrument that pays out upon the default of a bond. It is used to protect against credit exposure of the bond issuer but has also become an asset class of its own. A credit default swap is an example of a financial ­instrument

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that is not traded on an exchange but between individual banks. This type of trading is described as over the counter or OTC. In addition to the risk of price volatility, a financial instrument such as a credit default swap therefore also carries a credit or counterparty risk. If the bank that has sold the credit default swap for a premium is financially insecure, the credit default swap may not be honoured.

Banks also borrow from each other. The repurchase or Repo market works with banks borrowing short-term cash from each other, and also from investment funds, for one day and up to several weeks, but short term. The borrowing bank pledges high-quality securities as collateral.

The riskier the borrower, the more collateral is required by the lending bank. This is very short-term finance, and it became extensively used in the 2000s, particularly by investment banks that had no regulatory restrictions on their leverage.

So all banks are dangerous, like bulls. But unlike bulls, the banks that are more dangerous are not the strongest banks but the weakest, the banks that fail. When a bank fails, it can cause suspicions about the security of other banks.

Alternatively and sometimes as well, a failure can cause losses to other banks, which, in turn, can cause losses to their counterparties and so on.

The spread of suspicion of financial insecurity of more banks, or a spread of losses, is one example of what is called a systemic risk. And that is why a weak bank can cause a wider crisis, one weak bull causing a destructive stampede.

There are particularly complex, large and therefore dangerous banks, the universal banks. These are the banks that do all kinds of business, everywhere. They appear strong, but their strength is uncertain as it is masked by their complexity. They deal with retail and commercial customers as well as with investment banking clients including other banks. They act as asset managers investing on behalf of their private and institutional clients and as participants in the capital markets. Universal banks that own investment banks trade many types of instruments for clients and for the banks’ own account. They trade both on exchanges and over the counter, directly as sellers and buyers of financial instruments with other banks. In universal banks, the failure of one part of the bank, or just the suspicion of financial weakness in one part of the bank, can be enough to cause concern about all the bank’s activities. This concern may or may not be well founded, but if you believe your deposited money is in danger, some people may prefer to withdraw it. Maybe not to put it under a mattress, but

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to put it somewhere not exposed to the intricacies of a universal bank.

This was the reason the Swiss universal banks UBS and Credit Suisse suffered outflows from their asset management business when concerns were raised about their investment banking exposure to subprime lending during the 2008 financial crisis.

So all banks can cause a crisis, but some banks are more likely to do so than others. The bigger the bank and the more complex, the more difficult it is to manage. The more complex a bank is to manage, the more likely it is to experience absent management. And the more likely absent management, the more likely it is to fail. The more likely it is to fail, or just to be suspected of possible failure, the more likely it is to cause a crisis.

So when banks fail because of absent management and this failure is a cause of a wider financial crisis, absent management becomes a cause of a crisis.

However, banks are not here for the common good. I know because I was told this specific truth many times on the trading floor of the investment bank where I worked. Perhaps they should be. Or perhaps they should have a social responsibility. But many do not. They are primarily responsible to their owners, be they shareholders, partners or mutual deposit holders. They also have responsibilities to their customers, counterparties, employees, the environment and so on. But whether they have a social responsibility or not, they have a responsibility not to fail. This responsibility should be closely aligned to their other responsibilities, but it has an additional requirement. If a bank fails, it may cause a crisis. This makes it different from other nearly all corporate organisations, which can generally fail without a systemic, let alone wider financial and sovereign, crisis ensuing.

This book is not about whether banks should be managed to avoid causing a crisis. Of course they should. It is about absent management causing a crisis. Everyone makes mistakes. There will be mistakes in this book. Producer managers in banks are no different. The problem is that mistakes are expected and therefore have safety measures in place to prevent or at least mitigate them. This is generally what is termed risk management in banks. However, when there is absent management in banks, that is unexpected. Then there is nothing in place to prevent or mitigate failure because absent management is not expected. And when there is absent management in a bank, it can cause a lot of harm to other banks, their customers, employees, shareholders, countries, the countries’ taxpayers and those dependent on the country and its social security system.

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The United States home prices that peaked in July 2006 had doubled since 2000 (Schiller Home Price index). The subsequent fall in housing prices was one of the early triggers of the 2008 financial crisis. House prices in the United States fell over 2 per cent in 2006, 6 per cent in 2007 and almost 11 per cent in just the month of January 2008 alone. The proportion of subprime loans that were delinquent reached one-fifth in the second quarter of 2007 and a quarter in the third quarter of 2007. Close to 7 per cent of properties with subprime mortgages were being foreclosed (Harris 2014). This meant that millions of people were losing their homes. And absent management in the banks’ lending was one reason behind it. A little later the consideration of Washington Mutual will show how some of its absent management, and absent management of other banks, was a cause of the 2008 financial crisis. The uncontrolled lending growth, unmanaged exactly because it was uncontrolled, encapsulated by Washington Mutual’s ‘The Power of Yes’ to lend more campaign, contributed to the increase in housing prices.

A particular part of this growth was subprime lending. Subprime mortgage was lending to people with weaker capability to pay back the mortgage loans. This had become possible due to a loosening of regulation, with the Depository Institutions Deregulatory and Monetary Control Act in 1980 under President Carter. Since the Glass-Steagall Act of 1933, there had been a regulatory ceiling on the interest rates that could be charged on mortgages. Under the 1980 Act the level of interest charged became a matter of private discretion, meaning the banks could decide (FDIC 1997). The previous limit on what interest rates were charged had the effect of limiting mortgages to those who were likely to be able to pay them back. Those with lower credit capabilities were not able to take out a mortgage because the interest they would be charged would be above the legal limit. In the following two decades, increasing competition in the mortgage market for more creditworthy borrowers, the prime market and the development of securitisation, which will be described later, contributed to the rapid growth of subprime lending (Ho and Guan 2008).

Mortgage brokers, intermediaries between borrower and lender, were paid a commission often linked to the level of interest rate paid. This incentivised mortgage brokers to focus on subprime mortgages, where the interest rates and corresponding commissions were higher. So the higher the risk of no repayment, the higher the incentive for the broker. And the lower the capability of the borrower to pay back the loan.

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The mortgages could be structured so that the payments were low in the first two years. Thereafter, payments rose dramatically for the remaining 28 years of the mortgage. In a market with rising house prices, those with weaker loan repayment capability could sell the property within two years and gain equity for the next property. As long as the housing market kept rising.

Household International, owned by HSBC since 2002, and Washington Mutual, or WaMu, were active participants in subprime lending, as were many others such as Countrywide. By 2003 loans with adjustable rates made up a quarter of WaMu’s new house loans. In addition to lending to those less able to repay the loan, there was also an increased willingness to accept less rigid information in the loan application. This was all in the name of growth for the lender.

Subprime was not new. It had made up between one-twentieth and one-sixth of home loans since the 1990s. In 2005, it reached almost a quarter of all home loans, only to disappear almost completely by 2008 (Stowell and Meagher 2008).

In the past banks made a profit on the difference between what interest they paid depositors and what interest they charged the borrowers. This difference was called the spread. In addition to covering the interest paid to depositors, the spread was also intended to make a contribution to pay for those borrowers unable to repay the loans. The Medici did business like this in the fifteenth century. In good years banks could pay a dividend to their owners. In addition they could retain some of the profit to increase their capital. This capital would increase the bank’s buffer and enable them to lend more going forward, because they now had a greater security to do so in terms of increased capital.

The growth in lending was enabled by the growth in the packaging of loans and selling these securities on to investors. This was new. In the past banks had been restricted in their lending by the amount of deposits they had received and the amount of capital they had. Commercial banks in the United States and many other countries were also restricted by the amount of leverage they could raise, although this restriction did not apply to investment banks that did not accept deposits.

Once a lender has accumulated a portion of mortgage loans, an investment bank was engaged to package these loans and sell them to investors.

The lender received as commission and achieved a reduction in its loan book. This meant that the lender could lend more without the need for increasing its capital. The lender would no longer make profit on loans

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that were profitable, that is loans that were paid back with interest on time. Importantly the lender would not suffer any losses from loans that borrowers were unable to repay. The profit and risk of mortgage lending could be passed to investors in the capital market, insurers, pension funds, mutual funds and so on. These investors were now providing some of the capital required for mortgage lending that had been provided by lenders before mortgage-backed securities became established. Deposits and the capital of the lenders still backed some mortgage lending, but mortgage-­ backed securities and the vast global investment market grew rapidly in importance as the source of financing for mortgage lending.

Importantly the mortgage-backed securities were rated by the credit rating agencies. Depending on how the securities were structured, the rating achieved could be high indicating a low risk of default. This was due to the perceived diversification in the securities based on the high number of mortgages involved in the packaged securities and the belief that they would not all default simultaneously. The high ratings made the securities attractive to many investors who would normally only invest in secure assets typically rated at an ‘A’ level or investment grade. This was higher rated and therefore believed to be more secure than lower rated, non-­ investment grade or ‘junk’ assets.

Banks selling securities backed by mortgage loans in the United States to institutional investors exploded, increasing almost eight times from 2000 to 2006, from $100 billion to close to $800 billion. In 2008, it collapsed to less than $50 billion (SIFMA 2009). The growth in securitising of subprime also increased rapidly from about half of all subprime loans in 2001 to three-quarters in 2006 (Demyanyk and van Hemert 2008).

With large proportions of the loans being bundled together, structured in different tranches and sold on to investors, the lenders were now incentivised to lend as much as possible. It was less important if the borrowers were able to repay because that risk had to a large extent been passed on to investors. So the banks were lending as much as possible. The investment banks were assisting the lending banks by underwriting the packaged mortgage loans and laying of the risks to investors and earning substantial fees on these transactions.

This is where we have to stop. Later, we will consider how investors behaved and why the music eventually stopped. But to avoid being caught up in the increasingly complex process of excessive lending, increasingly sophisticated packaging and selling of these packaged loans, the different instances of absent management have to be considered.

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WaMu and the other aggressively growing lenders had abandoned management in the name of growth. Some of them had taken over so many other banks that additional takeovers would not make a sufficient difference in achieving further growth. So they grew their lending. What caused absent management was, again, complexity. Just like complexity had caused absent management when banks became involved in many different lines of business or in many countries or both, the increasing complexity of aggressive growth defeated management and the producer managers supposedly doing the management. The complexity arose from a combination of two highly interconnected developments.

It became possible for the lenders to sell on the loans to investors. This was the new development because traditional lending growth had been around since the Medici. Selling the loans meant that it became less necessary to manage the lending. It was no longer necessary to secure deposits within the lender to finance the lending. There were investment banks ready to structure the loans and investors keen to invest in these structures. So the historical combination of incentives to lend and to manage the lending shifted towards just growing the lending. It became more and more about production and less and less about management.

What the lenders did not understand, and might not have been expected to understand, was that the new market for packaged loans might end.

This is not because they were not experienced bankers, but because this was a new market that no one had seen before and no one understood. If some did understand this they did not behave accordingly. The unsustainability of the market for packed loans or mortgage-backed securities was a complexity that defeated the management in the lending banks, some of whom had become utterly dependent on it. But while the lenders might not be expected to understand that the market for mortgage-backed securities could end, they should have understood their complete dependence on it. And to be completely dependent on something you do not understand is absent management.

However, the first big bank failure happened at the end, not at the beginning of the process. When original house prices stopped rising in 2006, this was the first link of the complex chain to change. Wherever in the chain there was significant retention of risk, including at the end, the effect would be significant.

One of the first indications of subprime affecting larger banks, and banks outside the United States, came as early as February 2007 when HSBC issued the first profit warning in its 142 years of history. A profit

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warning is where a commercial operation issues a statement saying that profits will be lower than anticipated. HSBC was to make provisions for subprime loans of $11 billion, about a quarter higher than expected by equity analysts. HSBC announced that more provisions might be necessary and that it might take two to three years to resolve its subprime exposure.

In 2007 HSBC was one of the top five banks in the world, but its investment banking had not reached top ten. Originally established as a commercial bank in Hong Kong in 1865, the Hong Kong and Shanghai Bank had been a pioneer in the economic development of Asia. It survived the Second World War and the Communist Revolution in China to become the largest foreign-owned bank operating in this and many other Asian countries. It was listed on both the London and Hong Kong stock exchanges after Hong Kong reverted to Chinese rule in 1997. It had 10,000 offices in 82 countries across the globe, where it operated as a universal bank offering retail, commercial and increasingly investment banking and asset management services (O’Connor et al. 2013). The growth had been a combination of starting from scratch by establishing new banks and branches, particularly in Asian countries, to buying stakes in other banks, especially in China where foreign majority ownership was not allowed. It also included full takeovers such as Midland Bank in the United Kingdom in 1992, then one of the largest banking acquisitions in history. Midland Bank had been the largest bank in London early in the twentieth century, taking over that position from the Rothschilds. In 2002 HSBC bought Household International, a United States consumer finance company, for $15 billion. Household expanded rapidly in subprime mortgages and by 2006 HSBC was the largest subprime lender in the United States with $53 billion of subprime loans or just under a tenth of the market (Reuters 2008).

HSBC failed to achieve its investment banking growth targets but did not fail. The failure to reach the investment banking targets was partly due to the complexities of different cultures in a very large commercial bank aiming to grow its investment banking activities. Having hired a senior investment banker from Morgan Stanley, one of the leading pure investment banks, in 2003 this was followed by the hiring of an additional 2000 investment banking staff in just one year. The senior investment banker left three years later. During these three years $1 billion had been spent on building an investment bank, of which about four-fifths were staff remuneration. The bank had not made the list of top ten investment banks in

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the world nor achieved its various league table targets. In particular it was not a top ten mortgage-backed securities underwriter. It remained strong in its traditional activities such as international asset management. HSBC was perceived as conservative by equity analysts, achieving lower returns on equity than many of its large competitors. This had been one of the motivators for the strategy to grow in the higher margins available in investment banking.

Not achieving its investment banking ambitions was a management failure but not absent management. There was no uncontrolled, unmanaged growth into investment banking, for example through acquisition of a pure, major investment bank, which HSBC’s very large balance sheet would have made possible.

The subprime crises had cost HSBC over $32 billion in losses by 2009.

But this was due to poor management not absent management. It was a strategic and a very costly mistake to become a large subprime lender.

HSBC owned up quickly to the initial losses, as early as February 2007, when it announced the subprime-related losses of $11 billion. It announced that the subprime crises might last until 2009. The losses were to grow substantially, but HSBC addressed this early, being one of the first major banks to announce a large subprime loss.

The losses were due to primary subprime lending, not complex mortgage-­backed securities. Had HSBC succeeded in becoming a much larger investment bank, the losses from subprime could well have been much higher. But it had not been willing to sacrifice everything, including management, to achieve this growth.

Although a very large loss was caused by subprime lending in the United States, HSBC was so diversified that it remained profitable throughout 2007, 2008 and 2009 with $20 billion, $6 billion and $7 billion of profits, respectively. HSBC did not receive and was not made to receive any other government assistance. In April 2009 HSBC raised additional equity capital to strengthen its balance sheet with a rights issue of £12 billion (Mikes and Hamel 2014). In spite of the very large move into subprime lending and the resulting very large losses, HSBC did not fail, partly because it remained managed. It was large and complex but not so complex that it was unmanageable in terms of subprime lending.

Bear Stearns was an investment bank that made it through the Great Depression, the savings and loan crisis in 1980s and the dotcom stock market crash of the late 1990s. It had been founded in 1923 to take advantage of the early 1920s’ strong equity markets. It survived the Great

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Depression by trading in the safest, most liquid asset, United States government bonds (Stowell and Meagher 2008). It was to become the first well-known casualty of the 2008 crisis. The failure of Bear Stearns would start with its investments in subprime.

Bear Stearns was primarily focused on bond trading until it went public in 1985. It then diversified into a broad range of investment banking activities including equities, individual investor services and mortgage-­ related products (Stowell and Meagher 2008). Bear Stearns had unique traits including being somewhat of an outsider on Wall Street due to its strong trading culture and recruitment from diverse backgrounds. When the hedge fund Long-Term Capital Management was threatened with insolvency in 1998, the United States regulator, the Federal Reserve, arranged a market rescue of $4 billion. Bear Sterns was the only investment bank out of 14 to decline to participate. Bear Stearns continued to grow rapidly and successfully (Stowell and Meagher 2008).

The absent management in Bear Stearns was unusual. One aspect it did not manage was the relationships with its competitors, the other investment banks. The outsider status combined with the strong trading culture had been important contributors to Bear Stearns’ success. These features would now contribute to its downfall.

The significant new development was that mortgage loans were being packaged and sold to investors. Bear Stearns’ fund management business included clients’ funds invested in such mortgage exposures and invested through sophisticated credit derivatives. A lot of other funds were doing the same thing so there was nothing unusual about this. What was unusual was Bear Stearns’ decision to double the risk related to the United States housing market when house prices started to fall in 2006. Bear Stearns’ strong trading culture appears to have won and there was little apparent management. However it is easy to judge with hindsight. Bear Stearns had previously traded out of bad positions by increasing its position.

The funds were highly leveraged. This means that the funds had borrowed to make larger investments. The security for these loans was $1.2 billion. The original leverage was very high, at 35 times the funds held. As the housing market deteriorated the value of the funds fell. The Bear Stearns fund manager’s response was to raise a new fund with 100 times leverage. As the United States housing market continued to deteriorate the funds were left holding unprofitable mortgage exposure that no one wanted to buy. Many other funds were holding similar unattractive assets.

Because the funds were so highly leveraged the lenders asked for the

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s­ecurity for the loans to be increased when the value of the security fell.

Following intense discussions, Merrill Lynch, one of the lenders to the Bear Stearns fund, seized $400 million of the funds’ security. The funds defaulted in late July 2007, unable to repay clients’ money in full, with significant damage to Bear Stearns’ reputation.

There was also a literal but unusual example of actual absent management. The chief executive officer of Bear Stearns since 1993, during which its share price had multiplied six times over fourteen years, had been absent on a ten-day holiday and had not been contactable during the intense discussions with the lenders to the fund.

Not all of those foreign banks affected by United States subprime loans and the development of the complex mortgage-backed securities had the diversification of HSBC to handle the losses emanating therefrom.

The United States subprime crises had its first terminal, global effect in August 2007 when the German bank IKB was rescued by the German government. Established in 1924 to assist German corporate development after the First World War, IndustrieKreditBank was listed on the stock exchange in 1945 and merged with Deutsche Industriebank in 1974 to become IKB Deutsche Industriebank with a majority government ownership (Wikipedia “IKB”). IKB’s specific mandate was to finance small- and medium-sized business and long-term real estate in Germany. In spite of this specific mandate, the bank built up a mortgage-backed securities investment of €20 billion ($28 billion) in a Delaware investment vehicle called Rhineland Funding. IKB’s equity capital was only €1.4 billion (Spiegel Online 2007). IKB’s only motivation could have been a search for extra yield completely outside its technical and geographical areas of expertise. It was a complete abandonment of the management of its mandate.

When Deutsche Bank withdrew funding for the Rhineland Funding vehicle on 3 August 2007, IKB had incurred a loss of €1 billion and required rescuing. Initially, a €8 billion guarantee was provided by the government, followed by a further €2 billion in February 2008. The German Government bank KfW was the majority owner of IKB and provided the majority of the funds, with contributions from German commercial banks, including Deutsche Bank, Commerzbank and German cooperative banks. IKB was eventually acquired by the private equity firm Lone Star in August 2008.

The government support became the subject of an investigation by the European Union regarding German c­ ontravention of state aid regulation.

By August 2009, IKB had received Government guarantees of €7 billion

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which was accepted by the European Union. Another German bank, Sachsen LB, had also invested in subprime-related assets and was provided with liquidity support of €17 billion (European Commission 2009).

The rapid growth in United States subprime lending, the packaging and selling of these loans in the form of mortgage-backed securities and the complexities of these risks were central to absent management in some United States banks. Involvement in these developments from outside the United States added an additional layer of complexities for management of foreign banks. The development of mortgage-backed securities for loans in other countries and the dependency of some banks on this development for growth were to prove complex beyond their management, resulting in absent management and failure.

Within a week of IKB’s failure, on 9 August 2007, the largest bank in France, BNP Paribas, halted the return of money to investors from three of its investment funds that had been holding mortgage-backed securities. The reason given was that the bank was not able to value the assets in the funds because there was no longer anyone willing to buy the assets.

The bank said that the assets had experienced a “complete evaporation of liquidity” (Guillén 2012).

There were two important consequences of the action of halting the payment of money from the funds. Firstly, it was a trigger for the European Central Bank, supporting the European banking market, to make €95 billion of lending or liquidity available to banks, increased by a further €109 billion in the next few days. This resulted in the European Central Bank offering unlimited liquidity to banks at an interest rate of 4 per cent (Guillén 2012). The United States Federal Reserve, the Bank of Canada and the Bank of Japan also started to support their banks. As such BNP Paribas’ announcement has been seen as one of the triggers of the financial crises.

A second aspect was that BNP Paribas’ announcement was admitting absent management. The ability to value assets is a key function of any asset manager. The evaporation of liquidity had made traditional asset valuation, what price a buyer might pay for the assets, unworkable. A frequently used alternative, modelling or simulating the valuation, also appears to have been unworkable, although many investment banks were using this approach to value their own exposure at this time. The complexity of mortgage-backed securities and the absence of buyers had led to absent management in BNP Paribas.

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The United States economy had overtaken the British economy by the end of the nineteenth century, and several other economies including German, France and Japan would do so by the end of the twentieth century. However London had remained one of the major banking centres in the world and the leading centre by some measures. One of these measures was that it was the most important location for all international investment banks from whichever country. This leading role ensured that the new developments from other centres, and particularly New York, were exported to London. The London operations of international investment banks were central to exporting these new, complex developments.

One of these developments was mortgage-backed securities.

Excessive investing in mortgage-backed securities and being unable to value these investments were two types of absent management in Europe that caused the crises to spread beyond the United States. A third type of absent management was to cause the largest run on a bank in the United Kingdom for more than a century.

On Friday 14 September 2007, investors withdrew more than £1 billion from Northern Rock in a bank run. This followed a report on the BBC the day before that the Bank of England had granted Northern Rock financial support (Guillén 2012). To stop the bank run, the Government guaranteed the total deposits in Northern Rock. This action was a significant increase from the government guarantee for all deposits in British banks of up to £31,000 per account.

A building society is a mutual organisation, owned by its members, that takes deposits and lends money, particularly for buying residential properties. Building societies are similar to saving & loans and credit unions in the United States. The Northern Counties Permanent Building Society, founded in 1850, and the Rock Building Society, founded in 1865, merged in 1965 to form Northern Rock Building Society. They would both, just, have experienced the last major bank run in the United Kingdom, when Overend, Gurney and Company suspended payments in 1866 and the Bank of England refused to support it (Wikipedia “Northern Rock”).

Northern Rock grew rapidly through acquisition, taking over 53 smaller building societies over the next 30 years. It demutualised in 1997, becoming Northern Rock Bank, with distribution of the newly issued shares to its members who had savings accounts or mortgage loans.

While Northern Rock had grown rapidly through acquisition of other building societies, it was the financial innovation of mortgage-backed securities that enabled its further rapid growth. Northern Rock’s bank run

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and failure was due to absent management in turn caused by uncontrolled growth and complexity.

Retail depositors can contribute to financing a bank and its lending by their deposits. Withdrawing such deposits rapidly can cause a run on the bank. A bank financed by depositors who causes these depositors to withdraw their deposits is either badly managed or not managed at all. A well-­ managed bank will either not be the target of a bank run or will be able to sustain it as WaMu did during the Great Depression in the United States.

Banks can also be financed by the capital market, that is other banks and institutional investors, also called the wholesale market. Wholesale markets can cause a bank run too. That is sometimes called a liquidity run. A bank needs funds to finance its lending. Some of this financing is longer term, perhaps several years, some is very short term, such as Repo mentioned previously, all the way down to overnight financing.

It has been a central part of banking through history to lend for longer terms than it borrows to finance loans. This is because the interest on longer loans is generally higher than shorter loans, allowing banks to make a profit on the difference between lending long term and borrowing short term. Managing the required liquidity to pay back its shorter-term borrowing from its longer-term lending has always been one of the central requirements of bank management.

The complexity that resulted in absent management in Northern Rock was the uncertainty related to the future availability of mortgage-backed security investors. One of the most important aspects of the new development of mortgage-backed securities was the addition of the world investment markets to finance bank lending in addition to traditional deposit financing. The ability to sell mortgages on to investors, securitisation, created a dependence on these investors that was either not considered, not understood or, if understood, ignored. As seen earlier, mortgage-backed securities had been used extensively by those originating mortgages in the United States including for subprime mortgages. It worked just as well for mortgages in the United Kingdom and many other countries. It became known as the ‘originate to distribute’ business model, originating mortgages by issuing loans, which were then packaged and distributed, or sold, to investors. The old building society model of accepting deposits to finance lending was partly replaced with the ‘originate to distribute’ model. In 1997, at the time Northern Rock was listed on the stock exchange, retail deposits made up nearly two thirds of Northern Rock’s financing. Within a decade, retail deposits made up less than a third (Milne and Wood 2009).

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Abandoning management and focusing purely on production, this uncontrolled growth was largely dependent on additional securitisation.

Importance of securitisation to finance mortgage lending multiplied from 3 per cent in 1999 to close to half in 2006. Northern Rock issued less than £1 billion of securitisation in 1999. By 2006 the amount issued was £46 billion. In that year alone Northern Rock’s balance sheet grew by onefifth. Only just over one-tenth of the growth came from an increase in deposits, while the other three-tenths were due to securitisation and other forms of finance (Milne and Wood 2009).

Although many other banks used mortgage-backed securities, no other bank in the United Kingdom or Europe became as dependent on this source of financing as Northern Rock. In 2006 one other bank in the United Kingdom, HBOS, which will be described later, had deposits to cover half its loans while all the other large banks had deposits closer to two thirds or higher, just like Northern Rock had back in 1997 (Milne and Wood 2009).

The mortgage loans made by Northern Rock were of longer maturity than the mortgage-backed securitisation used to finance the loans. This meant that new mortgage-backed securities needed to be issued to replace those that expired, to maintain financing of the outstanding loans. This created a significantly increased dependency on Northern Rock to be able to refinance.

Additionally, early repayment of mortgages meant that investors in the mortgage-backed securities would be repaid earlier than expected. If early repayment increased, investors would face a risk of not being able to invest their money at the same terms. This is called the reinvestment risk.

Northern Rock unusually retained this risk by issuing mortgage-backed securities of different maturities to suit investors. The shorter the maturities of the mortgage-backed securities, the higher the dependency of being able to issue additional securities to finance the outstanding mortgages.

This retention of reinvestment risk significantly increased the complexity of Northern Rock’s financing.

If Northern Rock sounds too complicated to manage it is because it was. Furthermore, it was too complicated to regulate. When it failed in 2007 the Financial Services Authority, the British bank regulator since 1997, was as surprised as everyone else. Not only had Northern Rock been too complicated to manage, it had importantly been too complicated to regulate. Little had changed in respect of the dangers of regulatory complexity since Barings’ failure in 1995.

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And then the music stopped. Bear Sterns, IBK and BNP Paribas had all contributed to closing the market for mortgage-backed securities. The reason was that investors became reluctant to invest more. Northern Rock’s dependency on this market to refinance its aggressive lending growth was so great that the only avenue left was to ask the Bank of England for support. News that government support had been granted was enough for depositors to ask for their money back, forming queues outside Northern Rock branches.

The dependency on the securitisation was so extreme, in size and shorttermism, that Northern Rock lost over a quarter of its financing in the remaining four months of 2007. In February 2008, Northern Rock was nationalised. The bank was then split with the branch and retail operations eventually sold to the Virgin Group in 2012 and the high-risk mortgage assets finally sold to an investment fund, Cerberus Capital Management, in 2016. All depositors’ money was safe as they had been fully guaranteed by the government. The many former members of the building society who had received shares in the demutualisation, employees who had participated in the shareholder savings scheme and all other shareholders lost their investments.

In addition to absent management of Northern Rock, its failure is also important in that not all banks fail. Management, and particularly absent management, is the determining factor in bank failure. Other banks did not allow themselves to become so dependent on a market, mortgage-­ backed securities, which they did not understand. Other banks did not grow as aggressively based on this dependency. And Northern Rock was the first bank run in the United Kingdom in over 140 years.

While the government’s guaranteeing of the deposits of retail customers in Northern Rock set a precedent and prevented any further queues outside British banking branches, other spectacular failures of British banks were to follow.

In the meantime, subprime losses were affecting investment banks in the United States. Following a write-down of $1.9 billion of subprime-­ related losses in November 2007, Bear Stearns started looking for someone to buy the firm. This was happening at a time when mortgage-related and particularly subprime losses were big and consistent news headlines.

In March 2008, the Federal Reserve announced a $200 billion lending programme to support financial institutions through the crisis. Some interpreted this as particularly aimed at Bear Stearns. The firm then experienced a very modern bank run.

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Other banks and investors tried to sell the positions they had with Bears Stearns. There were rumours that Bear Stearns was facing a liquidity crisis, related to subprime assets that could not be sold. Hedge funds that had been important clients of Bear Stearns stopped trading with the firm.

But stopping trading with the firm was not the only negative impact hedge funds had on Bear Stearns. Hedge funds were also selling the Bear Stearns share short. Selling short was originally a hedging tool. If an investor owns a lot of stock, he/she can sell the stock short to have some protection against a fall in the price of the stock. This hedging mechanism works by the investor taking out a contract with another party for a certain number of shares at a certain price. If the price falls the investor can close the contract with a profit by delivering the number of shares. The number of shares now cost less as their price has fallen providing the investor with a profit under the contract. This profit can be set against the fall in the price of the remaining stock. The short selling contract therefore protects, or hedges, the whole shareholding against a fall in price. Short selling without owning any stock, naked short selling, is a highly speculative type of investment because of the risk that the share price increases sharply. In addition, if the investor does not own any shares, he/she needs to borrow the shares to settle the trade. There is a risk that there may not always be a willing lender of shares that rise sharply.

Short selling puts pressure on a share price, particularly if the positions are large. From 2001 until June 2007, Bear Stearns shares sold short had amounted to around 6 million shares. Between June and November, the number of shares sold short tripled to around 18 million shares (Brewster and Gangahar 2008).

Later research has disputed the impact of short selling and in particular the pressure on the share price from naked short sellers seeking to borrow shares to settle a short trade (Fotak et al. 2014). Whether short selling was a contributory factor is not easy to establish. It certainly added to the complexities of managing a bank deeply involved in a deteriorating asset class, such as the financing of United States housing in general and subprime lending in particular. Short sellers probably did not identify absent management, but they were certainly looking for its effects.

The Securities and Exchange Commission, the regulator of the United States stock exchange, did eventually ban naked short selling on 19 September 2008, in coordination with the United Kingdom Financial Services Authority. The United States action applied to 799 financial companies including Bear Stearns. The aim was to temporarily ban aggressive

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short selling of financial stocks to restore equilibrium to the markets (SEC 2008). However this was much too late to have any effect on Bear Stearns.

By early March 2008 the Bear Stearns share price was in free fall from its once lofty $90 per share at the end of 2007 to $32 by Friday 14 March.

By the weekend of 15–16 March 2008 Bear Stearns had run out of options except for an offer from J.P.Morgan, initially at $4 per share.

J.P.Morgan had been under significant pressure from the Federal Reserve to buy Bear Stearns. The Federal Reserve was now being led by a former chief executive officer of Goldman Sachs. He had deep and recent understanding of how intertwined investment banks were and what the possible effect of the failure of one of them could have on the other investment banks and possibly on other banks and wider financial markets.

The Federal Reserve had serious concerns that a default by Bear Stearns would significantly worsen an already very difficult financial market situation. J.P.Morgan reduced the offer to $2 per share. This maximised the burden on Bear Stearns shareholders. This was in the interest of the Federal Reserve, which was determined not to be seen to be bailing out failing investment banks while many citizens were being foreclosed on their mortgages and losing their homes. Bear Stearns was sold at this price on Sunday 16 March 2008, nine months after the mortgage funds had defaulted. It had traded at $32 per share on Friday afternoon and above $90 at the end of 2007 with an all time high of $173 during 2007.

Eventually, the price was finalised at $10 per share or $1.2 billion.

Because of an initial agreed condition that J.P.Morgan would cover Bear Stearns trades for up to a year even if the takeover was not approved, Bear Stearns had a little room for negotiation and achieved the higher price.

But $10 per share was still not much compared to the previous year’s $173.

J.P.Morgan would take the first $1 billion of losses. The Federal Reserve Bank of New York lent J.P.Morgan $30 billion, taking Bear Stearns’ mortgage holdings as collateral. This left the United States taxpayer with a $29 billion exposure to Bear Stearns’ liabilities (Meagher et al. 2008).

By buying Bear Stearns, J.P.Morgan, with the pressure and also the support of the Federal Reserve, prevented the crises spreading in March 2008. Triggering a full blown banking crises would be left to another investment bank.

The reason J.P.Morgan was able to support Bears Stearns was that it had managed its exposures. During the dotcom equity market boom and bust, J.P.Morgan had incurred significant losses including on the energy trading giant Enron. J.P.Morgan and Citi had provided finance to Enron

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that allowed it to present misleading financial results. J.P.Morgan and Citi were fined $135 million and $101 million, respectively (Reynolds 2004).

The total loss from Enron for J.P.Morgan was $3 billion including $2 billion from a class action from former Enron investors. These recent losses may have made J.P.Morgan more cautious. By 2007 J.P.Morgan was top three in many investment banking activities but outside the top ten in the more complex debt including mortgage-backed packages. J.P.Morgan had also limited reliance on short-term funding.

In addition to supporting the rescue of Bear Sterns, the Federal Reserve also reduced the discount rate, the interest rates it charged banks, by one-­ quarter of 1 per cent on 16 March 2008 and a further three-quarters of 1 per cent two days later. Lowering the cost of borrowing was intended to make anybody in debt and with their interest payments linked to the Federal Reserve interest rate pay less. This was meant to be helpful to banks.

Importantly and for the first time the Federal Reserve also allowed investment banks access to the discount window. This was a lending facility for banks financing themselves with deposits. The discount window had previously been reserved exclusively for commercial deposit-taking banks to ensure they had access to adequate liquidity in times of stress.

Banks using the discount window had to post high-quality security as collateral, rated investment grade by the credit rating agencies.

This blurring of regulation between deposit-taking commercial banks and investment banks relying on non-deposit financing was a historic step, indicating the severity of the financial situation in the United States. It had not happened since the Glass-Steagall Act in 1933. It also indicated the concerns of the Federal Reserve about the potential wider impact of a failure of a major investment bank on the wider economy. This latter risk had been the reason for supporting the rescue of Bear Stearns with a $29 billion loan.

Following the failure and rescue of Bear Stearns, two very large participants in the United States housing market had to be rescued. Founded in 1938 after the Great Depression, the purpose of the Federal National Mortgage Association, known as Fannie Mae, was to increase the level of home ownership and to make housing more affordable. This was done through the use of federal funds with the creation of a secondary market in residential mortgages by Fannie Mae buying mortgage loans issued by banks. Banks were able to sell the mortgages they had issued and were therefore able to issue more mortgages without the need for additional capital.

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For the first 30 years Fannie Mae primarily bought mortgages insured by the Federal Housing Administration that provided security for the mortgages. So the mortgages purchased by Fannie Mae had a government guarantee. After 30 years of federal ownership Fannie Mae was listed on the stock exchange in 1968. This was quickly followed by ending Fannie Mae’s monopoly of the secondary mortgage market, through the establishment of the Federal Home Loan Mortgage Corporation, known as Freddie Mac, in 1970. This was done to compete with Fannie Mae and to further enhance the solidity and competitiveness of the secondary market for buying residential mortgages. Freddie Mac was listed on the stock exchange in 1989.

Importantly the mortgages banks could sell to Fannie Mae and Freddie Mac had to be conforming in order to have a government guarantee. To conform the loan had to be limited by the size of the mortgage depending on the location of the property. In addition for a loan to conform it had to meet guidelines regarding how much could be lent as a proportion of the total value of the property, the borrower’s income, credit score and history as well as documentation requirements. During the 1990s the government remit of both organisations was widened to meet affordable housing goals for those with lower earnings. An example of how these goals were progressively increased between 1996 and 2007 was that the target for increased buying of low and moderate households mortgages went from two fifths to over half.

The second activity of the two organisations was investments in mortgages, their own mortgage-backed securities, other mortgage-backed securities and other debt instruments. This activity was financed by the agencies’ capital and the issuing of bonds, known as agency debt. The two agencies owned $300 billion of mortgage-backed securities issued by others including $186 billion of subprime by the end of 2007 (Frame et al. 2005).

Although both agencies were listed on the stock exchange, there was a widespread belief that they had an implicit guarantee from the government for the funds they borrowed. Their position was so important to the United States housing market and its economy that their default was hard to imagine. Their growth was phenomenal. Mortgage-backed securities issued and guaranteed by the two agencies went from $20 billion in 1981 to $3.4 trillion by 2007 (Frame et al. 2005). They owned close to half the mortgages in the United States before the subprime crisis, amounting to over $5 trillion.

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This belief in an implicit government guarantee became particularly important when the organisations started packaging mortgages and issuing mortgage-backed securities. For a fee, Fannie Mae and Freddie Mac guaranteed that the premiums and principals on these instruments would be paid to investors even if the original loans defaulted. Many investors in these mortgage-backed guarantees saw an implicit government guarantee behind the guarantee provided by Fannie Mae and Freddie Mac. There was, however, no explicit government guarantee. So while the government guaranteed the conforming mortgages bought by the two organisations, there was no government guarantee for investors in Fannie Mae and Freddie Mac issued securities and shares. However the implied guarantee which the market generally believed in meant that the two organisations could obtain funds from investors at much lower rates than commercial organisations. This meant that little competition developed in the secondary market for conforming loans (Islam et al. 2013).

The two organisations were important in establishing the market for mortgage-backed securities for conforming mortgages. Fannie Mae issued its first mortgage-backed security in 1970, followed by Freddie Mac the next year. This meant that Fannie Mae and Freddie Mac could finance the purchase of mortgages through investors rather than their own funds.

However they did not lead the development of mortgage-backed securities of non-conforming and subprime loans more than 20 years later. That was left to investment banks.

