Category Archives: Economics

RBS – My Part In Its Downfall…

Actually, I don’t think I had much part in the downfall of RBS, although I did work there for twelve years from 1994.

I am about to read an account of the bank’s collapse – Making It Happen, by Iain Martin (I also want to read Shredded: Inside RBS, the Bank That Broke Britain by Ian Fraser, but it wasn’t out in paperback when I was buying) – and I thought it would be a good idea to jot down my thoughts about RBS and its fall before I did so.

I don’t believe I have any special insight into RBS, and I don’t think I will have anything to say that isn’t already in the public domain. My job was far too lowly for that. My redundancy settlement, eight years ago, also had a clause about not bringing the bank into disrepute, but I think RBS has done a pretty good job of that without any assistance from me since I left.

DSCN5129
RBS flagship branch in St Andrew Sq, Edinburgh.

I joined RBS over twenty years ago as an analyst within a large change programme called Project Columbus, which, after a couple of bad years for the bank, was established to rethink the way the bank worked. It was Columbus which put RBS back on track and gave it the muscle and discipline to acquire NatWest in 2000, after a bidding war with local rival Bank of Scotland. (How many firms contain the name of their main rival within their own? People always confused RBS and BoS.)

Columbus refocused RBS on its customers. It brought in much better costing of its products and services – before, the bank hadn’t been able to tell how much it made or lost on each customer; it split (“segmented”) its customers into specific types, depending on the type of business (individuals – retail – and three different types of enterprises); and it established different types of specialist customer managers to meet the needs of those different types of customers, and in doing so it removed the generalist bank managers from branches.

Goodwin joined RBS in 1998, after Columbus was completed, as deputy CEO to George Mathewson. Goodwin masterminded the NatWest takeover.

By chance, I was one of the first RBS staff into NatWest. I had been at meetings in London the day before RBS took control, and, looking for people who could act as a presence, I was told to stay down in London. Three Jaguars drove a small raiding party from our midmarket hotel – there had always been a focus on cost management at RBS – to NatWest’s headquarters in Lothbury, in the shadow of both the Stock Exchange and the Bank of England. Fred Goodwin, the chief executive; Graeme Whitehead, the FD; Neil Roden, the HR director; Tony Williams, head of HR operations and systems (or something like that). And me.

(Actually, there were one or two other guys, too – I think we were six in total. All men.)

It was a symbolic occasion. Whitehead was wearing a kilt. There was little for me to do; I was secreted away in a small room, twiddling my thumbs, whilst the board directors established what there rules were.

At lunch, though, we all sat in the staff canteen, in a prominent spot; making a point. Jocks in kilts. This was a change. This bank was under new management.

* * *

Up until the NatWest takeover, RBS has been a medium sized regional bank. After it, it was (or saw itself) as a global. Before, it owned Direct Line, an insurance company, Citizens, a similar sized regional bank in north east USA, and a few other businesses. (The one that I always remember was Angel Trains, a train finance house that was spun off a few years later.) NatWest gave RBS global clout.

I believe the NatWest takeover was successful, though it probably lay the seeds for many of the problems that beset the bank later on.

RBS was a lean operation, with costs tightly controlled, and the same ethos. Fred Goodwin had earned the nickname “Fred the Shed” whilst at Clydesdale fire the way he shed costs – largely people (or alternatively, “Fred the Shred” – “shredded”). There was little fat at RBS, and there was much fat to be shed from NatWest. There were extensive wine cellars, an art collection, and lots of business units. And lots of efficiency savings to be made. RBS had a low cost/income ratio, one of the key measures city analysts and investors use to measure bank performance, and shifting NatWest’s operations to a similar C:I ratio would generate lots of profits.

The purchase of NatWest was based on cost cutting and removing duplicated services – essentially, economies of scale. NatWest, for instance, had something like twenty seven different versions of PeopleSoft (the database system used by HR departments) – which didn’t talk to each other. It was similar across other systems – there were multiple tax and accounting systems, all of which needed reconciling. Trimming the fat wasn’t difficult. (Bear in mind that there were many redundancies, too – a lot of people lost their jobs, from both NatWest and RBS.)

