Opinion
Street Smarts Reconsidered
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However business models evolve in global finance, all of the incumbent firms and new entrants will have to learn to manage internal misconduct risk far better than ever before. It’s now a matter of survival.
By Roy C. Smith and Ingo Walter
Now that Tom Hayes, a 35-year old former Citigroup and UBS trader, has been sentenced by a British court to 14 years in jail for attempting to rig LIBOR, young people keen on building careers and fortunes in high finance should stop and think. His defense was a common one for traders in trouble: He did not know that what he was doing was illegal, his bosses were fully aware of what was going on, and anyway it was common practice among all of the global banks.
The jury didn’t buy it, and convicted him on all eight counts of conspiracy to defraud. Hayes will be almost 50 when he gets out, the best part of his life gone, permanently barred from returning to his profession, and who knows about his wife and child?
Back in 1997, after an earlier run of financial misconduct prosecutions, we wrote a book called Street Smarts – Linking Shareholder Value with Professional Conduct in the Securities Industry. There were two basic themes. First, for financial firms and their shareholders, “reputation loss” was likely to far exceed any gains from misconduct, and so firms had to learn to manage the risk - with persistence backed by sufficient resources. Second, for finance professionals, the risk-adjusted “expected value” of carefully staying inside the rules over a full career far exceeds the value of breaking them.
Few paid much attention - in an industry where “the long term is after lunch” and memories are short as people, products and strategies turn over rapidly, everyone is preoccupied by the constant search for an “edge” in markets that became hypercompetitive. And so, in the years since our book was published there have been several waves of scandals, each separated only by a few years. And, as we predicted, the cost of reputation loss among major banks and other financial firms has been enormous, almost enough to destroy the industry.
Should shareholders care? Since 2008, the world’s top global banking firms have traded at book value or less – compared to roughly twice that historically. Legal settlements with government prosecutors have amounted to about $200 billion. Prosecutors have extracted guilty pleas to civil fraud or criminal charges from a number of the world’s most prominent financial firms, though none have availed themselves to their right to trial. Bank regulation has been totally revamped, and made much stricter. Even so, central banks and other regulators still treat the word “culture” with suspicion and have arranged a number of “qualitative” stress-test requirements focused on good behavior that bankers must meet.
The public has shared in the regulators concerns, and in some quarters has agitated for the bankers that wrecked the system in 2008 to go to jail. Top executives at all of the banks have been closely investigated without finding sufficient evidence to bring criminal charges. But, since 2007, two-thirds of the CEOs of the twelve largest global banks have been replaced, along with a large number of unit heads. Most of the highly paid mid- and senior-level executives from the time of the Crisis have lost a great deal of their personal wealth held in the shares and options to buy stock in their firms. Many also lost their personal reputations, and have become unemployable in their professions. Some have become a laughing-stock or poster-boy. Others keep their heads carefully below the parapet.
So the allegation that banks and bankers got off scot-free is not true. But maybe it’s worth repeating some of the lessons that we learned almost twenty-five years ago.
First, beginning in the 1980s, banks stopped being viewed largely as public utilities or (in the case of independent investment banks as small focused professional firms) as deregulation, globalization and technology combined to transition them to trading-oriented, high-margin growth firms. Such an extensive transformation changed the industry’s risk exposures considerably. With the change in strategy came much greater risk, not only from trading but also from competitive dynamics that pushed firms towards a morally ambiguous, “you eat what you kill” business culture. Transparency became an enemy. Valued clients became mere trading counterparties.
Second, the new competitive culture quickly transformed compensation practices into a turbocharged pay-for-performance model, which altered who was getting rewarded, how much and what for - without full recognition of associated risks, including hard to assess regulatory and reputation risks. Traders pushed out to the riskier end of the market and behavior patterns changed to justify almost any potentially profitable activity that was not obviously illegal. These notions jumped from firm to firm via chat-rooms and a high-mobility mindset that expected little loyalty from employers and gave little in return. Moral and business conduct issues became ambiguous and often were set aside. The ancient ideas that “if others are doing it, it must be all right” and “if we don’t do the business someone else will” reappeared essentially unchanged from the preceding scandal. Nothing much was learned.
Third, managing the moral and ethical components of risk was new, difficult to evaluate, and attracted little support from the top beyond fervent lip service. No one wanted to pay for it either, whether out of pocket or by foregoing profitable business opportunities. The longer this attitude persisted, the more inculcated it became in firm cultures. So, reputation loss was an unmeasured crisis waiting to happen – and when it came, it did so with a vengeance.