The two organisations’ market share was close to two thirds of originated, conforming mortgages in 2003. This fell drastically to under half by 2006 as subprime origination exploded. The two organisations did compensate for this fall in conforming mortgages by purchasing significant amounts of lesser quality mortgages, including $168 billion of subprime exposure in the form of mortgage-backed securities originated by investment banks. This loosening of standards for buying mortgages was done to stem the loss of market share and to continue to service the two organisations’ shareholders.

There has been an extensive debate on the role of Fannie Mae and Freddie Mac in the financial crisis. Because of their dual objectives of working for shareholders and providing a liquid secondary market for mortgages, theirs was a complex business. The two organisations ­dominated the secondary market for conforming mortgages. But this does not mean that they caused the development of the subprime mortgage market. This was left to banks. And the subprime market caused a fall in United States housing prices which, in turn, caused Fannie Mae and

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Freddie Mac to fail. There may have been absent management in the two agencies. As they were not banks this is not the place to determine that.

With their original remit of providing affordable financing of housing, their exclusive reliance on United States housing, their listing on the stock exchange requiring rewarding of shareholders and their phenomenal growth, perhaps these unique organisations were so complex that they were not possible to manage.

For the second half of 2007 the two agencies’ combined losses were close to $9 billion from credit losses on mortgages and reduced valuation on their investments. For the first half of 2008 losses were over $14 billion.

On Sunday, 7 September 2008, the United States government assumed majority ownership and control of Fannie Mae and Freddie Mac that together owned or guaranteed over $5 trillion of the United States mortgage debt (Pozen and Beresford 2010). This was done to stabilise the housing market. The two organisations continually financed their purchases of mortgages in the financial markets. Had the government not stepped in this, financing might not have been possible and the secondary market for mortgages would have dried up. This could have the most serious consequences for the prime mortgage market and house prices in the United States. In addition credit issues on mortgage-backed securities issued by the two agencies, which were backed by conforming and not subprime mortgages, would have made the crisis worse, possibly much worse.

An additional global aspect was the ownership of the two agencies’ mortgage-backed securities by foreign investors led by China with over $500 billion. Not explicitly guaranteeing this debt could raise questions about the financial standing of the United States. The government ultimately injected $188 billion into Fannie Mae and Freddie Mac (Frame et al. 2005).

References Brewster, Deborah, and Anuj Gangahar. 2008. Financial Times. 17 March 2008. https://www.ft.com/content/da8db5d2-f469-11dc-aaad-0000779fd2ac Calomiris, Charles W., and Gary Gorton. 1991. In The Origins of Banking Panics: Models, Facts, and Bank Regulation in Financial Markets and Financial Crises, ed. R. Glenn Hubbard, 109–174. National Bureau of Economics. University of Chicago Press.

Demyanyk, Yuliya S., and Otto van Hemert. 2008. Understanding the Subprime Mortgage Crisis. SSRN: https://ssrn.com/abstract=1020396 or https://doi. org/10.2139/ssrn.1020396

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European Commission. http://europa.eu/rapid/press-release_IP-09-1235_ en.htm. 17 August 2009.

FDIC. 1997. An Examination of the Banking Crises of the 1980s and Early 1990s.

Washington, DC: History of the Eighties – Lessons for the Future.

Fotak, Veljko, Vikas Raman, and Pradeep K. Yadav. 2014. Fails-to-Deliver, Short Selling, and Market Quality. Journal of Financial Economics (JFE) 114 (3): 493–516. (December 1, 2014).

Frame, W. Scott, Andreas Fuster, Joseph Tracy, and James Vickery. 2005. The Rescue of Fannie Mae and Freddie Mac. Federal Reserve Bank of New York.

Staff Reports. Staff Report No. 719. March 2015.

Guillén, Mauro F. 2012. The Global Economic & Financial Crisis: A Timeline.

The Lauder Institute. Wharton.

Harris, Randall D. 2014. Goldman Sachs and the Big Short: Time to Go Long?

Case Research Journal 34 (2): 133–162.

Ho, Mary, and Yanling Guan. 2008. Merrill Lynch’s Asset Write-Down. Hong Kong: The Asia Case Research Centre, The University of Hong Kong.

Islam, M., N. Seitz, J. Millar, J. Fisher, and J. Gilsinan. 2013. Fannie Mae and Freddie Mac: A Case Study in the Politics of Financial Reform. Journal of Financial Crime 20 (2): 148–162. https://doi.org/10.1108/13590791311322346.

Meagher, Evan, Rebecca Frezzano, and David Stowell. 2008. Investment Banking in 2008 (B): A Brave New World. Kellogg School of Management, Northwestern University.

Mikes, Anette, and Dominique Hamel. 2014. Capitalizing for the Future: HSBC in 2010. Boston: Harvard Business School.

Milne, Alistair, and Geoffrey Wood. 2009. Shattered on the Rock? United Kingdom Financial Stability from 1866 to 2007. Bank of Finland Research Discussion Papers 2008.

O’Connor, Anthony, Ingo Walter, and Seymour Milstein. 2013. HSBC Holdings PLC Building a Global Wholesale Banking Capability. Fontainebleau: INSEAD. Pozen, Robert C., and Charles E. Beresford. 2010. Bank of America Acquires Merrill Lynch (A). Boston: Harvard Business School.

Reuters. 2008. https://www.reuters.com/article/us-usa-subprime-originationid$N0335941820070508 Reynolds, Vaughn K. 2004. The Citigroup and J.P. Morgan Chase Enron Settlements: The Impact on the Financial Industry. Carolina Law Scholarship Repository. North Carolina Banking Institute 247.

Schiller Home Price Index. Trading Economics. https://tradingeconomics.com/ united-states/case-shiller-home-price-index SEC. 2008. https://www.sec.gov/news/press/2008/2008-211.htm SIFMA. 2009. https://www.sifma.org/wp-content/uploads/2017/05/us-researchquarterly-2009-q4.pdf

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Spiegel Online. http://www.spiegel.de/international/business/bad-debtsamerican-mortgage-crisis-rattles-german-banking-sector-a-499160.html. 10 August 2007.

Stowell, David, and Evan Meagher. 2008. Investment Banking in 2008 (A): Rise and Fall of the Bear. Evanston: Kellogg School of Management, Northwestern University.

Wikipedia “IKB”. https://en.m.wikipedia.org/wiki/IKB_Deutsche_Industriebank Wikipedia “Northern Rock”. https://en.m.wikipedia.org/wiki/Northern_Rock

CHAPTER 10

Bank Failure: Triggering Crisis—How Absent Management in Banks Triggered the 2008 Financial Crisis

Growth is generally a result of production. And when growth is not controlled, it can be the result of absent management. In 2004 Bear Stearns was the leading underwriter of United States mortgage-backed securities.

It had market share of over one-tenth. Second was the Swiss universal bank UBS and third was Lehman Brothers, both with around a tenth of the market. By 2006 and 2007 Lehman was top although with an unchanged market share. Bear Stearns was second also with close to the same market share.

Achieving leadership may have been successful management. Being the leader of the most talked about asset class at the time, United States housing and the securities related to it, came with a responsibility of leadership.

The second largest underwriter, Bear Stearns, had been rescued by J.P. Morgan with the Federal Reserve of New York providing a $29 billion loan. There were concerns that Lehman Brothers would be next.

Lehman Brothers had been founded by German immigrants in Montgomery, Alabama, in 1847. Firstly Lehman Brothers was a grocery store that developed into cotton traders. It subsequently became a member of the New York Stock Exchange in 1887. The family ownership was diluted by outside partners as early as 1925, by which time investment banking had become Lehman Brothers’ primary activity. It survived the Great Depression, possibly due to its involvement in a range of diverse industries, where it operated as a high-level corporate finance advisor and underwriter of securities. On the passing of the Glass-Steagall Act in 1933, © The Author(s) 2020 C. Dinesen, Absent Management in Banking, https://doi.org/10.1007/978-3-030-35824-2_10

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Lehman Brothers ceased taking deposits and chose to become a pure investment bank. By 1967 it was one of the top four United States investment banks. Overseas expansion followed including to Paris, London and Tokyo by 1973. It merged with another United States investment bank with international operation, Kuhn, Loeb & Co., in 1979. Poor results in difficult economic conditions necessitated a merger with Shearson American Express in 1984. When credit card company American Express’ financial supermarket strategy did not work, Lehman Brothers Inc. was separately listed on the stock exchange, under the leadership of a former trader as the new chairman and chief executive officer (Nicholas and Chen 2011). The history of the family of the firm has recently been dramatised in a wonderful play called The Lehman Trilogy by Stefano Massini.

Lehman Brothers’ leadership of mortgage-backed securities was the result of a long-term strategy to be best-in-class for commercial and residential mortgages, in the whole chain from origination, to packaging and distribution to investors. In addition to its leadership in underwriting mortgage-backed securities, Lehman Brothers also had a mortgage origination business that sourced original mortgages. This meant that Lehman Brothers was also lending to people and companies that wanted to buy property. These mortgages could, in turn, be packaged and sold as mortgage-­ backed securities. Mortgage-related securities and loans was Lehman Brothers’ largest asset class with over a quarter of total assets (Rose and Ahuja 2011). So Lehman Brothers had significant exposure to the United States housing market on its balance sheet. In addition, the firm was earning large fees from originating mortgages and then packaging these loans and selling them on to investors. This leadership looked like successful management execution of strategy. However the same market share in 2004 and 2007 did not mean the same amount of business.

There had been an explosion in banks issuing mortgage-backed securities in the United States. It had doubled from 2004 to 2007, from $400 billion to close to $800 billion.

All banks are leveraged, but there is an important difference between how this leverage is regulated. Commercial banks in the United States were ultimately regulated by the Federal Reserve with significant restrictions on their leverage. This meant that the amount they could lend above the deposits they had accepted was restricted by the amount of capital buffer they held. A bank with 10 per cent capital buffer would be considered well capitalised. In complete contrast investment banks were regulated by the Securities and Exchange Commission. Importantly,

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there were no regulatory restrictions on their leverage (Stowell and Meagher 2008).

Leverage is regulated for a reason. The higher the leverage, the riskier the bank is. The more risky the bank, the more need for management and particularly risk management. The regulatory limit on leverage for commercial banks is aimed at securing depositors’ money. A certain amount of loans made by the bank can turn bad and may not be paid back, partly or fully. The restrictions on leverage with a required capital buffer aim to secure that the depositors’ money is still safe, even when some loans made by the bank turn bad at a time of stress or crisis.

There was a reason why there was an absence of regulation of leverage for investment banks. Most importantly they were not allowed to accept deposits, so regulators did not have to worry about the safety of deposits.

Investment banks were therefore left to manage leverage themselves with no regulation. There was an assumption that investment banks would be restricted by market forces, by how much money the market would invest in them or lend to them. The credit rating agencies would take leverage into account when assigning their credit ratings of the investment banks.

Financial analysts would consider leverage when making their buy and sell recommendations on the shares and bonds issued by investment banks.

But in the end leverage was up to the management of investment banks.

Or to absent management of some investment banks.

In 1478 the unregulated Medici Milan branch had a 7 per cent capital buffer with all other funds coming from depositors. The Milan branch was therefore not well capitalised, according to Federal Reserve approach, and was eventually liquidated. Its largest customers, the Duke and Duchess of Milan, accounted for one-third of all loans or five times the capital buffer.

Over 500 years later, in the years up to the 2008 crises, the leverage of investment banks grew rapidly. In 2002 Goldman Sachs and Merrill Lynch had leverage around 20 per cent while Morgan Stanley was at 25 per cent and Lehman Brothers at 33 per cent. By 2007 Lehman Brothers had grown to 35 per cent but had been overtaken by both Morgan Stanley at around 38 per cent and Merrill Lynch at close to 40 per cent. Goldman Sachs’ leverage had also grown but was below 30 per cent. By 2008 Lehman Brothers had approximately $700 billion of assets and corresponding liabilities on capital of just $25 billion (Maedler and van Etten 2013).

One effect of leverage is that it makes management more complicated. The more you borrow from others, the more dependent you are on them. And the more you borrow, the less the margin for error. This

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is similar to the increased complexity a private person has managing a mortgage, a second mortgage, a car loan, credit cards and so on. For investment banks it can become very complicated. There is leverage from the issue of shares and bonds. You are not forced to pay a dividend on shares, but their value underpins your strength. If you do not pay a dividend the share price may fall. The bonds and loans issued by a bank, with fixed interest payments and maturities, are what are commonly ­considered as leverage. The ability to package and sell loans through securitisation was a new type of leverage. It created another complex dependency on investors in the packaged loans. And finally, investment banks are the masters of finance. The highly expert advice they gave to their largest clients could be used for their own business, increasingly innovative and increasingly leveraged.

There was a lot of management in Lehman Brothers by 2008, including a great deal of risk management. The organisation had made a virtue of managing risk. Risk management was mentioned as a strength by the senior management when presenting externally. Credit rating agencies, some of whom rated Lehman Brothers at the same level of credit strength as Goldman Sachs and Morgan Stanley in 2007, highlighted risk management as a particular strength of Lehman Brothers. Risk management was meant to be a sophisticated, comprehensive modelling of, in particular, the firm’s risk appetitive.

Financial risk modelling is the building of a representation of a financial situation, in this case the risks Lehman Brothers was exposed to. The modelling would aim to capture the amount of risk accepted, for example, when underwriting or investing in mortgage-backed securities. The model would also take account of any protections of these risks, for example by selling the risks on to other investors. Sophisticated models would also show the extent risks were diversified between several exposures, such as different types of lending or countries or both. It might also be possible to test or stress the model with such variables as a change in house prices, interest rates and so on. This would provide a theoretical indication of what would happen if, for example, house prices declined.

Risk appetite was expressed as an annual risk budget, taking account of the different types of risk faced by the firm, including market volatility, credit and event risks. The risk appetitive limit was $1.8 billion in 2004, being considered quarterly and rising rapidly, very rapidly, to $4 billion in 2008. During 2007 the estimated amount of risk taken by the firm was below its risk appetitive in the second quarter, above in the third and fourth

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quarters and again below the, increased, limit in the first quarter of 2008.

Risk management responsibilities were shared between the Executive and Risk Committees and the Global Risk Management and Finance Divisions.

The Global Risk Management Division operated independently and employed 450 people in 2008 (Maedler and van Etten 2013). When the record 2007 year results of over $4 billion were announced, Lehman Brothers’ chief risk officer said the results fundamentally reflected Lehman’s strong risk management culture (Rose and Ahuja 2011).

With this level of risk management, it is perhaps surprising that it all went wrong and that Lehman Brothers failed. But it did all go wrong. If the complexity of Lehman Brothers was beyond the ability of the risk management effort to control it, there was a gap, an occurrence of absent risk management.

One reason was incentives. There was no absence of incentives at Lehman. The incentives were very considerable. The success in achieving leadership had allowed the firm to remunerate handsomely. But the incentives were focused on growth of revenue, although not exclusively. As part of the risk appetite, any division exceeding its limit could incur a charge including a charge on its executive compensation (Rose and Ahuja 2011).

The intention was that there should be a link between what senior people were paid and the risk taken. However it was possible for traders at Lehman to get around the system because they could set the value of their risk positions themselves (Rose and Ahuja 2011). Over and undervaluing positions affected bonuses. Risk management linking incentives to risk was in place, but those in line for the bonuses had a way around this.

In 2004 expenses for compensation of $5.7 billion amounted to half the revenues of the firm. By 2007 the proportion was unchanged but compensation expense was now $9.5 billion, up one-third in only three years. One-third of the compensation was paid in cash, while the rest was paid in Lehman Brothers’ shares, which could be sold over two to five years. Net revenue was the primary decider for who got paid what bonus.

Other factors could also influence bonuses, but importantly there were no written guidelines in place for determining this (Maedler and van Etten 2013). So the rewards for production and management respectively had not been documented.

Management could not possibly control this level of incentives. Half the revenue was paid to employees, a much greater proportion than anything else. Employees were enormously incentivised to grow revenues.

And they were enormously successful at growing revenues and incentives.

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Perhaps this is another type of leverage, the leverage of the firm on paying its employees and particularly its top producers. If revenue grew bonuses grew. Management and risk management would have to be strong and ever present to control growth that was incentivised like this.

Lehman Brothers grew much faster than its main peers in the years before its failure. Headcount almost doubled between 2002 and 2005 to 23,000 when Bear Sterns, Goldman Sachs, Morgan Stanley and Merrill Lynch were stable or reduced. Revenue grew by two and half times to $15 billion in this period. That was 1.7 times Goldman Sachs and over three times the other three. Lehman Brothers’ market capitalisation more than doubled to $38 billion, twice as fast as Bear Stearns and even faster than the other three (Gilson et al. 2017).

The failure of Bear Stearns in March 2008 affected Lehman Brothers negatively. In other industries the failure of a major competitor can be a commercial advantage but rarely in banking. That is evidenced by the Lehman Brothers’ chief financial officer who said that Lehman Brothers always knew they were the next name on the list (Rose and Ahuja 2011).

When the credit rating agency Standard & Poor’s changed its outlook on Lehman Brothers’ credit rating to negative from stable, only indicating that a downgrade was becoming more likely than the credit rating remaining stable, Lehman Brothers’ share price almost halved.

It was then rumoured that the short sellers who had made significant amount of money on selling the Bear Stearns share short were now planning to take similar short positions on the Lehman Brothers’ share. The leadership by Bear Stearns and Lehman Brothers of underwriting United States securitised mortgages would have been one of the reasons for this.

Once traders have been successful in selling one share short for a particular reason, their typical action is to seek other shares with similar characteristics and therefore profit opportunities. If one of the two leaders of this asset class had already failed, selling the other short would have seemed a good opportunity. And naked short selling was still allowed by regulation.

For the first quarter of 2008 Lehman Brothers reported net income of close to $500 million, even if this was a reduction of more than half compared to the first quarter of 2007. Lehman Brothers stated that it had $30 billion in cash and $64 billion in highly liquid assets, which meant that these assets could easily be sold. The firm then raised $4 billion of additional capital, which resulted in its share price going up by more than one-­ tenth. Anyone having a short position on the Lehman Brothers’ share would have lost considerable amounts.

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This capital raising was important, not just because of the equity capital market support shown for Lehman Brothers. Two weeks after the failure and the Federal Reserve supported rescue of Bear Stearns, the capital market was willing to support the second leader of the mortgage securities market. At least according to the investors providing this new capital, Lehman Brothers would survive and a failure was an unlikely outcome.

The failure of Lehman Brothers was, unsurprisingly, complicated.

Lehman Brothers’ failure was not inevitable once Bears Stearns had failed.

Four billion dollars of new capital said so. And inevitable is a very big word. Baring in 1890 was rescued to live another 90 years. The complexities of Lehman Brothers and the uncertainties of the markets it operated in made survival possible.

However Lehman Brothers was probably too much like Bear Stearns to survive. Like Bear Stearns, Lehman Brothers bailed out some of its debt investment funds taking over $1.8 billion worth of their assets in April 2008 (Meagher et al. 2008). Raising additional capital and laying off thousands of people did not stop the share price falling.

The second quarter of 2008 saw Lehman Brothers announce its first quarterly loss since it listed on the stock exchange in 1994 of close to $3 billion. The total cost of mortgage-related and other assets losses was $10 billion. Without hedging, the amount would have been $17 billion.

On 9 September 2008 the share price fell by a third closing at $3 per share. This followed an announced $4 billion loss in the third quarter of 2008. By this stage doubts about Lehman Brothers’ financial strength were so strong that the counterparties that Lehman Brothers relied on were becoming unwilling to continue financing. A final complication of Lehman Brothers was, like Bear Stearns, the reliance on financing from other investment banks and investment funds. Many of Lehman Brothers’ assets were long term, while its liabilities were largely short term. Lehman Brothers funded itself through the short-term Repo markets. Like many other investment banks, the firm borrowed short-term cash, from one day to several weeks, and pledged high-quality securities as collateral. The riskier the firm’s borrowing, the more collateral would be required by the lender. Lehman Brothers borrowed sometimes hundreds of billions of dollars in the Repo markets each day to carry on its business (Maedler and van Etten 2013).

As the perception of the strength of Lehman Brothers reduced, so the demands for additional collateral increased. Once borrowers, including J.P. Morgan, asked Lehman Brothers for additional security for this

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financing, Lehman Brothers ran out of collateral on 12 September. Once Lehman Brothers was unable to refinance itself, its management, or lack thereof, was no longer the main issue. It was now up to the management of other banks and of the Federal Reserve.

Discussions had been held by Lehman Brothers in July 2008 about mergers with government-owned Korea Development Bank and China’s CITIC Securities. These came to nothing partly because Lehman Brothers could not agree to the price. Royal Bank of Canada considered Lehman Brothers but declined.

There was now a significant difference between Lehman Brothers’ situation and that of Bear Stearns. The Federal Reserve refused to provide protection for Lehman Brothers’ mortgage assets as had been done with the $29 billion loan to J.P. Morgan to save Bear Stearns. There had been a strong public reaction to this loan at a time when many people were being forced from their homes for not being able to pay their mortgages. The Federal Reserve, which like most central banks is ultimately backed by the taxpayer, did not want to make another commitment to an investment bank.

In addition, the loans made by the Federal Reserve to Bears Stearns had been fully secured on assets within these firms. Lehman Brothers did not have collateral left to provide security for a loan from the Federal Reserve that would be large enough to save Lehman Brothers from its creditors (Gilson et al. 2017).

Talks had already been held with other banks, including Bank of America in July and with Barclays. In the final weekend of 13–14 September 2008, Bank of America chose to take over another bank, which will be described later. Barclays declined taking over the business due to a lack of time to obtain shareholder approval, concerns by the British regulator, the Financial Services Authority and probably the lack of Federal Reserve support. On 15 September, Lehman Brothers announced the largest bankruptcy protection filing in U.S. history, listing assets of $639 billion and liabilities of $768 billion (Gilson et al. 2017).

The most important aspect about Lehman Brothers was the fact that it failed and the consequences of that failure for financial markets across the globe. Nobody manages a bank to fail. Banks can fail when management is absent in the face of great complexity and uncontrolled growth. But the big problem with Lehman Brothers was not its failure, but the consequences of its failure. The Board employed the management. If the management was not up to managing the bank and the bank failed, the Board

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had failed. This was devastating for shareholders, employees and other shareholders. Those who had lent Lehman Brothers money might not be repaid. But failure was primarily a Lehman Brothers’ problem. However, the unusual thing about a bank failure is the effect it can have beyond the bank itself. And Lehman Brothers triggered a global financial crisis.

If it had not been Lehman Brothers, another bank might well have triggered the crisis. There was absent management in other systemically important banks. But once Lehman Brothers failed, the tide went out.

And it was time to see who else had been swimming naked, where else there had been absent management.

One of the potential rescuers of Lehman Brothers was Bank of America.

But during that fatal weekend of 13–14 September 2008, Bank of America decided to rescue another leading investment bank.

The largest attraction of Merrill Lynch was it large retail stockbroker franchise, the largest in the world. But it also had an enormous mortgage exposure. By July 2008, Merrill Lynch had made $52 billion of write-­ downs related to mortgage losses. It was one of these successive write-­ downs, $14 billion announced in early 2008 as part of the full 2007 year results, that gave me the idea that perhaps Merrill Lynch was not managed. Before joining Merrill Lynch in 2002, I had been a management consultant for ten years. I had made a living on advising companies on how to manage themselves better. But I was unable to understand what was wrong with the management in the bank where I worked that it could lose $14 billion in a quarter. Perhaps the reason was that the bank was not managed.

Merrill Lynch had been founded in 1914, was listed on the stock exchange in 1971 and had 56,200 employees and a presence in 37 countries by 2006. It was the largest stockbroker in the world with 16,000 brokers globally, known as the Thundering Herd. Merrill Lynch’s logo was, famously, a bull. A bull market is a market of financial securities where prices are rising or expected to rise. It was one of the five largest U.S. investment banks together with Goldman Sachs, Morgan Stanley, Lehman Brothers and Bear Stearns at the beginning of 2008. The firm underwrote and traded many types of securities and was a leading corporate and ­mergers and acquisitions advisor and asset manager. The sale of part of its asset management business in early 2006 left it holding just under half of Blackrock, one of the largest asset managers in the world.

Merrill Lynch had a turbulent period around the time the new chief executive officer took his seat in 2001, a turbulence that had already

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started when he was President. Following the 11 September 2001 attacks, the chief executive officer instituted cost cuts of $2 billion. Fifteen thousand people were dismissed globally by the end of 2001, reducing the work force by one-fifth. When appointed chief executive officer, he replaced all but one of the direct reports to the former chief executive officer. This has become a typical approach of new chief executive officers in many large financial institutions. Their intention may be to have only direct reports that are known and trusted by themselves and that are also people who owe their new position to the new boss. This approach does not, however, ensure constructive challenge by the senior managers and has been criticised for producing yes men and women surrounding the chief executive officer.

The new chief executive officer had a range of challenges. Settlement was reached with 900 female employees claiming gender discrimination.

Without admitting any charges, Merrill Lynch paid $280 million to settle charges related to the Enron energy giant’s fraudulent inflation of profits.

In early 2003, the New York Attorney General produced evidence showing Merrill Lynch analysts having private concerns about companies they had positive public views and buy recommendations on. This resulted in charges that investors, including smaller private investors, had been misled. The negative publicity was such that Merrill Lynch’s share prices feel by over one-fifth. Merrill Lynch became the first investment bank to sign the global settlement on ensuring that research would be independent and paid $100 million to settle the charges. Dealing with these issues was considered impressive management action by the new chief executive officer and his new team. Following these actions, there were concerns amongst analysts and other that someone seen as a ruthless cost cutter might not be able to also grow the largest stockbroker in the world.

There was a major opportunity for growth in U.S. mortgages. The story is complex. That was why it led to absent management. At the end of this story, it will be simple why it was too complex to manage.

Mortgage-backed securities had added a layer of complexity to mortgage lending by packaging the mortgage loans and selling them on to investors. They had also changed the incentives for the lenders. Before mortgage-backed securities, lenders had to consider the risks associated with lending. These included how much could be lent and at what terms given the ability of the borrower to put up a cash deposit and pay back the loan. With the ability provided by mortgage-backed securities to sell these risks on to investors, lenders became incentivised to lend as much as pos-

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sible in order to earn the commissions paid for originating the loans.

Investors were in turn earning a return on the securities based on the interest paid by the original lenders but had taken over the exposures to the underlying mortgage.

Merrill Lynch became the leader of an even more complex asset class, collateralised debt obligations or CDOs. It makes sense to continue to call them collateralised debt obligations. CDO rolls of the tongue far too easily and provides a false idea that these instruments are simple and familiar.

In this packaging of loans into a mortgage-backed security, there is a separation of the exposures into different tranches of mortgage-backed securities that are then sold to different investors. Junior tranches are more exposed to losses on the underlying loans and pay a correspondingly higher rate of interest. Junior tranches attract a lower credit rating because of their higher risk. The senior tranches are only exposed at a more severe level of distress of the underlying loans. Senior tranches pay a lower rate of interest. They attract a higher credit rating because of their lower risk. The most senior tranches were often able to attract the highest credit rating of AAA, indicating that credit rating agencies believed they were very unlikely to suffer losses. Collateralised debt obligations could be used for many types of loans, including mortgages, but also other types such as car loans.

When used for mortgages, collateralised debt obligations were a complex type of mortgage-backed securities. As innovation increased, collateralised debt obligations were structured for existing collateralised debt obligations rather than for original loans. These became known as collateralised debt obligations squared. These were a further step away from the original loans, making understanding their exposure a whole additional level more complicated. As one measure of complexity, it has been estimated that the number of mortgages behind a collateralised debt obligations squared was around 93 million with over 1 billion pages of documentation (Liechtenstein et al. 2009). Finally, collateralised debt obligations of collateralised debt obligations of collateralised debt obligations were structured, called collateralised debt obligations cubed.

Understanding the true exposures of these various levels of structures would have been truly challenging if at all possible. The complexity is ­perhaps best illustrated by their names. The complexity was possibly not doubled or tripled, but multiplied, squared and cubed.

Another innovation was to construct collateralised debt obligations on credit default swaps. These were the hedges used to protect against credit losses and traded with individual counterparties rather than on an

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exchange. Credit default swaps in turn were based on underlying credit quality of bonds and loans issued by corporates. Collateralised debt obligations involving credit default swaps were called synthetic collateralised debt obligations, because a credit default swap is a synthetic rather than a loan. It is a hedge, a derivative of an underlying loan.

Even with the benefit of hindsight reading this description of the complexity of how mortgages and other loans were transferred from the original lenders to investors should appear so complex that it would cause absent management. And it did. But at the time the concern was not to manage but to sell more collateralised debt obligations to earn the related commissions. It is not important to understand collateralised debt obligations just that they were too complex to manage.

The Merrill Lynch chief executive officer had taken the decision to expand the mortgage securitisation business shortly after his appointment in 2001. Merrill Lynch underwrote $3 billion of collateralised debt obligations in 2003, multiplying over 14 times to $44 billion in 2006 and earning fees of $800 million that year. Merrill Lynch was the collateralised debt obligations’ market leader by 2005 having hired a team from former market leader Credit Suisse only two years earlier.

In 2005, a third of the $35 billion of collateralised debt obligations underwritten by Merrill Lynch was backed by subprime mortgages. Partly to supply subprime mortgages for new collateralised debt obligations, Merrill Lynch acquired the First Franklin mortgage origination operations in September 2006 for $1.3 billion. First Franklin was one of the largest subprime mortgages’ originators in the United States (Ho and Guan 2008). The U.S. housing market had already seen weakness in 2006, after many years of increases. Subprime loans in particular were deteriorating.

The acquisition of First Franklin was growth focused with little sign of risk management.

When a bank underwrites a mortgage-backed security, such as collateralised debt obligations, the assets stay on the balance sheet of the bank until all the assets have been gathered and the package has been sold to investors.

This is known as warehousing. It means that the bank is exposed to the possibility of not being able to sell the mortgage-backed security or the collateralised debt obligations tranches. During the warehousing period, the bank can protect itself against deterioration in the warehoused assets by buying hedges (Ho and Guan 2008). Ultimately, the bank is reliant on the continued appetite of investors for buying mortgage-backed securities to be able to empty its warehouse, reliant on the music keeping playing.

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Like Lehman Brothers and other investment banks, Merrill Lynch had significant risk management, with one department for market risk, focused on price volatility, and one on credit risk, focused on non-payment. These departments did not report to the chief executive officer but to the chief financial officer and the vice chairman. These risk management departments did not stop the underwriting of new collateralised debt obligations, although it had become apparent that it was more difficult to sell those collateralised debt obligations already underwritten and currently warehoused (Ho and Guan 2008). It would have been a complex decision to decide at what stage underwriting new collateralised debt obligations should have been stopped. It is possible that the focus of growth was so strong that it was difficult for risk management to stop it. There also appears to have been a lack of accurate internal reporting of the increasingly large stockpiling of unsold collateralised debt obligations in the warehouse. The combination of complexity and the focus on growth was so great that it led to absent management and in particular absent risk management.

There was, unsurprisingly, a particular complexity in the selling of collateralised debt obligations by Merrill Lynch, resulting in absent management. The very rapid growth had generated very large amounts of the most highly rated AAA tranches. These were the tranches at the top of the structures, furthest away from the risk of loss. By the end of 2007, the fairly conservative investment funds, life insurance companies and pension funds that had been important buyers of AAA tranches had stopped buying. These investors had already bought significant amounts and had concerns about the underlying credits. Merrill Lynch was still underwriting collateralised debt obligations as the market leader and started to retain the AAA tranches. With such a high credit rating, they would not weigh too heavily on the firm’s balance sheet. With a AAA rating, they were highly unlikely to default, according to the rating agencies. Merrill Lynch held $41 billion of subprime collateralised debt obligations and mortgage bonds. This was above its share capital of $38 billion. A very large ­proportion of the collateralised debt obligations exposure was AAA, perhaps as much as four fifths.

A combination of downgrades by the credit agencies and an inability to either sell or hedge the AAA tranches caused the value of these exposures to fall sharply (Fortune Magazine 2007). It did not require any of the original loans that had been packaged to default and cause losses to the tranches. Downgrades by the credit agencies and a lack of buyers for the

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tranches were enough. Growth and complexity had caused an occurrence of absent management. Collateralised debt obligations were not badly managed; they were not managed at all.

There was also an absence of management effectiveness. In the first half of 2007, the chief executive officer and the Board requested that the mortgage department reduced the subprime exposure. However, Merrill Lynch was still the largest underwriter of collateralised debt obligations in the first eight months of 2007 underwriting $43 billion. Second was Citi with $34 billion, and UBS was third with $21 billon (Fortune Magazine 2007).

Merrill Lynch tried to save itself. Following the losses from the Bear Stearns’ funds, to which Merrill Lynch had been one of the largest lenders, the chief executive officer contacted the large commercial bank Wachovia about a possible merger. But he did so without advising the Board that he was having this conversation and was therefore promptly replaced in October 2007. The chief executive officer was quoted as saying that: “we got it wrong by being overexposed to subprime. It turned out that both our assessment of the potential risk and mitigation strategies were inadequate” (Wilchins 2007). ‘Inadequate’ is as blunt an admission of absent management as a Wall Street chief executive officer is ever likely to make.

As losses increased, the next chief executive officer sold Merrill Lynch’s 20 per cent stake in the Bloomberg, the major global provider of financial news, information and trading platforms, for over $4 billion in July 2008.

But this capital raising was inadequate given the size of the losses. Once the failure of Lehman Brothers became increasingly likely in September 2008, the new chief executive officer contacted Bank of America (Meagher et al.

2008). On Sunday 14 September, as we went to bed in London, it was clear to many of us at Merrill Lynch that on Monday either we or Lehman would belong to Bank of America. Those working for the bank who was not bought by Bank of America would be going home early Monday afternoon with the contents of their desk in a cardboard box.

Very strong, very complex growth caused absent management in Merrill Lynch and was a cause of its failure and resulting rescue by Bank of America. Mortgage-backed securities and collateralised debt obligations in particular were too complex to manage, in terms of their actual exposure to underlying loans, particularly subprime loans. This complexity also meant that it was impossible to foresee how rating agencies would react to deterioration in the underlying loans. The extremely rapid growth

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of the asset class made saturation amongst buyers a possibility. When that happened, Merrill Lynch retained the exposures least expected to cause loss. But the assets and how they were structured were too complex and had grown too quickly. The complexity of the structure and the continued growth, in the face of a deteriorating housing market, combined to leave Merrill Lynch unmanageable due to the losses of the deteriorating assets. These were assets even the world largest stockbroker in the world could not sell.

Bank of America was the largest bank in the United States when the chief executive officer was appointed in 2001, with a 7 per cent share of total deposits of $4 trillion. Originally called North Carolina National Bank, it had changed its name to Bank of America after the acquisition of BankAmerica Corporation in California in 1998 (Pozen and Beresford 2010). Bank of America had not been successful in becoming a major investment bank, in addition to being one of the leading commercial banks in the United States. It had made very significant acquisitions of over $100 billion, but they had all been commercial banks such as Fleet Boston Financial for $47 billion in 2004, credit card company MBNA for $35 billion in 2005 and La Salle for $21 billion in 2007. None of these had made Bank of America a significant investment bank. Organic growth in investment banking had been selectively successful, such as in the underwriting and issuing of corporate debt, where Bank of America could use its large deposit financed balance sheet to be a leader alongside JPMorgan Chase. However, it did not have the investment banking franchise to attract the best talent. In January 2008, Bank of America instead bought Countrywide, a large mortgage lender with a fifth of the total market for $4 billion. By 2008, the chief executive officer said that he “had all the fun I can stand in investment banking”. He then started shrinking the investment banking operations by reducing the workforce by 1100 people as mortgage losses rose (Meagher et al. 2008).

Bank of America was very close to a regulatory restriction of growth by acquisition of additional commercial banks in the United States. Under the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, banks could only exceed a tenth share of U.S. deposits through organic growth. By 2008, Bank of America had reached 9.98 per cent of the country’s $7 trillion deposits (Pozen and Beresford 2010). Growth by acquisition could now only come though non-deposit-taking financial institutions, such as investment banks, or outside the United States.

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On 15 September 2008, Bank of America made an offer of $50 billion for Merrill Lynch paying $29 per share. This was about half of Merrill Lynch’s top value in 2007 when its market capitalisation had been $64 billion. The offer resulted in a downgrade of Bank of America’s rating by one notch on the rating scale, to AA minus from AA, by Standard & Poor’s rating agency, with likelihood of a further downgrade in the months to come (Pozen and Beresford. 2010). The market reacted negatively to the offer, and Bank of America’s share price fell by a fifth.

The decision by Bank of America to buy Merrill Lynch provides an interesting question of whether this was absent management. The only two days of due diligence and the subsequent deterioration in the estimate of Merrill Lynch losses for the fourth quarter from $5 billion to $12 billion during the months of November and December 2008 are indications that this was the case. The decision could be seen as driven exclusively by growth in the one area of United States banking open to Bank of America with commercial banking growth being restricted by the 10 per cent market limit on deposit growths by acquisition. Bank of America’s share price fell one fifth on 15 September, the day after the deal was announced. Management considered revoking the deal by invoking a Material Adverse Effects clause. An additional $25 billion was required from the government’s Troubled Asset Relief Program or TARP, of which more later, on top of the $25 billion already injected. All these point to absent management. But ultimately Bank of America Merrill Lynch did not fail and the acquisition did achieve the investment banking league position aspired to by the chief executive officer. So while questions about price paid and ultimate value of the combined entity can be disputed, the decision and the highly challenging integrations were managed rather than unmanaged.

The financial crisis also affected insurance companies. Not because of traditional insurance risks, but because they expanded into capital market activities that had previously been the domain of investment banking.

Insurance companies also invested in subprime and other affected assets.

Expansion into additional lines of business involves additional complexity as seen when commercial banks expanded into investment banking. In two past examples, Citi and Credit Suisse, the complexity of managing both major banks and insurance companies had contributed to the divestment of the insurance entities within a few years.

The expansion by insurance companies involved a level of complexity that often resulted in absent management. How this management com-

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plexity arose from insurance companies expanding into traditionally investment banking areas can be illustrated by the difference between an insurance policy and credit default swaps. Credit default swaps were central to much of the insurance expansion and a large part of the losses.