But relatively quickly RBS started to become as bloated as NatWest. When I joined RBS, the emphasis has been on servicing the customer-facing parts of the operation: I worked in a head office department which had cobbled together, second hand furniture in a building above a bus station; if you opened a window, you got a whiff of diesel fumes. True, this was somewhat the exception, but it made the point that we were an overhead, and what we were doing was working to make the customer-facing, revenue-generating parts of the organisation more successful.

RBS had central departments scattered throughout Edinburgh, many of them in somewhat dilapidated buildings, and it had been planned to redevelop a city centre site to house them all. After the NatWest takeover, Fred Goodwin apparently decided that something else was needed. Something out by the airport.

When Gogarburn was opened in 2005 – by the Queen – it seemed very opulent. There is an old investing adage – maybe from Jim Slater – that when a business starts investing in sparkly new headquarters, it is time to short the company. It would have been a very effective sell signal for RBS.

Gogarburn was very self contained. It had very good restaurants, a health club (with a full length swimming pool), a social club and bar, several shops, and a couple of Starbucks franchises. It had a nursery and a management school, delivering courses for the large numbers of executives it now had. It had a separate directors’ wing. There was no reason to leave.

Whereas RBS had been part of the city, after Gogarburn opened it was apart from the city. Gogarburn was isolated, and RBS became very insular. Being in Gogarburn felt like being part of the “Truman Show”. Everyone there worked for RBS. There were no more serendipitous meetings with contacts from other firms. You only saw people from outside RBS at Gogarburn if they were there for a specific meeting. Whilst communications within RBS undoubtedly improved, a broader understanding of and communication with those outside plummeted.

It was as if RBS saw itself above all that.

(I don’t think I lasted a year at Gogarburn, taking the opportunity to leave when I was offered a redundancy package during yet another internal reorganisation, in 2006.)

* * *

There were stories that Goodwin was intricately involved in the design of Gogarburn. Many may have been apocryphal – such as one saying he had personally been responsible for sending a shipment of marble back because it was the wrong shade, or that he personally spoke to the CEO of Vodafone to get a mast put on the roof to ensure adequate mobile coverage (under threat of removing the RBS contract). Either way, it was apparent that he was involved in details of RBS, rather than delegating and letting others get on with it.

He apparently held early morning meetings – “prayers” – add which he would grill his direct reportees. Failure was not an option. Some described his approach as bullying. It certainly don’t seem to have been particularly collegiate or collaborative. I don’t imagine he was easy to work for. The watchword was JFDI – “just ffffing do it!”

This permeated the firm, I would say. People were not happy making mistakes or getting things wrong. Success at any price. Thinking too much – or at all – was seen as a weakness. Decisions were made quickly and, once made, that was that.

Success at any cost is what probably broke the firm. When Barclays bid for ABN Amro (a year or two after I had gratefully left RBS), it was seen as a risk to RBS’s dominance – it’s claim to be the biggest bank in Britain – and, as a part of consortium of other firms (Santander, which had a long standing relationship with RBS, and a Belgian insurance firm), a counter bid was made. ABN Amro would be broken up and each member of the consortium would get the bits they wanted. RBS wanted the US retail business, which fitted well with Citizens, and some of the investment banking bits.

I’m sure the figures stacked up, at first: the deal would have made sense. But then as part of its defence ABN sold its US retail arm. And more importantly, the downturn started, and kept going. Barclays had dropped out. RBS continued. And ended up paying a lot of money for lots of toxic assets. And effectively going bust, and relying on a UK government bail out.

Between 1994 and 2007, RBS made accounting profits of £55bn before tax, and £39bn after tax. In 2008, it wrote off about £47bn according to Robert Peston on BBC Radio4’s “Today Programme”. In the seven financial years 2008 to 2014, RBS has has reported total losses attributed to shareholders of, by my calculation, £49bn. Basically, RBS hasn’t made any money since 1994, despite paying billions to the government in tax and to shareholders as dividends.

* * *

Personally, whilst I believe Fred Goodwin was the driving force both of the bank and the sour deal, I don’t believe all blame for the collapse of RBS lies with him. A lot does – it was his strategy – and his hubris which pushed forward with the ABN takeover.

Wanted Poster at Holburn Station (London, UK)
From takomabibelot on flickr, used under Creative Commons licence.

