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

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

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 management 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.

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.

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_7 117

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.

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.

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

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

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 performancedriven culture. In 1975, problems of not paying bonuses were identified when times were less favourable due to the first Oil Crises in 1973. The

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

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 longterm 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.

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 secondlargest 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.

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

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.

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