Credit default swaps have always been and are still referred to as a type of insurance. However, insurance and credit default swaps differ in a number of ways, which means that being involved in both is not the same as only doing insurance and significantly increases complexity. Firstly, insurance and credit default swaps are regulated by different regulators for insurance and banking. Secondly in insurance, the value of what is insured does not change due to market forces. In contrast, the bond, loan or other financial instrument hedged by a credit default swap changes with the credit strength of the issuer of the bond and with credit market conditions. Thirdly, an insurer has to be trusted to be able to pay the claims for the duration of the insurance contract, even if the financial strength of the insurer deteriorates. In contrast, a seller of credit default swaps may need to provide collateral security to the buyer if the seller’s financial strength deteriorates and before any default has occurred or any payment is made.

A little more detail on the second difference, the valuation of what is insured or hedged. The purpose of insurance is to put the buyer in the same position as before a loss happened. What insurance must not do is to put the buyer in a better position than before the loss. Under most insurance regulation, this would be considered gambling and be prohibited. A factory can be insured against fire based on a valuation. If a wildfire approaches the insurance, policy is extremely valuable to the factory owners. In the tragic event where the factory is destroyed by fire and the insurance policy fully indemnifies the factory owners, they are in no better position than before the loss. So the value of an insurance policy does not go up and down.

For the insurance company providing the policy, there is a loss. Most importantly, the maximum value of the loss is the value of the factory as originally determined. Because this value is known and does not change, a well-managed insurance company can cover this loss by premiums from other policies and investment income earned on premiums. There is uncertainty regarding whether a loss will happen, how big the loss will be according to the damage caused by the fire, but not regarding the value of the property insured. This insurance characteristic is known as the principle of indemnity, of placing the insured in the same position as before the loss.

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In contrast, the original purpose of credit default swaps is to provide a financial hedge for the default of a referenced bond, loan or other credit-­ related instrument. The clue is in the name. The seller swaps, or exchanges, an obligation to pay up to the limit of the swap in return for the premium from the buyer. It is this exchange of risk for premium that causes credit default swaps to be considered a kind of insurance. However, it is not insurance but a financial transaction. In case of default of the underlying bond, the seller of the credit default swap is bound to provide the amount of referenced bonds that the hedge protects or cash equivalent to the buyer. This means that the seller’s potential pay out relates to the valuation of the underlying bond. And this valuation can change. In a fundamental difference from insurance, where the value of the factory is determined at the outset, the value of the underlying bond can go up or down. If the credit strength of the issuer of the bond goes down, the value of the bond goes down. But for the seller of the credit default swap, it will now require more bonds to settle a potential loss. So the potential pay out or value of the credit default swap, to add to the complexity, moves in the opposite direction.

Should credit markets in general deteriorate and availability of credit default swaps reduce, the value of the credit default swap may increase further. The buyer may now be in a better position than when the credit default swap was bought. So a credit default swap is not insurance, is not a contract of indemnity, but a complex financial transaction, a derivative hedge. It derives its value from the value of another financial instrument, the underlying bond.

And the value of this financial instrument can change.

As to the third difference between insurance and credit default swap, an insurance buyer has to trust the financial strength of the insurer to pay the insured loss. In contrast, the buyer of a credit default swap will want to make sure that the seller has adequate funds to pay a possible loss.

Depending on the contract for the credit default swap, this could involve requiring increased collateral from the seller as the credit strength of the seller reduces. This could be triggered by the seller’s credit rating being downgraded by one or more credit agencies. Crucially, this requirement for increased collateral can be triggered simply because the seller’s credit rating is downgraded. The underlying bonds do not have to default. So insurance and credit default swaps are not the same, and the differences between them are highly complex.

American International Group (AIG) had been founded in 1919 in Shanghai and developed into the most international insurance company in the world with operations in 130 countries. One of its areas of leadership

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was insuring large multinationals in all their many locations across the globe. Having moved to New York City in 1949 in response to the Chinese communist revolution, AIG went public in 1969. Under the same chief executive officer from 1968 to 2005, AIG expanded enormously (Nagel 2015). Through acquisitions such as SunAmerica, Inc. in 1999 for $18 billion and American General Corporation in 2001 for $23 billion, AIG became the second largest insurance group in the United States behind those owned by Warren Buffet’s Berkshire Hathaway. Operations included general and life insurance, retirement and financial services and asset management. AIG’s 116,000 people generated revenues of $110 billion with assets above $1 trillion in 2007 (Blair and McNichols 2009).

In addition to expansion geographically and by different lines of insurance, AIG expanded into the different, and highly complex, capital markets business, traditionally the preserve of investment banking. AIG hired a team from Drexel Burnham Lambert in 1987. Drexel Burnham Lambert would subsequently be involved in a major scandal involving trading on insider information and failed due to its leadership of the junk bond market in 1990. AIG’s investment banking activities were located in London.

It was, however, not regulated by the United Kingdom banking and insurance regulator, the Financial Services Authority. It was regulated by the United States Office of Thrift Supervision, because this regulator also regulated a small savings and loans institution owned by AIG. The London activities included many types of financial derivatives and credit default swaps from the late 1990s when this market first developed (Nagel 2015). The credit default swaps sold by AIG were not regulated, as derivatives were unregulated under the United States Commodity Futures Modernization Act of 2000.

An important objective for the expansion was the opportunity to take advantage of AIG’s highly valued AAA credit rating. A credit default swap is a transaction between two parties and not bought and sold on an exchange. This makes the credit strength of the seller important. The buyer of the credit default swaps relies to a great extent on the credit rating of the seller. This is so the buyer can feel secure that the seller will be able to meet its obligations in case of default on the protected asset, such as the bond that the credit default swap is meant to protect. In addition, purchasing credit default swap protection from a AAA-rated entity such as AIG meant that the credit rating of the underlying, referenced bond increased to AAA for the buyer. This increased security reduces the capital needed by the buyer to hold the asset.

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Some of the credit default swaps sold by AIG were particularly complex. As previously shown, the structuring of mortgage-backed securities involved different tranches rated from the lowest rated BBB to the highest rated AAA. When these tranches proved difficult to sell, further packaging was arranged, in collateral debt obligations or CDOs. This created a new package of a package with new tranches rated from BBB to AAA. Above the AAA tranche was a tranche called super senior because the risk of default was estimated to be even lower than AAA. These tranches would only incur losses after the tranches rated AAA had incurred a total loss.

The collateralised debt obligation market grew by more than three times in as many years from $157 billion in 2004 to $551 billion in 2006 (Blair and McNichols 2009).

AIG became a major provider of credit default swaps of super senior tranches of collateral debt obligations. It sounds complex because it is.

These collateral debt obligations contained BBB-rated tranches of mortgage-­backed securities containing original loans. Just reading these sentences may be enough to make you feel slightly lightheaded, but show the complexity involved. From the original borrower to AIG, there were four levels of complexity, being the loan, the mortgage-backed security, the collateral debt obligation and the credit default swap.

An increasingly large proportion of these very large super senior exposures were retained by the investment banks, such as Merrill Lynch. These investment banks were underwriting the mortgage-backed securities and collateralised debt obligations and selling tranches to investors. Banks were estimated to be holding $216 billion of super senior tranches in 2007. By the end of 2007, AIG’s estimated largest counterparties for super senior collateralised debt obligation were Goldman Sachs with $23 billion, Société Générale $19 billion, Merrill Lynch $10 billion and UBS $6 billion (Blair and McNichols 2009).

In 2005, the chief executive officer of AIG since 1968 resigned in connection with regulatory investigations by the New York State Attorney General. These investigations focused on irregularities regarding transactions with General Re Corporation, owned by Berkshire Hathaway and allegedly aimed at making AIG’s profits appear higher than they were (Hawkins and Lynch 2011). The investigation was settled with $1.6 billion of fines. The rating agencies consequently downgraded AIG’s long-­ held and highly valued AAA rating to the still high rating of AA. These credit rating downgrades, in turn, caused counterparties to require collateral to be posted under some of the credit default swaps sold

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by AIG. The demands were for relatively small amounts as AIG was still highly rated and the chance of any default under the credit default swaps was considered remote. AIG did not write additional credit default swaps on super senior collateralised debt obligations with subprime exposures after December 2005 (Blair and McNichols 2009). This decision was made after AIG conducted internal discussion and criticism of the lack of understanding of the diligence of subprime mortgage-backed securities.

There was thought to have been too much belief in the low risks of the credit default swaps, based on the view that house prices would not fall across the United States simultaneously (Hawkins and Lynch 2011).

The first call for collateral was for $1.8 billion made on 27 July 2007, later revised to $1.2 billion. AIG continued to dispute the amount but paid $450 million on 10 August (Hawkins and Lynch 2011). In October 2007, it paid a further $1 billion.

AIG then made an investor presentation stating that it did not expect to incur any losses on its total super senior exposure of close to half a trillion dollars. Of this $79 billion was credit default swaps on credit default obligations of which $64 billion had subprime exposure through mortgage-­backed securities. The total exposure to posting collateral was $26 billion (AIG 2007).

Two major differences between credit default swaps and insurance now caused AIG to fail. Firstly, it had to continue to provide collateral to counterparties of credit default swaps while AIG’s insurance clients had to rely on its financial strength to get their insurance losses paid. Secondly, AIG had to value its credit default swap exposures according to the market, while insurance reserves related to the insurance losses and did not change based on financial markets.

Announcing its full-year 2007 result at the end of February 2008, AIG had posted $5 billion of collateral and recorded a $12 billion loss on credit default swaps. No losses had been paid under the credit default swaps, but the requirement to value them according to market valuation caused the loss. The chief executive officer of the capital market activities resigned the next day, and the chief executive officer of the group followed in June 2008. In August, the collateral requirements had risen to $17 billion, and credit default losses amounted to $26 billion. Following these results, AIG was downgraded by all three rating agencies on 15 September, the day Lehman Brothers failed. These downgrades further increased the need to post collateral by $15 billion (Hawkins and Lynch 2011).

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AIG had another major exposure to subprime completely unrelated to credit default swaps. As a major insurer, it was a major investor and AIG had investments of $70 billion in highly rated mortgage-backed securities (Blair and McNichols 2009).

The incentive plans of the capital markets division were unique within AIG. The incentive plans originally retained close to two fifths of profits up front including for longer-term contracts for payment to employees and then passed on the rest to the parent company. In 1994, this was changed to a one-third, two-third split with part of the retained compensation deferred over several years. But the capital markets activities remained highly incentivised to grow.

The United States government decided that AIG’s bankruptcy would have catastrophic consequences for the banking industry because of the close to half trillion of credit default swaps sold by AIG. A rarely used Federal Reserve act enables the Federal Reserve to lend AIG $85 billion, receiving a stake of four fifths of AIG’s equity capital in return. By November 2008, the deterioration in AIG’s results meant that the total rescue package had to be increased to $153 billion including from the government’s Troubled Asset Release Program, which will be described later. AIG’s $62 billion loss for 2008 was the largest of any company in history. Eventually the rescue was estimated at $182 billion.

There was significant poor management in the failure of AIG. The incentive schemes for the capital market division were one example. When these schemes were left in place, after the failure of the company, with the argument that staff that knew what had gone wrong needed to be retained, this caused a public outrage.

The absent management in the failure of AIG was due to complexity and uncontrolled growth. Entering into capital market activities involved a level of complexity beyond the capabilities of AIG’s top management.

The four levels of complexity between a subprime loan and the credit default swap sold by AIG, with the packaging and repackaging, tranching and associated credit ratings, were supposed to provide diversity and remoteness from loss. But the need to post collateral to counterparties when AIG itself was downgraded and the requirement to value its exposures in deteriorating markets were completely different from its insurance business. The uncontrolled, but incentivised, growth of this highly complex and different business resulted in absent management and the largest corporate loss and bailout at the time. Such large losses requiring an enormous government rescue, starting on the same day Lehman Brothers failed, significantly added to the size and impact of the crisis.

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References AIG. 2007. AIG Residential Mortgage Presentation. 9 Aug. 2007 (financial figures are as of June 30, 2007). http://www.aig.com/Chartis/internet/ UnitedStates/en/REVISED_AIG_and_the_Residential_Mortgage_Market_ FINAL_08-09-07_tcm3171-443320.pdf.

Blair, Nathan T., and Maureen McNichols. 2009. AIG–Blame for the Bailout.

Stanford/Boston: Harvard Business School.

Fortune Magazine. 2007. http://archive.fortune.com/magazines/fortune/fortune_archive/2007/11/26/101232838/index.htm. November 2007.

Gilson, Stuart C., Kristin W. Mugford, and Sarah L. Abbott. 2017. The Rise and Fall of Lehman Brothers. Boston: Harvard Business School.

Hawkins, John, and Luann J. Lynch. 2011. American International Group, Inc.The Financial Crisis. Charlottesville: Darden School Foundation, University of Virginia.

Ho, Mary, and Yanling Guan. 2008. Merrill Lynch’s Asset Write-Down. Hong Kong: The Asia Case Research Centre, The University of Hong Kong.

Liechtenstein, Heinrich, Jorge Soley, Joan Juny, and Sergi Cutillas. 2009. Banking Industry Analysis. Madrid. IESE Business School of Navarre.

Maedler, Markus, and Scott van Etten. 2013. Risk Management at Lehman Brothers, 2007–2008. Madrid: IESE Business School of Navarre.

Meagher, Evan, Rebecca Frezzano, and David Stowell. 2008. Investment Banking in 2008 (B): A Brave New World. Illinois: Kellogg School of Management, Northwestern University.

Nagel, Stefan. 2015. From Free Lunch to Black Hole: Credit Default Swaps at AIG. Illinois: WDI Publishing. University of Michigan.

Nicholas, Tom, and David Chen. 2011. Lehman Brothers. Boston: Harvard Business School.

Pozen, Robert C., and Charles E. Beresford. 2010. Bank of America Acquires Merrill Lynch (A). Boston: Harvard Business School.

Rose, Clayton S., and Anand Ahuja. 2011. Before the Fall: Lehman Brothers 2008.

Boston: Harvard Business School.

Stowell, David, and Evan Meagher. 2008. Investment Banking in 2008 (A): Rise and Fall of the Bear. Evanston: Kellogg School of Management, Northwestern University.

Wilchins, D. 2007. Merrill Writedowns May Signal Broader Risk Problems. 24 October 2007 Reuters.

CHAPTER 11

Bank Failures Cause a Global Crisis: How the Complexities of United States Mortgage Securities Devastated Banks and Made the Banking Crises Global

Of the five largest investment banks in the United States, Bear Stearns was bought by J.P.Morgan with a $29 billion government loan in March 2008, Lehman Brothers filed for bankruptcy and Merrill Lynch was bought by Bank of America both on 15 September 2008. The two remaining, Morgan Stanley and Goldman Sachs, did not fail. But they stopped being pure investment banks and converted into bank holding companies on 23 September, just one week after Lehman Brothers’ bankruptcy and Merrill Lynch’s rescue (Pozen and Beresford 2010). This meant that these two pure investment banks would become regulated by the Federal Reserve, could accept deposits and would have to deleverage their balance sheets considerably. Most importantly, they could access the Federal Reserve’s window for liquidity.

The following month both Morgan Stanley and Goldman Sachs accepted a capital injection under the Troubled Asset Relief Program or TARP. This was part of the United States Emergency Economic Stabilization Act of 2008, a systemic solution initially allowing the government to buy up to $700 billion of assets from banks but changed to enabling the government to inject capital into financial institutions. This late change was done as injecting equity could be done much faster than buying assets, which would require evaluation. Originally $250 billion was allocated to banks of which half went to the eight largest being Citigroup ($25 billion), JPMorgan Chase ($25 billion), Wells Fargo ($25 billion), Bank of America © The Author(s) 2020 C. Dinesen, Absent Management in Banking, https://doi.org/10.1007/978-3-030-35824-2_11

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including Merrill Lynch ($25 billion), Goldman Sachs ($10 billion), Morgan Stanley ($10 billion), BNY Mellon ($3 billion) and State Street ($2 billion). Receiving TARP funds meant that the compensation of the top managers and earners would be restricted. Some banks, allegedly including Goldman Sachs, tried to refuse the TARP injections claiming they did not require it. The Federal Reserve, as the regulator, insisted that all the large eight banks accepted the injections to avoid only those banks accepting the injection becoming subject of speculation (Pozen and Beresford 2010).

Morgan Stanley and Goldman Sachs are two important examples of the fact that not all banks fail in a crisis. And that the difference between failure and survival is management.

Morgan Stanley had been created by the largest ever regulatory effort to simplify banks, the Glass-Steagall Act of 1933. This Act forced J.P.Morgan, then the largest bank in the world, to divest its investment bank from its deposit-taking commercial bank. The resulting Morgan Stanley had leveraged up its capital 35 times, only just overtaken by Merrill Lynch in 2007. Morgan Stanley had lost $10 billion on mortgage-related securities by the end of 2007. But Morgan Stanley’s management acted to save the bank’s independence. It sold just under one-tenth of itself to the China Investment Corporation for $5 billion and later that year obtained a $9 billion investment from Japan’s Mitsubishi UFJ Financial Group.

Combined with access to the Federal Reserve liquidity window and the TARP injection, Morgan Stanley’s management preserved its independence (Pozen and Beresford 2010).

Goldman Sachs had been the last of the top five investment banks to become a listed company, in 1999, 13 years after the last of the other top four investment banks had ceased being partnerships and 28 years after the first. Merrill Lynch had gone public as early as 1971, Bear Stearns in 1985, Morgan Stanley in 1986 and Lehman Brothers in 1993, having been owned by American Express since 1983.

Although owned by shareholders some of the Goldman Sachs partnership culture had been maintained. In particular there appears to have been a greater sharing of information across activities, as well as top management involvement in risk management, than in the other large investment banks at the time. All risk management functions within Goldman Sachs ultimately reported to the 16-member Executive Management Committee chaired by the chief executive officer (Harris 2014).

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Goldman Sachs had never been as exposed to subprime as the other investment banks. As early as between December 2006 and February 2007, Goldman Sachs reduced its subprime exposure by two-thirds. This happened when most of the market was still positive on these exposures (Harris 2014). But it did not stop there. One division took a short position on the mortgage market amounting to $10 billion of exposure, expecting that the subprime market would deteriorate further. This contrarian position earned Goldman Sachs a significant profit as the mortgage market continued to deteriorate. The short position was then significantly reduced in March 2007. Goldman Sachs was later criticised for continuing to sell mortgage-backed securities to investors, while at the same time making money on the deteriorating mortgage market.

With the third largest subprime lender, New Century, having filed for bankruptcy in early April 2007 and Bear Stearns’ two hedge funds collapsing in early June, Goldman Sachs then increased its short position, reaching close to $14 billion by late June 2008. Goldman Sachs still had to take a loss on subprime exposures of $322 million in July, but the very large profits on the short positions mitigated this, with a profit of $1 billion that month alone (Harris 2014).

By 2008 Goldman Sachs’ leverage had not risen above the still very high 30 times. Its write-down of mortgage-related losses was comparatively low at $2 billion. Its reliance on short-term Repo financing from counterparties was only one-seventh of its balance sheet in comparison to Lehman Brothers’ one-third. During the summer of 2008 management substantially reduced risk, including lowering real estate exposure by over $6 billion. In spite of these measures Goldman Sachs still reported its first historical quarterly loss of close to $400 million in the fourth quarter of 2008 (Harris 2014).

So Goldman Sachs was involved in the mortgage market, lost money and announced 3200 redundancies, being over ten per cent of total. But it lost substantially less money than the other big banks. On 23 September, Goldman Sachs raised capital of $5 billion from Warren Buffett and his investment company Berkshire Hathaway. The following day Goldman Sachs was able to raise an additional $5 billion of new equity capital from the stock market (Meagher et al. 2008). Goldman Sachs converted to a bank holding company. It had to accept $10 billion of TARP injection, whether it needed it, wanted it or neither, because the regulator, the Federal Reserve demanded it. But Goldman Sachs was different. The risk management in Goldman Sachs was not perfect, but it was not absent.

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The complexity of Goldman Sachs’ business was not beyond the ­capabilities of its risk management. The drive for growth was not so overwhelming that it made management absent.

What started with Lehman Brothers’ bankruptcy was not limited to a crisis for subprime lenders and investment banks in what was becoming a global banking, financial and sovereign crisis. The banks with absent management were in grave peril.

The largest bank failure in American history happened on 25 December 2008 when federal regulators took over Washington Mutual or WaMu, put its assets up for sale and then sold most of it to JPMorgan Chase for $1.9 billion. WaMu had been worth $46 billion in 2006. WaMu customers’ deposits were left safe and accessible. Shareholders and other investors lost most of their investment. It was the inglorious end to what had been an apparently successful and very rapid growth story. At the end, management had been absent.

The Washington National Building Loan and Investment Association was founded in 1889 using the example of the United Kingdom building societies. Depositors owned the Association and had the right to borrow for building homes. WaMu survived the Great Depression by allowing depositors to make withdrawals, amounting to 12 per cent of total assets, until confidence was restored and many depositors returned their money to the Association. In surviving the Great Depression, WaMu was well managed. It is simple, brave approach, enabled by having adequate liquid assets to pay enough deposits back to customers, meant that it survived when many other banks failed.

WaMu’s customer and community focus also enabled it to grow (Dewar and Hayagreeva 2010). It lobbied successfully to change regulation to allow it, having first become a mutual savings bank, to merge with a savings and loan association in 1966. In 1969, it was allowed to compete with banks on consumer loans. WaMu experienced severe losses during the Savings & Loan Crisis in 1981 and 1982, when interest rates were 17 per cent, but it survived and was the able to expand. One thousand and forty-three of the other 3034 savings and loan associations in the United States failed. WaMu became the first bank, rather than investment firm, to own a securities brokerage firm. It gave up its mutual status and went public in 1983. From the late 1980s to 2002 WaMu made 32 acquisitions, starting small but later doubling its assets to over $40 billion by buying the American Savings Bank in 1996 and increasing to $135 billion by buying Great Western Financial Corp and Home Savings of America in the next two years. WaMu had a total of 60,000 employees by 2000.

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There were many strong management traits in WaMu, from strategic focus on retail customers, brand development, learning from successful retailers such as Starbucks and technical innovation. Branch managers were given a great deal of autonomy and the incentive scheme was simple with a high proportion based on total company performance particularly at the higher levels of seniority. By the early 2000s WaMu was the largest bank holding company in the United States and issued one in eight home loans (Dewar and Hayagreeva 2010). WaMu returned an impressive 20 per cent to shareholders from 1983 to 1996.

Mergers and acquisitions are the riskiest actions in business due to the inability to truly understand the complexity of what you are buying.

Compared to this the buying itself is easy and mainly a question of whether you have the finance. Going public and performing well enables you to use your shares to buy other banks. The greatest uncertainty for any business is whether you have bought what you thought you have bought. That is why hostile takeovers are particularly risky and dangerous because they prevent you from conducting thorough due diligence beyond the public information available. Hostile takeovers almost always involve an element of absent management. Deciding to take over a bank that is not well understood is not only a bad decision but absent management. The really hard management task is integration of what you have bought with what you already have. If the integration is incomplete that is absent management. The management work has not been done. In common with many other merged entities, WaMu had nine separate and outdated loan origination IT systems from its acquisitions by 2000. The new system that was supposed to take over never got off the ground and was abandoned in 2004 (Dewar 2010).

WaMu succumbed to the consequences of unmanaged, uncontrolled growth. The growth originally involved 32 acquisitions over 15 years.

Mortgage lending growth was next. A campaign called ‘The Power of Yes’ was not only advertising but also internally influenced the rapid growth in lending. By the early 2000s over one-eighth of United States mortgages were with WaMu, and the revenues from home lending grew from $707 million in 2002 to $2 billion in 2003. Retail branches almost doubled in three years from around 1170 in 2000 to 2000 branches in 2003 (Dewar and Hayagreeva 2010).

The lack of up to date systems contributed to the inadequate hedging against higher interest rates. Hedging is a protection purchased in the financial markets to reduce exposure to a change in prices or other ­variables. Hedging costs money but reduces volatility. When interest rates

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rose in 2004 the WaMu mortgage business made no money after having made $2 billion the year before.

The growth came from lending at such a growth rate, and with so little consideration for the risks attached, that it cannot be considered to have been managed. The data upon which mortgage loans were made was inappropriate, inadequate or fraudulent and sometimes two or all three. There was considerable pressure on employees to lend, while also handling their other tasks. The incentives offered to the independent distribution channels, such as mortgage brokers, were so high that the incentives distorted these agents’ duty to their clients. The agents became overly dependent on WaMu for their income rather than from serving their clients, the borrowers, to get them the best loan deal. The loans offered could be beyond the ability of the borrowers to repay them, particularly the subprime loans to borrowers with low incomes.

This uncontrolled growth was made possible by the ability of lenders, including WaMu, to package the loans and sell them as financial structures to investors, as described earlier. However not all risk was passed on.

House prices in the United States fell over 2 per cent in 2006, 6 per cent in 2007 and almost 11 per cent in just the month of January 2008 alone. In 2007 WaMu stopped subprime lending having suffered a small $67 million loss. By the middle of 2008 bad loans in WaMu, those that required provisions against possible non-payment, had reached $12 billion, triple the $4 billion in mid-2007. Loan losses in the first three quarters of 2008 came to $6 billion. There was a run on deposits in WaMu in July 2008 amounting to $9 billion of withdrawals. In September 2008, a second run reduced deposits by an additional $17 billion. Then the bank was taken over by regulators and sold.

Lending ever more mortgages had completely consumed WaMu. All traces of the management of the past had disappeared. The autonomy of the branches had been overruled by ‘The Power of Yes’ campaign. Growth, perhaps for the sake of growth, but certainly to grow returns to shareholders, was all that mattered. It was a far cry from the customer and community-­ focused bank that had survived the Great Depression by allowing depositors to withdraw their money until confidence, and subsequently deposits, was restored.

It is not easy to understand how management was so completely abandoned. Perhaps the example of retailers, more branches, more types of coffee and more and more sales, had persuaded WaMu’s leadership that more sales was all that counted including for a bank. Perhaps the past per-

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formance of 20 per cent return to shareholders for well over a decade could only be achieved by growing lending.

One argument is that the top management had always been producer managers with 32 acquisitions as their production. Management had always played second fiddle to production, as seen by the lack of completion of the integration of many of the acquisitions. Fully integrating the acquisitions would have been active and present management. This was abandoned for the sake of the next acquisition. And the next. Once further acquisitions were no longer going to make a significant difference to the now extremely large WaMu, the top producer managers turned their production attention to sales. And what impressive salesmen they were.

The increased sales were phenomenal. Possibly they were so great that they contributed to the increase in United States house prices by enabling borrowers who were unable to repay loans to participate. This loan growth added unsustainable demand to the housing market. This would mean that the absent management in WaMu contributed to the rise and subsequent fall in United States house prices and the 2008 financial crisis. The sales production then consumed the top management and the rest of WaMu to an extent where management was absent.

If bank failure is defined as the closure of a bank by its regulator, Citi did not fail. But in 2008 it lost close to $28 billion, almost exactly a quarter of its equity capital (Rose and Sesia 2011). The year before Citi was the largest financial institution in the world. It had 375,000 employees, was present in over 100 countries and had assets of over $2 trillion and equity capital of $113 billion (Rose and Sesia 2011). Citi had been the second largest underwriter of collateralised debt obligations in the first eight months of 2007 with $34 billion, after Merrill Lynch with $43 billion. It was in early 2007 that the Citi chief executive officer was infamously quoted as saying that “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing” (Nakamoto and Wighton 2007). Admitting to not stopping dancing, however incongruous, is an admission of absent management.

The Securities and Exchange Commission had banned the short selling of shares in close to 800 financial institutions on 19 September 2008.

The day after Citi’s share price increased by 24 per cent. This recovery was a strong indication that short positions were being taken on Citi’s shares, possibly by the hedge funds that had taken similar positions on Bear Stearns and Lehman Brothers. The ban on short selling provided

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protection against further pressure from this type of speculation for Citi and other financial institutions.

Citi received an initial $25 billion of injected TARP capital in early October 2008 followed two months later by another $20 billion, after regulators had more thoroughly been through Citi’s financial position. In the intervening month Citi had reached agreement with the Government that the Treasury would guarantee $301 billion of Citi assets if losses of $29 billion of assets were incurred (Greenwood and Quinn 2015). The Government’s total involvement in Citi was now $346 billion.

The ban on short selling and the massive government support were still not enough to quell rumours around the future of Citi. The concern amongst investors was whether Citi would be able to pass the new regulatory capital tests planned for 2009. If the bank would not be able to pass these new regulatory requirements, the consequences could range from requiring more capital to being closed down (Greenwood and Quinn 2015).

Citi not only had the largest and one of the most complicated banking operations in the world, it also had a very complex capital structure. Like most large banks, Citi’s capital was made up of different types. Some was fully paid up equity capital based on shares with a discretionary dividend and considered the highest quality of capital. Another type was preference shares with a fixed interest coupon that could only be cancelled in more extreme circumstances. To improve its tangible common equity Citi converted $58 billion of preference shares into common equity. This meant that the Government owned just over one-third of the total equity share capital of Citi (Rose and Sesia 2011).

So while Citi did not fail it was effectively taken over by the Government, given the combined $45 billion of TARP injections, $351 billion of asset guarantees and one-third shareholding.

In 2009 a Citi Board director wrote in his retiring letter of his regret that “I and so many of us who have been involved in this industry for so long did not recognise the serious possibilities of the extreme circumstances that the financial system face today” (Rose and Sesia 2011). If there is no recognition there can be no management. This lack of recognitions meant that, for a long time, there had been absent management at the highest level of the largest bank in the world.

The United States did not have a monopoly of fast growing loan associations as shown by Northern Rock. Halifax, the largest British building society, was one of the last to demutualise in 1997. It was an almost ­exclusive retail loan provider and the largest mortgage lender in the United

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Kingdom with a market share of a fifth of all mortgages. In 2001 the Halifax merged with the Bank of Scotland, a retail and commercial bank with a limited deposit base relative to its corporate lending and a reliance on wholesale funding. The result was HBOS. In 2004 the British regulator characterised HBOS with “the Group’s growth has outpaced the ability to control risks” (Parliamentary Commission 2015). This is a good description of absent management. If growth is so extensive that the associated risks cannot be controlled, then the management is not good or bad but absent. HBOS was further described as an “accident waiting to happen” (Parliamentary Commission 2015).

And the growth causing absent management was considered by the regulator to be “markedly different than the peer group”. That difference was management, which was present in some other United Kingdom banks, but absent in HBOS. Because HBOS was all about growth, all about production.

After the merger of Bank of Scotland and Halifax Building Society in 2001, lending more than doubled by 2008, but deposits only grew by two thirds or only one-third as fast as lending. This created a greater dependency on other funding than deposits, funding from the wholesale or capital market through the extensive use of securitisation. In the lending to corporates the gap between deposits and lending was £33 billion in 2001, almost trebling to £85 billion by 2008. The amount lent to a single corporate increased from just under £1 million in 2001 to nearly £3 billion in 2008 with nine corporates being lent over £1 billion. In addition the bank increased lending to corporates with lower credit quality and therefore greater risk. Growth was further accelerated in 2007 when other banks reduced their lending. HBOS also added complexity to growth by expanding internationally, primarily in Ireland and Australia. Furthermore HBOS grew the investment return on its own capital, through its treasury function, by investing in securitised instruments too complex to be understood by most senior HBOS management or its board. In February 2008 half its £81 billion debt investment portfolio consisted of asset-backed securities including mortgage-backed securities (FCA and PRA 2015).

Retail was HBOS largest activity where aggressive growth was also pursued, including in risky areas such as buy-to-let and self-certified mortgages, achieving higher proportions of these risky loans than its large peers. The size of the retail activity and the aggressive growth resulted in retail accounting for more than half HBOS’ total funding gap between deposits and loans of £213 billion (Parliamentary Commission 2015).

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Although the British regulator had pointed out serious weaknesses in 2004, a subsequent review by one of the large accounting firms appears to have eased regulatory pressure for change. A later identification of overreliance on non-deposit funding by the regulator was also not followed up with enforced change. In 2006, the bank acknowledged internally that it had the highest non-deposit funding requirements of any United Kingdom bank. So HBOS was one of the top five banks in the United Kingdom that was most reliant on wholesale funding including securitisation. Not only was it the largest. The total non-deposit funding requirement was close to the combined non-deposit funding requirement of the four larger peer banks combined (Parliamentary Commission 2015). HBOS dependency on funding by other sources than deposit was therefore equal to the dependency of its four largest peer banks combined.

Impairments and losses from these high-risk strategies included £25 billion from corporate lending, £15 billion from Australia and Ireland, £7 billion from own capital investments by the treasury function and an estimated £7 billion from retail from 2008 to 2011. The impairments for this period were one-tenth of the 2008 loan book, twice as high as any of the other five largest United Kingdom banks (Parliamentary Commission 2015). In contrast a well-diversified bank, such as the Rothschilds historically and HSBC at the same time as HBOS, had ensured that losses in one area could be covered by profits in other areas plus capital.

Once Lehman Brothers failed on 15 September 2008 HBOS suffered over £30 billion of deposit withdrawals from its corporate customers. This was a corporate bank run rather than a retail bank run. There may not have been queues out HBOS branches, but the telephone lines with corporate customers must have been glowing. HBOS’ £60 billion liquidity pool proved inadequate because the complex but high-yield and risky investments made by the treasury function could not be sold or borrowed against. So the liquidity pool contained illiquid assets. Many of these investments were those that contributed to Lehman Brothers’ collapse.

When non-deposit financing, particularly securitisation, became extremely constrained, HBOS was unable to finance itself and had to be rescued. Importantly HBOS failed because of a lack of funding and liquidity at an extremely difficult time in the wholesale markets. However the impairments on its loan book would possibly have required a rescue a few years later, even if liquidity had not caused it to fail in 2008 (Parliamentary Commission 2015).

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The senior management of HBOS said that they were caught on a beach by a tsunami and admitted that they were not on the high ground when it struck in September 2008. To stay within the management’s metaphor HBOS management had been swimming naked for years. This was exposed by a historically low tide but would probably have been exposed within a few years anyway. Not all banks fail in a crisis. Those who grow without management are much more likely to do so.

HBOS was rescued by a combination of being taken over by Lloyds TSB and significant injection of capital by the government. HBOS received a total of £21 billion from the government, £9 billion directly and £12 billion provided to Lloyds TSB, now Lloyds Banking Group, by the government. Lloyds Banking Group itself injected £8 billion into HBOS. The terms of the takeover were announced on 18 September 2008, three days after the collapse of Lehman Brothers, and completed one year later in September 2009. During this year, HBOS required Emergency Liquidity Assistance from the Bank of England (Parliamentary Commission 2015).

Lloyds TSB was one of the big four United Kingdom banks, having been established in 1765. A string of acquisitions included the building society Cheltenham and Gloucester and the formation of Lloyds TSB with the merger with the former Trustees Savings Bank in 1999. By 2001 Lloyds TSB was so large that the competition authorities blocked an £18 billion takeover of former building society Abbey National. In 2006 Lloyds TSB considered a takeover of HBOS but decided against it as such a merger was also expected to be blocked by competition authorities.

Lloyds TSB’s eventual takeover of HBOS was either poor management or absent management, given that it resulted in Lloyds TSB requiring government support. Lloyds TSB wanted to take over HBOS. If this takeover had not happened and no other buyer had been available, the British Government would most likely have had to take over HBOS. The government would probably have had to nationalise HBOS like it had Northern Rock, in order to preserve financial stability. That is what the Chancellor of the Exchequer (the British Finance Minister) said subsequently (Dunkley and Jenkins 2017). With a buyer willing to take over HBOS, the government waived the competition rules that would most probably have prevented a takeover. And Lloyds TSB then agreed to buy HBOS. But Lloyds TSB did not have to. Lloyds TSB decided to. A number of banks had refused to buy Lehman Brothers. But Lloyds TSB buying HBOS was a case of absent management, because the decision was so driven by growth and involved such complexity that Lloyds TSB management was absent.

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Lloyds TSB had been determined to grow further in the United Kingdom. It had considered buying Abbey National and HBOS in previous years but had been prevented by competition or perceived competition rules. So when these rules were waived, because the government preferred a market solution to nationalisation, Lloyds TSB went ahead.

And it was done with so little assessment of the risks involved that management cannot have been said to have been present.

Lloyds TSB knew about the risk of subprime in the United States. In December 2007, the bank had taken a £200 million write-down related to subprime and in July 2008 a further £585 million of general write-down related to the financial crises. Lloyds Banking Group including HBOS eventually lost $8 billion on United States subprime (Wikipedia 2010) with the majority coming from HBOS’ investments.

But it was the unique aggressive lending growth of HBOS and its absent management that Lloyds TSB failed to comprehend. In spite of having considered a takeover of HBOS in 2006 and having been approached by HBOS in July 2008 about a possible merger, Lloyds TSB decided to take over HBOS in just two days in September 2008. There was time for only two days of due diligence after the government waived the competition restrictions.

Taking over HBOS caused Lloyds TSB to fail. The results of absent management are rarely seen so quickly. Only one month after the takeover the government had to rescue Lloyds TSB and provide £20 billion of capital and in 2009 take a two-fifth holding in the bank, becoming by far the largest shareholder. Lloyds TSB had paid £8 billion for HBOS and incurred losses of £53 billion from the acquisition.

Another leading British bank, Royal Bank of Scotland (RBS), was established by royal charter in Edinburgh in 1727. Having expanded to London in nineteenth century it expanded further through the United Kingdom, mainly through acquisitions. In the 1980s the bank also diversified into different lines of business, including into property casualty or general insurance, by distribution channel becoming the first United Kingdom online bank and geographically by taking over Citizens Financial Group in the United States. Citizens then made 25 acquisitions in the United States while owned by RBS. In 2000 RBS took over one of the largest British banks, National Westminster (NatWest), in a £23 billion transaction, the largest ever in the United Kingdom, and beating Bank of Scotland for NatWest in the process. The RBS group was one of the largest banks in the world by April

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2008 with 171,000 people, operating in over 50 countries and having made £10 billion profit in 2007 (Financial Services Authority 2012). It would be its last profit for ten years.