But many other people need to share some – or even much – of the responsibility:

  • other executive directors – the management team – should have been up to challenging Goodwin’s behaviour, including the more bullying, trampling aspects of it. I don’t know if any doubts were expressed by other members of the management team, but they probably should have been. Except that they would probably see their jobs and salaries get bigger as a result of the takeover. Could they be objective, even if they could stand up to Goodwin? Groupthink might also have played a role: it might have been hard to break rank. No one loves a naysayer
  • the board – particularly the non-executive board members. It should have been their role to make Goodwin and the management team accountable. Perhaps they did, though they all left under a cloud following the collapse of RBS
  • other employees. It is hard to tell the boss he’s wrong. It’s harder when the response is “jfdi!” But someone must have had doubts – all those people poring over the figures in finance; all those providing management training in the brand new management school
  • shareholders. Under market capitalism as practiced in the UK, shareholders are more likely to sell a firms shares than try to engage with management about corporate strategy that isn’t liked
  • regulators. They could easily have put an end to the folly. Following the crash and the collapse of RBS, the role if regulators had been greatly changed. (Until the next crash …)

I must point out that I fall into two of those categories – though as a fairly insignificant employee and a very small investor, I believe I had little influence (but lost a lot of money!).

I believe the real issue – the blame – lies with the board, both execs and non execs. They had oversight of the strategy and the deal. When the crash came, they should have pulled the plug. RBS would have looked weak – it might even have become a takeover target itself – but it would have survived the deal. Instead, they pushed on, buying illusory assets which quickly turned to dust, taking much of the UK economy with it.

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Why Do The Campaigns In The Scottish Referendum Concentrate On Economics?

I was at (another) debate on the economics of Scottish independence on Monday. One of the panel members, Christine O’Neill, the chairman of a firm, expressed her surprise and dismay that both campaigns – for and against independence – had focused almost exclusively on economic issues, rather than, for instance, what it means for our culture and values, and what kind of society we would like to create in Scotland.

I’m with her – particularly when the economics is so up in the air, with both sides throwing around contradictory “facts” which are frankly nothing of the sort. O’Neill likened it to the campaigns trying to buy votes – with Better Together offering us £4bn (about £1000 each) and the SNP offering £5bn. (Both these claims are based huge assumptions which make them impossible to compare.)

Her question, though has a simple answer, as sephologist and pollster John Curtice described at a talk back in April. (See, I’m a glutton for punishment.) Then, in discussion with Stephen Reicher and Jan Eichhoin – it was like a public version of Newsnight Scotland (before it got axed) – Curtice explained that the prime determinant of voting intentions in the referendum was voters’ view on the economy, ahead of cultural identity and values. It apparently explains many anomalies, such the long standing gap between male and female voting intentions – women are more pessimistic about the economy, and more risk averse.

Both sides know this and are tailoring their campaigns accordingly.

Indeed, Curtice admitted he was also responsible for the campaigns focussing on £500 – all it would take to swing their votes: it was his research that identified this low price-point. How cheaply our votes can be bought.

The Scottish Economy and Independence.

Talking at Edinburgh University Business School earlier this month, Jeremy Peat from the David Hume Institute (and formerly head economist at RBS) reckons that the debate on independence for Scotland needs the injection of some rational thinking, so that voters can make an informed decision in the referendum next year.

His beef is that there are a lot of questions, and each side is picking its answers politically, rather than factually: for example, his institute produced a paper on the possible range of oil income; one newspaper printed only the lower limit, and the campaign for the opposing argument used only the upper limit. Neither is wrong, but both warp the discussion – and confuse people by promoting the figure which supports their argument as “fact”.

Peat set out to clarify what the questions are, and what the options might be. He doesn’t have a fixed viewpoint, and wouldn’t say whether he was pro- or anti-independence. Indeed, he believed remaining objective was key, giving access to all parties and bringing informed debate to their arguments.

He covered both macro and micro economic issues.

The main macro concern is the currency, where he saw four options:

  • keep formal currency union with the UK
  • use sterling as a parallel currency (just as some countries use the US dollar) without formal currency union
  • join the euro
  • establish a new, Scottish currency

No surprise there, then. For me, this is the crucial matter. But Peat went on to identify several issues around the currency.