Fourth, professionals working in such firms had to follow a difficult script. Attracted by and comfortable in precisely this just this kind of culture, unless they were very watchful and careful while at the same time treading softly and going with the flow it was easy to imperil their careers. Once their firms felt the sting of reputation-related losses and penalties, so did all employees compensated via bonuses linked to the share price. When the stock price tanked so did the personal wealth of employees from Drexel Burnham, Bear Stearns, Lehman Brothers, AIG, Citigroup, Bank of America, and many others. And during times of trouble many competent employees (including people who had nothing to do with any misconduct) were fired or otherwise let go in periodic waves of lay-offs and cost-cutting.
Fifth, few employees that engaged in misconduct seem to have understood the basic math. To adjust what may seem like a large difference in compensation from creating more profit for the firm, one has to estimate the probability of getting caught and the consequences that will follow (financial and otherwise). The probability of being caught may be low - although the technology that is your friend can be turned against you very quickly to locate a smoking gun, and there are plenty of people up and down the line who can squeal on you. And adverse consequences applied over a full span of a 30-year career are almost infinite: Loss of accumulated fortunes (through stock losses and clawback provisions), loss of future income, fines, personal and familial shame, and possibly even incarceration.
Despite efforts by some firms to reward internal monitoring and increase surveillance, the industry as a whole seems to have failed in learning how to manage these risks and still satisfy shareholders that they are performing well against the competition. Market discipline has, in effect, failed as a behavioral and cultural safeguard.
So the big fist of public policy has been applied, and financial firms have been forced to improve by Dodd Frank and other extensive regulatory efforts that have made it nearly impossible to compete as they once did. Some are reverting to the public utilities they used to be, others are focusing on less risky areas like asset management where they see a competitive advantage. A few are doubling-down on trading in securities markets and striving to reengineer themselves to remain leaders – knowing that the future risks of misconduct are ever-present. Each has its own behavioral and cultural traps, but at least they are easier to identify and perhaps to manage effectively.
However business models evolve in global finance, all of the incumbent firms and new entrants will have to learn to manage internal misconduct risk far better than ever before. It’s now a matter of survival.
___
Roy C. Smith is the Kenneth G. Langone Professor of Entrepreneurship and Finance and a Professor of Management Practice. Ingo Walter is the Seymour Milstein Professor of Finance, Corporate Governance and Ethics.
The jury didn’t buy it, and convicted him on all eight counts of conspiracy to defraud. Hayes will be almost 50 when he gets out, the best part of his life gone, permanently barred from returning to his profession, and who knows about his wife and child?
Back in 1997, after an earlier run of financial misconduct prosecutions, we wrote a book called Street Smarts – Linking Shareholder Value with Professional Conduct in the Securities Industry. There were two basic themes. First, for financial firms and their shareholders, “reputation loss” was likely to far exceed any gains from misconduct, and so firms had to learn to manage the risk - with persistence backed by sufficient resources. Second, for finance professionals, the risk-adjusted “expected value” of carefully staying inside the rules over a full career far exceeds the value of breaking them.
Few paid much attention - in an industry where “the long term is after lunch” and memories are short as people, products and strategies turn over rapidly, everyone is preoccupied by the constant search for an “edge” in markets that became hypercompetitive. And so, in the years since our book was published there have been several waves of scandals, each separated only by a few years. And, as we predicted, the cost of reputation loss among major banks and other financial firms has been enormous, almost enough to destroy the industry.
Should shareholders care? Since 2008, the world’s top global banking firms have traded at book value or less – compared to roughly twice that historically. Legal settlements with government prosecutors have amounted to about $200 billion. Prosecutors have extracted guilty pleas to civil fraud or criminal charges from a number of the world’s most prominent financial firms, though none have availed themselves to their right to trial. Bank regulation has been totally revamped, and made much stricter. Even so, central banks and other regulators still treat the word “culture” with suspicion and have arranged a number of “qualitative” stress-test requirements focused on good behavior that bankers must meet.