The NatWest takeover was not only very large, but also hostile and considered extremely successful. NatWest was larger than RBS at the time of the merger. It essentially did the same type of retail and commercial banking, primarily in the United Kingdom. A hostile acquisition is where the target does not agree to be acquired. It is rare amongst large bank takeovers because it allows for no due diligence. The acquiring bank, RBS, was limited to the publicly available information such as NatWest’s annual reports and regulatory filings. There was no access to non-public information, little understanding of the increasingly important IT systems or any meetings with senior management in the target bank. Because of this limited ability to carry out due diligence, hostile takeovers involve an element of absent management.

The NatWest acquisition was also unusual in that it was very successful.

RBS’ strong track record of taking over other banks enabled a fast and efficient integration of a very large bank. The successful NatWest acquisition significantly enhanced the reputation of RBS and its chief executive officer, with shareholders, regulators and in the financial services industry and capital markets.

What made the NatWest acquisition by RBS particularly unusual was that it was an example of successful absent management. Perhaps it is the most important exception that proves the rule that absent management is a bad idea. After all Lloyds TSB taking over HBOS with limited due diligence caused Lloyds TSB to fail.

RBS’ later hostile takeover of Dutch bank ABN AMRO, in the middle of a financial crisis, would be central to RBS’ failure. The failure of RBS was due to those who financed it no longer being willing to do so. This unwillingness was strongly accelerated by RBS’ perseverance in the hostile takeover of ABN AMRO. RBS was not the only bank relying on wholesale market and shortterm funding but it was one of the most exposed in the United Kingdom.

By September 2007 RBS had the second highest reliance on overnight funding of the largest five British banks and twice as large as the third bank. It was still much lower than HBOS’ dependency but still large.

Counterparties providing RBS finance were not perfectly managed themselves, but they knew who their largest counterparties were and who to worry about the most.

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The wholesale market must have faith in a bank to continue to finance it. A bank that becomes dependent on wholesale markets for its financing and then loses the trust of the wholesale markets is either badly managed or not managed. A bank that becomes dependent on the wholesale market for funding, particularly short-term funding, and then loses that trust will no longer be able to fund itself. And that trust will depend on what the wholesale market thinks. A loss of trust can cause a wholesale market bank run, a liquidity run.

This is central to the historical importance of trust within banking.

Depositors must trust a bank to be able to repay their deposits. The wholesale market must trust a bank to be able to repay its financing. If the depositors or the wholesale funding market loses confidence in a bank it does not matter if the bank is either solvent, liquid or both. To maintain this particular and specific trust that deposits and financing will be repaid is perhaps the single highest priority of bank management. To forget this is absent management in banking. It assumes that your bank is bigger than the market, because the banking market is based on this trust. And RBS lost this trust because of absent management.

The £47 billion takeover of ABN AMRO by a consortium including RBS, Spanish bank Santander and Dutch bank Fortis significantly raised RBS reliance on wholesale market finance. RBS initial share of that takeover was about two fifths or about £19 billion, but RBS paid for its share with increased borrowing rather than with its own shares. The NatWest acquisition had been much larger but had been financed by shares. Future financing also became more difficult because counterparties had limits on what they would lend to a combined RBS–ABN AMRO entity. Additionally ABN AMRO had a large trading portfolio, which almost doubled RBS’ own trading book, thereby doubling the risk if assets were to become more volatile. The market already knew that RBS had aggressively expanded its securitisation business in mid-2006. All of these were issues the wholesale market would know about in lesser or greater details from being trading counterparties with, and lenders to, RBS and ABN AMRO. Importantly RBS did not need regulatory approval for the ABN AMRO takeover. The merger did not affect competition issues in the United Kingdom. Because other banks were also interested in ABN AMRO the acquisition was hostile and diligence was limited to public information, as had been the case for NatWest. But ABN AMRO was a much more complicated bank than NatWest had been, operating truly multinationally as opposed to mainly in the United Kingdom and with a significant trading

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portfolio of the same size as RBS. So in the same way as there was absent management in the takeover of NatWest so there was in that of ABN AMRO, caused by limited due diligence. This time this absent management would be a cause of RBS’ failure.

The British regulator did not have to approve the takeover but it did want RBS to have stronger capital and the bank was able to raise £12 billion by issuing new shares in April 2008. By this stage RBS had reported credit market losses of £9 billion for 2007 and the beginning of 2008. In August 2008 RBS reported its first quarterly loss for 40 years of £691 million.

Once Lehman Brothers failed the wholesale market lost confidence in RBS. The bank then required the Bank of England’s Emergency Liquidity Assistance to fund itself. On 13 October 2008, the government provided £20 billion of new capital, increased in the following year to a total of £46 billion with the Government now owning four fifths of RBS. The management of RBS had been absent in ignoring the risks of dependency on the trust by the wholesale market. When this trust was lost, RBS failed.

Different types of swimwear become apparent when the tide goes out.

Dry suits and wet suits, Victorian full body swimsuits, bikinis and speedos.

But naked is naked.

In addition to London and New York, Zurich is a major banking centre. Zurich had bred two global universal banking giants, as global and complicated as any United States or United Kingdom banks.

In the universal Swiss bank UBS, whose growth by merger and acquisition was detailed earlier, a key strategy was to operate as ‘One firm’. This strategy involved being able to refer clients across the offerings of the bank from corporate to investment banking to asset management and also exchanging products between these businesses (UBS 2008). No client should need to go anywhere else than UBS for any banking service, in any country. With the right management the universality of UBS should ensure that the growth strategy put in place for 2007–2011 would be successful.

One growth initiative was developing alternative asset management products for investors. Swiss Banking Corporation, one of the main predecessors of UBS, bought United States investment bank Dillon Read in 1997 for $600 million and merged it with its existing investment bank SBC Warburg. Within this operation the asset manager Dillon Read Capital Management was created in 2004, partly to allow asset management clients to invest in certain strategies developed by investment

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banking (UBS 2008). This was an example of the ‘One Firm’ approach that was central to UBS’ strategy.

To identify specific growth areas where the investment bank was behind its competitors, an external consultant produced a report. This suggested that UBS lagged behind its major peers in a number of areas including mortgage-backed securities for subprime. The strategy recommendation from the investment bank to the group management was to build a new securitised products group for origination and trading for UBS own account (UBS 2008).

Dillon Read Capital Management had more than one trading strategy for UBS’ own capital and its assets management clients. It traded in and out of mortgage-backed securities, bonds and derivatives, going long and short, buying and selling credit default swaps, providing warehousing for clients’ collateralised debt obligations and investing in AAA-rated tranches of collateralised debt obligations. When the subprime market deteriorated, Dillon Read Capital Management was responsible for close to one-fifth of UBS total subprime losses or $6 billion in 2007.

In addition to asset management, the UBS investment bank was also involved in several other activities with subprime exposure that accounted for around two thirds of UBS subprime losses or $25 billion. Of the various activities, the single largest loss came from investment in the highest rated tranches of collateralised debt obligations, as had been the case at Merrill Lynch. These tranches were the part of the packaged mortgages that were considered the most remote from losses on default of the underlying mortgages, because they would be the last tranches to be affected by mortgage defaults. For this reason these tranches were known as super senior and generally given the highest credit rating of AAA by the credit rating agencies. UBS retained these tranches for two reasons. Firstly they were seen as attractive given the higher investment yield compared to other AAA investments. Secondly retaining AAA tranches assisted the bank’s underwriting of collateralised debt obligations. Traditional buyers of these tranches were reducing their involvement due to the large amounts they had already bought as part of the explosive growth of the issuing of collateralised debt obligations. Losses on these positions amounted to half of UBS subprime losses or about $19 billion. There was a lag of one to four months between accumulating the mortgages, packaging them into mortgage-backed securities and selling the tranches to investors. During this time the mortgages were warehoused by UBS on its balance sheet.

When the accumulated securities could not be sold in 2007, this cost UBS about $6 billion (UBS 2008).

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To complete the picture UBS’ treasury function was also exposed to United States subprime mortgages. The treasury function of a bank is responsible for financing and liquidity of the bank as well as investing the bank’s own capital. In addition to its trading investments in AAA-rated government and corporate bonds, the UBS treasury function invested in AAA-rated collateralised debt obligations tranches and incurred a loss of close to $4 billion (UBS 2008).

UBS losses from subprime amounted to $38 billion. This was the largest loss from subprime from any bank outside the United States. Total losses from the crisis amounted to $53 billion. A loss of this size was partly due to absent management. While there was an active management effort to grow this highly diversified, universal and very complex bank, there was no management of the accumulated exposures. By July 2007 the top management did not have a reliable assessment of its subprime exposure nor did the investment bank, the part of the bank with the largest exposure.

Given that another bank, HSBC, had made a profit warning and an $11 billion provision for subprime five months earlier, this was not poor management but absent management in UBS. The absent management of a loss this size came from the combined complexity and growth of this universal bank (UBS 2008).

There were many underlying reasons for the failure of UBS, underneath the absent management of the complexities of the large and complex, universal bank. Inadequate risk management, reporting and challenge of and by management at senior levels are all listed as reasons for failure in the UBS Shareholders Report of April 2008. One specific example of absent management that UBS had in common with many other banks including Merrill Lynch was that it did not itself consider the creditworthiness of the rating of super senior AAA-rated tranches of collateralised debt obligations. It was convenient and supportive of the growth strategy of the bank not to challenge the ratings of the credit rating agencies.

Neither was there management of the risk that these instruments could become completely illiquid and impossible to sell if every buyer already had enough. The super senior AAA tranches did not have to incur losses to cause losses to their owners. It would be enough if their value was affected by a lack of liquidity or by downgrades of their credit ratings.

When UBS reported its first quarter results for 2008, it also announced a CHF15 billion rights issue and that the chairman of the board would not seek re-election. When markets continued to deteriorate, including due to the failure of Lehman Brothers in September 2008, Swiss government

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support followed in the form of a $38 billion loan to rescue UBS from bankruptcy. In October 2008 the Swiss Government created a Stabilisation Fund, a so-called bad bank, that took over large amounts of deteriorated assets that could otherwise have caused UBS to fail (SWI 2013).

One important effect of UBS’ problems from being a universal bank was concerns amongst its asset management clients. In the third quarter of 2008 it saw $75 billion of assets withdrawn from its wealth and asset management businesses (Gow 2008). Rather than the asset management business providing diversification to this complex, universal bank, losses in several parts of the ‘One Firm’ caused damage to other parts of the firm due to a loss of the single most important asset of any bank, the trust of its clients.

The other Swiss Universal bank Credit Suisse saw the subprime crisis coming early. It reduced its exposure to subprime as early as the last quarter of 2006, acting on information from its mortgage servicing company on subprime mortgages regarding increasing arrear of payments (Finma 2009). This active management enabled Credit Suisse to have a comparably less damaging crisis than many other large banks. It entered the crisis with a subprime exposure of CHF6 billion by the end of 2007, further reduced to below CHF2 billion by the end of 2008. Its total subprime loss was CHF9 billion. A part of the loss related to collateralised debt obligation assets. The Swiss regulator insisted that Credit Suisse raise capital, and in October 2008, the bank raised CHF10 billion from large Qatari, Saudi Arabian and Israeli investors (Rose and Sesia 2010). No government support was received, Credit Suisse did not fail and after a loss of CHF8 billion in 2008 was profitable in 2009.

However, the subprime crisis was to come back to haunt Credit Suisse.

While it did manage the crisis better than many other large banks, two later developments indicated absent management. The first was the only jail sentence of a high-level banker for fraud during the subprime crisis, when a Credit Suisse employee was sentenced to two and a half year in prison in April 2013. This trader had deliberately overvalued collateralised debt obligations positions to hide a $100 million loss in 2007, contributing to the $3 billion loss for collateralised debt obligations positions. This was done, according to his own admission, to enhance his position in the bank, and possibly also to receive a large bonus. He returned $25 million of received remuneration to Credit Suisse. Credit Suisse had reported the suspected fraud immediately upon discovery and no corporate charge of the bank was made. While Credit Suisse recovered past remuneration, the

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judge did not sentence the trader to pay any restitution to Credit Suisse because of the “terrible climate” created by the bank (Matthews 2013).

Secondly, Credit Suisse agreed to pay the United States Department of Justice a fine of $5 billion for alleged miss-selling of mortgage-backed securities, made up of half in a civil penalty and half in consumer relief.

Other banks agreed similar fines, including Deutsche Bank and Citi with $7 billion each (Rodionova 2010).

Many other banks in at least 24 countries suffered severe losses and failures due to the financial crisis of 2008. Iceland and Ireland in particular suffered worse than most due to the catastrophic failures of their banks.

There is little doubt that absent management could be detected in many of the bank failures outside those considered in this book.

However the 2008 financial crisis was not the only recent event at least partly caused by an absent management and in turn exposing numerous examples of absent management in banks. Other examples not related to the recent crisis deserve a mention and in particular the absent management around the setting of interbank lending rates.

Official lending or interest rates are set by central banks. The United States Federal Reserve, the European Central Bank and the Bank of England periodically set official lending or base interest rates. The interest rates at which large banks borrow from each other each day are reflected in the London Inter-Bank Offered Rate or LIBOR. In turn, LIBOR can be used as the reference interest rate for what banks charge their customers for loans in many different forms, including mortgages, credit cards, student loans, other consumer loans and so on. When used as such a reference, LIBOR affects not just banks dealing with each other, but also millions of people and many trillions of dollars, pounds, euros and so on of loans, derivatives, futures and hedging contracts (Rose and Sesia 2014).

From 1986, the British Bankers Association, an association of 200 banks, became responsible for managing LIBOR. By 2012 this developed into a 150 multicurrency and maturity benchmark system, involving 10 currencies and 15 maturities (Rose and Sesia 2014).

LIBOR was constructed each day by a selection of banks electronically submitting the rates they estimated to be borrowing at between 11.00 and 11.10 United Kingdom Time. Of the 15 banks submitting rates, the four highest and four lowest were ignored, and the average of the remaining seven rates became the LIBOR rate for that currency and maturity, say Pound Sterling for three months. The rates, and all the submissions, were then made public at 12.00 United Kingdom time. There were different

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panels of banks for different currencies and maturities. A similar process existed for the Euro Inter-Bank Offer Rate or EURIBOR overseen by the European Banking Federation. Here between 40 and 50 banks made submissions with the top and bottom 15 per cent being excluded (Rose and Sesia 2014).

Submitting a very high or low rate does not affect the outcome, because these will be ignored in calculating LIBOR. But if a bank submits an artificially slightly higher or lower rate, which remains amongst the seven that make up LIBOR that day, this affects the final result. Once the final LIBOR is used to calculate payment on that day, the bank and specifically the trader involved in a contract with payment on that day can benefit from a higher or lower rate.

As an example, if a bank has a $4 billion contract coming up for payment on a given day, submitting an interest rate of 4.815 per cent rather than 4.820 per cent might affect the average of the eight submissions by 0.000625 per cent. The actual effect would depend on the other seven submissions. This manipulation may not seem worthwhile but on $4 billion it enough to reduce the payment by $25,000. If the settlements are big enough so is the material difference. In one case a bank had settlements of $80 billion. In that case the possible gain would be $500,000.

Should there be collusions with other bank or banks, so that other submissions are also marginally lower, then this further affects the average and the possible gain.

The person in the bank submitting the rate will not be the same person involved in trading with a reference to LIBOR. It will be necessary for the trader to make an internal request to the person submitting the daily rate for a slightly lower or higher rate on any given date.

In addition to seeking a lower or higher settlement, a second incentive for a bank submitting an incorrect rate is to appear strong. The cost at which one bank can borrow from another bank is an indication of the bank’s financial strength. Submitting lower rates indicates that the bank is stronger than it actually is. This can be helpful in a situation where the bank is suspected of having problems, individually or in a broader banking crisis such as in the 2008 financial crisis. As all the submissions to calculate LIBOR are made public, it is possible to analyse which banks are submitting higher or lower.

Barclays plc was the sixth largest bank in Europe based on total assets and one of the largest banks in the world. It was founded 300 years earlier and had been primarily a retail and commercial bank. It later established

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an investment bank, BarCap, and became a universal bank by 2011 with activities also including credit cards and asset management. One-third of Barclay’s revenues came from BarCap, where trading made up half the revenues and was focused on debt trading and underwriting. Barclays had purchased parts of what remained of the failed Lehman Brothers’ United States business in 2008, adding equity trading and underwriting as well as mergers and acquisitions advice. The value of the Barclay’s brand had been ranked a top ten banking brand in the world (Rose and Sesia 2014).

In June 2012 Barclays admitted that it repeatedly attempted to manipulate LIBOR between 2005 and 2009 (Melvin and Shotts 2013). When Barclays settled with regulators in the United Kingdom and the United States, Barclays admitted two wrongs. Firstly, rate manipulation; between 2005 and 2009, Barclays had submitted incorrect LIBOR rates to generate profits or reduce losses for its derivative trading desk, and for the benefit of traders at other banks. Secondly low-balling LIBOR; between 2007 and 2009, Barclays had submitted LIBOR rates that were lower than they should have been to try to avoid the perception that the bank was financially weaker than its competitors. Barclays was the first bank to acknowledge wrongdoing and to settle with the authorities (Melvin and Shotts 2013). As part of the settlement Barclays agreed to pay $453 million in fines and penalties to bank regulators in the United Kingdom and the United States. The $93 million fine to the United Kingdom regulator had been reduced by a third because of Barclays’ cooperation with the regulator and early settlement. The largest LIBOR fine of any bank was the $2.5 billion paid by Deutsche Bank, with the United Kingdom regulator fining a dozen other banks (The Independent 2016).

During the investigations extensive evidence came to light of communication between traders and those submitting interest rates in the LIBOR system. These were requests for lower or higher submissions to serve the bank’s purposes rather than reflecting the interest rates the bank was able to borrow at. Between 2005 and 2007 regulators identified at least 173 instances within Barclays where traders requested those colleagues submitting daily rates to manipulate the United States dollar LIBOR. In some 120 of these instances, the submitted LIBOR rates were consistent with the traders’ requests (Rose and Sesia 2014). The requests were made on standard internal communication systems, such as email or messaging, which were known to be recorded. There were also records of traders trying to influence the submission of other banks.

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Given the immense complexity of Barclays it is by no means certain that the bank benefitted from each manipulation of LIBOR. Requests from traders were most probably made when they had a particularly large settlement on a given day where a lower or higher LIBOR rate would benefit this particular trader. However Barclays may well have had other positions that were negatively affected by the specific manipulation. Barclays would almost certainly have clients who were negatively affected, and those in Barclay responsible for these clients would have been against a specific manipulation, had they known about it. So not only was the LIBOR submission absent of any management, so were the individual trader’s requests for manipulation.

Separately, and unrelated to trading, it became public in September 2007 that Barclays had submitted comparatively higher rates than other banks. This raised questions about Barclays’ having to pay more to borrow than competitors. There are records of senior managers instructing subordinates to submit no higher than one-tenth of a percentage higher than competitors. Using the figures from the above example, this would mean not submitting a higher rate than 4.920 per cent if the average was 4.820 per cent.

Suggestions were made that misrepresentations under the LIBOR arrangement had taken place as early as 1991 (Melvin and Shotts 2013).

This would indicate that the behaviour had become path dependent. The openness with which traders asked for submissions to be higher or lower, using recorded communication system, supports the possibility that this had been going on for several years and had become common practice and even path dependent.

The BarCap compliance function was notified about LIBOR issues three times in 2007 to 2008 but did not take effective action. Not having the appropriate or effective systems of control, as was admitted by the top Barclays management (Melvin and Shotts 2013), is a specific example of absent management.

Between November 2007 and October 2008, Barclay employees notified the British Bankers Association, central banks and regulators that the LIBOR submissions for United States dollar were artificially low. Some commented that all the banks, not just Barclays, were submitting low rates. The New York Federal Reserve, one of the most important central banks in the United States, issued a report raising questions about the LIBOR setting process. The New York Federal Reserve contacted the Bank of England with recommendations for improvements to the process,

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which the Bank of England in turn made to the British Bankers Association.

After a review, the British Bankers Association decided to retain the existing process (Rose and Sesia 2014). However in 2017 the United Kingdom regulator the Financial Conduct Authority communicated the intention to transition away from LIBOR to alternative reference rates by the end of 2021, with the expectation that this will be a development to be led by the financial markets and its various associations. The Euro benchmark currently used to price €24 trillion of derivatives, loans and bonds is planned to be replaced with the new €STR benchmark based on submissions from 50 banks by the beginning of 2022. The introduction has already been delayed by two years.

It would be possible to consider many other banks for possible absent management both before, during and after the 2008 financial crisis. The Icelandic and Irish banks are examples of banks that experienced such great losses that they are more likely to have had no management at all than management so bad as to have caused such horrendous losses to themselves, their shareholders and their countries. The Payment Protection Insurance miss-selling scandal in the United Kingdom, which has so far involved payment of over £34 billion in compensation to customers, may also show absent management by banks if it was considered from this angle.

It has been traditional to view banks incurring large fines as evidence of either very badly managed or deliberately manipulative banking practice.

Once a fine is imposed, the evidence for poor management is often easy to accept. Proving deliberate manipulation by the top leadership has been much more difficult. The ability of top management of fined banks to remain in their jobs or walk away unpunished, and sometimes with their stock options and even recent bonuses, has contributed to the criticism of banks and even the whole financial and capital system.

The argument here is not bad management, it is no management. The cost to the bank of its actions are so detrimental that to manage so badly would be irrational. Neither is the argument that the bank management was so arrogant that it thought it could get away with its management.

Bankers have certainly displayed ample evidence of arrogance, but again the detrimental effects are so great that arrogance itself is an unlikely explanation. Deliberate manipulation, and its potential legal implications, is best left to the courts. Regulators may have been satisfied that a combination of large fines and limited damage to the banking system was preferable to a successful criminal sentencing.

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The argument that seems more persuasive is that a large fine is a strong indication of absent management. When banks had become complex, were managed by producer managers more focused on production than management and were path dependent because this is how we have always done it, there is no management. The LIBOR scandal in Barclays and other banks is a very large and recent example of absent management. The chief executive officer of BarCap from 1997 to 2009 and later chief executive officer of Barclays from 2009 to 2012 was quoted as saying that culture was how people behave when no one is watching. With regard to LIBOR in Barclays that may have meant that when no one was watching, bankers were producing but not managing. That is a culture of absent management in banking.

References Dewar, Robert. 2010. Washington Mutual (B): From Forty-Six to Sixteen. Kellogg School of Management, Northwestern University, Illinois.

Dewar, Robert, and Hayagreeva, Rao. 2010. Washington Mutual (A): A Very Old Bank Can Grow—A Lot! Kellogg School of Management, Northwestern University, Illinois.

Dunkley, Emma, and Patrick Jenkins. 2017. How Lloyds Bank Came Back from the Brink. Financial Times, 18 May 2017. https://www.ft.com/ content/34e57e76-3a87-11e7-821a-6027b8a20f23 Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA). 2015. The Failure of HBOS plc (HBOS).

Financial Services Authority. 2012. Board Report – The Failure of the Royal Bank of Scotland. London.

Finma. 2009. Financial Market Crisis and Financial Market Supervision Report. Bern.

Gow, David. 2008. Switzerland unveils bank bail-out plan. https://www.theguardian.com/business/2008/oct/16/ubs-creditsuisse. The Guardian, 30 October 2008.

Greenwood, Robin, and James Quinn. 2015. Citigroup’s Exchange Offer. Boston: Harvard Business School.

Harris, Randall D. 2014. Goldman Sachs and the Big Short: Time to Go Long?

Case Research Journal 34(2, Spring). Texas A&M - Corpus Christi, Texas.

Matthews, Christoffer. 2013. Former Credit Suisse Investment Banker Sentenced in Financial Crisis Case. https://www.wsj.com/articles/former-credit-suisseinvestment-banker-sentenced-to-2189-years-in-prison-1385151965. The Wall Street Journal, 22 November 2013.

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Meagher, Evan, Rebecca Frezzano, and David Stowell. 2008. Investment Banking in 2008 (B): A Brave New World. Kellogg School of Management, Northwestern University, Illinois.

Melvin, Sheila, and Ken Shotts. 2013. Barclays and the LIBOR: Anatomy of a Scandal. Stanford Graduate School of Business: Stanford.

Nakamoto, Michiyo, and David Wighton. 2007. Citigroup Chief Stays Bullish on Buy-outs. Financial Times, 9 July 2007.

Parliamentary Commission on Banking Standards. 2015. An Accident Waiting to Happen: The Failure of HBOS. London.

Pozen, Robert C., and Charles E. Beresford. 2010. Bank of America Acquires Merrill Lynch (A). Boston: Harvard Business School.

Rodionova, Zlata. 2010. Deutsche Bank and Credit Suisse to Pay $12.5bn in US Fines Over Role in 2008 Financial Crisis.

Rose, Clayton S., and Aldo Sesia. 2010. Post Crisis Compensation at Credit Suisse (A). Boston: Harvard Business School.

Rose, Clayton S., and Aldo Sesia. 2014. Barclays and the LIBOR Scandal. Boston: Harvard Business School.

Rose, Clayton, and Aldington Sesia. 2011. What Happened at Citigroup (B)?

Boston: Harvard Business School.

SWI. 2013. Buy Buy Bad Bank. www.swissinfo.ch/eng/business/bye-bye-badbank_swiss-bank-bailout-turned-poison-into-profit/37218080 (2013).

The Independent. 2016. Deutsche Bank, Credit Suisse, Barclays Pay US Fine. The Independent, December 23. https://www.independent.co.uk/news/business/news/deutsche-bank-credit-suisse-barclays-banks-pay-us-fine-2008-financial-crisis-housing-market-a7491901.html.

UBS. 2008. Shareholder Report on UBS’s Write-Downs. Zurich.

Wikipedia. 2010. List of Write Downs Due to Subprime Crisis.

CHAPTER 12

The Cost of Financial Crisis: How Absent Management in Banking Became Costly

Absent management need not be costly. Sometimes an organisation, even a bank, carries on without management but does not fail. In rare cases, it is even successful, such as when RBS made a hostile bid for NatWest and took it over without more due diligence than the publicly available information.

Absent management in banking becomes costly when it is the cause of a bank failing. When a bank fails this absence causes costs to customers, owners, employees and suppliers. If the bank needs support from government this support has an associated cost that is ultimately borne by the taxpayer.

When absent management causes a bank to fail, that in turn causes or worsens a financial crisis, this absence can become enormously costly.

Before considering the cost of a financial crisis, the cost of the failure of a single bank can be serious enough. The customers, private and corporate, can lose their deposits in the bank. In many, particularly developed, countries private deposits are protected by the government up to a certain level. In the United Kingdom private depositors are protected by the Financial Services Compensation Scheme up to £85,000. Before the banking crisis in 2007 this protection was only £31,700 per person. Where the government is unable to recover compensation made to depositors the banking industry is responsible for making up the difference. The British banks had to fund a shortfall of over £500 million that the Financial Services Compensation Scheme was unable to recover from three failed Icelandic banks operating in the United Kingdom in 2008. In the United © The Author(s) 2020 C. Dinesen, Absent Management in Banking, https://doi.org/10.1007/978-3-030-35824-2_12

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States the Federal Deposit Insurance Corporation now insures all deposit accounts up to $250,000 per depositor, per insured bank. When established after the Great Depression in 1934 it was $2500. In between the Depository Institutions Deregulatory and Monetary Control Act of 1980 increased the insured amount from $40,000 to $100,000 (FDIC 2019).

Depositors withdrew over £12 billion from Northern Rock in the second half of 2007, estimated at two-fifths of the bank’s total deposits (Arnold 2017). To stem the run on Northern Rock, the British government guaranteed all private deposits in this institution on 17 September 2007. This guarantee was subsequently withdrawn and aligned with the protected £85,000 limit for all banks on 24 May 2010.

In addition to the loss of deposits a failed bank also ceases to provide services of which one of the most important is lending. Private and corporate customers depend on banks to be able to finance purchases beyond their accumulated savings or corporate capital. When a single bank fails, customers are often able to borrow from another bank, so the loss may be more of a temporary inconvenience than a long-term problem. However if more than one bank fails the lack of available and affordable finance can become problematic. Private customers will be less able to make larger purchase, such as cars and houses, affecting their lives and possibly causing the prices of exiting assets, particularly property, to fall.

Businesses can become less able to expand or just refinance their existing borrowings leading to lower earnings, possible reduction in staff and even failure. A reduction in bank lending can be particularly problematic for small- to medium-sized companies and organisations. This is because they lack the size and name recognition to seek alternative finance such as from debt and equity capital markets. In the second quarter of 2008, industrial and commercial lending in the United States peaked at $1700 billion falling by a quarter to below $1300 billion in the third quarter of 2010. Lending took a long time to recover and did not exceed $1500 billion until the beginning of 2013 (U.S. Department of the Treasury 2013).

Bank employees will often lose their employment when a bank fails.

The vast majority of them would not have been managers but been as diligent and hard working as in other industries and organisations. They would have played no role in the possible absent management that may have been the cause of the failure of the bank. In the 2008 financial crisis, the hostility felt towards senior bankers in failed banks, all of whom should have been managing the banks, also affected other bank employees.

Because banks were seen as instrumental in the crisis, these former employ-

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ees may have found less sympathy for the loss of their employment amongst the rest of society than was the case when non-banks failed and laid off their employees. In a buoyant economy, many employees of a failed bank should be able to find other employment. In the case of single bank failure, the failed bank is often taken over by another bank, such as was the case when Barings was taken over by ING in 1995. In such a case, only few employees may lose their jobs. In a situation where more than one bank fails, and particularly if the economy is negatively affected by numerous bank failures, finding new employment can be extremely difficult.

Banks use a wide range of suppliers, from paper to information technology to professional services, such as for example auditors. A bank failure means reduced income for the bank’s suppliers. More than one bank failure can be serious, particularly for suppliers heavily dependent on not just one bank but also on the banking sector.

Bank owners often lose everything when a bank fails. ING paid £1 for Barings, a bank that had once been the second largest in London. The Baring family was the majority owner at the time of the bank’s failure and lost their investment. For banks listed on the stock exchange, a failed bank causes loss to shareholders. This loss will range from what the shares can be sold at to a possible acquirer to a total loss if the shares have no value.

While Lehman Brothers’ shares were worth nothing on 17 September 2008, Merrill Lynch was sold to Bank of America for $29 per share. Had Bank of America decided to buy Lehman Brothers instead of Merrill Lynch, the loss to the respective shareholders would have been different, if not perhaps completely opposite, depending on what Bank of America might have paid for Lehman Brothers. AIG’s shares were widely held by pensioners who lost part of their pensions when AIG’s market capitalisation of $140 billion in 2007 fell to almost nil.

Some customers are also owners of their banks. When mutual or savings banks demutualise, the issued shares are generally distributed to depositors and other customers. This was the case with Northern Rock, which demutualised in 1997. More than 100,000 smaller shareholders lost their investment when the bank was nationalised in 2008. An action group is still pursuing the British government for compensation.

In other cases banks encouraged their customers to invest in the bank’s shares only for the customers to lose their investment when the bank failed. From 2000 onwards the Danish Roskilde Bank raised DKR370 million in equity capital from its customers with the majority of these investments being financed by loans from the bank. This amounted to

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margin lending as seen prior to the Great Depression. When the bank failed in 2008 the customer investors lost their investments with the total loss to all shareholders being DKR7 billion. The management was found not to be personally liable for the losses in a compensation trial. The judge said that the court had found that the bank had in some instances been managed irresponsible. Irresponsible management is not really management at all, particularly for a bank, and is close to absent management.

And shareholders lost their investment.

A particular unfortunate group are those employees who lost both their job and the value of their shares. Northern Rock employees were often also customers, so received shares upon demutualisation and lost both their employment and the value of these shares. Only months before the government had to take over RBS in 2008, employees were still being offered shares at £2.20 per share in a £12 billion capital raising exercise.

Ten years later, a compensation of £0.82 per share was offered.

The deposits of corporate customers are generally not protected by the government. This means that any organisation, including for example charities and local councils, need to weigh up the risk of bank failure when placing their deposits. Kent Council in the United Kingdom was one of 125 local councils with deposits with one of three Icelandic banks with operations in the United Kingdom. Kent Council fully recovered its deposits of £50 m plus interest after ten years, but many other councils did not. For these councils, the result was either a need to cut expenditure or to increase council tax where allowed by central government.

The biggest debtors of a bank are often other banks. Some banks, for example investment banks, often deposit surplus cash with other banks.

Much more important is that banks lend to each other. This creates a dependency of one bank on other banks. In the case of Bear Sterns and Lehman Brothers, the dependency on very short-term, often overnight, financing with other banks was so high that the refusal of other banks to continue the financing triggered these two investment banks’ failures.

When a bank fails, other banks may not be able to recover their outstanding lending. In the case of Northern Rock, around one-quarter of all its financing was loans from other banks, with deposits making up another quarter and securitisation in the form of mortgage-backed securities being by far the largest at half the bank’s total financing.

One way a bank failing can cause a wider crisis is when a run on a single bank causes runs on additional banks. This happens when the lack of ­confidence by its customers in one bank leads to a loss of confidence in

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other banks by their customers. Some banks have been able to stop bank runs by returning deposits to customers until the confidence returns. This was Washington Mutual’s approach in the Great Depression. This approach requires that the bank has enough liquid assets to pay out deposits until confidence returns. If the bank has lent out or invested too much, it may run out of liquid assets before confidence can be restored.

Alternatively the government can step in and support the banks such as by guaranteeing deposits. This requires that the government is trusted to be able to support the guarantees in what can become very substantial amounts.

One of the ways a single bank failure can cause a wider banking crisis, and become a lot more costly, is when the run on one bank causes runs on other banks. The British government action on guaranteeing the private retail deposits of Northern Rock was critical to avoid the first run on a British bank in 140 years spreading to runs on other banks. Northern Rock was mostly considered a unique case, including by parts of the media.

The guaranteeing of deposits of this one institution by the government avoided the crises spreading by runs on other banks. The customers of other British banks had enough confidence that Northern Rock was unique. In case it was not, customers probably believed that their deposits in other banks would also be guaranteed by the government.

So it is not difficult to see how the failure of one, possibly unmanaged, bank can cause problems and failures of other banks. This can happen through a widening loss of confidence or because a failing bank can cause losses to other banks due to being unable to repay loans or to financing them.

Another cause of wider financial crisis by bank failure is the disruption of debt markets in which banks finance themselves. The disruption of the new highly complex part of the debt market made up of mortgage-backed securities, credit default swaps, collateralised debt obligation and so on was possibly the single most important reason for the 2008 bank crisis spreading so quickly and so widely.

The German bank IKB was one of the first banks outside the United States to incur losses from its investments in these complex debt instruments. The disruption of the mortgage-backed securities market, following the problems at the IKB and BNP Paribas in 2007, was the single most important trigger for Northern Rock to need rescuing. This was because Northern Rock had developed a dependency on this complex debt market amounting to half its financing.

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It is not just banks that swim naked, governments do so as well. When debt markets are severely disrupted, this makes it more expensive, even difficult for governments to refinance themselves. Sometimes the link is direct between the debt issued by banks and those of the government of the country of the banks. One of the earliest analysis that identified problems banks might have to refinance themselves prior to the 2008 financial crisis was the case of Icelandic banks in March 2006. This analysis identified potential problems the three largest banks might have to refinance debt that in total was larger than the gross domestic product of Iceland during 2007 (Thomas 2006). The banks eventually did refinance themselves during 2007, but after the collapse of Lehman Brothers in September 2008 and the severe disruption of debt markets, all three large banks were taken over by the Icelandic government in October 2008. On 24 October, Iceland then requested a rescue package from the International Monetary Fund to stem the banking crisis that had become a currency crisis. The currency had collapsed from around Icelandic Krona100 to the Euro to more than Krona300 during the month of October.

Whether and how a banking crisis becomes a wider financial crisis, a currency crisis, a sovereign crisis and finally causes an economic recession or depression are complicated. There are times when factors outside banking cause economic conditions that are detrimental to banks and may cause some banks to fail. The plague in Europe in the fourteenth century that caused the failure of the predecessors banks of the Medici, the European structural imbalance of money flows in the fifteenth century that made the Medici’s business so complicated, wars and revolutions that created problems for the Rothschilds in the nineteenth century and the two Oil Crises of the 1970s that caused recessions across the globe, were all examples of economic crises not caused by banks.

But many are.

Each bank has management. Management has choices. That is why not all banks fail due to circumstances outside the control of the management of banks. The management of some banks chooses and implements a strategy that avoids failure when external pressure is applied. There are exceptions where all banks do fail. The circumstances can be so overwhelming that no bank can survive. This was probably the case in plague-ridden Europe in the fourteenth century. In the Great Depression, it is often emphasised that thousands of banks failed and rarely noted that the majority of banks did not fail. Those that did not fail must have taken or avoided action that contributed to their survival. Those that did fail must have

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taken, or avoided, action that contributed to their failure. Some of them were not managed and were so absorbed by growth, by lending more, that their absent management contributed to their failure.

But it is complicated to which extent bank crises cause wider and more costly crisis. Fortunately, most banking crises do not cause either a currency crisis or a sovereign debt crisis. Of 146 banking crisis since 1970, a fifth was followed by a currency crisis within three years. A currency crisis is where a country’s currency depreciates by at least one third against the United States dollar and by a tenth more than it depreciated the previous year (Laeven and Valencia 2012). This is not meant to imply that these 34 bank crises all caused a currency crisis. Other economic factors would have contributed.

Nineteen bank crises were followed by a sovereign debt crisis (Laeven and Valencia 2012). A sovereign debt crisis is where there is either a default of the sovereign debt, or a restructuring of the debt causing loss to investors. Again other economic factors than the bank crisis could have contributed, for example the disruption of debt markets, which could affect the ability of sovereigns to refinance and issue additional debt.

The individual complexity of each banking crisis and the additional complexity of whether it caused a currency or sovereign debt crisis are beyond the scope of this book. Perhaps a future book will be titled “Absent Containment of Banking Crises”. Instead, the rest of this chapter will explain some of the costs of the most recent banking crisis that did become the 2008 financial crisis, both currency and sovereign crises, and is now referred to as the Great Recession.

The 2008 financial crisis, still felt in some countries, affected at least 25 countries (Laeven and Valencia 2012). This book has primarily focused on the Anglo and American banks but also considered French, German and Swiss Banks and mentioned banks from other countries.

Governments have a very complex decision to make when a bank fails.

The government can allow a bank to fail or it can decide to support the bank. The United States government decided to support Bear Stearns by providing $29 billion of guarantees to J.P.Morgan that took over Bear Stearns. It rescued Fannie Mae and Freddie Mac as well as AIG. The government did not support Lehman Brothers, which then failed.