Both a formal currency union and adoption of the euro would introduce strict fiscal and monetary constraints. Monetary policy would be set by either the BoE or the ECB, and Scotland would have limited influence over either.

Adopting the euro would take time to negotiate following independence (including membership of the EU and the need to meet the euro stability requirements, which could take years), and there would need to be an interim solution; similarly, the UK government has said that an independent Scotland would need to negotiate currency union. The impact on borrowing and trade under any option need to be assessed. (Peat recommended a paper by Brian Quinn, a Scot and former deputy governor of the Bank of England, on the impact of currency on an independent Scotland [PDF].)

Under any currency solution, who would be the lender of last resort? What about bank regulation? These are things that can only be decided once the result of the referendum is known, but the make a rational decision, the options and likely outcomes need to be considered.

Peat did say that Scotland wouldn’t be wholly independent inked it controlled its own monetary and fiscal policies – that is, its own currency. This may be why some of the Yes campaign have come out in favor of an independent currency, despite the SNP favouring sterling. (I couldn’t find a statement on the Yes campaign website – they do not have a search function on their website [at least not one I could find] – and the SNP doesn’t mention “sterling”, “pound” or “currency” in its vision.) There would however be significant costs transitioning from sterling, and small countries with a stable currency tend to have very rigid monetary and fiscal policies to protect the value of their currency. Any benefits of independent mindset and fiscal policies could therefore be lost.

The other major macro issue concerns the public finances. The global economic situation means that an independent Scotland would be starting from a very weak position. Public spending in Scotland is higher than the non-North Sea tax take from Scotland; the difference is generally made up by the income from oil and gas. The value of the income from the North Sea is therefore crucial, and depends on the price of hydrocarbons, the volume of production – and the basis of taxation. These are unknowable, though it is possible to estimate likely ranges. (These are the figures which Peat was irritated had been taken out of context, each side quoting the figure which supported their argument rather than the range in context.)

Much would depend on the share of government debt taken on by Scotland. There’s a lot of uncertainty about this. For instance, what comprises government debt? There’s government borrowing; a share of the RBS and HBoS bailouts; public pension liabilities. What about the decommissioning liability for nuclear power stations? The cost of decommissioning North Sea installations? Rail infrastructure? And so on. Much of this is unknowable – but of course it is possible to estimate these debts, and to model what it might mean for the economy.

The micro issues Peat discussed mostly involved the opportunities that existed for policy which an independent government would need to decide and enact. These were legion. What would competition policy look like? Financial regulation? Transport (though already a devolved power)? Energy policy? All these need regulation, as well – the competition for economists might mean a boom in wages… There would need to be the creation (or duplication!) of all sorts of institutions, including an equivalent to the Office of Budget Responsibility to keep government accountable. (Peat suggested the “Scottish Office of Budgetary Accountability” – or SoBA…)

The policy involving the non-Scottish bits of UK-wide firms represents lots of issues. How about cross-border mergers and transactions (and that is after the currency has been decided…). The interactions with the rest of the UK over all sorts of matters could become key – and might involve all sorts of transaction costs.

Once policies have been decided – government’s role – implementation and regulation would down to other bodies, operated at arm’s-length from government to reduce political interference. What others might call quangos. The establishment of these might cause a surge in the demand for skilled economists, administrators – and change managers (like me! I definitely see a way of hedging my bets here…). The SNP has set out a timetable to independence following a “yes” vote of about 18 months. Not long to get all the institutional infrastructure set up. Where will these skills come from? And what will this mean for business competing for the same talent?

One of the key benefits of independence identified by Peat would be freedom over taxation. Under devolution, the Scotland Act 2012 allows the Scottish government to set income tax and land transactions tax (currently stamp duty). An independent Scotland could completely revamp the tax system – simplifying it (and therefore saving individuals and businesses large costs in fulfilling their obligations), and designing it to meet specific policy objectives. This could be quite powerful in driving policy outcomes and the economy. (ICAS have an extensive report on the practicalities of tax devolution [PDF].)

It is hard to know how an independent Scotland would perform. David Skilling reckons that that small countries outperform larger ones, though Peat thought the jury was still out on that one. The psychological outcome of independence might be positive – the “Braveheart” factor – which could spur innovation, but of course (as so much else) this is unknowable before independence. (It would be interesting to see if there were any such boost to the economy following the start of devolution in the early 2000s.)