The public has shared in the regulators concerns, and in some quarters has agitated for the bankers that wrecked the system in 2008 to go to jail. Top executives at all of the banks have been closely investigated without finding sufficient evidence to bring criminal charges. But, since 2007, two-thirds of the CEOs of the twelve largest global banks have been replaced, along with a large number of unit heads. Most of the highly paid mid- and senior-level executives from the time of the Crisis have lost a great deal of their personal wealth held in the shares and options to buy stock in their firms. Many also lost their personal reputations, and have become unemployable in their professions. Some have become a laughing-stock or poster-boy. Others keep their heads carefully below the parapet.
So the allegation that banks and bankers got off scot-free is not true. But maybe it’s worth repeating some of the lessons that we learned almost twenty-five years ago.
First, beginning in the 1980s, banks stopped being viewed largely as public utilities or (in the case of independent investment banks as small focused professional firms) as deregulation, globalization and technology combined to transition them to trading-oriented, high-margin growth firms. Such an extensive transformation changed the industry’s risk exposures considerably. With the change in strategy came much greater risk, not only from trading but also from competitive dynamics that pushed firms towards a morally ambiguous, “you eat what you kill” business culture. Transparency became an enemy. Valued clients became mere trading counterparties.
Second, the new competitive culture quickly transformed compensation practices into a turbocharged pay-for-performance model, which altered who was getting rewarded, how much and what for - without full recognition of associated risks, including hard to assess regulatory and reputation risks. Traders pushed out to the riskier end of the market and behavior patterns changed to justify almost any potentially profitable activity that was not obviously illegal. These notions jumped from firm to firm via chat-rooms and a high-mobility mindset that expected little loyalty from employers and gave little in return. Moral and business conduct issues became ambiguous and often were set aside. The ancient ideas that “if others are doing it, it must be all right” and “if we don’t do the business someone else will” reappeared essentially unchanged from the preceding scandal. Nothing much was learned.
Third, managing the moral and ethical components of risk was new, difficult to evaluate, and attracted little support from the top beyond fervent lip service. No one wanted to pay for it either, whether out of pocket or by foregoing profitable business opportunities. The longer this attitude persisted, the more inculcated it became in firm cultures. So, reputation loss was an unmeasured crisis waiting to happen – and when it came, it did so with a vengeance.
Fourth, professionals working in such firms had to follow a difficult script. Attracted by and comfortable in precisely this just this kind of culture, unless they were very watchful and careful while at the same time treading softly and going with the flow it was easy to imperil their careers. Once their firms felt the sting of reputation-related losses and penalties, so did all employees compensated via bonuses linked to the share price. When the stock price tanked so did the personal wealth of employees from Drexel Burnham, Bear Stearns, Lehman Brothers, AIG, Citigroup, Bank of America, and many others. And during times of trouble many competent employees (including people who had nothing to do with any misconduct) were fired or otherwise let go in periodic waves of lay-offs and cost-cutting.
Fifth, few employees that engaged in misconduct seem to have understood the basic math. To adjust what may seem like a large difference in compensation from creating more profit for the firm, one has to estimate the probability of getting caught and the consequences that will follow (financial and otherwise). The probability of being caught may be low - although the technology that is your friend can be turned against you very quickly to locate a smoking gun, and there are plenty of people up and down the line who can squeal on you. And adverse consequences applied over a full span of a 30-year career are almost infinite: Loss of accumulated fortunes (through stock losses and clawback provisions), loss of future income, fines, personal and familial shame, and possibly even incarceration.
Despite efforts by some firms to reward internal monitoring and increase surveillance, the industry as a whole seems to have failed in learning how to manage these risks and still satisfy shareholders that they are performing well against the competition. Market discipline has, in effect, failed as a behavioral and cultural safeguard.
So the big fist of public policy has been applied, and financial firms have been forced to improve by Dodd Frank and other extensive regulatory efforts that have made it nearly impossible to compete as they once did. Some are reverting to the public utilities they used to be, others are focusing on less risky areas like asset management where they see a competitive advantage. A few are doubling-down on trading in securities markets and striving to reengineer themselves to remain leaders – knowing that the future risks of misconduct are ever-present. Each has its own behavioral and cultural traps, but at least they are easier to identify and perhaps to manage effectively.
However business models evolve in global finance, all of the incumbent firms and new entrants will have to learn to manage internal misconduct risk far better than ever before. It’s now a matter of survival.
___
Roy C. Smith is the Kenneth G. Langone Professor of Entrepreneurship and Finance and a Professor of Management Practice. Ingo Walter is the Seymour Milstein Professor of Finance, Corporate Governance and Ethics.