Second guessing the United States government action after the event is not the purpose here. Considering the cost of absent management in banking is. When government supports failing banks, there are three important ways for a government to pay for this, being increased ­borrowing

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and taxation and reduced expenditure. It may be necessary for the government to do all three.

Rescuing banks is expensive. About 11,000 banks failed in the Great Depression between 1929 and 1933. One billion dollar of public money was injected into the 6000 of the remaining 14,000 banks that had not failed. One billion dollar was equivalent to about a third of the equity capital on the total United States banking system. Importantly 8000 banks not only did not fail but also did not receive public money. Not all banks fail in a crisis. Those 11,000 banks that did fail and those 6000 that did require public money probably had a higher rate of absent management than the 8000 that neither failed nor received public money. But absent management is not easy to identify based on statistics.

The United States Troubled Asset Relief Program (TARP) had injected an astonishing $238 billion into banks by March 2009. Four years later, an even more remarkable 99 per cent of this had been paid back to the government with only $3 billion outstanding (U.S. Department of the Treasury 2013). One estimate of the truly astonishing cost of the Great Recession in the United States is an estimated $13 trillion in extraordinary government assistance allocated to struggling businesses and households. Had the country averted the financial crisis, these funds, belonging to the United States taxpayer or raised in debt on their behalf, would not have been deployed or been at risk of deployment. Without a financial crisis debt levels might still have risen, but much less. With no financial crisis these funds could have been deployed to improve society, for example in education or infrastructure (Atkinson et al. 2013). One of the costs of a banking crisis is the lost opportunity of not investing elsewhere in society. This lost opportunity cost will always be difficult to estimate. That does not mean that it was not very large and the impact of its absence not profound for society.

The government of the United Kingdom reduced overall government spending by around 5 per cent and increased taxation by around 1 per cent of national income. It still saw borrowing increase by 7 per cent by 2014. This policy of austerity intensified with a change of government in 2010 and spending on public services in the United Kingdom was over 9 per cent lower in 2014–2015 than it had been in 2010–2011 (Bozio et al. 2015). Only in 2018, 11 years after the nationalisation of Northern Rock, did the government propose to bring austerity to an end.

The Irish government reduction in expenditure was three times as severe as that of the United Kingdom. Ireland had experienced one of the worst banking crises of any country in 2008 and in history. Irish govern-

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ment expenditure was cut by over one-tenth, taxation increased by over one-twentieth and borrowing increased by close to a quarter. In sharp contrast, Germany did not reduce expenditure, did not increase taxation and only marginally increased borrowing. Germany had a very strong economy and comparatively low importance of banking sector relative to other services and industry. This meant that the rest of the economy could provide substantial support to banks with relatively limited impact on government borrowing, taxation or expenditure.

Within the European Union, member states are not allowed to support private corporations such as banks without authorisation from the European Commission. This is to avoid governments providing their own corporations with an unfair competitive advantage. Between September 2008 and December 2010, the Commission authorised support for 215 financial institutions. The overall authorised amount was a staggering €4.3 trillion equivalent to one-third of the total production or gross domestic product of the European Union. The amount actually used to support financial institutions was about one-third, which is still an enormous amount of €1.2 trillion, equivalent to one-tenth of the European Union gross domestic product. Again more than half of this amount was in the form of guarantees granted that were not necessarily paid out. So actual amounts within the European Union from 2008 to 2015 were over €466 billion for recapitalisations of financial institutions and €187 billion to buy impaired assets (Millaruelo and del Río 2017).

Banks are very important for all societies and the more so the more developed an economy is. Borrowing to finance investment has become one of the key drivers of economic growth, particularly since the Industrial Revolution from the second half of the eighteenth century. A reduction in lending by banks is likely to have a negative effect on economic growth. If banks fail and need rescuing, the cost of this rescue, from increased government borrowing, increased taxation and reduced government spending, is likely to affect economic growth negatively. The exact effects on economic growth of a banking crisis are extremely complex to estimate.

This is where economic history is helpful because it takes a view over a historical period rather than on one particular crisis. The median loss of output in 146 banking crises between 1970 and 2012 has been estimated at close to a quarter of the annual gross domestic product of the country suffering the crisis (Laeven and Valencia 2012). But the worst crises are far more costly than that as was the case of Ireland. Managing banks rather than not managing them, so that bank failures are less likely, seems a good

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idea against such a reduction in growth from the average banking crisis.

Given how much effort it takes to achieve any economic growth, even one or two percentage points, this is a strong indication, if not perhaps conclusive proof that banking crises are best avoided. And even if there are economic crises not caused by banks, bank crisis makes economic crisis worse.

Ireland probably experienced the most costly banking crisis in 2008 and onwards, estimated at a loss of more than its total gross domestic product in one year. This is equivalent to the country producing nothing in a whole year. Ireland’s direct support of its financial system was an amount equal to almost half its gross domestic product. Ireland’s sovereign debt increased by an amount equal to nearly three-quarters of its gross domestic product. This may have made Ireland the costliest banking crisis since the Great Depression relative to the size of the country’s economy. In Ireland the Anglo Irish Bank was fully nationalised at a cost of €23 billion in January 2009, while the Irish Government took a stake of over one-third in Bank of Ireland at a cost of €3.5 billion and close to two-fifths in Allied Irish Bank for a similar amount. Iceland also spent amounts close to half its domestic product on supporting its financial system and experienced a similar increase in its debt of nearly three-quarters (Laeven and Valencia 2012). All the three Icelandic banks mentioned in that early analysis in March 2006 were nationalised by October 2008.

Governments also have to support banks with increased liquidity. This can be essential to enable banks to repay depositors. From 2008 banks in the United States and United Kingdom were supported by close to one-­ twentieth of total deposits. The support was much higher in the Eurozone amounting to over one-seventh of total deposits.

The longest monetary effect of a banking crisis may be the increased government debt. Unless the economy recovers quickly and strongly and there is a political mandate and will to reduce government borrowing, the increased government debt effectively shifts the cost of a banking crisis to the next generation. Government debt has been estimated to rise by over two-fifths in the three years following a bank crisis (Reinhart and Rogoff 2009). Some of this debt is reduced over time, but some remains. Overall the increase in government debt from banking crises between 1970 and 2012 has been estimated at above one-tenth.

In January 2008, the United States Congressional Budget Office forecast that the federal debt held by the public would be $6.7 trillion in 2012. The actual debt in that year was over $11 trillion or two thirds higher than estimated. Reasons included reduced government revenue

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because earnings and related taxation were lower, the cost of government support for banks and the economy as well as tax cuts to stimulate the economy. It is not possible to attribute a precise number to the cost of the 2008 financial crisis. But without it the United States government debt would probably have been several trillion dollars lower. This additional debt burden will be passed on to future generations (Atkinson et al. 2013).

The increase in sovereign debt in the United States was close to one-­third while the increase in the Euro area and in the United Kingdom was around one-quarter by 2012 (Laeven and Valencia 2012). From 2008 to 2015, overall government debt increased by two-fifths for the United Kingdom and one-third for Ireland, but less than one-tenth for Germany, having by far the largest European economy. Specifically related to financial sector interventions, the highest amounts were in Germany with €225 billion, the United Kingdom with €131 billion and Ireland with €58 billion. By 2015, the United Kingdom and Irish amounts had halved and Germany was reduced by two-fifths. Relative to gross domestic product the countries that saw the largest increase in government debt were Greece with over a quarter and Ireland just below one-quarter (Millaruelo and del Río 2017).

The United Kingdom increased taxation by around 1 per cent of national income. A new top income tax rate of 50 per cent was introduced on incomes over £150,000, later reduced to 45 per cent. The tax-free personal allowance was increased but removed for those with incomes above £100,000. The other major European countries, except Germany, all increased their main income tax rates by one or more percentage points, and Ireland did likewise. All the countries increased their sales tax rates with one or more percentage points with the United Kingdom increasing from 17.5 per cent to 20 per cent.

The United States took a different approach to taxation and implemented tax cuts of $188 billion to stimulate the economy, split about four-fifths to individuals and one-fifth to business (Blinder and Zandi 2010).

Whatever one’s political standpoint, an increase in taxation to pay for the support of the financial system is likely to result in reduced consumption and less economic growth. When taxation is increased due to a banking crisis it is also likely to cause resentment amongst a wide range of the population.

Another cause for resentment was the cost of reduced social expenditure. The United Kingdom reduced overall spending by around 5 per cent in addition to the increased taxation by around 1 per cent of national income. This is all in addition to the increased borrowing. Spending on

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public services in the United Kingdom was nearly one-tenth lower in 2014–2015 than it had been in 2010–2011 (Bozio et al. 2015). Of the larger European economies only the United Kingdom financed the largest proportion of the costs of the financial crises with spending costs. Both the United Kingdom and Ireland protected spending on health and education (Bozio et al. 2015).

The impact on households in the larger European countries was reasonably similar across the different income groups with the important exception of the United Kingdom. Here the lowest five out of ten income groups saw an estimated reduction in household income from 4 per cent for the lowest income group to 1 per cent for the fifth lowest. The sixth to ninth income groups saw little change while the top tenth income group saw a negative impact of some 7 per cent by 2014. So even if the highest income group saw the largest reduction, the 2008 financial crisis contributed to increased income inequality.

In Ireland, as one of the worst-hit economies, the impact was around onetenth for most income groups with only the lowest seeing a 13 per cent reduction and the highest a 16 per cent reduction (Bozio et al. 2015).

In the United Kingdom it has been estimated, by a leading charity, that the poorest tenth of the population was by far the hardest hit, when all austerity measures are taken into account including cuts to public services and changes to taxes and welfare. According to this estimate, this part of the population experienced close to two-fifth reduction in their net income over the period 2010–2015.41 By comparison, the richest tenth lost the least, comparatively, seeing an only a 5 per cent fall in their income (OXFAM 2013).

Using a different measure for the United States, household net worth fell by a quarter from the middle of 2007 to the beginning of 2009 or by $16 trillion (OXFAM 2013).

Economic growth in the United States was negative in four of the five quarters from the beginning of 2008 until the third quarter 2009. The worst contraction was close to one-tenth of real gross domestic product in third quarter of 2008. Real gross domestic product measures total spending in the economy, consumer spending, industry investment, exports less imports and government spending adjusted for inflation.

In the United Kingdom economic growth was negative from the second quarter of 2008 until the third quarter of 2009, with the worst c­ ontraction being the last quarter of 2008 where the economy shrank by close to 3 per cent. In Ireland the economy shrank by around 4 per cent in 2008 and 2009.

Germany only experienced one year of negative growth, 2009, when the

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economy contracted by over 5 per cent. This was more of a result of reduced global demand for German exports than a direct effect of the 2008 financial crisis in Germany. For the European Union growth was negative from third quarter of 2008 until second quarter of 2010, with the first half of 2009 being the worst with contraction of over one-twentieth.

The United States Department of the Treasury estimates that nine million jobs were lost due to the 2008 financial crisis known as the Great Recession. Job growth in the private sector only exceeded job losses by the second half of 2010. Unemployment had been below 5 per cent in 2007, peaking at 10 per cent in October 2009 and was still above 7 per cent in 2013. Those out of work for more than 27 weeks had been below 1 per cent in 2007 rising to above 4 per cent in 2009 and remaining above 3 per cent by 2013 (U.S. Department of the Treasury 2013).

Unemployment in the United Kingdom had been just above 5 per cent in 2007 before the crisis, rising to over 8 per cent until 2013 and only reducing to precrisis levels in 2015. Irish unemployment had also been around 5 per cent before the crisis, doubling to over 10 per cent from 2009 to 2015 and trebling to over 15 per cent in 2012 and 2013. Precrisis levels have only been achieved in 2018. Iceland’s historically low unemployment rate of below 3 per cent reached almost 8 per cent in 2010–2011 before returning to precrisis levels in 2017.

Stress is perhaps the worst cost of a banking crisis, immeasurable, and even worse for that. The emotional cost can be terrible for the individual and detrimental for society. There were undoubtedly suicides as a result of stress caused by the absent management of banks.

Stress is often related to what is outside one’s control. Losing one’s job for reasons completely outside one’s control is a very stressful experience.

Millions of people lost their employment because a few hundred did not do their job, which was to manage banks.

There are many additional sources of stress stemming from a financial crisis. The customers of Northern Rock lined up outside the branches to alleviate the stress related to the possible loss of their savings. This type of stress had not been seen in the United Kingdom for 140 years. Those with AIG shares in their pension fund saw their retirement income reduced, as did many investors and employees with Northern Rock, RBS and other bank shares as part of their savings.

Many businesses were lost, particularly small and medium sized, because they were unable to renew their borrowings as their bank had stopped lending.

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Some of those depending on state support saw this cut including in the United Kingdom due to the austerity regime introduced to pay for the 2008 financial crisis.

The recent financial crisis has had a high cost in the loss of trust in Western government institutions and the capitalist economic system. The loss of income and household wealth was ascribed by many to inadequate regulation by governments. The bail out of banks, using taxpayer’s money for the last ten years and into the future, to pay for increased debt was seen as unfair. The need to rescue the financial system was often not well explained by government. One reason Lehman Brothers was not rescued and was allowed to fail and trigger the 2008 financial crisis, was public resentment of support for Bear Stearns. Bailing out another investment bank when hundreds of thousands were losing their homes to foreclosures was not considered politically explainable and acceptable, so Lehman Brothers failed, and the crises erupted.

The lack of actions against bankers seen to be responsible for the crisis was particularly resented by large proportions of the public. That many of those at senior levels were able to retain large bonuses for the exact business that caused the crisis was the result of inappropriate incentive structures.

The resentment that almost no bankers went to jail was understandable but misunderstood. Bankers were not proven to have broken laws.

What should have been resented, and what this book hopes to contribute to the understanding of banking crisis, is that a few senior and very senior bankers did not do their job. They did not manage the banks they had responsibility for and that was a reason why many banks failed.

Financial institutions paid more than $150 billion in fines in the United States relating to the credit crisis. Bank of America paid $56 billion in settlements with state and federal regulators and the Department of Justice to cover its own mortgage sales and actions by two companies it acquired, subprime mortgage lender Countrywide and investment bank Merrill Lynch. J.P.Morgan paid the second-largest amount of $27 billion including an estimated $6 billion for Bear Stearns and $8 billion for Washington Mutual.

The on-going effect of the financial crisis continues to negatively affect the public’s view of political institutions. The combined effects of what is seen as failed regulation, inadequate sanctions against bankers and severe economic costs and emotional hardship have had and may continue to have political consequences. It seems likely that the votes for new, alternative political parties and figures in a number of large Western countries as well as an element of protest votes have something to do with the public

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resentment of the occurrence of the 2008 financial crisis and its consequences. Some consider the 2008 financial crisis to have contributed to political changes including the referendum on the United Kingdom leaving the European Union, the 2016 United States presidential election and the rise of populism as a political force in Europe (Stephens 2018).

The absent management in some banks and remedial austerity may be responsible for increased deaths in addition to suicides caused by stress. In some Western countries, the growth in longevity, how long people are expected to live, has reduced since 2010. One of the reasons may be reduced public medical and social expenditure. One study in the United Kingdom found that spending constraints between 2010 and 2014 were associated with over 45,000 higher than expected number of deaths compared to trends before 2010. If these findings were projected to 2020, the additional number of deaths would be above 150,000 (Watkins et al.

2017). The study finds association but not causation. So causes other than a banking crisis, austerity and reduced public expenditure on social and medical care may have been involved. But it is probably better not to risk this and to prevent another financial crisis.

A banking crisis affects a country’s relative strength in the world.

Specifically, the United States had to consider the role of foreign investors of its Treasury Bonds and ensure that confidence was not lost in the United States ability to support its financial system. With China owning over $500 billion of mortgage-backed securities issued by Freddie Mac and Fannie Mae, the United States possibly felt forced to explicitly guarantee this debt to avoid raising questions about the financial standing of the United States. The increased debt levels of those countries suffering a banking crisis make the countries relatively weaker. Perhaps those countries not affected by the 2008 financial crisis and Great Recession will suffer their own banking crisis in due course. But until then those countries whose banks were unmanaged and failed have seen their relative position in the world weakened.

It is probably too early to judge how important the 2008 financial crisis was in affecting the relative strength of world powers. One indication is that the top four banks in the world, measured by the highest quality of capital, are now all Chinese, being ICBC, China Construction Bank, Bank of China and Agricultural Bank of China. The latter has seen the most phenomenal rise to one of the top four positions, having been outside the top 50 in 2007. In 2007 the highest ranked Chinese bank ICBC was only ranked seventh in the world.

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J.P.Morgan is the largest non-Chinese bank and still the fifth largest as it was in 2007. In 2008, J.P.Morgan was the largest bank in the world, as it was at the beginning of the twentieth century, having taken over Bear Stearns and Washington Mutual. Three other United States banks, Bank of America, Citi and Wells Fargo, are next in the ranking. The first European bank HSBC is ninth having briefly been the largest bank in the world in 2007. French banks BNP Paribas and Credit Agricola have fairly similar places around 11 to 16 as have Santander, Goldman Sachs, Barclays and Deutsche Bank. The big loser is RBS having been the third largest bank in the world in 2007, it is now not in the top 25.

So China now has the largest banks in the world, although United States banks are still the largest international banks. Europe, and particularly the United Kingdom, has been relegated to third. This may be an indication of a future trend in world power although the Chinese banks will have to avoid a major crisis to maintain their leading positions. To do this Chinese banks will have to be managed.

A cost that will never be known is what would have been possible had the crisis not happened, the lost opportunity cost. What investments could have been made, what economic prosperity achieved, what personal stress and misery avoided.

Economist underestimated the impact of the 2008 financial crisis on the broader economy. The underestimation was of such magnitude that it implicated basic macroeconomics and requires some significant rethinking of standard economic models. One example was the severity and longevity of unemployment in the United States in 2009. This failure has been an important conclusion by the head of the Federal Reserve from 2006 to 2014 (Bernanke 2018). In other words we knew that banking crisis makes other crisis worse but we were unable to predict how costly a financial crisis would be (Reinhart and Rogoff 2009). And economics as a discipline requires fundamental rethinking before we will be able to estimate the cost of a financial crisis in the future. This is an indication that there is significant uncertainty of how costly the next crisis will be.

Bank crisis can be expensive, really, really expensive. They can cause incalculable costs and human misery. Economics fundamentally failed to predict how costly the 2008 crisis would be. There were no banking crisis between 1945 and 1970 so they are not part of an economic cycle, nor should they be considered either acceptable or inevitable. If we can contain medical epidemics we should also be able to prevent bank crisis. With this in mind, the next chapter is about what has changed since the last banking crisis.

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References Arnold, Martin. 2017. Northern Rock in Facts and Figures. Financial Times, 17 August. https://www.ft.com/content/5bf237e6-8d0e-11e7-a352-e46f43c5825d Atkinson, Tyler, David Luttrell, and Harvey Rosenblum. 2013. How Bad Was It? The Costs and Consequences of the 2007–09 Financial Crisis. Federal Reserve Bank of Dallas.

Bernanke, Ben. 2018. The Real Effects of the Financial Crisis. The Brookings Institution. Washington D.C. Blinder, Alan S., and Maerk Zandi. 2010. How the Great Recession Was Brought to an End. Princeton University and Moody’s Analytics, New Jersey.

Bozio, Antoine, Carl Emmerson, Andreas Peichl, and Gemma Tetlow. 2015.

European Public Finances and the Great Recession: France, Germany, Ireland, Italy, Spain and the United Kingdom Compared. Fiscal Studies 36 (4): 405–430. (2015) 0143–5671. John Wylie & Sons Ltd. FDIC Federal Deposit Insurance Corporation. 2019. https://www.fdic.gov/ deposit/insurance/history.html. Washington, D.C. Laeven, Luc, and Fabián Valencia. 2012. Systemic Banking Crises Database: An Update. International Monetary Fund, Washington, D.C. Millaruelo, Antonio, and Ana del Río. 2017. The Cost of Interventions in the Financial Sector Since 2008 in the EU Countries. Banco de Espana.

OXFAM. 2013. The True Cost of Austerity and Inequality. London.

Reinhart, Carmen, and Kenneth Rogoff. 2009. This Time Is Different: Eight Centuries of Financial Folly. Princeton: Princeton University Press.

Stephens, Philip. 2018. Populism is the True Legacy of the Global Financial Crisis.

Financial Times, 30 August.

Thomas, Richard. 2006. Icelandic Banks. Not What You Are Thinking (March 2006). https://notendur.hi.is/ajonsson/kennsla2006/Merrill%20Lynch%20 -%20Icelandic%20Banks.pdf. In the interest of full disclosure and transparency Richard Thomas was the best hire I made during my time in investment banking.

U.S. Department of the Treasury. 2013. The Financial Crisis Five Years Later.

Response, Reform and Progress September 2013. Washington, DC. Watkins, Johnathan, Wahyu Wulaningsih, Charlie Da Zhou, Dominic C. Marshall, Guia D.C. Sylianteng, Phyllis G. Dela Rosa, Viveka A. Miguel, Rosalind Raine, Lawrence P. King, and Mahiben Maruthappu. 2017. Effects of Health and Social Care Spending Constraints on Mortality in England: A Time Trend Analysis. BMJ Open 2017 (7): e017722. https://doi.org/10.1136/ bmjopen-2017-017722.

CHAPTER 13

What Has Changed: How Little Has Changed in Terms of Complexity, Producer Managers and Absent Management in Banking

Having mentioned plagues in relation to the Florentine bankers in the fourteenth century, it is illuminating to compare the historical ability to manage major global crisis of health and finance. The Plague killed over a third of Europe’s population in the fourteenth century, and as a side effect caused the failure of the Medici predecessor banks in Florence. The influenza epidemic in 1918–1919 may have killed between 50 and 100 million people worldwide or between 3 and 5 per cent of the world’s population.

Since then there has thankfully been a considerable improvement in the containment of medical epidemics. More recent outbreaks of plague, such as the Ebola tragedy in Western Africa in 2013 that caused the loss of over 11,000 lives, were contained mainly to the unfortunate countries of Guinea, Liberia and Sierra Leone and eradicated within three years from its outbreak. This is a remarkable, historical improvement in containing medical crisis.

Compare this to the 2008 financial crisis. Importantly this probably caused mainly material losses rather than human life. However this financial crisis was not contained to a few countries but went global and spread from individual country’s banking crises to become an international sovereign crisis affecting dozens of countries. There had been no improvement in containing financial crisis such as the Great Recession to one country compared to the Great Depression nearly 80 years earlier. The Great Recession is still widely felt in many countries through personal and © The Author(s) 2020 C. Dinesen, Absent Management in Banking, https://doi.org/10.1007/978-3-030-35824-2_13

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corporate financial loss, continued political and economic austerity and significantly tightened financial regulation and fines of banks. In the days of the Medici, there was little ability to geographically control either medical epidemics or financial crises. Since then we have improved our capabilities to contain medical but not financial crisis.

And perhaps the recent financial crisis did not just cause material loss and misery. How long we can expect to live in has increased fairly steadily since the end of the Second World War in most countries, but this increase has almost stalled in the Western World since 2009. This reduced increase in life expectancy in the Western World (Campbell 2017), for example in the United Kingdom, may have been influenced by government austerity and reduced social spending, in turn caused by the recent banking crises.

If this is correct, and the evidence is not conclusive, banking crises may have significant health implications. So while we are much better at controlling medical crises from spreading geographically, financial crises still spread very rapidly globally and may even have health implications in addition to the devastating costs and stress.

Absent management in banks is caused by a combination of complexity and the producer manager approach. Absent management can cause a bank to fail, as we have seen many examples. Bank failure is bad enough in itself, but it also has the ability to cause a crisis, to make another type of crisis much worse or both. This chapter will look at what has changed in terms of complexity and the producer manager approach since the 2008 financial crisis. It will finish with three recent yet to be historical examples of possible absent management in banks.

The loosening of bank regulation was widely perceived to have been a cause of the bank failures and the 2008 financial crisis. In this book the argument is that it is the management of banks that matters most in terms of bank failure. Regulation provides rules. And these rules are applicable to all banks. But all banks do not fail in a crisis and nor did all banks fail in the 2008 financial crisis. It is not logical to argue that loose regulation caused some banks to fail. So management is the determinant of failure, not the rules and regulations.

A loosening of rules allows banks to do things that may make failure more likely. But it is the management of banks that decides what the bank does. So it was not the loosening of regulation that caused banks to fail.

Loosening of rules allowed the management of some banks to take actions that caused them to fail. A former Lehman Brothers executive, who still works in Wall Street, was quoted as saying in 2017: “At the end of the day,

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the crisis was the banks’ fault. You can’t blame the regulator - just because a gun is left sitting on the counter, it doesn’t mean you have to pick it up and shoot someone” (Jenkins 2017).

And almost whatever the rules, if there is absent management the risk of failure is greater. So regulation should ensure that banks are managed.

But changes in regulations in the last three years have not significantly addressed two of the causes of absent management in banking, namely complexity and the producer manager approach. In some ways regulation has made absent management more likely, which will be described later.

So as far as regulation is concerned the absent management in banks continues, as will be seen at the end of this chapter.

After the financial crisis the primary aim of regulation was to stabilise the financial system and then to stimulate demand by restoring the ability of banks to provide credit. As seen in the previous chapter on the cost of the financial crisis, stabilising the financial system was achieved by injecting taxpayers’ money into banks, primarily paid for by increasing government borrowing and taxation and reducing other government expenditure.

Restoring demand in the economy was firstly done by dramatically reducing interest rates and keeping them low. Secondly central banks, particularly the Federal Reserve and the European Central Bank (ECB), both of which are ultimately backed by taxpayers, dramatically increased their balance sheets by buying astronomical amounts of bonds, particularly corporate bonds. The Federal Reserve balance sheet increased more than four times to over $4 trillion from 2008 to 2014 and has only very recently begun to descend from this plateau. The European Central Bank balance sheet more than doubled to over €4 trillion and has shown no signs of reducing yet. This bond buying became known as quantitative easing.

Once the banking and financial crisis had become a sovereign crisis in Europe, the head of the European Central Bank said that, in order to secure the European Currency: “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough” (Draghi 2012).

In 2009 the United States introduced stress test for banks to determine how much capital they would need in various crisis situations. This information was then made public and did much to restore confidence on many of the banks’ financial solidity. Stress tests were also seen as superior to the banks’ internal, risk-based capital models that had not prevented their failure. Stress tests are parameters, in this case decided by the regulator, that banks have to model in order to understand what their capital

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strength will be after the occurrence of specific negative events, for ­example, a fall in the value of real estate. The Federal Reserve then required the banks that had received support to raise capital to be able to pay the support back to the government (Tarullo 2016).

These regulatory measures and interventions prevented another Great Depression, but not a Great Recession. However, important historical lessons had been learnt and, crucially, the economic collapse of the 1930s was prevented (Wolf 2018).

These measures contrasted sharply with the actions of central banks after the Great Depression. Then banks were allowed to fail in their thousands culminating in the shutdown of the United States banking system on the Bank Holiday in March 1933. And the Federal Reserve did not expand the money supply. When a central bank buys government bonds, this increases the amount of money or cash in circulation. When a central bank reduces the rate at which commercial banks can borrow, the discount rate, this also increases the money supply. It was this historical lack of action in not expanding the money supply, as was done by quantitative easing, that the Governor of the Federal Reserve apologised for when he said in 2002 that “Regarding the Great Depression. You’re right, we did it.

We’re very sorry. But thanks to you, we won’t do it again” (Bernanke 2002).

The second aim of regulation after the 2008 financial crisis was to prevent a recurrence. Here a possible historic mistake was made. Regulators accepted the status quo of banks and decided to regulate banks as they were rather than change the banks. In particular regulation did not make banks less complex and therefore more manageable or at least possible to manage. This was also in contrast with regulatory changes after the Great Depression and the Glass-Steagall Act of 1933 which separated commercial and investment banks. This Act was the most important regulatory measure ever to make banks less complex. And this simplification of banks by regulatory measures made the banks easier to manage, even for producer managers. This regulatory simplification in turn made absent management less likely, thereby making bank failure less likely. And less bank failures made financial crisis less likely and less severe.

So while the United States did not repeat the mistake of not expanding the money supply, the regulatory success of simplifying banks after the Great Recession was not repeated.

Because no single capital measure can capture all possible sources of loss, United States banking regulation had for three decades required both a leverage ratio and a risk-based capital requirement. In responding to the

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crisis, regulation applied a higher leverage ratio and stronger risk-based capital requirements, including a stress testing programme, to larger banks.

To some extent the United States regulatory response after the 2008 financial crisis was more of the same. In response to the crisis regulators requested a lower leverage ratio and stronger risk-based capital requirements than had been in place for three decades (Tarullo 2016). This did not question the regulatory approach that had allowed the 2008 financial crisis, merely that the approach had not required low enough leverage ratios and high enough levels of capital. But stricter leverage and capital rules did not address absent management of in banks.

Implementing complex regulation after the 2008 financial crisis meant that the battle against future bank failure and crisis may have been lost before it was begun. There are several reasons for this. The more complex the regulation the more difficult it will be to implement and supervise.

Firstly large banks will always have greater resources than regulators.

When the teams of highly paid bankers arrive to discuss regulation with their regulatory supervisors, these supervisors will have the power of the law behind them. But the bankers will have the most skilled and highly paid specialists, sometimes including former regulatory supervisors, now much higher paid. Within the framework of the law, the bankers will win.

And the bankers will be highly, sometimes very highly, incentivised to take advantage of any complexities within the new regulation. And the more complex the regulation the more possibilities for taking advantage.

When a large amount of the regulation is focused on capital, this gives the banks another, second advantage. Capital is what bankers do. Capital is one thing bankers do know how to manage. In the game of capital management regulators are there to enforce the rules, but bankers are the experts at playing the game.

A third reason why complex regulation may defeat the objective of preventing future bank failure is that the more complex the regulation the more it drives consolidation of banks. The larger banks are able to dedicate significantly greater resources to regulation than smaller banks. This gives them a competitive advantage in being able to understand regulatory complexity and to extract any available advantages. So the complexity of the postcrisis regulation is likely to have made banks larger and more complex and therefore more difficult, or less possible, to manage. This may contribute to, rather than prevent, future bank failure.

One possible approach would now be to go through the very extensive and highly complex regulations implemented since the 2008 financial

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c­ risis to prevent it happening again. Others have done this, in both expert and sometimes excruciating detail. A simpler, different and hopefully additive and helpful approach is to consider what has not been addressed by regulation, what is absent from regulatory change. It is also worth considering why regulation in some cases has made things worse, but mainly why regulation has not addressed the causes of absent management in banking.

Banks are now subject to regulation by more authorities compared to before 2008. In the United States nine federal agencies and several state agencies regulate the financial sector (Bruner 2018). In the United Kingdom the Financial Services Authority was abolished in 2012 and replaced by the Prudential Regulatory Authority and the Financial Conduct Authority. Both regulators were returned to come under the Bank of England. Previously, the Bank of England had been the regulator of banks but lost this role in 1997 when it was given its independence from the Government. This was when the Financial Services Authority had been established to regulate the financial sector together with the Treasury and the Bank of England, partly in response to criticism of a failure of the Bank of England to do this adequately on its own.

More than one regulator is obviously more complex for banks than being subject to a single regulator. Conversely the management of a single regulator would be a highly complex task for those taking on this challenge. However risks exist that with more than one regulator gaps may occur between them. An important conclusion is that banks remain significantly too complex to be regulated by one entity in the United States and the United Kingdom. This is strong evidence that bank remains complex and perhaps increasingly so.

The United States Dodd-Frank Wall Street Reform and Consumer Protection Act 2010 is a comprehensive set of new regulations having the aim of making the United States financial system sustainable. It was signed into law on 21 July 2010 and is the most significant national regulation enacted in response to the financial crisis encompassing 2300 pages and some 400 rules. Amongst the many rules it introduced is a resolution regime to allow the orderly winding down of failed banks including authorising the Federal Reserve to extend credit in “unusual or exigent circumstances” (Minor and Persic 2012). The Act also aims to monitor bankers’ compensation.

The Act did contain some rules reducing the complexity of banks, including the so-called Volcker Rule. Under this rule, “large, systemically important banking institutions should be restricted in undertaking

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p­ roprietary activities that present particularly high risks” (Group of Thirty 2009). This means that banks would be restricted from trading for their own book. Commercial banks would also be prohibited from owning hedge funds and private equity firms.

Regulators would now be able to identify both banks and non-banks as ‘Systemically important’ and subject to additional supervision. A systemically important firm is one that could pose a threat to the financial stability of the United States if it failed or engaged in risky activities. Any firm designated a systemically important firm is subject to stricter oversight from the Federal Reserve, including stress tests, writing bankruptcy plans known as living wills and meeting stricter capital requirements.

By early 2017, 275 of the 400 rules had become law, while some 125 had not or not yet. In February 2017 the president of the United States signed an executive order to review the Act. The Dodd-Frank Act did not include recommendations on capital adequacy. This was to be enacted under international rules with Basel III providing this complement to the act (Blaylock and Conklin 2010).

In 1974, following the abolition of the international Bretton Woods currency management system in 1971, the Group of Ten central bank countries, later to grow to the Group of Thirty, established the Basel Committee on Banking Supervision at the Bank for International Settlements. The aim was to promote cooperation in international global banking regulation with a primary focus on ensuring that banks have enough capital. The committee has no power to impose its rules on member countries or to regulate banks. The publishing of the so-called Basel I in 1988 was a response to deteriorating capital in many banks in the early 1980s. This was later replaced by Basel II in 2004. In December 2009 the Committee published what became known as Basel III consisting of the International Framework for Liquidity Risk Measurement, Standards and Monitoring and the Strengthening the Resilience of the Banking Sector in response to the 2008 financial crisis (Basel Committee 2010). Basel III recommends a more sophisticated and also more complex approach to capital held by banks. This involves increasing the quality, consistency and transparency of the capital held by banks while reducing the required capital ratio to 7 per cent (Basel Committee 2010).

Designing global bank regulation is obviously a complex task not least because of the global aspect. However the more complex the approach the less able the system may be to accommodate local requirements, often based on tradition and culture, even path dependencies. A completely

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consistent global regulatory system is highly unlikely to be achieved for these reasons, but also because some countries are keen to attract banks with less stringent regulation. This may make such countries more prone to future bank failures and crisis (Blaylock and Conklin 2010).

Countries have taken different approaches to the adoption of the Basel III rules. Canadian regulators support a principle-based regulatory system rather than one based on rules. A principle-based approach uses general frameworks to guide banks’ compliance without establishing specific rules.

This principle-based regulation requires banks to establish their own risk management with the regulator focused on the quality of controls and stress testing to anticipate problems and crisis. Canada has never had a banking crisis (Arjanil and Paulin 2013). That is worthy of attention as not many developed countries can say the same. Following the failure of two small banks Canadian Commercial Bank and the Northland Bank of Canada in 1985, which did not result in a crisis, regulation was improved. This included the establishment of the Office of the Superintendent of Financial Institutions in 1987, consolidating various supervisory activities. The Financial Institutions Supervisory Committee was also established to coordinate activities by the Superintendent of Financial Institutions and the Governor of the Bank of Canada, the Deputy Minister of Finance and the President of the Canadian Deposit Insurance Corporation (Arjanil and Paulin 2013).

Compared to many other countries Canadian banks were more resilient to the 2008 financial crisis. The largest Canadian losses from subprime were Canadian Imperial Bank of Commerce with $3 billion and Royal Bank of Canada with $1 billion ranked 24 and 37 amongst world banks’ subprime losses respectively (Wikipedia 2010).

A principles-based supervisory approach puts the onus on banks to prove that they are compliant with the principles laid out by the regulation. The Canadian regulator evaluates each bank according to its approach and has extensive authority to provide guidance for improvements backed up by extensive legal powers to enforce compliance with the guidance.

Risk management has been a strongly emphasised principle since the establishment of this supervisory approach.

Canadian regulation also has rules and these were earlier and stricter in terms of quality of capital and leverage than in the United States and the United Kingdom. However a greater emphasis on banks having to prove their adherence to principles to the regulator may have created a stronger culture of management. This means that the banks have to show that they manage their risks, not just that they follow regulatory rules.

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The relatively benign crisis may have been because Canadian banks were responsible for their own risk management (Blaylock and Conklin 2010) and, as should always be the most important requirement of any bank, to manage themselves.

A principle-based, rather than a rules-based, system of regulation may also have advantage in terms of dealing with financial innovation. A rules-­ based system will never do better than playing catch up with innovation.

It is not possible to make rules for an activity that has not been fully thought of yet. The onus is on bank management to prove it can manage the new activity. This may but does not guarantee better management than following regulatory rules.

Principle-based regulation will require that regulators become much more focused on regulating management rather than balance sheets. Many current regulators have highly numerical capabilities but are perhaps less experienced and skilled in assessing management. Principle-based regulation would require at least significant training of existing regulators and probably changes to recruitment of differently skilled people, with experience of management rather than numbers.

However a principle-based approach utterly failed in the United Kingdom including in the case of Northern Rock. This was probably partly due to the lack of rigour in the supervision as this was remote and intermittent rather than close and continuous as had been the regulatory intention (Black 2010).

Principle-based regulation may encourage banks to be managed rather than just complying with rules. It does however require a significant regulatory effort, not just in terms of sustained diligence but also in having the resources to understand the complexities of banks and whether they are being managed. This effort may be so great that it is beyond regulators and one reason why rules-based regulation remains the dominant approach in developed countries.

In the United Kingdom, there is now much increased focus on the senior executives who occupy ‘significant influence functions’. Banks have to produce an organisation chart naming a range of senior executives and their responsibilities. Those holding the positions can be subject to interviews by the regulators and to receiving a regulatory ‘no objection’ before they can take up the post. There is also a greater responsibility on board of directors, including those who are not executives and expected to be ­independent (Black 2010). This Senior Manager and Certification Regime has the potential to make a positive difference in reducing absent manage-

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ment in banking. By making individuals personally responsible for specific activities it can be expected that these individuals will pay greater attention to manage these responsibilities. However the activities have to have a level of complexity that is manageable and incentive structures have to be aligned with the responsibilities. Only time will tell if this new regime will reduce absent management.

