The financial crisis has imposed immense costs on the United States. Some 10 million households face foreclosure. Families have lost trillions of dollars of net worth. Almost a quarter of American households owe more on their mortgages than their homes are worth.
And it didn’t need to happen. Better governance and management could have saved our largest institutions (Citi, Fannie Mae, WaMu, AIG, Lehman, etc.) from failure. As a senior member of the Financial Crisis Inquiry Commission staff, I interviewed CEOs, traders, risk officers, board members, and regulators to try to understand: what successful firms did that kept them out of trouble.
My new book, Why Some Firms Thrive While Others Fail: Governance and Management Lessons from the Crisis (Oxford University Press, 2012), compares four firms that successfully navigated the crisis—JPMorgan Chase, Goldman Sachs, Wells Fargo, and Toronto Dominion Bank (TD Bank)—with eight that did not. Successful firms possessed: (1) discipline and long-term perspective, (2) robust communications and information systems, (3) capacity to respond effectively to early warning signs, and (4) a process of constructive dialogue between business units and risk managers;. Each of the successful firms applied these according to its distinctive culture. Unsuccessful firms lacked most or all of these attributes.
Perhaps the most important characteristic of CEOs of successful firms was their ability to create constructive dialogue between the risk function and revenue producing units in their firms. This helped them avoid poor decisions that brought down other firms. These CEOs didn’t give up power when they fostered risk awareness; rather, they became more aware of downsides of potential actions and then made better decisions.
Managers at surviving firms seemed to solicit feedback continuously. While they didn’t act on all, or perhaps most, such feedback, they developed a robust understanding of their firm and its environment that otherwise might not have been possible. Because of constructive dialogue and a robust sense of risk-reward tradeoffs, surviving firms sometimes retained more capital than their competitors and many times refrained from lucrative but risky types of financial products or transactions that seemed to make so much money for their competitors.
Among the firms that I studied that weathered the financial crisis and showed strong risk management, senior people, often the CEO or top management more generally, applied their influence to make constructive dialogue work. They brought revenue-producers together with risk people and ensured that the discussion was constructive and mutually respectful, and that it led to positive results. Constructive dialogue was ingrained in company culture.
Unsuccessful firms often had dominant CEOs, weak boards, and risk managers that they disregarded. These firms couldn’t detect or respond to signs that the mortgage market was weakening. Their leaders often lacked access to feedback that could prompt them to ask and consider simple questions that would have raised warning flags. Compensation systems compounded the problem by emphasizing short-term rather than long-term financial performance; without strong governance and management, the lure of immediate rewards predominated over consideration of downside risks.
Risk officers needed support from the CEO and the board to be useful. Absent that support, they could not do their jobs in the face of pressures for their companies to reap what appeared to be easy profits. Without constructive dialogue, risk management often became a pro forma exercise in which company officials went through the motions without adding value to the company’s decisions. Officials of unsuccessful firms afterwards complained that they could not have been expected to foresee a drop of 30 to 40% in housing prices. But successful firms did not foresee this either; rather, successful company leaders took defensive positions by maintaining strong balance sheets or by becoming alert to early signs of a troubled market and reducing risk.
Constructive dialogue was a part of robust communications more generally. Successful CEOs solicited feedback from their boards, engaged management teams, their risk officers, and others before making decisions. One gentleman at a successful major financial company said proudly, "The CEO often asks my opinion on major issues," and then added, "but he asks 200 other people their opinions too."
Successful companies backed up their communications with effective information systems that allowed early warnings and bad news and other information to travel up and down the hierarchy and across organizational silos. Dan Sparks, former head of the Goldman mortgage desk, told Commission staff, "Part of my job was to be sure people I reported to knew what they needed to know." Once the Goldman mortgage desk took unexpected losses in late 2006, Sparks sent the news to top management which began an inquiry into possible causes. Goldman decided to "get closer to home," as Goldman's CFO David Viniar put it, thereby riding out the period of uncertainty without incurring an unacceptable degree of financial exposure on either side of a neutral position.
By contrast, there is a pattern, seen in the Challenger space shuttle disaster, the costly BP oil spill, and at numerous financial and other firms, that poorly managed organizations may have front-line employees or contractors who see serious problems, but who are unable to obtain a respectful hearing at higher levels of the organization, if the information travels at all, before risks materialize. ecent travails at JPMorgan Chase (JPM) were unexpected, given that company’s excellent record in weathering the crisis. Where JPMorgan Chase had been a firm with constructive dialogue ingrained in the culture before the crisis, it seems that complacency since then lulled top management, and JPM’s risk management function, into laxity. News accounts suggest that JPM employees may have expressed concern about risk-taking at the JPM London office, but to no avail, and that regulators requested information about the office and its risk exposures which JPM apparently denied them. The cost could be large: JPM has appeared in recent news accounts, not only about the multibillion dollar loss in London, but also concerning possible infractions concerning the LIBOR index, and energy markets. As with unsuccessful firms in the financial crisis, laxity can permeate a broad range of company activities.
Ultimately, CEOs of regulated firms may find it advantageous to view their regulators as sources of constructive feedback. While regulators may not have access to the detailed information available to the CEO, they can raise pertinent questions and prompt constructive dialogue and further inquiry by management. This relationship may prove superior to efforts of too many companies before the crisis to hamper and disregard their regulators while engaging in risky practices that brought them to ruin. CEO Edmund Clark, who successfully led TD Bank through the crisis, argues that there must be “productive working partnerships between the industry and its regulators, enabling both parties to agree in principle on what needs to be done, and on the least intrusive way in making it happen.”
That is a win-win approach that could lighten the burdens imposed by regulators while making their input more valuable. Among other benefits, regulators could help strengthen the roles of boards and risk managers and encourage companies to make better decisions and thereby avoid the types of mistakes that cost so many firms—and the rest of us—so dearly in the crisis.