Peat concluded that independence was feasible, but that there were so many unanswered – and even unasked – questions that we cannot say if it would be beneficial. (Indeed, we’d have to define what “beneficial” means – there is more to this world than economics!) To get answers, we need to have a more subtle, nuanced debate, rather than the rather shabby level we’ve currently got.

We also need to think about the alternatives. A “no” vote wouldn’t mean “keep Britain and carry on”. All three unionist parties are contemplating further devolution following a “no” vote, be it “devo plus” or “devo max” (neither of which is defined). To decide if “yes” or “no” is the right choice, we need to understand the different options.

But why wait for independence? There is much that the government could do under the current conditional set up. Blaming Westminster for a lack of progress seems rather childlike – always blaming the big boys, and never taking responsibility for our own actions. The SNP have been in power for six years; what have they really achieved? (I think I’ll have to go and find out. I may be sometime.)

[The David Hume Institute has several papers relevant to the debate on its research page.]

John Kay on Bankers’ High Salaries.

John Kay, economist and chair of the Government review of equity markets and long term decision making [PDF; and it’s long!], was speaking to the Edinburgh University Business School, ostensibly on “Why are financial services so profitable?”, but essentially discussing remuneration in financial services. (This may because the answer to the original topic is a quick “they’re not!” – profits from the boom years were wiped out in the crash of 2007 and the ongoing global financial crisis: the profits were illusory).

Remuneration is of course a hot topic. The EU is developing proposals to cap bonuses; bankers’ salaries and bonuses regularly feature in the news.

The standard economic model of wages is that workers receive the same as their marginal unit productivity (I think!). The article in Wikipedia explains it better than I could… A big problem with this model is that it is very hard for organisations to know what the marginal productivity actually is. In large corporations through to the smallest business employing people, whilst the theory might say this is how wages are calculated, my guess is that actually no one knows. What is the marginal productivity of a waiter, a bar tender, a bank teller – or the CEO of a major company?

Kay discussed three different economic theories to explain real remuneration patterns and income distribution, each of which comes from different economic and political assumptions.

The first is that what may be perceived as excessive wages reflect political power and rent seeking. Economic rent the amount paid for a resource in excess of the amount to get that resource into productivity. In the example Kay used, the amount that Wayne Rooney is paid by Manchester United is probably far more than the minimum that Wooney would need to be paid to get him to play football: the difference is because ManU have to pay this excess to stop him moving to another club, who might pay more: in an open market, those other clubs bid up the price. (Kay may have been a little premature on this specific point, though the principal stands…)

The economic power in this case is with Rooney; similarly, successful bankers can threaten to move to another employer – or even another country. They could work anywhere – they have highly transferable skills – and their employers might worry that if they don’t pay their high salaries, they would lose access to the bankers’ skills. (I am not so sure that this threat is a problem now that much of their success has been proved to be illusory.)

The second model Kay covered is what he called “the estate agent problem”. The economics of estate agency is, according to Kay, curious: the rate of fees is generally static, with competition not acting to drive down prices. Estate agents generally charge the roughly the same fees as their competitors. This is because users want to pay for the best service; no one want to pay for an ok, but cheap, estate agent (let alone a bad but dirt cheap agent!), since the benefit accruing from paying a bit more for an excellent agent would far outweigh the cost.

Banks therefore pay for the quality they perceive they receive. They don’t want to pay for a mediocre performance when they believe they can pay a bit more and get excellent performance. Similarly, no board of directors is going to hire a CEO or MD they believe to be average: they will all want the best, and their recruitment firms will help – and bid up the price. But it is doubtful how much difference CEOs can actually make. Luck has an awful lot to do with their success or failure, as do the people they hire.

(Recruitment agencies and remuneration consultants have a lot to answer for, too. All firms want to be seen to be good payers – management roles, at least: job ads often describe roles – firms – as “top quartile pay”; I don’t think I have ever seen a role described as “bottom quartile pay”, though of course 25% of jobs, and firms, must be! Remuneration consultancies produce regular reports showing the market rate for specific jobs, which firms expect to have to pay to get the people they want – and the market rate inflates each year as firms adjust their rates to stay with the market.)