Banks in most major economies are now backed by an estimated ten times the equity capital than before the financial crises (Editorial Board 2018). There is no doubt that a larger amount of capital provides a greater cushion against bank failure. However much larger levels of capital put greater pressure on banks to achieve what many and perhaps all of them still consider their primary objective, which is making an attractive return to shareholders. This increased pressure could incentivise banks to take greater risks in search of greater returns. It will certainly make banks explore every avenue in their most expert domain of capital to extract every possible advantage from the regulations.

Significantly important banks have submitted a ‘living will’ to regulators that can be implemented in a crisis and assist in an orderly winding down (Editorial Board 2018). This rule is a central pillar of the Dodd-­ Frank Act and has been replicated in other countries including the United Kingdom. While a plan for an orderly wind down appears to be a sensible precaution to mitigate the need for taxpayers to bail out banks, the functioning has yet to be tested. It is possible to imagine it working for a single bank that has overextended itself. It is perhaps less credible in a full blown banking crisis where several major banks fail.

Another increase in the complexity of banks’ capital is the introduction of ‘bail-in bonds’. These bonds are intended to assist in an orderly wind down of a failing bank, by converting from a bond into equity. The bank would no longer be obliged to pay back the principle of the bond and investors could no longer expect to receive back the money invested. Bond investors receive a higher premium for these bonds than for more traditional bonds due to this risk of becoming an equity rather than a bond investor (Editorial Board 2018). Making bond investors take more risk in banks provides an additional cushion, but it also adds significant complexity to the composition of the capital of banks.

Basel III also recommends a leverage ratio that includes monitoring leverage outside the banks’ balance sheet. This should overcome the expansion of leverage both on and off balance sheet seen before the financial crisis.

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On liquidity the Basel III recommendations seek to improve banks’ resilience to periods of low liquidity with both short- and long-term liquidity ratios. Stress testing is recommended including such stresses as a downgrade of the bank’s public credit rating, a partial loss of deposits, a loss of unsecured wholesale funding and an increase in call for collateral under derivative contracts, all of which were experienced in bank failures in 2008 as we have seen.

Implementing Basel III rules is a decision of national governments and their regulators. By the end of 2017, all 24 of the countries had adopted core elements of the capital and liquidity rules. All countries with globally systemically important banks have enforced final rules on higher loss absorption. This often means banks issuing bail-in bonds. Final rules on higher loss absorbency requirements for domestic systemically important banks have been implemented in 23 countries. However, rules on leverage and funding are only in force in 15 and 11 countries respectively. The aim is for all rules to be implemented by 2022 and phased in over five years.

That is 20 years after the beginning of the financial crisis in 2007 (FSB 2018). This would create comparable regulation in the major countries but taking more than two decades to be implemented. The complexity of the rules and regulations is one reason why implementing will take so long. There is also a danger that the time to implement such complex global rules will cause individual countries to adopt different rules because they are unwilling to wait for the implementation. Finally, some countries may delay implementation because they are concerned about losing competitive advantages for their banks compared to other countries that delay implementation.

Consistent global rules have the attractions of reducing competition between regulators to attract banks to locate in their country. However concerns have been raised that consistent rules, globally as well as within countries, can result in banks behaving uniformly in a crisis. Such behaviour might make a crisis worse, such as when many banks seek to sell the same type of assets because regulation makes these assets onerous to own, for example due to a downgrade of the credit rating of this type of asset (Plender 2017). However, without such regulation banks could easily all decide to divest certain assets by simply acting according to market movements and without consistent regulatory rules.

Increased regulation has caused consolidation as it nearly always does.

It has also meant increased complexity. It is a dangerous irony that regulations that were concerned about banks that were too big to fail have

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caused banks to become larger and therefore more complex. J.P.Morgan’s investment bank chief acknowledged this irony in 2018 when he said that “When you think about the amount of capital, liquidity, the increase in the control environment, compliance, risk - all the things we have to do - [then] the more you put through the pipes, the [cheaper] it is” (Weber 2018).

The 2008 financial crisis made some very large banks bigger. Increased regulation, particularly significantly increased and complex regulation, has the effect of consolidating the banks being regulated. The first regulatory measures were the government-supported takeover of Bear Stearns and later Washington Mutual by J.P.Morgan. These actions were instrumental in making J.P.Morgan first the largest investment bank in the world and then the largest universal bank in 2008. After the acquisitions introduced by the crises, and a decade of growth since then, if one of the largest banks in the world was to fail, in spite of its increased capital and more restrictive leverage and funding, the consequences might be unprecedented (Editorial Board 2018).

Some banks were too big and complex to be manageable before the crisis. The regulatory interventions have done little to reduce this risk but have increased the size and complexities of banks. As one experienced commentator said in 2017:“Many are simply too big to be manageable.

J.P.Morgan Chase is widely regarded as the best managed international bank. But when a group of traders lost $6bn in 2012 in the so-called London Whale scandal it was clear that top management in New York had absolutely no clue as to what was going on” (Plender 2017). We will return to the London Whale at the end of this chapter.

As has been the case historically, and particularly since the 1970s, as banks grow, they become more difficult to manage. HSBC was supposedly surprised by the more recent problems in its Swiss private banking operation. Problems more than a decade old emerged in 2015 at which time the chief executive officer said, “Can I know what every one of 257,000 people is doing? Clearly I can’t” (Hill 2015). The statement is literally correct, but it is also an admission of potential absent management.

While some regulation has yet to be implemented other regulation is being loosened ten years after the 2008 financial crisis. In 2009 the Federal Reserve introduced regulation that required a deep regulatory probe of any bank merger exceeding $25 billion. In the period 2010 to 2017, the total value of banks merging in the United States has been below $50 billion per year. In the previous period from 2005 to 2009 it was only below $50 billion in one year. The threshold for mergers requiring deep regula-

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tory probe has been lifted to $100 billion from 2017, loosening regulation for bank mergers below this level. Additionally, the Federal Reserve would grade management teams from one to five with four or five being required to achieve regulatory approval for a merger. From 2017 this scale will lose a grade and be reduced to one from four. This will probably result in more management teams being acceptable to merge banks. Finally the level at which the strictest on-going regulation is required has been increased five times from banks with $50 billion of asset to only apply to banks with assets above $250 billion (McLannahan 2018b). The result is that more smaller- and medium-sized banks can merge into large banks that will be more complex and therefore more difficult to manage.

In February 2019, the two banks, bb&t and SunTrust, announced a $66 billion merger, by far the largest since the 2008 financial crisis. The new bank, Truist Financial Corp. will be the United States sixth largest commercial retail bank and the fifth largest deposit holder with $332 billion. Citi holds around $500 billion of deposits while the three largest, Bank of America, JPMorgan Chase and Wells Fargo all hold over $1 trillion in deposits (Economist 2019).

Perhaps the largest gap in regulation has been the lack of any restrictions on what lines of business banks can operate in. The Glass-Stiegel Act of 1933 separated commercial and investment banks. British banks were prevented from stock market activities until the Big Bang in 1986. The loosening of regulations of what types of activities any one bank can undertake made banks more complex to manage and contributed to absent management. But little regulation has been introduced to simplify banks activities and thereby make absent management less likely. This may be the single greatest error in regulation, an absence of regulation that does nothing about absent management in banking.

The Vickers rule in the United Kingdom came into force on 1 January 2019, more than ten years after the 2008 financial crisis, as part of the Financial Services (Banking Reform) Act 2013. Under this rule banks can operate as both commercial and investment banks but must ring fence the deposits of core retail banking. The intention of the Act is that it will make banks safer because if one part of the bank fails, it will not affect the other part (HM Treasury 2017). That may have some validity, although the examples of some universal banks during the 2008 financial crisis appear to have been forgotten. Banks such as UBS saw significant outflows from its wealth management business, where clients’ assets were completely separate or ring fenced, due to problems in the investment bank. Whatever

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regulatory ring fencing the Vickers rule will introduce, it cannot prevent depositors from withdrawing their deposits if they have concerns about problems in the investment banking part of a universal bank. Ring fencing may not persuade depositors that their deposits are safe.

This also questions the aim of the Vickers rule that the government will not be required to bail out the bank. If problems in the investment bank cause it to fail, the government may allow it to do so. If the failure causes depositors to withdraw their deposits, however ring fenced they may be, the government may find itself in the situation that the retail bank has to be rescued to stop the bank run, and avoid possible contagion spreading to other banks.

Another aim of the Vickers rule is that the ring fencing will make the bank simpler. This is hard to credit given that the top management will still have to manage both investment and commercial banking activities.

Ring fencing does not necessarily make this simpler and could in fact make it more complicated, particularly in a crisis. Only divestment of one of the activities would truly make a bank simpler to manage.

Regulators have made some specific requirements for banks to reduce their activities. They have however been so limited as to make little impact on the size of the bank and therefore, most likely, in reducing complexity.

In the United Kingdom Lloyds was forced to divest the TSB retail operation. This is estimated to have cost Lloyds £2.5 billion to carry out, but importantly the divestment reduced Lloyds’ asset by less than 3 per cent.

Similarly, RBS was requested to divest Williams & Glyn with its 300 branches, which also amounted to less than 3 per cent of RBS’ assets. After eight years, regulators abandoned the request as RBS argued that no suitable buyer could be found. The process still cost RBS more than £1.5 billion (Samuels 2016).

There has been no regulation to reduce banks geographically.

Operations outside a bank’s home country add significantly to the complexity of managing the bank, but this has remained unchanged.

International operations also dramatically increase the complexity of regulating a bank, both for the regulator in the home country and where the bank has subsidiaries. Coordination between head office and subsidiary regulators is complex, particularly where the supervisory rules differ ­significantly. Such differences offer opportunity for banks to exploit to achieve the most favourable regulatory treatment for its activities.

Some banks decided to reduce some of their activities themselves.

Regulatory pressure may have played a part in these decisions. UBS has

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reduced the capital employed in its investment bank by one-third to SFR8 billion to focus more on wealth management. Other banks may reduce their involvement in a sector or geographically, such as Deutsche Bank’s announcement that it will reduce investment banking outside Europe (Deutsche Bank 2018).

In the United States, all investment banks were made to become commercial banks from a regulatory point of view as part of the initial regulatory intervention in 2008. One of the reasons was to allow them to access the Federal Reserve discount window for liquidity assistance as this was previously only available to commercial banks. With Bear Stearns and Lehman Brothers having failed and Merrill Lynch being taken over by Bank of America, only Morgan Stanley and Goldman Sachs remained as major, pure investment banks, which had to become commercial banks from a regulatory point of view. Both confirmed they would make this conversion on 21 September 2008. Goldman Sachs became the fourth largest bank in the United States.

Somewhat surprisingly Goldman Sachs have since expanded into retail banking at the end of 2016 through an entity named Marcus, after its founder Marcus Goldman. Marcus has subsequently expanded into the British retail market. Given the existing and long-term complexity of Goldman Sachs, this expansion may not add much in terms of additional complexity. However it is noteworthy that the largest pure investment bank, which survived the 2008 financial crisis better than most, is taking on more complexity. This is also a sharp contrast to the simplification of regulation after the Great Depression that has been almost completely absent after the Great Recession.

A further increase in complexity in European banking would have been likely if a merger between Deutsche Bank and Commerzbank had gone ahead. It would have been possible to devote more attention to Deutsche Bank in this book in addition to the fines it incurred for alleged miss-­ selling of mortgage-backed securities of $7 billion and the largest LIBOR fine of any bank of $2.5 billion. The merger that was explored with Commerzbank was supposedly partly driven by the German regulator and government who would like to reverse the poor performance of the country’s two largest banks and would like to create a national champion to support German industry to expand internationally (Storbeck and Chazan 2019). The combination would have created Europe’s third largest and the Eurozone’s second largest bank with €1.9 trillion of assets (Storbeck 2019). Interestingly, when the merger was abandoned in 2019 ‘execution

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risk’ was given by both parties as one of the reasons for abandonment. No one mentioned that the complexities of managing a combined entity might have been too much for management teams that have struggled to manage either bank.

Subprime mortgage lending in the United States is no longer called that, with other terms such as ‘no prime’ and ‘non-qualifying’ mortgages being mentioned. Non-qualifying means that these mortgages are not qualified to be bought from the lender by Fannie Mae or Freddie Mac. The market for securitisation of these loans has remerged although from a low base. Mortgages included in securitisation have to conform by eight ‘ability to pay’ parameters for the original lender to avoid future liability from investors in the securitisation. Also the sponsors or arrangers of the mortgage-backed securities cannot sell all of the issue but must retain at least one-twentieth on its own balance sheet. The year 2017 saw the issuing of $4 billion of what would have been called subprime mortgage-­ backed securities before the crisis (McLannahan 2017). About $29 billion was issued in 2018, almost doubling the previous year (NAIC 2019).

Before 2008 rating agencies were largely unregulated. The Dodd-Frank and European regulations introduced significant new rules to improve the quality and methodology of rating agencies. This regulation addressed requirements for board approval of procedures and methodologies, record keeping of decisions and analysts’ training. Rating decisions remain under the control of the agencies, although the Securities & Exchange Control can bring action for fraudulent ratings. The European Securities and Market Authority now regulates the European credit rating agencies on a similar basis to the United States. Both regulators have sought to separate the credit analysis activity from both advice on how to achieve a desired level of rating and the commercial aspects of selling rating services. Analysts are now prohibited from guiding the rated issuer. The position where the rated issuers pay for the ratings, much criticised after the 2008 financial crisis, has not changed. But the analysis and payment are now handled by two separated parts of the rating agencies.

However credit ratings remain as embedded in regulation as ever and probably more. Regulators take a strong lead from the agencies’ ratings when assessing the capital models, stress tests and so on of banks. And banks continue to rely heavily on rating agencies. Rating processes are now regulated and the processed probably of a higher quality, less conflicted and more transparent. Whether banks do more of their own credit

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analytical work or continue to rely on rating agencies at the continued request of bank regulators will probably not be known until the next crisis.

If little has been done to reduce the complexity of banks neither has there been much change to the producer manager approach. The path dependency remains whereby many senior bankers remain involved with clients and production, even as they reach the very top of management.

Many senior managers have had to spend a great deal of their time, sometimes the majority, dealing with the fallout from the crisis and the resulting regulation. But they have remained producer managers. Specialist managers, who are trained in management and have no other role, have not emerged as dominant in banking, particularly in the large combined commercial and investment banks, the most complex of all with the most demand for specialist management.

One area of management addressed by regulation has been incentives.

The much criticised bankers’ bonuses, reviled by the public that suffered the consequences of the 2008 financial crisis, have been checked, at least partly. The Dodd-Frank Act ensured that shareholders of United States banks have the right to vote on remuneration of senior managers in banks at least every three years, or more frequently, should shareholders so desire. Banks are also required to provide details of any ‘golden parachute’ arrangements, being provisions for senior executives who leave the bank, and shareholders must approve these (SEC 2011).

In Europe, a limitation of bonuses was introduced at one time fixed salary or two times with shareholders’ approval in 2014. This applied to all those who have a potential impact on the risks of the banks, amounting to some 60,000 individuals in Europe. Banks responded by significantly increasing the fixed salaries. The corresponding provisions for deferral of payment of bonuses have been implemented inconsistently across Europe affected by local regulation (EBA 2016). Provisions have also been made for bonuses to be ‘clawed back’ where losses emerge from business conducted during the period where the bonuses were awarded.

There is now a link between the level of capital, under the new Basil III rules, whereby banks face restrictions on bonuses to employees, and dividends to shareholders if the bank’s capital is below a 7 per cent ratio (Plender 2017).

Incentives have been restricted but are still large. Bankers have been paid more than other industries for many years but this accelerated. In 1980 remuneration in the United States financial securities industry was twice the average of the private sector. By 2000 it was five times higher. In

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spite of the financial crisis it is now again more than five times the average and approaching the peak of six times seen just before the financial crisis.

In 2017 Wall Street bonuses were up close to one-fifth to over $180,000 compared to 2016 and not far below the 2006 record of just over $190,000 (McLannahan 26 March 2018a). Some have said that this represents a disturbing failure of regulatory policy.

Lobbying by banks is perhaps the main reason why so little has changed.

In the United States, President Obama observed in 2010 that “What we’ve seen so far, in recent weeks, is an army of industry lobbyists from Wall Street descending on Capitol Hill to try and block basic and common-sense rules of the road that would protect our economy and the American people. So if these folks want a fight, it’s a fight I’m ready to have” (Obama 2010). The fight more specifically meant that by mid-2009, the financial sector had deployed three or four lobbyists for each member of Congress and was spending an estimated $1.4 million a day lobbying against the financial reform legislation. They succeeded in blocking legislation to break up the largest banks (Johnson 2010).

One of the large banks’ key arguments was a repeat of the argument made by the chief executive officer of Chemical Bank, when previously merging with Manufacturers Hannover Bank in 1991 that “If it’s important for the United States to have large, globally competitive automobile companies, globally competitive chemical companies, globally competitive computer companies, it’s important to have large globally competitive banks as well” (Gilson and Escalle 1998). Splitting up the banks was thereby linked to reducing the power of the United States. This argument was largely self-serving. Western non-financial conglomerates have been in a decade-long process of splitting themselves up to focus on their core businesses and core management competencies. An important example was General Electric’s divestment of its finance division in GE Capital in 2015.

Banks were, as usual, decades behind the management developments of corporates. Secondly, the 2008 financial crisis, partly caused by large complex banks, damaged the standing of the Western countries it affected.

The banks won the fight, and the president lost. While there was a great deal of talk about breaking up the big banks, which would have made them simpler to manage, reduced the possibility of absent management and therefore of failure, perhaps more than any other measure could have done, it never became part of the Dodd-Frank Act. One of the most extraordinary arguments put forward by the big banks is that they are simply too complicated to break up. Their capital, funding,

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information technology and legal structures have been argued to be so intricate that breaking up is impossible (Samuels 2016). In making such an argument there seems to be no self-awareness on the part of the managers of the largest banks that if they are too complicated to break up, they may be too complicated to manage.

Domestic United States banks were also opposed to the implementation of the Volcker Rule that would limit banks’ ability to trade for their own account and the associated revenue (Minor and Persic 2012). The Volcker Rule, as part of the Dodd-Franck Act was another highly complex piece of regulation. It was finally implemented in 2013 having been jointly agreed by five regulatory entities being the Federal Reserve Board, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Securities and Exchange Commission and the Commodity Futures Trading Commission (FED 2016). The latest development is that the rule will now be lifted for smaller banks, having only been in place for four years. Further amendments to the rule are being considered by regulators, and the direction appears to be towards a loosening of the restriction on banks to trade for their own account. It is hard to imagine a loosening of regulation with more potential for increasing risks and complexity in banks. This is a sad development as we mourn the passing of Paul Volcker in 2019, a giant of prudent governance.

More generally the current United States administration is reviewing all the regulation put in place by the Obama administration after the 2018 financial crisis. Further loosening of regulation may result.

In spite of the extensive and complicated regulations enacted since the 2008 financial crisis, absent management in banks is still having a highly detrimental impact.

JPMorgan Chase, including the merged Banc One, was considered to have had a less bad 2008 Financial Crises than many large peers. However, the complexity of this mammoth bank still resulted in an occurrence of absent management a few years later. An incident initially described as a tempest in a teapot by the chief executive officer in relation to the 2012 first quarter results, involved losses on credit derivatives from trading the bank’s own capital that eventually amounted to $6 billion. The losses emanated from the chief investment officer entity whose mandate was to manage the bank’s liquidity and conservatively invest those funds that were in excess of what the bank could lend. The trader responsible became known as the London Whale, due to the size of the positions taken by the chief investment officer’s London operation. A task force was established to investigate the losses. One of the observations was that the bank had

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not made sure that the controls and oversight had evolved commensurately with the increased complexity and risks of chief investment officer’s activities. The chief executive officer was later quoted as saying that “If I’d asked some basic questions earlier, I would have caught it but I didn’t”. Even for this largest of all producer managers, perhaps the most highly regarded banker and the only one still in place from the 2008 financial crisis, this was in instance of absent management (Weber 2018).

Complexity had grown beyond management’s capability, leading to absent management. In frankly admitting to the loss and the bank’s errors the chief executive officer described the strategy as flawed, complex, poorly reviewed, poorly executed and poorly monitored. One would never expect one of the world’s most senior financial managers to use words such as absent management, but his description is fairly close (J.P.Morgan 2013).

As I was writing the last chapter of this book, I received a letter from Danske Bank. It was assuring me that the bank was doing everything to sort out an issue in its Estonian branch that would have no impact on my personal account. It is too early to say if what has been termed the largest money laundering scandal in history is about absent management, but the signs are there. In 2007 Danske Bank, Denmark’s largest bank, took over Sampo Bank from a Finnish insurer including a branch in Estonia. During the next ten years, some €200 billion of money from residents outside Estonia would flow through the branch. In 2011, the Estonian non-­ resident activity generated over one-tenth of Danske Bank’s profits. There were many warnings including as early as just after the takeover in 2007.

The Estonian regulator warned over non-compliance and problems with know-your-customer rules to detect money laundering. The Russian Central Bank warned about the Estonian branch being used for tax evasion and money laundering of billions of roubles per month. The Danish regulator requested information from Danske Bank in 2012 regarding complaints from the Estonian regulator about serious money laundering issues. The head of the Estonia branch between 2007 and 2014 reported his concerns in 2013, using the whistleblowing route with several emails.

When resigning in 2014, he blamed the lack of response to his whistleblowing. An internal audit was conducted in 2014, after the whistleblowing, and confirming many of the allegations. Only in 2017 after several newspaper publications did Danske Bank have an investigation conducted by an external lawyer that brought the extent of the non-resident money flow to light. This was followed by the dismissal of Danske Bank’s chief executive, later followed by the chairman and most of the board (Milne and Winter 2018). The whistleblower has become central to the case and

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in November 2018 testified to the Danish Parliament. Other banks including Bank of America, J.P.Morgan and Deutsche Bank had been correspondents to Danske Bank’s Estonian branch. The United States Department of Justice is conducting an investigation. Danske Bank has announced a provision of close to €3 billion against possible fines. In one case of money laundering the United States Treasury suspended the licence to clear United States dollars under the Patriot Act of the largest Latvian bank ABLV, an action that contributed to ABLV’s complete failure (Ford 2018). A similar action against Danske Bank may seem unlikely now but would have serious consequences.

It is difficult to imagine that Danske Bank’s management did manage the Estonian business, however badly. There are strong indications of absent of management. The statement “We overlooked the suspicious circumstances because we had too little focus on and knowledge about the part of the business and the risk that followed” (Danske Bank 2018) is close to an admittance of absent management. Danske Bank did not respond to early warnings and whistleblowing. It had no person responsible for money laundering for the whole group in the first 11 months of 2013, in contravention of regulation. Danske Bank did not reduce the non-resident business until 2015. Perhaps most remarkably is that Danske Bank had a very difficult 2008 financial crisis, partly due to another acquisition of Irish banks, and received significant support of DKR26 billion in loans from the Danish government and taxpayer. Danske Bank only had to extend its operations as far as Estonia for an apparent occurrence of absent management to cause unprecedented damage to its reputation and possibly to its balance sheets, once the full impact of one of the historical largest cases of money laundering is known.

So many of the signs of absent management are there. Growth by acquisition, increased complexity by geography and new lines of business and management that did not appear to manage. If absent management was the case in what has been considered one of the most respected financial institutions in the world, in a country that makes claims of superior regulation and cultural transparency and even after extensive state support, the chance is that management will also be absent in other large banks now and in the future. None of the extensive regulatory changes since the 2008 financial crisis appear to have had any effect on this scandal.

A similar lack of effect of the financial crisis appears to be the case for Goldman Sachs and the 1MBD scandal. On 1 February 2019, Goldman Sachs said that it was deferring decisions on long-term incentives for three former executives “until more information is available” about the “ongoing

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government and regulatory investigations” into the 1MDB scandal (Noonan 1 February 2019). One of the executives is believed to be the former chief executive officer since 2006 who retired in 2018. The incentives had been granted to in 2011 and had been due to vest in 2018, presumably meaning that the executives could then have been able to turn them into cash.

Deferral of incentives and possible claw backs is new and related to the changes in regulations, employment contracts and attitudes since the 2008 financial crisis. What is not new is a scandal with the indications of an occurrence of absent management.

In 2012 and 2013 Goldman Sachs was the sole underwriter of a $6.5 billion bond issue for the Malaysian government-owned fund 1 Malaysia Development Berhad or 1MBD and received a $600 million fee. Close to $3 billion of the issue was allegedly used by a Malaysian financier on lavish spending and bribes to government officials including a former prime minister. In November 2018 a former Goldman Sachs partner pleaded guilty to bribery, conspiracy and money laundering charges in connection with what appears to be a significant case of fraud in 1MBD. The bank is being investigated by the United States Department of Justice and has had criminal charges filed against it by the Malaysian Attorney General.

Goldman Sachs has seen a significant fall in its share price at the end of 2018 of about two-fifths, although the latter had recovered about half of that at the beginning of 2019. Goldman Sachs has said that it knew nothing of the alleged role of its former partner in fraudulent use of funds in the 1MBD scandal (Crow and Noonan 23 December 2019).

It is too early to say what Goldman Sachs’ role was. Given the fall in the share price and the damage caused to the bank’s reputation, it does not seem likely that the otherwise strong management would have made such bad decisions. Perhaps the complexities of operating in a different country and culture were too great to manage. Given the timing following the 2008 financial crisis, including the $500 million fine imposed for miss-­ selling mortgage-backed securities in 2010, and the extensive internal compliance supposedly in place perhaps there was absent management.

References Arjani, Neville, and Graydon Paulin. 2013. Lessons from the Financial Crisis: Bank Performance and Regulatory Reform. Bank of Canada. Discussion Paper 2013–4.

Basel Committee on Banking Supervision. 2010. Annex. http://www.bis.org/ press/p100726/annex.pdf

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Bernanke, Ben S. 2002. Conference to honor Milton Friedman. Federal Reserve Board Speeches.

Black, Julia. 2010. The Rise, Fall and Fate of Principles Based Regulation. LSE Law, Society and Economy Working. Papers at: www.lse.ac.uk/collections/ law/wps/wps.htm Blaylock, David, and David Conklin. 2010. Basel III: An Evaluation of New Banking Regulations. Richard Ivey School of Business Foundation, The University of Western Ontario, London, Ontario.

Bruner, Robert F. 2018. Fighting Financial Crises: Making Policy. Charlottesville: University of Virginia Darden School Foundation.

Campbell, Denis. 2017. Rise in Life Expectancy has Stalled Since 2010, Research Shows. London. The Guardian, July 18.

Crow, David, and Laura Noonan. 2019. Tim Leissner: Goldman Sachs Banker at the Heart of 1MDB Scandal. Financial Times, 23 December 2019.

Danske Bank. 2018. In Danish. Investigations about Money Laundering. https://danskebank.com/da/om-os/corporate-governance/undersoegelserom-hvidvask Deutsche Bank. 2018. Deutsche Bank Announces Actions to Reshape Its Corporate & Investment Bank and Additional Cost-Cutting Measures. Deutsche Bank Press release April 2018. Frankfurt.

Draghi, Mario. 2012. Speech at the Global Investment Conference. London: European Central Bank. 26 July 2012.

EBA European Banking Authority. 2016. Reports on High Earners and the Effects of the Bonus Cap. Paris.

Editorial Board. 2018. Waning Co-operation makes Next Crisis More Difficult to Tackle. Financial Times, September 13.

FED Federal Reserve. 2016. Federal Reserve Board Formalizes Previously Announced One-Year Conformance Period Extension for Certain Volcker Rule Legacy Fund Investments. Washington, DC. Ford, Jonathan. 2018. Danske and the Incentive Problem with Money Laundering.

Financial Times, November 25.

FSB Financial Stability Board. 2018. Basel III Implementation. http://www.fsb. org/what-we-do/implementation-monitoring/monitoring-of-priority-areas/ basel-iii/ Gilson, Stuart C., and Cedric X. Escalle. 1998. Chase Manhattan Corporation: The Making of America’s Largest Bank. Boston: Harvard Business School.

Group of Thirty. 2009. Financial Reform: A Framework for Financial Stability. https://group30.org/images/uploads/publications/G30_FinancialReform FrameworkFinStability.pdf Hill, Andrew. 2015. When is a Company Too Big to Manage? Financial Times, February 27.

HM Treasury. 2017. Policy Paper, Ring-fencing Information. London.

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J.P. Morgan. 2013. Report of J.P. Morgan Chase & Co. Management Task Force Regarding 2012 CIO Losses. New York.

Jenkins, Patrick. 2017. A Decade on from the Financial Crisis, What Have We Learnt? Financial Times, August 30.

Johnson, Simon. 2010. The Next Financial Crisis. Forum for the Future of Higher Education.

McLannahan, Ben. 2017. Nonprime has a Nice Ring to It’: The Return of the High-Risk Mortgage. Financial Times, August 31. https://www.ft.com/ content/3c245dee-8d0f-11e7-a352-e46f43c5825d ———. 2018a. Wall Street Bonuses Rise 17% to Pre-Crisis Levels. Financial Times, March 26.

———. 2018b. United States has more Than 5,600 Banks. Consolidation is coming. Financial Times, May 23.

Milne, Richard, and Daniel Winter. 2018. Danske-anatomy of a Money Laundering Scandal. Financial Times, December 19.

Minor, Dylan, and Nicola Persic. 2012. The Volcker Rule: Financial Crisis, Bailouts, and the Need for Financial Regulation. Kellogg School of Management. Northwestern University.

NAIC National Association of Insurance Commissioners. 2019. Mortgage backed Securities. https://www.naic.org/cipr_topics/topic_mortgage_backed_ securities.htm Noonan, Laura. 2019. Goldman could Withhold Blankfein Pay Over 1MBD Scandal. Financial Times, February 1.

Obama, Barack. 2010. Remarks on Financial Reform. Washington Post January 21, 2010, transcript, http://projects.washingtonpost.com/obama-speeches/ speech/167 Plender, John. 2017. Lessons from the Credit Crunch. Financial Times, 2017.

Samuels, Simon. 2016. Some Banks are Simply Too Complicated to Break Up. Financial Times, October 11.

SEC United States Securities and Exchange Commission. 2011. SEC Adopts Rules for Say-on-Pay and Golden Parachute Compensation as Required Under Dodd-Frank Act. Washington, DC. Storbeck. 2019. Regulators Fear Deutsche Bank could Bungle Commerzbank Merger. https://www.ft.com/content/fe910f7e-4412-11e9-b168-96a37d002cd3.

Financial Times, March 12.

Storbeck, Olaf, and Chazan, Guy. 2019. Germany Steps Up Work on Potential Deutsche-Commerzbank tie-up. Financial Times, January 17. https://www. ft.com/content/7d145738-19b2-11e9-9e64-d150b3105d21 Tarullo, Daniel K. 2016. Financial Regulation Since the Crisis. Federal Reserve Bank of Cleveland and Office of Financial Research 2016 Financial Stability Conference. Washington, DC.

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The Economist. 2019. The Biggest Bank Merger Since the Crisis may Herald More. The Economist, February 14. https://www.economist.com/financeand-economics/2019/02/14/the-biggest-bank-merger-since-the-crisismay-herald-more Weber, Alex. 2018. J.P.Morgan – Defying Attempts to End Too Big to Fail.

Financial Times, September 18.

Wikipedia. 2010. List of Writedowns Due to Subprime Crisis.

Wolf, Martin. 2018. Why So Little has Changed Since the Financial Crash.

Financial Times, September 4.

CHAPTER 14

Conclusion

It has been the intention and hope of this book to have added something to the causation of bank failure and financial crisis by a combined approach of economic history, management consultancy and banking experience.

This approach has led to understanding absent management in banking as a reason for bank failure and a cause of financial crisis.

There have been banks for at least 600 years in the Western World and probably much longer. Something as potentially impactful and dangerous as absent management in banks would surely have been noticed at some stage over this long period. Considering this apparent omission was one reason for taking a long-term historical approach to write about absent management in banks. The other reason was to try and understand how and why we ended up in a situation where some banks are not managed.

Management is a determining factor in bank failure. It is possible for all banks to fail in a crisis, such as the Plague in Europe in the fourteenth century. All major banks can be nationalised such as happened in France in 1982, including the Rothschild, BNP, Paribas and Société Générale banks.

In nearly all other bank failures it is management that is the determining factor. Sometimes it is management that has put the bank in harm’s way over a period of time by the choice of business lines, location or both. In other cases the management makes the wrong decision when external factors threaten the future of the bank.

© The Author(s) 2020 C. Dinesen, Absent Management in Banking, https://doi.org/10.1007/978-3-030-35824-2_14

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Bad management causes failure of banks. Mistakes are made by management of banks and by management of other commercial organisations.

Sometimes these mistakes result in the failure of the bank or organisation.

Since the 2008 financial crisis bankers have been accused of greed and worse. Some of these accusations were justified. Some bankers had become bankers to make as much money as possible with little or no regard for the consequences. A few infamous individuals were traders rather than senior managers. They caused their banks such losses from unauthorised actions that their bank might fail, as Baring did in 1995 and Société Générale nearly did in 2008.

The top management in the largest banks that failed were intelligent and hardworking people. They may have been greedy and ‘not here for the common good’. But it is difficult to believe that they managed so badly as to cause the largest banking and even corporate failures in history, destroying their institutions, causing devastation to their own and other countries and have their reputations tarnished forever. During the 2008 financial crisis some bank failures were devastating in terms of size and loss to the banks’ owners, employees, customers and other stakeholders. It seemed and still seems unfathomable that anybody would manage so badly as to lose over $50 billion as did Merrill Lynch by 2008. It seemed impossible that anybody would manage that badly.

Bad management, mistakes, seemed unlikely to be the reason for many of the most spectacular failures in banks. If it is difficult to believe that anybody would manage so badly as to cause such major bank failures as were seen in the 2008 financial crisis, there is one other possible reason for these astounding bank failures. Perhaps some of these banks were not managed, perhaps there was absent management.

There are two main reasons for absent management, complexity and inability to manage the complexity. Complexity partly comes about because it is allowed by regulation.

Regulation has been much criticised for being the cause of bank crisis including the most recent crisis. But regulation does not cause bank failure. Regulation provides parameters within which banks are allowed to operate and to fail. But it is up to banks to fail. If regulation prohibits a certain action or approach and the bank proceeds anyway that is breaking the law. Sometimes banks do that and sometimes there is absent management involved in that. This was the case when Salomon submitted auction bids for Treasury bonds above what the regulatory rules permitted. But it was not regulation, but absent management, that caused heavy fines and that was close to causing a failure of Salomon.

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Regulation is important in the level of complexity it allows banks.

Before the Great Depression in the 1930s United States regulation allowed banks to become involved in additional lines of business. The margin lending that allowed customers to borrow in order to invest in the stock market contributed to the stock market bubble, to the crash itself and to many, perhaps thousands of bank failures. The complexity of the new line of business of margin lending was beyond what these previously simple banks could manage and caused absent management. But it was not regulation but the banks’ management that engaged in margin lending that contributed to the Great Depression and caused the many bank failures. And the many bank failures made the Great Depression much worse.

Regulation often tightens after a crisis to avoid a repetition, as it did after the Great Depression. Then regulation reduced the complexity of managing banks in the United States by separating commercial, deposittaking banks from investment banks. The prime motive of this regulation was to protect deposits. An additional, probably unintended, effect was to make the management of banks less complex. Regulation had long restricted United States banks to simple one state banking. In the United Kingdom banking was historically separated into commercial and investment banking with stock broking being a specialist separate activity and this tradition was enshrined in regulations.

Tightening of regulation after the Great Depression, together with the international currency regulations provided by the Bretton Woods Agreement, resulted in a less complex banking environment. This contributed to the longest period in modern times without a banking crisis, 25 years, from 1946 to 1971. So regulation can, possibly, restrict complexity, bank failure and financial crisis. While regulation can contribute to making banks more or less manageable, it does not cause bank failure. As regulation applies to all banks, and all banks do not fail in a crisis, failure is caused by management and sometimes by its absence.

When these regulations were loosened in the 1980s and 1990s in the United States, and similarly in the United Kingdom, the complexities of managing combined commercial and investment banks appeared and were multiplied if the banks also operated internationally. In some cases, the complexity was beyond what bankers could manage and caused absent management.

Citi, as the largest and most complex of these banks, became subject to United States government inspections in 1990 due to its losses from the crash on Black Monday on 19 October 1987 and in turn caused by unmanageable complexity. SG Warburg was unable to scale its ­management in line with its rapid and vastly increased complexity and was taken over by UBS in 1995.

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After the 2008 financial crisis and Great Recession, regulation has again been tightened. This tightening has primarily been about much more of the same regulation as was in place before the crisis. It has been about requesting banks to have more capital. There have been some simplifications such as restrictions on banks trading for their own account. In the United Kingdom, deposits have been ring fenced within combined commercial and investment banks. Regulation still allows very large and complex banks, and there has been almost no reduction in this complexity, for example by splitting them up, as was done after the Great Depression.

Avoiding such regulatory intervention has been a major success for the large banks. And it was a success achieved in spite of the damage caused by large complicated banks. The success has been partly achieved by the banks’ extensive political lobbying against being split up.

Regulation itself is now significantly more complex, for example in terms of the types of capital banks must hold. Complex regulation favours larger banks and consolidation, as larger banks have more resources to meet the demands of more complex regulation. Larger banks also have more resources to take advantage of any gaps in complex regulation. This can result in regulatory arbitrage, which has been a banking practice since the Medici found ways around regulation banning usury.

The historical approach showed that specialist management of banks had not been important for perhaps the first 500 years of banking, except in a few very large banks. During this period, these five centuries, almost all banks did not need management because they were simple operations.

They nearly all operated in a single line of business or possibly two, and nearly all in a single location. These were simple operations so the senior bankers could carry on with banking and had almost no need for management.

There were exceptions and two of these have been considered in more detail, the Medici and the Rothschilds. They were chosen because they were much larger, involved in more lines of business and in more locations than nearly all their contemporaries. And because the source to understand some of their management was available and had been written about by great historians.

The Medici was an enormously successful bank, becoming the largest bank in Europe in the fifteenth century. Its owners amassed a great fortune, achieved the highest political office and lasting fame as arts patrons.