The third issue Kay identified is that of “bezzle“, a word coined by J. K. Galbraith to describe the undetected amount of corporate fraud. Before the fraud is discovered, the victims believe themselves better off than they are. Prior to the global financial crisis, we all thought we were better off than we actually were, because of those non-existent banking profits. As someone said (attributed to Nassim Nicholas Taleb), “we borrowed from the future, and now the future wants it back!”

Until a fraud is discovered, we are all better off! (Kay has writen about the global financial crisis in terms of the bezzle.)

The asymmetric information between financial institutions and their customers – that is, just about everyone – and between fraudsters (call them bankers, fund managers… people who are claiming their bonus for no special performance) and institutions are able to make excess profits. Until of course they get found out. Clearly, even though they have been found out, a great many still think they are worth it.

There was a discussion about how better to align reward and performance – locked-in long term share options, maybe – and perhaps a more apposite debate on the kind of people we want running our companies. This last is important. The traders who do the jobs in banks may do so precisely because they are attracted to the high risk, high return environment. Whilst we might benefit from people with less risky approaches, they are unlikely to be attracted to those jobs. Similarly, the CEOs we appoint might actually be wrong for the job – but less aggressive, flamboyant people aren’t going to apply. And what board would appoint a wall-flower against an alpha male bull? Maybe we get the management we deserve.

I’m not sure if any of this really explains extravagant remuneration and the bonus culture that has been laid bare by the crisis. Maybe it is simply greed, and people gaming the system: trying to get as much as they can.

Internships

On Wednesday I had a debate on Twitter about internships. Liz Cable tweeted

I tweeted my immediate reaction (well, thought about it, and edited it down to 140 characters, thought better of sending it and then changed my mind – as one does…):

And hence I got into a friendly discussion with Liz, and also with Doug Shaw, who joined in. (As an aside, this kind of discussion emphasises some of the values of Twitter: we clearly hold different viewpoints, but are able to engage with each other and debate a topic back and forth. In 140 characters…)

I was surprised by strength of my reaction, and thought I’d set out my reasons hear.

Fundamentally, it stems from a belief that if one is engaged in productive work, one should be paid for it. We have laws protecting workers from exploitation – including setting a minimum wage. (Which isn’t much.) Using interns to do “real” work – tasks which an organisation would otherwise have to pay someone to do – is exploiting them. And, because of those laws, illegal.

If firms couldn’t use interns, they may need to hire more employees, paying them real wages at the minimum wage or above.

Only those who can afford to work for (more or less) nothing can be interns. They are therefore the realm of the privileged, increasing inequality and reducing social mobility.

I also think internships teach some of the wrong lessons. If someone’s first experience of a working environment is exploitative, exploiting others appears to be ok. Indeed, by allowing this exploitation, society is implicitly making it ok. And yet we bemoan a lack of business ethics as a cause of some of our economic ills.

I can understand why young people want to do internships: in a tough job market, anything that can demonstrate skills, determination and ambition – anything that might make a CV stand out from the crowd – will be pursued.

I can definitely see why companies want interns: a cheap supply of labour; and potentially seeing able candidates perform in a working environment must be better than more formal interview processes. The major benefit will accrue to shareholders: those firms using interns will make more profits (none of which go to the interns).

It is of course not this black and white. Interns are, I’m sure, willing: they want the experience. But the power in such a relationship is so skewed towards the firms that willing or not, it is still exploitative.

I can’t reconcile where voluntary work fits in to this, either. I have done voluntary work at different times in my career, and it can be rewarding for both the worker and organisation they volunteer for. But I think the power in this relationship is much more toward the volunteer.

I’m not the only person who thinks like this. The Guardian website describes internships as “institutional exploitation” and “a scandal” – as does the Daily Telegraph’s website (the latter referring specifically to internships with MPs in Parliament). The website JobMarketSuccess outlines many of the objections I’ve expressed.

None of my criticism of internships is directed towards Liz: I’m sure she is trying to do the best those for whom she needs to source internships, and I have no doubt she, the organisations she works with, and any interns placed would work in an ethically fashion.

“Greed, Governance and Ethics”: a talk about corporate failures.