Their growth resulted in significant complexity which in turn resulted in absent management. Regulation banning usury had made their products

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more complex because interest could not be made on the deposits in their bank or the loans they made to sovereigns. The complexity related to deposits was overcome by the Medici through the making of informal gifts, closely aligned with what other banks were gifting, but not in breach of regulations because they were informal. The cash imbalance created by the papacy collecting enormous volumes of tithes made trade with Northern Europe highly complex and eventually impossible. The absent management that caused the failure of the Medici Bank was due to their political success with the fourth generation becoming de facto rulers of Florence. And this political success meant absent management and failure of the bank after 100 years.

The Rothschilds were another extremely successful bank, becoming the largest bank in the world for most of the nineteenth century. The management of this first, and for most of the nineteenth century only, multinational bank was based on family and religion. Restricting ownership to family partners and reinforcing this by extensive intermarriages continued this for three and into the fourth generation. The Rothschilds grew by line of business and territory but almost always kept the complexity to within what they could successfully manage. There were early signs of absent management such as their inability to account for their enormously profitable positions related to the Napoleonic Wars. The Rothschilds dominated sovereign bond issues and bullion trading. They overcame the complexities of political upheavals through diversification and support of those suffering local crisis in London in 1829 and in all the other four locations of Frankfurt, Paris, Vienna and Naples in the 1848 year of revolutions. James Rothschild in France required both family support and French government restructuring of a loan to survive. The Rothschilds remained producer managers at all times, although they would never have recognised themselves as anything but bankers. The Rothschilds could not find a family member willing to start up in the United States in the nineteenth century. This absence of a family member manager there eventually contributed to their comparative decline as a major multinational investment bank when the importance of the United States economy and its leading bank J.P.Morgan grew. Neither the Medici nor Rothschilds, the largest banks of their time, developed specialist management.

Growth in the size of banks results in complexity. The larger an organisation is the more complex it is to manage. Growth of the first Industrial Revolution factories was where corporate management was born.

Regulation or lack of it is what allowed modern banks to grow. Once

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regulation allowed banks to grow, by line of business and territory, their growth was spectacular. Mergers and acquisitions were the most important growth mechanism rather than organic growth. And the deal making of banks buying other banks became an essential part of the role of the leaders of banks. And acquiring other banks is a lot more exciting than day-to-day management. Just like being the head of a large bank is more exciting, more prestigious and better rewarded than heading a smaller bank.

Siegmund Warburg and the bank he founded was characterised as managed by a ‘renaissance prince’ until his retirement the 1970s (Ferguson 2010). Subsequent growth from less than 200 people to over 5000 in the 1990s involved astoundingly increased complexities, with little evidence of corresponding development and transformation of management. To prevent it from possible failure this large British financial institution was taken over by the Swiss giant and universal bank UBS. The lack of development of specialist management leads to absent management. This in turn made it impossible for SG Warburg to bridge the history of management of a small and simple to a large and complex bank.

Managing a larger bank is more complex than a smaller bank. In the United States some banks grew very rapidly by acquisition, and once they had grown very large they then merged with each other. Citi emerged from the merger of National Citi Bank of New York with First National Bank of New York while also starting up operations in nearly 100 countries. Banc One had acquired 137 banks in 74 different transactions over 25 years before merging with J.P.Morgan, which itself had merged with Chemical Bank and Chase Manhattan. Bank of America had grown so large by the early 2000s that it had reached the regulatory limit of a tenth of all United States deposits. In the United Kingdom, Northern Rock had taken over 30 smaller building societies. Lloyds TSB had reached a size where the competition authorities would not allow it to take over any more banks. RBS had become one of the largest banks in the world after its takeover of NatWest in the United Kingdom and Citizens Bank in the United States, which then in turn made 25 acquisitions there. The acceleration in size and complexity was phenomenal. It would be a phenomenal and at times impossible challenge for management to keep up with the resulting complexity.

These mergers and acquisitions were possible partly because the banks were listed on the stock exchange. The acquiring bank could pay for the acquisition with issuing additional shares. Most of the larger commercial banks had been listed for decades. Pure investment banks listed from 1971 and primarily during the 1980s. Additional capital also increased their

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trading with their own capital and enabled them to grow underwriting of share and bond issues. The change in ownership affected incentives, particularly in investment banks that had previously been partnerships.

Incentives have always been central to bank management. For the Medici, the change in incentives with succession of general managers probably resulted in increased fractions between the branches. A lack of additional incentives for the Rothschilds’ established and wealthy positions in Europe may have been a reason why no one from the third or fourth generation wanted to go to the increasingly important United States in the nineteenth century to set up a branch.

Path dependent incentives were present in banks as early as the 1980s.

It became difficult for banks not to pay bonuses in bad years because of the impact on morale and retention of the best people. Not changing these often inefficient incentive structures meant that they had become path dependent. This was absent management because nothing was done.

Change in ownership structures, in particular from family ownership and partnerships to listed corporations, was instrumental in changing incentives and management of banks and particularly investment banks.

Titles were changed from partners to managing directors but with little evidence of enhanced management capability. Receiving bonuses partly in shares that could not be sold for a few years incentivised employees for this short period. But it was a much shorter incentive period than the partnership or family structure that had provided incentives to prevent failure of banks in the long term.

Incentives were directed at making more money for the bank and the bankers by lending more, taking more risk and taking over other banks.

And incentives were very substantial. In some investment banks, some employees became multimillionaires in only a few years. This level of wealth meant that these employees became increasingly difficult, sometimes impossible to manage, because additional incentives or lack of the same had little or no effect on behaviour.

Incentive structures continued to promote growth but do not appear to have encouraged management including risk management. This was because incentives were often related to profit rather than specific management task. Incentives also lacked downside when things went badly. These incentive structures made banks more prone to risk from unmanaged growth.

Bankers’ bonuses were a prime target of regulation after the 2008 financial crisis, not least because of public outrage, and various regulation

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limited bonuses to a maximum of one times salaries, longer pay out periods, claw back clauses or a combination of these. Although subject to more regulatory restrictions, the amount of bonuses on Wall Street in 2018 had almost reached the level of the previous highest year of 2006, just before the 2008 financial crisis.

With the exceptions of a few early banks, such as the Medici, Rothschilds and J.P.Morgan, and Citi after the First World War, banks were small and therefore simple to manage until about the 1970s. That is the main reason why banks did not develop specialist management. Management was a development reserved for non-financial institutions from the time of the Industrial Revolution in the eighteenth and nineteenth centuries and, in its modern form, in the 1920s and 1930s.

When banks grew very rapidly in size and complexity from the 1980s, allowed by regulation, management development could not keep pace.

This made banking crises more likely particularly from a risk management point. Management in banks did eventually develop many of the same capabilities as in industry, particularly in retail banks, where low value and large number processing was important. Management’s development in banking segments involving high value, single-item transactions was still, however, underdeveloped by the time of the 2008 financial crisis.

People mostly join banks to be producers but not managers, to lend and do transactions, but not to manage. During the time of available banking history the story is of bankers running banks, sometimes with little evidence of management. Bankers generally did not want to manage, were not incentivised to manage and had no management training. So they managed as producer managers, with production mostly being what they wanted to do, what they were paid to do and what they were good at.

Management came a poor second. Management was at times considered a second rate activity and something what restrained banking success, particularly in investment banks. This history of management in banking has been the path from the earliest banks. Managing banks as renaissance princes rather than full time, specialist managers had become the tradition, possibly even path dependent by the time banks became very large and very complex at the beginning of the twenty-first century.

The combination of increased complexity of banks and the path dependent approach of producer managers resulted in absent management.

There were many banks and instances where banks were well managed and badly managed. But there were other times when some banks were not managed at all. Some of those banks failed and some of those failures

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were causes of financial crisis, including a Great Depression and a Great Recession.

If it is right that absent management of banking exists and is a cause of bank failure, it is puzzling that it has not been mentioned more before.

One reason may be that there was a lack of academic interest in the management of banks, so little was written about management when much was written by bankers doing banking. One possible explanation may be that most approaches to banks have been biographical, focused on a single person or a few people, economic, financial or journalistic. And there has been little focus on something that is not there.

Absent management described in other words can be detected by some of the comments made by bankers themselves. They included Siegmund Warburg being concerned that his firm was becoming unmanageable large in the 1950s (Ferguson 2010). In 1990, the chief executive officer, chairman and president of Salomon were observed as having lost the ability to lead (Sharp Payne and Santoro 2004). In early 2007, the chief executive officer of Citi was professing to keep dancing as long as the music was playing. The chief executive officer of Merrill Lynch said in October 2007 that assessment and potential risk of subprime and mitigation strategies were inadequate (Wilchins 2007). Not wrong, but inadequate, because of absent management. In 2009 a retiring Citi Board Director said that he and many others did not recognise the serious possibilities of the extreme circumstances that faced the financial system then (Rose and Sesia 2011).

In 2015 the chief executive officer of HSBC said that he clearly could not know what every one of the 257,000 employees were doing, when surprising problems emerged in its Swiss operations (Hill 2015). Regulators have also talked about what was effectively absent management such as when the British regulator characterised HBOS as a group whose growth had outpaced its ability to control risk in 2004, four years before HBOS failed (Parliamentary Commission 2015).

There have been many examples of absent management in banking, once banks became large, diversified or both. If absent management causes the failure of that bank and it has no wider consequences, it is still a grave event for that bank’s customer, owners, employees, suppliers and other stakeholders. One example of this was the failure of Barings in 1997, caused by a rogue trader. A rogue trader is initially an example of absent management. When there is a continuous and complete absent management, the rogue trader threatens and can cause a bank failure. And when Barings failed, the owners lost their money and those not subsequently

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employed by the new owner ING lost their employment. But there was no wider ramifications, no banking, financial, currency or sovereign debt crises.

It is when absent management in banking caused a wider banking and financial crisis, or makes another type of crisis much worse, that this absent management in banking has such devastating effects. And these are effects that range from loss of savings and pensions to an economic recession or depression that affects the lives of millions of people, sometimes for a decade or more.

Some big complicated banks manage themselves in crises, such as HSBC, which had the largest loss of any foreign bank from United States subprime lending. But HSBC was highly diversified so could cover the losses from earnings elsewhere. It also acknowledged the losses early and managed its way through the 2008 financial crisis.

Other banks simply kept lending, such as Washington Mutual. Some banks leveraged up and traded like Bear Stearns. Some banks leveraged up, lent to subprime borrowers, packaged the loans and sold them on to investors, as did Lehman Brothers. Some banks packaged and sold so many packaged subprime loans that when there were no more willing investor for all parts of the packages, the bank kept what they could not sell, one of which was Merrill Lynch. And some did all of these, a universal bank like UBS. And these banks did all this to such a degree that it is very difficult to detect any management at all. Nobody would manage that badly, so one possible, likely conclusion is that there was absent management.

And the costs of these occurrences of absent management were devastating, so devastating that it seems morbid to repeat them in any detail from the chapter on the cost of the 2008 financial crisis. The loss of savings and pensions, businesses and employment, the stress, increased taxation and indebtedness of the next generation were so costly that not preventing it reoccurring seems an absence of political responsibility.

Possible impact on mortality as social spending was cut and political ramifications in the outcome of elections have yet to be understood.

The regulatory response in terms of preventing a reoccurrence of a similarly devastating impact has mainly been to require banks to hold more capital. Little has been done to make banks simpler or better ­managed, even managed at all. The examples of absent management in some of the highest regarded banks after the 2008 financial crisis, including in J.P.Morgan, Danske Bank and Goldman Sachs, indicate that absent management has not been addressed by regulation.

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So what about the future. It is, of course, difficult for anyone to predict, particularly about the future, as Niels Bohr, the Nobel Laureate in Physics, said. Historians are notoriously poor at predicting the future, perhaps because history does not repeat itself, being much too complicated.

Banking experience teaches you mainly about the here or now so is not much use for prediction either. Management consultants sometimes use optionality to at least attempt to consider a range of options of what might happen rather than what will happen.

Possible options for reducing future incidents of absent management include continuing regulating banks based on high level of capital, the current option. A second option is for banks to become less complex by line of business, geography or both and thereby less challenging to manage and less likely to fail. A third option would be to ensure that those responsible for managing banks always do so because they have the capability and are incentivised, positively and negatively. A fourth option is a combination of several or all of these options. No doubt additional options or combination of options exits.

It is possible to ask banks to hold so much capital that it cannot be eroded however absent the management. This is close to the regulatory approach currently adopted. This is an argument with some validity, but such levels of capital are unlikely to allow banks to make an attractive return on this capital. And bankers being the innovative and energetic masters of capital they have been for six centuries will find ways to expose this larger capital to risk to achieve attractive returns. Given the very large amounts of capital required for banks to appear safe from failure, attractive returns are likely to require very large risk exposures. These exposures are likely to be complicated. And if these exposures are very complicated they may also be unmanageable. So requesting that banks hold more capital is likely to make banks more rather than less complex. This option completely ignores complexity and is not aimed at reducing it. It is therefore not going to reduce the risks of absent management. It may increase it.

Regulation itself has also become increasingly complex. This makes it difficult to implement and supervise for regulators and to adhere to for banks. Substantial amounts of intended regulation have not yet been implemented ten years after the 2008 financial crisis. Many of the rules of the most important United States regulation contained in the Dodd-Frank Act are yet to come into effect. Basel III is not fully implemented.

Regulatory loosening is now on the political agenda in the United States,

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before all of the post-2008 financial crisis regulation has been implemented. One of the reasons the regulation has not been implemented before it is being loosened is that it is very complex.

Increased capital required by more complex regulation will not make management of banks simpler. The exception was the post-Great Depression regulation that split commercial and investment banks. Post-­ 2008 financial regulation will make banks larger and more complex, because increased regulation nearly always does. This is because larger banks have more resources to deal with complex regulation than smaller banks. So it gives a competitive advantage to larger banks. This often results in large banks taking over smaller banks although regulation has at least kept this limited to takeover of failing banks since the 2008 financial crisis. Regulation allowing mergers and takeover amongst medium and smaller banks has now been relaxed in the United States. After ten years of only a few large mergers, Truist Fanacial Corp, the new sixth largest bank United States bank, has just resulted from a merger.

Absent management was not identified as a target of regulation after the 2008 financial crisis. It is therefore understandable why the increased regulation is unlikely to reduce the risk of absent management. If anything, regulation has increased the risk of absent management.

The second option would be to simplify the banks. After the Great Depression, simplifying banks was a side effect of protecting depositors by splitting commercial and investment banks. This simplification probably contributed to the longest absence of banking crisis in modern history.

One reason was because banks became simpler to manage and there was less absent management.

Given this experience and the likely cost of a future financial crisis, it is surprising that banks have not been split into separate lines of business.

This would make them simpler to manage and make absent management less likely and failure even less likely. This has not happened and seems unlikely to happen now partly because of time passed since the last financial crisis and partly because of inadequate political will. In the face of extensive political lobbying by the banking sector, and perhaps a lack of understanding or willingness to face the potential economic consequences, politicians missed the opportunity to simplify banks after the 2008 financial crisis.

In addition to the Glass-Steagall Act of 1933, politicians of the past have stood up to larger corporations with anticompetition legislation such as the United States Sherman Act of 1890, the Clayton Act of 1914 and the

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Federal Trade Commission Act of 1914 in the United States. The European Union has proven resilient in protecting competition and taking on the largest corporations in more recent times. But this has all been to ensure a competitive marketplace. It is difficult to find examples of political action and regulation that ensures that corporations know what they are doing simply in terms of size and complexities of management. Many governments are as bad as banks in this respect. The United Kingdom’s National Health Service is the fifth largest employer in the world, with 1.7 million employees (Nuffield Trust 2017) only exceeded by the United States Department of Defence, the Chinese People’s Liberation Army, Walmart and McDonalds.

So it was perhaps difficult for the British government to tell RBS with 170,000 employees that it was too large and complex to manage.

If regulators and politicians accepted that some banks were too complex to manage, this might persuade them to request that banks need to be simpler. This could be achieved by splitting them up or banning them from some combinations of lines of business. But with politicians themselves being in charge of operations even more complex than banks, this is not easy to see being implemented.

Another possible development within the option of simplifying banks is shareholders selling the shares of banks that are unmanageable. Both Danske Bank and Goldman Sachs saw significant selling of their shares following their recent scandals. Perhaps shareholders will go one step further and push for a breakup of large complicated banks in the same way shareholders have influenced the simplification of General Electric and the proposed geographical split of insurer Prudential Plc into British and Asian entities.

As a third option, politicians and regulators could instead ensure that managers in banks, actually and always, managed the banks. The Senior Manager and Certification Regime in the United Kingdom seeks to make individuals responsible for specific functions in banks and may reduce absent management. That is assuming that these functions are not too complex to manage and that incentives are aligned with the responsibilities to manage and not just to produce.

Incentives may not work as they do, historically, not seem to have ensured consistent management. The production part of the producer managers’ role appears to have dominated. Incentives have resulted in exceptional production sometimes to the complete exclusion of management, as in some investment and commercial banks in the 2008 financial crisis. One possible approach would be for regulation to require evidence

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of consistent management before any bonus could be made for production. The response to the regulations of incentives so far provides little encouragement for this approach. When incentives were limited to one times fixed salary, banks simply increased fixed salaries. Wall Street bonuses are now close to reaching the amounts paid in 2006, the highest year on record. One recent encouraging example is that Goldman Sachs is withholding part of the bonuses for its top management while awaiting clarification of the 1MBD scandal.

A change to the producer manager approach and developing specialist management in banks also seems unlikely to be successful. There are very few areas of professional services where this approach has led to improved management. The four largest accounting firms are possibly examples of better managed professional services than banks. However, their most senior partners still have relationships with clients so the producer manager approach is still present. And the complexity of the big accountants also appear too great with a prime example being the complete failure of what was previously one of the five largest accountants, Arthur Anderson, over the Enron scandal in 2001.

Bank managers would not have to be faultless, being only human. But they would have to prove that there was always someone managing not only the bank, but each and every one of its activities. In terms of the more recent examples of absent management, J.P.Morgan, Danske Bank and Goldman Sachs, this may not have gone far enough. It is possible that the sanctions against these events have yet to be fully implemented. Such sanctions may set the examples for other managers in banks to ensure that they always manage the banks, well or less well.

Perhaps other industries have something to teach banking, just as they originally taught banks the rudimentaries of management when banks became large and complex in the 1970s. Perhaps the same sanctions for transgressions should be applied to absent management in banks as is applied to ship captains or airline pilots including lifetime bans. Currently, such sanctions are only applied in banks in cases of more severe situations such as fraud and other criminal activity.

There is no real indication that management is able to effectively manage the complexity of the larger banks. Regulation requesting the banks to hold more capital, restricting incentives and making management more responsible has yet to provide a convincing certainty against bank failure caused by absent management and particularly against bank failure causing a wider financial crisis. Given the cost of the 2008 financial crisis, particu-

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larly in terms of stress and cost to millions of customers, taxpayers and recipients of government support, surely this should be prevented if at all possible. The ability of central banks and taxpayers to deal with another crisis is significantly less given the cost of the 2008 financial crisis. And the most important lesson from history is that reducing complexity of banks is the only way to make them manageable, to reduce the risk of absent management and the risk of another financial crisis caused or made worse by unmanaged banks.

Producer managers will always prioritise production as long as they are incentivised to do so. Management, including producer managers, will always believe and argue that it is able to manage any size, complexity and future growth. The history of absent management in banking tells a different story.

This book has attempted to show that the complexity of banks and their producer manager approach results in absent management that can cause bank failure and financial crisis. History has shown that banks have been too complex to manage, and current developments show that this absent management continues today. Acknowledging absence of management will require humility amongst bank management. And humility has been in short supply in the history of management of banks. So shareholders of banks could influence reduced complexity by buying the shares of banks that are manageable and selling those that or not. Perhaps shareholders will pressure for the breakup of complicated banks as shareholders have done with non-financial corporates. Most importantly regulation should enforce simplicity and ever present management of banks. This will require political will on our behalf to protect us from absent management in banking and its devastating cost.

References Ferguson, Niall. 2010. High Financier, The lives and Time of Siegmund Warburg.

London: Penguin.

Hill, Andrew. 2015. When is a Company Too Big to Manage? Financial Times, February 27.

Nuffield Trust. 2017. The NHS is the World’s Fifth Largest Employer. https:// www.nuffieldtrust.org.uk/chart/the-nhs-is-the-world-s-fifth-largest-employer Parliamentary Commission on Banking Standards. 2015. An Accident Waiting to Happen’: The Failure of HBOS. London: Parliamentary Commission on Banking Standards.

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Rose, Clayton, and Aldington Sesia. 2011. What Happened at Citigroup (B)?

Boston: Harvard Business School.

Sharp Paine, Lynn, and Michael A. Santoro. 2004. Forging the New Salomon.

Boston: Harvard Business School.

Wilchins, D. 2007. Merrill Writedowns May Signal Broader Risk Problems.

Reuters, October 24.

Index1

A AAA credit rating, 195 Abbey National, 81, 82, 211, 212 Abbreviations, 6 Ability to pay, 60, 155, 260 ABLV, 265 ABN AMRO, 90, 91, 213–215 Absent management, 1–13, 15–17, 19, 22, 25, 27–31, 36–38, 40–42, 44, 45, 48, 49, 51–72, 75–93, 95–115, 117–131, 133–173, 177–198, 204, 205, 207–209, 211–215, 217–219, 222–224, 227–242, 245–266, 271–285 Acciaiuoli, 15 Accountability, 4, 128, 130 Accounting, 37, 113, 209, 210, 284 Accumulating risks, 89

Acquisitions, 9, 12, 54, 61, 62, 64, 67, 75, 79, 81–86, 88, 93, 95–97, 104, 110, 128, 130, 134, 149, 159, 160, 164, 185, 188, 191, 192, 195, 204, 205, 207, 211–215, 221, 256, 265, 276 Administrations, 9, 13n1, 137, 139, 145, 263 Administrators, 9, 13n1, 134 Advisors, 100, 130, 177, 185 Agricultural Bank of China, 241 Alum, 19–21 American Bankers, 138 American Civil War, 41, 42 American General Corporation, 195 American International Group (AIG), 194–198, 229, 233, 239 American Savings Bank, 204 Anti-Semitism, 48

Note: Page numbers followed by ‘n’ refer to notes.

1

© The Author(s) 2020 C. Dinesen, Absent Management in Banking, https://doi.org/10.1007/978-3-030-35824-2

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INDEX

Arbitrage, 18, 33, 43, 52, 53, 57, 114, 129, 274 Argentina, 44, 45, 103 Asian, 145, 159, 283 Asset management, 82, 87, 92, 96–98, 114, 125, 126, 144, 145, 154, 159, 160, 185, 195, 215, 216, 218, 221 Assets, 20, 24, 25, 27–30, 44, 45, 47–49, 59, 65, 78, 79, 82, 85, 87, 88, 90–92, 96–98, 105, 108, 110, 113, 114, 120, 125, 126, 128, 144, 145, 151–154, 157, 159–161, 163, 167, 168, 177–179, 182–185, 187, 188, 191, 192, 195, 198, 201, 204, 207–210, 214–216, 218, 220, 221, 228, 231, 234, 235, 255, 257–259 AT&T, 47 Attorney General, 196, 266, 286 Auger, Philip, 7, 62, 140 Austerity, 118, 234, 238, 240, 241, 246 Australia, 103, 109, 110 Avignon, 24, 25 Axa, 87 B Bad bank, 218 Bagehot, Walter, 41 Bail-in bonds, 254, 255 Bancassurance, 87 Banc One, 77, 79, 85, 88, 103, 104, 106, 139, 263, 276 Bank Act, 60, 64, 104 BankAmerica Corporation, 191 Bank Antonveneta, 91 Bankers’ bonuses, 118, 261, 277 Bank failure, 2, 13, 52, 66, 87, 151–173, 177–198, 201, 224, 229–231, 235, 246, 248, 249, 252, 254, 255, 271–273, 279, 284, 285

Bank for International Settlements, 58, 251 Bank Holding Company Act, 64 Banking, 1, 15–31, 38, 51–72, 76, 95–115, 117, 133–151, 177, 201–224, 227–242, 245–266, 271 Banking crisis, 4, 8, 15, 16, 22, 38, 40, 42, 55, 56, 68–72, 118, 150–152, 169, 201–224, 227, 231–237, 239–242, 245, 246, 252, 254, 273, 278, 282 Banking system, 2, 38, 39, 53, 56, 136, 152, 223, 234, 248 Bank of America, 79, 89, 91, 184, 185, 190–192, 201, 229, 240, 242, 257, 259, 265, 276 Bank of Canada, 64, 97, 163, 184, 252 Bank of England, 38, 39, 41, 42, 44, 45, 53, 63, 110, 111, 152, 164, 167, 211, 215, 219, 222, 223, 250 Bank of Japan, 163 Bank of Montreal, 64 Bank of New York, 92, 169, 276 Bank of Nova Scotia, 64 Bank of Scotland, 91, 209, 212–215, 227, 230, 239, 242, 258, 276, 283 The Bank of the Future, 139 Bank of the United States, 42, 56, 185, 191 Bank run, 40, 41, 55, 68, 89, 151, 164, 165, 167, 210, 214, 231, 258 Banks, 1, 8, 15–31, 33–49, 51–72, 75, 95, 117, 133, 151–173, 177–198, 201–224, 227, 245, 271 BarCap, 221, 222, 224 Barclays, 62, 90, 91, 99, 184, 220–222, 224, 242 Bardi, 15, 16, 19 Barings, 33, 34, 42, 44, 45, 47–49, 56, 63, 66, 89, 109–111, 113, 127, 149, 152, 166, 183, 229, 272, 279 Baring Securities, 89, 110 Barings crisis, 44, 49, 109, 110, 152

INDEX

Basel Committee, 58, 251 Basel I, 59, 251 Basel II, 59, 251, 252, 254, 255, 281 Basel III, 251, 252, 254, 255, 281 BBC, 109, 164 Bear Stearns, 99, 160–162, 167–170, 177, 182–185, 190, 201–203, 207, 233, 240, 242, 256, 259, 280 Belgium, 41, 58, 79, 91 Benci, Giovanni d’Amengo, 24, 25, 27, 29, 31, 120 Berkshire Hathaway, 195, 196, 203 Big Bang, 62, 63, 68, 78, 98, 99, 257 Bills of exchange, 17, 18, 21, 22, 25, 26, 35, 36, 40, 52, 66 Bismarck, Otto von, 41 Black Monday, 66, 81, 97, 273 Blair, Nathan T., 33, 195–198 Blucker, Gebhard von, 36 BNP Paribas, 163, 167, 231, 242, 271 BNP, 112 Paribas, 112 BNY Mellon, 92, 202 Board of directors, 6, 100, 253 Bond, 9, 36–42, 44, 46, 48, 57, 59, 60, 62, 65, 83, 86, 87, 95, 96, 98, 106–108, 111, 112, 114, 128, 129, 142, 152, 161, 171, 179, 180, 188, 189, 193–195, 216, 217, 223, 241, 247, 248, 254, 255, 266, 272, 275, 277 Bonuses, 10–12, 96, 101, 104, 118, 122–127, 129–131, 148, 181, 182, 223, 240, 261, 262, 277, 278, 284 Borrowing, 2, 15, 37, 55, 65, 69, 114, 153, 165, 170, 183, 214, 219, 228, 233–237, 239, 247 Bought deal, 96, 97 Branch, 9, 16, 17, 22–31, 35, 52, 64, 75, 76, 90, 100, 120, 134, 139,

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148, 159, 167, 179, 205, 206, 210, 239, 258, 264, 265, 277 Branching Efficiency Act, 64 Brazil, 44, 45, 90 Breton Woods, 58 British, 3, 36, 38, 39, 47, 56, 62, 63, 78, 97, 99, 110, 164, 166, 167, 184, 208–213, 215, 219, 222, 223, 227–229, 231, 257, 259, 276, 279, 283 British Bankers Association, 219, 222, 223 British Empire, 47 British Petroleum, 97 British Treasury, 63 Bruges, 22, 24, 25, 27, 28 Buderus, Carl, 33, 36 Buffett, Warren, 83, 106–109, 129, 130, 135, 203 Building societies, 164, 165, 167, 204, 208, 211, 276 Bulge bracket, 99 Bull market, 185 Bureaucracy, 77, 106, 108, 141 Business lines, 3, 78, 105, 271 Business school case studies, 6–9, 12, 77, 83, 119, 136 Business school graduates, 101 Byzantine Empire, 26 C Cambridge, 110 Canada, 58, 60, 64, 97, 103, 104, 163, 184, 252 Canadian Bank Act, 64 Canadian Commercial Bank, 252 Canadian Deposit Insurance Corporation, 252 Canadian Imperial Bank of Commerce, 64, 97, 252 Canigiani, Gherardo, 28

290

INDEX

Capital, 24, 26, 27, 33–35, 39, 41, 44–48, 52–54, 58–60, 68, 69, 71, 77, 80, 82, 89, 95–100, 104, 109–115, 126, 128, 130, 141, 145, 153, 156, 157, 160–162, 165, 167, 170, 171, 178, 179, 182, 183, 189, 190, 192, 195, 197, 198, 201–203, 207–213, 215–218, 223, 228–230, 234, 241, 247–249, 251, 252, 254–256, 259–263, 274, 276, 277, 280–282, 284 Capitalism, 119 Capital ratios, 59, 251 Caribbean, 64 Carlsberg, 76 Carter, President, 155 Casualty, 5, 87, 88, 161, 212 Catholic Church, 18, 20 Cause, 2–4, 6, 7, 12, 13, 18, 47, 49, 54, 56, 71, 72, 75, 81, 98, 113, 114, 118, 124, 126, 147, 151, 152, 154–173, 188–191, 194, 201–224, 227–233, 237, 241, 242, 246, 247, 250, 255, 258, 265, 271–273, 279, 285 Cayman Islands, 64 Cerberus Capital Management, 167 Chairman, 77, 78, 107, 109, 113, 134, 178, 189, 217, 264, 279 Chairman of the Board, 107, 113–114, 217 Chancellor of the Exchequer, 211 Chandler, Alfred, 9, 71, 137, 138 Charging interest, 52 Charter One, 85, 86 Chase, 57, 61, 79, 82, 88, 89, 147 Chase Manhattan, 82, 99, 106, 276 Cheltenham, 211 Chemical Bank, 82, 105, 106, 262, 276 Chemins de Fer du Nord, 47 Chicago, 97, 100–104, 110

Chief executive officers, 3, 7, 34, 82, 85, 86, 90, 103, 104, 107, 109, 113, 115, 121, 134, 135, 139, 140, 145, 162, 169, 178, 185, 186, 188–192, 195–197, 202, 207, 213, 224, 256, 262–264, 266, 279 Chief investment officer, 263, 264 China, 69, 103, 159, 173, 184, 202, 241, 242 China Construction Bank, 241 China Investment Corporation, 202 Chinese People’s Liberation Army, 283 Christian VIII, King, 34 Church, 18, 20–22, 136 Citi, 3, 34, 57, 80, 81, 84, 85, 87–90, 106, 109, 115, 124, 125, 129, 131, 136–139, 169, 170, 190, 192, 207, 208, 219, 242, 257, 273, 276, 278, 279 Citibank, 61, 90, 99 Citicorp, 61, 87 Citigroup, 87, 98, 201 CITIC Securities, 184 Citizens Bank, 85, 276 Citizens Financial Group, 212 City of London, 36, 41, 45, 63, 136 Claw backs, 261, 266, 278 Clayton Act, 282 Clearing banks, 62 Clement VII, 30 Client, 5, 16, 17, 20, 21, 30, 36, 61, 62, 69, 80, 81, 85, 87, 90, 95, 97, 98, 100–102, 104, 105, 107–112, 119, 123, 134, 139–144, 146–149, 153, 161, 162, 168, 180, 197, 206, 215, 216, 218, 222, 257, 261, 284 Clinton, President, 61 Coal, 76, 135, 136 Coin, 21, 22, 33 Collaboration, 43, 44, 47, 48, 102, 105, 115

INDEX

Collateral, 153, 169, 170, 183, 184, 193, 194, 196–198, 255 Collateralised debt obligations (CDOs), 187–190, 196, 197, 207, 216–218, 231 Combined investment and commercial, 100 Commercial banks, 54–57, 59–62, 64–66, 80, 83–87, 95, 98, 100–104, 119, 123, 127, 146, 156, 159, 162, 170, 178, 179, 190–192, 202, 209, 213, 220, 248, 251, 252, 258, 259, 276, 283 Commerzbank, 162, 259 Commodities, 18, 19, 59, 96, 98, 128, 145 Commodity Futures Modernization Act, 195 Commodity Futures Trading Commission, 263 Common good, 120, 154, 272 Communication, 22, 43–46, 49, 108, 141, 143, 221, 222 Communist revolution, 159, 195 Compensation, 101, 117, 127, 129–131, 181, 198, 202, 223, 227, 229, 230, 250 Competitive advantage, 36, 43, 84, 149, 235, 249, 255, 282 Complex, 1–3, 8, 9, 12, 13, 17–19, 21, 22, 27, 30, 31, 38, 51, 52, 56, 58, 62–68, 72, 75, 78, 81–83, 85–91, 99, 100, 102, 104, 105, 108, 109, 111, 112, 114, 115, 117, 124, 131, 133, 136, 149, 150, 152–154, 157, 158, 160, 162–164, 170, 172, 173, 180–191, 194–196, 198, 208–210, 217, 218, 224, 231, 233, 235, 248–251, 255–258, 261–264, 273–276, 278, 281–285

291

Complexity, 1, 2, 6, 7, 9, 11, 12, 15–31, 33–49, 51–72, 75–93, 95–115, 117, 118, 125–129, 133, 137, 138, 148–150, 153, 158, 159, 163, 165, 166, 168, 180, 181, 183, 184, 186–194, 196, 198, 201–224, 233, 245–266, 272–276, 278, 281, 283–285 Concentration, 19, 26, 27, 79, 136, 146 Congressional Budget Office, 236 Constantinople, 26 Consumer finance, 19, 82, 159 Continental Europe, 41, 48 Continental European, 36, 41, 47, 136 Cooperatives (Volks-und Raiffeisenbanken), 80, 162 Corporate banking, 38, 80, 81, 112 Corporate lending, 44, 48, 80, 95, 209, 210 Cost, 13, 26, 30, 35, 43, 58, 66, 82, 92, 95, 97, 115, 118, 143, 144, 160, 168, 170, 183, 186, 205, 216, 220, 223, 227–242, 246, 247, 258, 280, 282, 284, 285 Counterparties, 136, 153, 154, 183, 187, 196–198, 203, 213, 214 Counterparty risk, 153 Countrywide, 156, 191, 240 Credit Agricola, 242 Credit cards, 103, 178, 180, 191, 219, 221 Credit default swap, 152, 153, 187, 188, 193–198, 216, 231 Crédit Mobilier, 40, 41, 53 Credit rating agencies, 61, 157, 170, 179, 180, 182, 187, 216, 217, 260 Credit ratings, 59, 61, 65, 157, 170, 179, 180, 182, 187, 189, 194–196, 198, 216, 217, 255, 260

292

INDEX

Credit Suisse, 61, 86–88, 125, 126, 154, 188, 192, 218, 219 Credit Suisse First Boston (CSFB), 61, 86–88 Credit unions, 59, 164 Crises, 6, 8, 11, 12, 15, 22, 33, 34, 42, 48, 55, 56, 59, 68–71, 81, 87–89, 91, 110, 118, 122, 123, 131, 140, 147, 150–152, 160, 162–164, 169, 179, 201–224, 231–236, 238, 240, 245, 246, 254, 256, 263, 278, 280 Culture, 3, 10, 62, 64, 76, 78, 85, 103, 108–110, 112, 122, 125, 126, 128, 129, 131, 139, 145, 146, 159, 161, 181, 202, 224, 251, 252, 266 Cumulative exposure, 90 Currencies, 17, 18, 56, 58, 62, 64, 68, 69, 90, 111, 112, 151, 219, 220, 232, 233, 251, 263, 273, 280 Curries & Co, 45 Customers, 1–3, 9, 11, 18, 19, 21, 27, 51–53, 55, 69, 72, 76, 78–80, 82–84, 87, 89, 90, 92, 95, 97, 100, 103, 105, 106, 118, 123, 125, 126, 128, 139, 140, 153, 154, 167, 179, 204–206, 210, 219, 223, 227–231, 239, 267, 272, 273, 279, 285 D Dalglish, Kenny, 135 Danske Bank, 76, 264, 265, 280, 283, 284 Day-to-day, 9, 10, 24, 66, 134, 276 Deal making, 118, 276 Dean Witter, 61, 88 Denmark, 34, 41, 264 Department of Justice, 219, 240, 265, 266

Deposit, 2, 4, 17, 20, 55, 57, 59, 60, 62, 101, 107, 139, 154, 156–158, 164–167, 170, 178, 179, 186, 191, 192, 201, 202, 204, 206, 209, 210, 214, 227, 228, 230, 231, 236, 255, 257, 258, 273–276 Depositors, 4, 20, 26, 38, 52, 56, 59, 95, 123, 155, 156, 165, 167, 179, 204, 206, 214, 227–229, 236, 252, 258, 282 Depository Institutions Deregulatory and Monetary Control Act, 59, 155, 288 Deposit taking, 17, 20, 59, 60, 139, 170, 191, 202, 273 deposit-taking institutions, 59 Depression, 26, 232, 280 Deregulation, 68, 70, 71, 75, 83, 85, 112 Derivatives, 63, 65–67, 96, 98, 100, 109, 111, 112, 114, 152, 161, 188, 194, 195, 216, 219, 221, 223, 255, 263 Deutsche Bank, 99, 162, 219, 221, 242, 259, 265 Deutsche Industriebank, 162 Dillon Read, 57, 215 Dillon Read Capital Management, 215, 216 Disconto-Gesellschaft, 47 Discount house, 40 Discount window, 170, 259 Distributing, 89, 128 Diversification, 19, 33–35, 39, 43, 66, 85, 86, 89, 90, 98, 157, 162, 218, 275 Diversified risks, 89 Dividends, 38, 104, 115, 156, 180, 208, 261 Dodd-Frank Wall Street Reform and Consumer Protection Act, 250 Dodd-Frank, 251, 254, 260–262, 281

INDEX

Donaldson Lufkin & Jenrette, 88 Double accounting, 37 Double bookkeeping, 23 Dresdner Kleinwort Benson, 61 Drexel Burnham Lambert, 87, 108, 195 Due Bills, 105, 106 Due diligence, 78, 79, 192, 205, 212, 213, 215, 227 Duke of Milan, 26, 31, 38 Sforza, Francesco, 26 Duke of Savoy, 27 Duke of Urbino, 30 Duke of Wellington, 36, 38 Dukes, 16, 18, 27, 30, 179 Dukes of Milan and Savoy, 16, 26, 27, 31, 38 Du Pont, 9, 137 E Eastern European, 80 East India Company, 36 Ebola, 245 Economic growth, 69, 235–238 Economic history, 6–9, 11, 56, 119, 235, 271 Education, 76, 110, 133, 234, 238 Edward III, 16, 21 Edward IV, 28 1825 crisis, 34, 38, 39 1830, 39, 42, 34, 42, 49 1848, 39, 34, 39, 40, 42, 46, 275 Eighteenth century, 11, 53, 121, 235 Electrolux, 76 Emergency Economic Stabilization Act, 201 Emergency Liquidity Assistance, 211, 215 Employees, 4, 10, 11, 60, 66, 68, 77, 79, 81–83, 85, 86, 90, 92, 100, 101, 103, 105–107, 111, 113, 120, 122–126, 128–131, 137, 144, 145, 149, 154, 167, 181,

293

182, 185, 186, 198, 204, 206, 207, 218, 222, 227–230, 239, 261, 272, 277, 279, 283 Endogamy, 34, 47 England, 16, 21, 33, 38, 39, 53, 103, 136 Entrepreneurial culture, 108, 128, 145 Equity capital, 96, 160, 162, 183, 198, 203, 207, 208, 228, 229, 234, 254 Estonia, 76, 264, 265 Estonian, 264, 265 Euro, 4, 66, 69, 82, 219, 220, 223, 232, 236, 237, 247 Eurozone, 82, 236 Euro Inter-Bank Offer Rate (EURIBOR), 220 Europe, 16, 21, 26, 34, 35, 47, 48, 61, 79, 82, 121, 164, 166, 220, 232, 241, 242, 247, 259, 261, 271, 274, 277 European, 11, 21, 26, 30, 31, 35, 36, 38, 41, 42, 46–48, 56, 67, 68, 80, 81, 90, 125, 136, 145, 163, 232, 237, 238, 242, 247, 259, 260 European Banking Federation, 220 European Central Bank, 163, 219, 247 European Commission, 163, 235 European Securities and Market Authority, 260 European Union, 162, 163, 235, 239, 241, 283 Exchange rate, 18, 56, 58, 68–70 Excommunication, 18 Executive Committee, 48, 137 Expenditure, 2, 19, 29–31, 230, 234, 235, 237, 241, 247 Expenses, 80, 81, 92, 103, 104, 123, 181 Experience, 6, 10, 17, 24, 34, 67, 70, 75, 81, 83, 87, 101, 104, 110, 119, 124, 154, 239, 253, 271, 281, 282

294

INDEX

F Fail/failures, 2–4, 6, 7, 12, 13, 16, 17, 25, 31, 38, 39, 41, 42, 45, 52, 54, 56, 62, 66, 71, 72, 78, 79, 87, 89, 90, 97, 107, 108, 111, 115, 119, 129, 140, 151–173, 177–198, 201–224, 227–235, 240, 242, 245–250, 252, 254–258, 262, 265, 271–273, 275–279, 281, 282, 284, 285 Family, 16, 22–25, 28–31, 33–38, 42–49, 53, 70, 120, 121, 127, 178, 229, 275, 277 Family ownership, 33–49, 127, 130, 177, 277 family owned, 28, 40, 53, 62, 111, 127 Fannie Mae, 170–173, 233, 241, 260 Federal Deposit Insurance Corporation, 228, 263 Federal Home Loan Mortgage Corporation, 171 Federal Housing Administration, 171 Federal insurance, 59 Federal National Mortgage Association, 170 Federal Reserve Board, 263 Federal Trade Commission Act, 283 Ferguson, Niall, 7, 36, 77, 78, 120, 276, 279 Fifteenth century, 15, 17, 18, 20–23, 26, 33, 37, 52, 156, 232, 274 Finance, 2, 8, 11, 19, 20, 28, 39, 47, 48, 52–54, 62, 63, 82, 96, 99, 100, 108, 110, 112, 118, 137, 140, 145, 153, 158, 159, 162, 165, 166, 169, 172, 177, 180, 205, 210, 213, 214, 228, 231, 235, 245, 262 Financial Conduct Authority, 223, 250 Financial crisis, 2–6, 11–13, 34, 48, 54, 60, 63, 66, 68, 69, 83,

87–89, 91, 98, 115, 118, 126, 131, 135, 140, 151, 152, 154, 155, 163, 172, 177–198, 207, 212, 213, 219, 220, 223, 227–242, 245–252, 254–257, 259–266, 271–274, 277–285 Financial institutions, 68, 72, 76, 83, 90, 92, 123, 128, 137, 139, 145, 167, 186, 191, 201, 207, 208, 235, 240, 265, 276, 278 Financial Institutions Supervisory Committee, 252 Financial Services (Banking Reform) Act, 257 Financial Services Authority, 63, 166, 168, 184, 195, 213, 250 Financial Services Compensation Scheme, 227 Financial Services Modernization Act, 60 Financial Times, 3, 8 Fines, 4, 10, 66, 89, 196, 219, 221, 223, 224, 240, 246, 259, 265, 266, 272 Firms’ own accounts, 97, 98 First Boston Corporation, 57 First Chicago Corporation, 100, 101 First Federal Savings, 123, 124 First Franklin, 188 First Interstate Bank, 79 First National Bank, 136 First National Bank of Boston, 86 First World War, 3, 5, 47, 48, 162, 278 Fitzroy, Henry, 34 Fixed income, 145 FleetBoston, 79 Fleet Boston Financial, 191 Florence, 11, 15–20, 22–25, 27, 29–31, 52, 134, 245, 275 Florentine, 15, 21, 30, 245

INDEX

Ford, Henry, 141 Fortis, 91, 214 Fourteenth century, 15, 16, 23, 26, 56, 62, 70, 134, 232, 245, 271 France, 27, 35, 36, 41, 45, 47, 48, 53, 56, 58, 79, 111, 112, 136, 163, 164, 271, 275 Frankfurt, 11, 33–35, 45, 80, 121, 275 Fraud, 42, 57, 108, 110, 111, 114, 218, 266, 284 Freddie Mac, 171, 172, 233, 241, 260 French government, 39, 48, 49, 53, 111, 112, 275 G Gates, Bill, 141 General Electric, 47, 262, 283 General manager, 23–25, 27–29, 31, 120, 277 General Motors, 9, 121, 124, 129, 130, 137, 138, 145 General Re Corporation, 196 Generations, 28, 30, 42, 44–46, 121, 236, 237, 275, 277, 280 Geneva, 25, 27, 52 Germany, 47, 48, 56, 58, 76, 79, 82, 103, 136, 162, 235, 237–239 Glass-Steagall Act, 57–61, 68, 86, 87, 102, 155, 170, 177, 202, 248, 282 Global, 11, 23, 63, 67–69, 75, 77, 81, 87, 90, 99, 125, 130, 144, 157, 162, 173, 185, 186, 190, 201–224, 239, 245, 251, 252, 255 Global bank, 11, 65, 77, 80, 251 Globalisation, 9 Gloucester, 211 Gold, 36, 39, 56, 58 Golden parachute, 261 Gold standard, 56, 58, 68

295

Golf, 140 Governance, 25, 109, 112, 263 Government bonds, 37, 40, 46, 59, 105, 107, 108, 161, 248 Governor of the Bank of Canada, 252 Graduates, 101, 118 Gramm-Leach-Bliley Act, 60 Great Depression, 11, 47, 54–57, 59, 68, 91, 111, 152, 160, 165, 170, 177, 204, 206, 228, 230–232, 234, 236, 245, 248, 259, 273, 274, 279, 282 Great Western Financial Corp, 204 Greed, 118, 272 Greek, 34 Greenland, 21 Gross domestic product (GDP), 57, 232, 235–238 Group chief executive officer, 113 Group of Ten, 58, 251 Group of Thirty, 251 Guarantee, 45, 49, 96, 107, 162, 164, 171, 172, 208, 228, 231, 233, 235, 241, 253 Guaranteeing a bought deal, 97 Guinea, 245 H Hamilton, Alexander, 42 Hapsburg Empire, 47 Harvard Business School, 8, 138 Haute Banque, 47 Headcount, 182 Hedge, 67, 112, 152, 161, 168, 187–189, 194, 203, 207, 251 Henderson Crosthwaite, 110 Heraclitus, 15 Herries, John Charles, 36 Higher loss absorption, 255

296

INDEX

High yield, 65, 210 History, 5–9, 11–13, 15, 20, 26, 36, 38, 43, 48, 51, 53, 64, 70, 71, 77, 111, 119, 121, 122, 138, 158, 159, 165, 171, 178, 184, 198, 204, 234, 235, 264, 271, 272, 276, 278, 281, 282, 285 historical, 1, 2, 5, 7, 8, 10, 15, 26, 31, 45, 53, 68, 70, 83, 89, 104, 117, 124, 129, 136, 152, 158, 203, 214, 235, 245, 246, 248, 265, 271, 274 Holocaust, 48 Home Savings of America, 204 Hong Kong, 80, 159 Hong Kong and Shanghai Bank, 159 Hostile acquisition, 213 hostile takeovers, 78, 79, 112, 205, 213 Hostile bid, 79, 227 Household, 156, 159, 171, 234, 238, 240 House of Representatives, 67 HSBC, 62, 156, 158–160, 162, 210, 217, 242, 256, 279, 280 Hutton, E.F., 67 I ICBC, 241 Iceland, 21, 219, 232, 236, 239 Icelandic, 223, 227, 230, 232, 236 IKB, 162, 163, 231 IKB Deutsche Industriebank, 162 IndustrieKreditBank, 162 IKEA, 76 Impairments, 210 Implementation, 4, 58, 117, 125, 147, 255, 263 Implicit guarantee, 171 Incentives, 2, 6, 8, 10–12, 23–25, 31, 53, 60, 62, 72, 99, 100, 102, 110, 117–131, 143, 144, 146,

147, 155, 158, 181, 186, 198, 205, 206, 220, 240, 254, 261, 265, 266, 277, 283, 284 incentive structures, 25, 60, 62, 72, 102, 118, 120, 121, 127, 240, 254, 277 Increased borrowing, 2, 214, 233, 235, 237 Industrial development, 35 Industrialists, 136, 145 Industrial Revolution, 53, 54, 84, 135, 136, 235, 275, 278 Industry, 8, 9, 40, 54, 68, 76, 80, 84, 88, 111, 118, 121, 131, 135–139, 149, 150, 177, 182, 198, 208, 213, 227, 228, 235, 238, 259, 261, 262, 278, 284 Influenza epidemic, 245 Innovative, 7, 23, 180, 281 Insurance, 8, 24, 59, 63, 66, 87, 88, 95, 125, 139, 145, 189, 192–195, 197, 198, 212 Insurance of deposits, 59 Integration, 78, 79, 83, 91–93, 103, 104, 192, 205, 207, 213 Interest, 5, 8, 11, 18–20, 24, 25, 27, 29, 37, 41, 46, 47, 52, 55, 59, 60, 65, 67, 95, 105, 106, 112, 120, 121, 128, 141, 155–157, 163, 165, 169, 170, 180, 187, 204, 205, 208, 219–221, 230, 247, 275, 279 Interim Chairman, 107 Intermarriage, 34, 35, 44, 121, 275 International capital mobility, 68, 69 International Framework for Liquidity Risk Measurement, 251 International Monetary Fund (IMF), 58, 232 Investment banks, 1, 6, 7, 42, 54, 55, 57–62, 64, 66, 68, 78, 80, 81, 83–87, 89, 90, 95–104, 106, 108, 110–112, 114, 115, 119, 123,

INDEX

126–128, 130, 131, 134, 139, 140, 142, 145, 148–150, 153, 154, 156–161, 163, 164, 167, 169, 170, 172, 178–180, 183–186, 189, 191, 196, 201–204, 215–217, 221, 230, 240, 248, 256–259, 261, 273–278, 282 Investment grade, 65, 108, 157, 170 Investors, 7, 38, 41–44, 47, 53–57, 60, 65, 67, 95, 96, 98, 99, 106, 113, 126, 128, 146, 156–158, 161, 163–168, 170, 172, 173, 178, 180, 183, 186–189, 196–198, 203, 204, 206, 208, 215, 216, 218, 230, 233, 239, 241, 254, 260, 280 Ireland, 209, 210, 219, 234–238 Irish, 223, 234, 237, 239, 265 Iron, 40, 135, 136 Israeli, 218 Italian, 15, 91 J Jackson, Andrew, 42 Japan, 3, 58, 61, 103, 163, 164, 202 Jefferson, Thomas, 42 Jersey, 64 Jewish, 34, 42 Jews, 38, 47 Jobbers, 62, 78, 99 Jobs, 9, 25, 86, 88, 99, 109, 119, 120, 133, 144–147, 223, 229, 230, 239, 240 growth, 239 losses, 239 Joint stock banks, 40, 53 J.P.Morgan, 47, 48, 57, 60, 61, 79, 88, 98, 102, 106, 113, 121, 134, 135, 169, 170, 177, 183, 184, 201, 202, 233, 240, 242, 256, 264, 265, 275, 276, 278, 280, 284 JPMorgan Chase, 79, 88, 98, 191, 201, 204, 256, 257, 263 Junk bonds, 65, 87, 108, 114, 195

297

K Kerviel, Jérôme, 113 KfW, 162 King Henry VIII, 136 Kings, 16, 18, 21, 26, 28, 34 Kleinwort Benson, 61, 62, 99 Kobe earthquake, 66, 111 Korea Development Bank, 184 Kreditanstalt, 47, 48, 53, 56 Kuhn, Loeb & Co., 178 L Laffitte, Jacques, 34 Lancaster, 26 La Salle, 91, 191 Latin America, 35, 38, 80, 82 Lazard Frères, 130 Leaders, 5, 8, 10, 28, 39, 57, 68, 77, 85, 86, 88, 96, 125, 128, 134, 145, 148, 177, 182, 183, 187–189, 191, 276 Leadership, 5, 33, 41, 45, 77, 82, 84, 86, 108, 134, 135, 137, 139, 141, 147, 177, 178, 181, 182, 194, 195, 206, 223 Leeson, Nick, 109–111, 113 Lego, 76 Lehman Brothers, 11, 57, 96, 99, 131, 177–185, 189, 190, 197, 198, 201–204, 207, 210, 211, 215, 217, 221, 229, 230, 232, 233, 240, 246, 259, 280 The Lehman Trilogy, 178 Lending, 4, 16–22, 25–29, 37, 44, 47, 48, 54–56, 66, 69, 80, 95, 113, 118, 121, 128, 153–158, 160, 163, 165–168, 170, 178, 180, 186, 205–207, 209, 210, 212, 219, 228, 230, 233, 235, 239, 260, 273, 277, 280 Leverage, 59–61, 153, 156, 161, 178–180, 182, 203, 248, 249, 252, 254–256

298

INDEX

Levy, Gus, 134 Liabilities, 20, 26–28, 44, 49, 97, 110, 169, 179, 183, 184, 260 Liberia, 245 LIBOR, 219–224, 259 London Inter-Bank Offered Rate (LIBOR), 219 Lidderdale, William (Governor of the Bank of England), 44 Life insurance, 87, 189, 195 Light touch, 63 Line of business, 12, 22, 30, 56, 59, 62, 66, 70, 84, 85, 89, 105, 106, 134, 149, 273–276, 281 Liquid, 21, 22, 37, 65, 108, 161, 172, 182, 204, 214, 231 Liquidity, 3, 33, 37, 43, 65, 71, 72, 91, 114, 163, 165, 168, 170, 201, 202, 207, 210, 214, 217, 236, 255, 256, 259, 263 Listing on stock exchanges, 99, 126 Living will, 251, 254 Lloyds Banking Group, 211, 212 Lloyds TSB, 211–213, 276 Loans, 16–22, 24, 26–29, 37–40, 44, 46–49, 52, 54–57, 59, 60, 65, 71, 101–103, 111–113, 115, 121, 122, 128, 139, 151, 155–166, 170–172, 177–180, 184, 186–190, 193–196, 198, 201, 204–210, 218, 219, 223, 229–231, 260, 265, 275, 280 Lobbying, 53, 61, 262, 274, 282 London, 17, 18, 22, 24, 25, 27–29, 33–35, 38–40, 43, 45–49, 63, 80, 86, 121, 130, 152, 159, 164, 178, 190, 195, 212, 215, 229, 263, 275 London Stock Exchange, 99, 130 London Whale, 256, 263 Lone Star, 162

Longer term, 10, 46, 68, 101, 102, 110, 118, 119, 121, 123, 126, 127, 129, 131, 143, 165, 198 Long term, 33, 57, 60, 93, 95, 102, 118, 119, 121, 123–129, 146, 147, 162, 165, 178, 183, 228, 255, 259, 265, 271, 277 Long-Term Capital Management (LTCM), 114, 161 Loosening regulation, 11, 12, 53, 58, 64, 257 Lorenzo, 16, 22, 27, 29–31 Lost opportunity cost, 234, 242 Louis Philippe, King, 43 Louis XI of France, 27 Louis XVIII, 37 Low-balling, 221 Luxury, 18–21, 26–28, 38, 52 Lyon, 27–29, 52 M Macroeconomic, 21, 31, 123, 124, 242 Madison, James, 33, 42 Maersk, 76 Main, 4 Malaysian Attorney General, 266 Management, 1–13, 15–17, 19, 22–31, 32n5, 33–49, 51–72, 75–93, 95–115, 117–131, 133–173, 177–198, 202–209, 211–219, 221–224, 227–242, 245–266, 271–285 consultancy, 6, 11–13, 271 people management, 24, 28, 142 of risks, 105, 124 stretch, 72 Manager of managers, 86 Managing directors, 99–101, 119, 130, 145, 146, 277 Managing player, 135

INDEX

Manège, 4 Manufacturers, 2, 19, 44, 137 Manufacturers Hanover Bank, 82 Margin lending, 54, 55, 230, 273 Margins, 54, 55, 60, 62, 65, 67, 96, 98, 101, 102, 105, 114, 160, 179, 230, 273 Massachusetts Institute of Technology, 138 Massini, Steffano, 178 Master of Business Administration (MBA), 13n1, 138, 139, 145 Mayer, Hannah, 34 MBNA, 191 McDonalds, 283 McFadden Act, 64 Medici, 10, 11, 13, 15–32, 36–38, 52, 62, 66, 70, 75, 80, 98, 120, 134, 156, 158, 232, 245, 246, 274, 275, 277, 278 Bank, 7, 15–18, 20–26, 29–31, 31n3, 32n5, 33, 35, 120, 275 Catherine, 30 Cosimo, 16, 23–29, 31, 77, 141 Giovanni di Bicci de,’ 16, 23 Giuliano, 29, 30 Giulio, 30 Piero, 16, 28–30 Mellon Financial, 92 Merchant banks, 62, 99, 145 Mergers, 9, 12, 54, 56, 61, 62, 64, 72, 75, 77–80, 82–84, 86, 88, 92, 93, 95, 96, 103, 104, 115, 128, 130, 139, 149, 178, 184, 185, 190, 205, 209, 211–215, 221, 256, 257, 259, 276, 282 Merrill Lynch, 1, 99, 135, 144, 145, 162, 179, 182, 185–192, 196, 201, 202, 207, 216, 217, 229, 240, 259, 272, 279, 280 MetLife, 88 Metternich, Prince, 43

299

Mexico, 103 Midland, 62 Midland Bank, 45, 48, 159 Milan, 20, 23, 26, 27, 29, 179 Mistakes, 43, 48, 107, 121, 154, 160, 248, 272 Mitsubishi UFJ Financial Group, 202 Model, 114, 123, 141, 165, 180, 242, 247, 260 modeling, 163, 180 Monetary Control Act, 59, 155, 228 Money culture, 10, 126, 129 laundering, 264–266 supply, 248 Monitoring, 4, 117, 254 Monte Paschi, 91 Morgan Grenfell, 99 Morgan, John Pierpont, 141 Morgan Stanley, 57, 61, 77, 78, 82, 88, 99, 113, 145, 149, 159, 179, 180, 182, 185, 201, 202, 259 Mortgage-backed securities, 128, 157, 158, 160, 162–167, 171–173, 177, 178, 180, 186–188, 190, 196–198, 203, 209, 216, 219, 230, 231, 241, 259, 260, 266 Mortgages, 1, 3, 55, 59, 60, 63, 65, 86, 89, 123, 128, 155–157, 159, 161, 164–167, 169–173, 178, 180, 182–191, 201–224, 240, 260 Multidivisional, 8, 9, 83, 84, 106, 125, 137, 139, 145 Multiline, 15, 31, 82, 83, 87, 91, 92 Multinational, 8, 11, 15–49, 53, 61, 65, 69, 70, 75–77, 80, 82, 83, 85, 87, 91, 99, 103, 121, 145, 195, 275 Multistate, 64, 83 Mutual funds, 157

300

INDEX

N Naples, 23, 33, 34, 41, 121, 275 Napoleon, 36, 37 Napoleonic Wars, 36, 48, 275 Napoleon III, 53 Nathanial (Natty), 39 National Health Service, 283 Nationalised, 111, 112, 167, 229, 236, 271 National Westminster (NatWest), 62, 212–215, 227, 276 Net capital, 61 Netherlands, 58, 82, 90, 91 New Century, 203 New York, 42, 55, 63, 92, 100, 130, 131, 164, 169, 177, 195, 215, 256 New York Federal Reserve, 222 1930s, 11, 48, 64, 248, 273, 278 1970s, 9, 11, 51, 84, 96, 97, 99, 123, 124, 138, 139, 145, 149, 232, 256, 276, 278, 284 Nineteenth century, 11, 33–35, 37, 38, 46, 47, 53, 70, 89, 121, 135, 164, 212, 232, 275, 277, 278 Nixon, President, 58 Nobel Prize, 114 Nokia, 76 Non-deposit, 170, 191, 210 Non-investment grade, 65, 108, 157 Non-qualifying, 260 No prime, 260 Nordic, 76, 79 Nori, Simone, 28 Norsk Hydro, 76 North Carolina National Bank, 191 North, Douglass, 9, 10 Northern Counties Permanent, 164 Northern Rock, 164–167, 208, 211, 228–231, 234, 239, 253, 276 Northern Rock Bank, 164 Northern Rock Building Society, 164 Northland Bank of Canada, 252 North South European monetary imbalance, 21

Norway, 82 Not managed, 1–13, 15, 27, 108, 114, 165, 185, 190, 214, 233, 271, 272, 278 O Obama, Barack (president), 262, 263 Objectives, 4, 8, 11, 19, 82, 83, 102, 119, 122, 124, 129, 172, 195, 249, 254 Office of the Comptroller of the Currency, 263 Office of the Superintendent of Financial Institutions, 252 Office of Thrift Supervision, 195 Ohio Life Insurance and Trust Company, 42 One firm, 215, 216, 218 1 Malaysia Development Berhad (1MBD), 265, 266, 284 Online bank, 212 Operating Group, 137, 138 Organic growth, 75, 100, 191, 276 Organisations, 1, 2, 6, 8, 10, 62, 67, 70, 72, 80, 81, 84, 91, 99, 104, 107, 115, 117, 141, 148, 150, 154, 171–173, 228, 272 Originate to distribute, 165 Originating, 89, 165, 178, 187 Ottoman Empire, 26 Ottoman Turks, 26 Overend, Gurney and Company, 40, 41, 44, 164 Over the counter (OTC), 153 over-the-counter derivatives, 63 Owners, 1, 23, 43, 51, 52, 60, 62, 98, 134, 135, 154, 156, 193, 217, 227, 229, 272, 274, 279 Ownership, 16, 33–49, 53, 77, 80, 86, 99, 112, 126–130, 136, 159, 162, 170, 171, 173, 177, 275, 277 Oxford, 110

INDEX

P Packaging, 89, 156, 157, 163, 172, 178, 186, 187, 196, 198, 216 Paine Webber, 61 Papacy, 17, 20 papal, 20, 21, 23, 26, 38, 275 popes, 16, 18, 20, 30 Paris, 33–35, 39, 40, 43, 45–48, 53, 80, 121, 178, 275 Partners, 23, 24, 27, 41, 47, 60, 62, 99, 100, 120, 126, 127, 129, 130, 134, 154, 177, 275, 277, 284 Partnerships, 23, 35, 43, 53, 60, 62, 99, 127, 130, 202, 277 Path dependency, 6, 10, 122–127, 130, 144, 261 path dependence, 10, 11, 122, 124 Payment Protection Insurance, 223 Pazzi, 29 Pension funds, 157, 189, 239 Pereires, 47 Personal leadership, 77, 86 Peruzzi, 15, 16, 19 Pfizer, 134 Pisa, 25 Plague, 16, 26, 56, 232, 245, 271 Player managers, 135 Poland, 82 Political institutions, 240 Politics, 22–24, 28, 29, 31, 35 Pope Sixtus IV, 20, 30 Portugal, 36, 41, 81 The Power of Yes, 155, 205, 206 Practical experience, 6 President, 42, 45, 58, 61, 107, 155, 186, 251, 252, 262, 279 President of France, 45 Primary dealers, 107, 108 Prime, 36, 48, 59, 99, 152, 155, 173, 260, 266, 273, 277, 284 Princes, 15, 18, 84, 278

301

Principal, 69, 96, 97, 105, 121, 172 Principle-based regulation, 252, 253 Private banking, 87, 125, 256 Producer manager, 6, 9, 12, 71, 107, 133–150, 154, 158, 207, 224, 245–266, 275, 278, 283–285 producing manager, 135 Producers, 4, 5, 12, 66, 76, 114, 134, 141, 142, 145, 148, 278 Production/producing, 4, 5, 9, 12, 40, 55, 75, 123, 135, 136, 138, 140–144, 146–149, 158, 166, 177, 181, 186, 207, 209, 224, 235, 236, 261, 278, 283–285 Profit warning, 78, 158–159, 217 Programme trading, 67 Property casualty insurer, 87 Provisions, 25, 159, 206, 261 Proximate cause, 56 The Prudent, 27 Prudential Plc, 283 Prudential Regulatory Authority, 250 Prussia, 41 Q Qatari, 218 Queen of France, 30 Queens, 18 QWERTY, 10, 122, 127 R Railways, 2, 38–40, 47, 84, 136, 137 Rate manipulation, 221 Real estate, 56, 59, 63, 139, 162, 203, 248 Real gross domestic product, 238 Recapitalisations, 235 Reduced expenditure, 2, 234 Reference interest rate, 219

302

INDEX

Regulation, 3, 11, 18, 27, 51–72, 76, 98, 117, 155, 179, 204, 240, 246, 272–275, 281, 282, 284 Regulators, 1, 9, 18, 51–54, 57–61, 63, 70–72, 83, 87, 91, 108, 110, 111, 113, 115, 152, 161, 166, 168, 179, 184, 193, 195, 202–204, 206–210, 213, 215, 218, 221–223, 240, 247–255, 258–261, 263, 264, 279, 281, 283 Regulatory arbitrage, 18, 52, 57, 274 Reinhart, Carmen, 7, 68, 70, 236, 242 Relationships, 9, 26, 36, 40, 42, 77, 78, 81, 86, 90, 101, 102, 104, 110, 123, 126, 140, 148, 161, 284 Religion, 35, 275 Remunerate, 104, 181 Renaissance Italy, 11 Renaissance princes, 15, 276, 278 Renaissance principality, 77, 84 Reputation, 3, 41, 66, 89, 97, 162, 213, 265, 266, 272 Research, 5, 7, 21, 22, 145, 168, 186 Rhineland Funding, 162 Riegle-Neal Interstate Banking and Branching Efficiency Act, 64, 191 Risk appetite, 180, 181 Risk management, 11, 112, 122, 128, 154, 179–182, 188, 189, 202, 203, 217, 252, 253, 277, 278 Robert of Naples, 16 Rock Building Society, 164 Rockefeller, John D., 141 Rogoff, Kenneth, 7, 68, 70, 236, 242 Rome, 16, 20, 21, 23, 25–27, 30 Roover, Raymond de, 7, 21, 22, 120 Rossi, Lionetto, 27 Rothschilds, 7, 11, 33–49, 56, 67, 70, 75, 80, 89, 98, 112, 120, 121, 127, 134, 137, 141, 159, 210, 232, 271, 274, 275, 277, 278 Amschel, 33–36, 45, 53 Anselm, 34, 47, 53

Bank, 33, 35, 37–40, 43, 44, 46, 48, 112, 121 Carl, 33, 36 Edouard, 48 French, 39, 40, 112 Frères, 39, 40, 49 James, 33, 34, 39–43, 46–49, 53 London, 39, 40, 46, 48, 49 Nathan, 33, 34, 36, 39, 44, 53, 141 Salomon, 33, 43 third Lord, 36 Rothschild, L.F., 42, 67 Rothschild, Louis, 42 Royal Bank of Canada, 64, 97, 184, 252 Royal Bank of Scotland (RBS), 91, 212 Rules-based regulation, 253 Russia, 114 Russian Central Bank, 264 Russian tsar, 34 S Sachsen LB, 163 Salomon, 33, 43, 61, 83, 84, 87, 99, 106–109, 114, 128–130, 147, 272, 279 Salomon Brothers, 61, 114 Sampo Bank, 264 Santander, 81, 82, 91, 214, 242 Sassetti, Francesco, 25, 27–30, 120 Saudi Arabian, 218 Savings, 4, 20, 59, 82, 92, 123, 124, 129, 160, 164, 167, 195, 204, 211, 228, 229, 239, 280 Savings & Loan Association, 123 saving & loans, 164 Savings & Loan Crisis, 204 Savings banks (Sparkassen), 80, 129, 204, 211, 229 Scandinavia, 21 Schemes, 10, 11, 110, 121–124, 126, 127, 129, 167, 198, 205, 227 Schleswig Holstein, 41

INDEX

Schroders, 62, 99 Schultz, William, 34 Secondary market, 40, 170–173 Second Bank of the United States, 42 Second World War, 58, 68, 111, 159, 246 Securities & Exchange Control, 260 Securities and Exchange Commission, 57, 59, 60, 168, 178, 207, 263 Securities Exchange Act, 57 Securitising, 157 Senior bankers, 7, 15, 84, 86, 101, 134, 228, 240, 261, 274 Senior Manager and Certification Regime, 253, 283 S.G. Warburg, 62, 77, 78, 82, 84, 99, 273, 276 Shanghai, 159, 194 Shareholders, 1, 11, 38, 40, 43, 51, 61, 83, 90, 97, 99, 104, 106, 112, 118, 130, 133, 154, 167, 169, 172, 173, 184, 185, 202, 204–207, 212, 213, 217, 223, 229, 230, 254, 261, 283, 285 Shearson American Express, 178 Sherman Act, 282 Short sellers, 182 ban naked short selling, 168 Short term, 100, 102, 118, 119, 123, 124, 129, 130, 143, 146, 147, 153, 165, 170, 183, 203, 214, 230 Sierra Leone, 245 Significant influence functions, 253 Silk, 19–21, 25, 28 Singapore, 103, 109, 152 Size, 1, 2, 9, 11, 34, 37, 39, 42, 46, 47, 64, 70, 72, 75–93, 98, 101, 102, 107, 128, 131, 135, 167, 171, 190, 198, 209, 215, 217, 228, 236, 256, 258, 263, 272, 275, 276, 278, 283, 285 Sloan, Alfred, 9, 121

303

Smith Barney, 61, 109 Société Générale (SocGen), 111, 196, 271, 272 Sources, 7–9, 12, 20, 37, 39, 43, 108, 128, 148, 157, 166, 210, 239, 248, 274 South African, 48 South Korea, 103 Sovereign, 15–22, 24, 26–30, 37–40, 48, 52, 114, 151, 152, 154, 204, 232, 233, 236, 237, 245, 247, 275, 280 Soviet Union, 80 Spanish colonies, 38, 39 Specialist, 5, 9, 15, 31, 40, 52, 54, 62, 71, 76, 84–86, 99, 106, 107, 117, 118, 134–138, 140, 141, 148, 149, 249, 261, 273–276, 278, 284 Specialist management, 31, 62, 76, 84, 86, 117, 118, 134, 136, 138, 261, 274–276, 278, 284 Stabilisation Fund, 218 Stakeholders, 1, 11, 83, 118, 272, 279 Standard & Poor, 182, 192 Starbucks, 205 State Street, 202 Stockbrokers, 62, 99, 109, 110, 144, 145, 185, 186, 191 Stock exchange, 54, 57, 60, 62, 63, 96, 99, 101, 112, 123, 126, 128, 130, 133, 159, 162, 165, 168, 171, 173, 178, 183, 185, 229, 276 Stock market, 41, 54–56, 66, 67, 81, 93, 97, 99, 160, 203, 257, 273 Stock underwriting, 55 Strategy, 1, 4, 8, 22, 34, 35, 39, 67, 71, 76, 90, 103, 106, 109, 112, 117, 125, 147, 160, 178, 215–217, 232, 264 Stress testing, 249, 252, 255

304

INDEX

Structured, 23, 85, 99, 102, 112, 156, 157, 187, 191 Student loans, 219 Subprime, 89, 113, 154–163, 165, 167, 168, 171–173, 188–190, 192, 197, 198, 203, 204, 206, 212, 216–218, 240, 252, 260, 279, 280 SunAmerica, 195 Super senior, 196, 197, 216, 217 Superintendent of Financial Institutions, 252 Sweden, 58, 76 Swimming naked, 83, 185, 211 Swiss Banking Corporation, 78, 88, 215 SBC Warburg, 215 Switzerland, 58, 88, 125 Synergies, 87, 88, 92, 102, 105, 115 Synthetic instrument, 65 Systemically important, 4, 185, 250, 251, 255 Systemic banking crisis, 151, 152 T Taiwan, 103 Takeovers, 67, 68, 78, 79, 91, 97, 112, 158, 159, 169, 205, 211–215, 256, 264, 276, 282 Tani, Angelo, 28 Taxation, 2, 20, 48, 234, 235, 237, 247, 280 Tax collectors, 19, 20 Taxpayer, 154, 169, 184, 227, 234, 240, 247, 254, 265, 285 Technology, 10, 38, 80, 82, 92, 103, 122, 138, 229, 263 Territory, 12, 51, 59, 75–93, 275, 276 Thundering Herd, 185 Tokyo, 80, 178 Too big to fail, 4, 39, 255 Tornabuini, Giovanni, 30 Toronto Dominion, 64

Trade/trading, 4, 5, 17, 19, 21, 22, 26, 27, 30, 35, 36, 38, 44, 46, 53, 60, 67, 69, 80, 81, 86, 87, 90, 95–98, 100, 105–107, 109, 111, 112, 118, 123, 126, 128, 131, 142, 143, 146, 152–154, 161, 168, 169, 190, 195, 214, 216, 217, 220–222, 251, 263, 274, 275, 277 as principals, 96, 97 Traders, 5, 7, 98, 100, 112, 113, 131, 145, 177, 181, 182, 221, 222, 272 Travelers Property, 88 Treasury, 83, 105, 107, 128, 208–210, 217, 272 Treasury bond, 83, 241, 272 Troubled Asset Relief Program (TARP), 192, 201–203, 208, 234 Trust, 2, 3, 45, 46, 56, 72, 98, 109, 152, 194, 214, 215, 218, 240 Trustees Savings Bank, 211 Twentieth century, 11, 33, 39, 63, 70, 106, 130, 134, 159, 164, 242 Twenty-first century, 34, 69, 117, 134, 278 U UBS, 61, 78, 88, 98, 125, 154, 177, 190, 196, 215–218, 257, 258, 276, 280 The Uncommon Partnership, 103 Understand/understanding, 6, 15–17, 22, 30, 36, 40, 65, 66, 71, 72, 77, 81, 89, 90, 105, 108, 111, 113, 115, 120, 133, 137, 149, 158, 167, 169, 185, 187, 188, 197, 205, 206, 213, 240, 247, 249, 253, 271, 274, 282 Underwriting, 54, 55, 57, 95–97, 128, 157, 178, 180, 182, 189–191, 196, 216, 221, 277 underwriting of share issues, 96

INDEX

Unemployment, 57, 239, 242 Union Bank of Switzerland, 88 United States (US), 1, 34, 47, 54, 77, 96, 117, 134, 152, 177, 201–224, 228, 247, 273 United States Banker of the Year, 77 United States Department of Defence, 283 United States government bonds, 105, 161 United States Steel, 47 Universal, 60–62, 65, 82, 87, 88, 98, 99, 139, 140, 153, 154, 159, 177, 215, 217, 218, 221, 256–258, 276, 280 Unmanageable, 12, 19, 51, 55, 68, 75, 89, 93, 111, 112, 129, 149, 160, 191, 273, 279, 281, 283 Usury, 18, 52, 274 ban on usury, 20, 27, 37, 52 V Venice, 17, 23, 25, 26, 29 Vialli, Gianluca, 135 Vice chairman, 107, 189 Vickers rule, 257, 258 Vienna, 33, 34, 43, 45–47, 53, 56, 121, 275 Vietnam War, 58 Virgin Group, 167 Volatility, 18, 41, 152, 153, 180, 189, 205 Volcker Rule, 250, 263

305

W Wachovia, 190 Wall Street, 56, 67, 86, 100, 101, 109, 118, 131, 161, 190, 246, 250, 262, 278, 284 Wall Street management, 145 Walmart, 283 WaMu, 156, 158, 165, 204–207 Washington Mutual, 156, 204 Washington National Building Loan and Investment Association, 204 Warburg, Siegmund, 7, 77, 78, 84, 120, 141, 276, 279 Warehousing, 188, 216 War of the Roses, 26, 28 Wars, 5, 6, 16, 18, 19, 26, 28, 36–38, 41, 44, 48, 53 Washington, George, 42 Wasserstein Perella, 61 Waterloo, 36, 37 Weinberg, Sydney, 134 Wells Fargo, 79, 201, 242, 257 Western Europe, 16, 22, 57 Whistleblowing, 264, 265 Wholesale market, 165, 210, 213–215 William of Hesse-Kassel, 36 Winterthur, 87, 88 Wolfe, N.H. and Company, 42 Wood Grundy, 97, 104 Wool, 19–22, 25, 27, 28, 38, 52 Wyeth, 134