Stewart Hamilton spoke at the Business School on the history of economic bubbles and business failures. Unfortunately, he had a lot to go on. His main thesis seemed to be that we were incapable of learning from history: and governance and ethics were no match for greed…

I found four different kinds of failure in the sorry list of collapse that he ran through:

These are widespread market failures engulfing many organisations, often arising from speculative asset bubbles (in all those above, either commercial or residential property, but he could have included the 2000 dot.com bust, resulting from a bubble in internet company shares, or the Dutch tulip crisis of the 17th century, where the asset bubble involved the price of tulip bulbs – bizarre but true). In these bubbles, no one wants to be left out of rising asset prices, causing assets prices to rise further, pulling more buyers in – until something pricks the bubble and the asset prices tumble, leading to an economic crisis.

  • corporate malfeasance, such as
    • Enron
    • BCCI
    • WorldCom
    • Olympus (not mentioned by Hamilton, but a recent, agressive example)
    • Ferranti through its takeover of ISS (again, not raised by Hamilton, but one that affected a great many citizens of Edinburgh)

where illegal or unethical behaviour is widespread and systematic at a senior management and board level, with many people involved.

and perhaps RBS and HBoS – these last three all victims of the global financial crisis, but their collapse specifically related to bad management decision-making.

Not all of these cases resulted in the complete corporate collapse of the organisation in question – AIB is still going (albeit mired in tax evasion and overcharging issues), as is Olympus; RBS and HBoS survived thanks to government intervention.

Greed (from which stem fraud and other illegal and unethical behaviours) and incompetence are nothing new. The real problem is that corporate governance is no real counterbalance to them: similar issues seem to have affected UBS, which lost $2bn as a result of a “rogue trader” seems to have learnt nothing from the collapse of Barings, as a result of Nick Leeson’s illegal trading. Organisations have processes and controls in place to stop people exceeding their authority – and risking the bank. But these didn’t work at Barings or UBS, nor at any of the huge institutions like AIG, RBS or HBoS, nor smaller banks like Northern Rock. They didn’t understand the risks of the products they traded and held (and they weren’t alone – Chuck Prince, CEO of Citibank, said in early July 2007 “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” – days later, the music stopped, and banks started to go bust – but not Citi (though it apparently came close).

Hamilton used AIG as an example of an organisation that was not only “too big to fail”, but more importantly too big to manage or regulate. He said AIG comprised of over 7,000 legal entities in 150 different countries, trading in countless different business areas. How could any one regulator – or the company’s auditors – know what was going on, and what or where the real risks were?

Hamilton reckoned the real problems lie when there is a combination of a dominant CEO and an ineffective board – the board failing to keep the CEO in check, particularly regarding the governance of poor strategy. (Of course, poor strategy may only be knowable with hindsight: Fred Goodwin was hailed as great leader after the takeover of NatWest by RBS, and it was perhaps only the timing of the RBS bid for ABN AMRO that was RBS’ undoing.) Large corporations attract strong leaders, though that might not be what they need. Strong leaders see attraction in growing their organisations – not least because, as Hamilton pointed out, the bigger the company, the bigger the remuneration (it doesn’t take long for greed to creep in!): and acquisition is the quickest way to grow. But maybe the least sustainable.

Throughout all this, I was unclear on the role of management education. Hamilton is emeritus professor at a management school, IMD; we were sitting in the lecture theatre of a business school. I have done an MBA; there was an ethics course, but little more – I don’t remember any specific teaching in, for instance, directors’ responsibilities. Anyone can become a company director. One cannot legislate for ignorance or foolishness; but requiring directors to be educated on their role might be a start.

Thoughts on “Shareholder Value”…

A couple of weeks ago, after yet another corporate tax avoidance wheeze came to light, I was having a Twitter-based conversation with Steve and Gordon about “shareholder value” – specifically, whether the need to maximise shareholder value was dictated by company law. (The answer, by the way, is – predictably – “it depends”. More on that later!) It echoed something that economist Robert Shiller said when he spoke at he spoke at the RSA last May – he said something like the pursuit of shareholder value was so enshrined in (US common) law that social entrepreneurs needed new legal forms of organisation structures to do what they wanted to do – otherwise they could be sued for failing to maximise shareholder value. (I wasn’t convinced by Shiller’s argument that a new form of company was needed, at least within the UK.)

These exchanges made me question the concept of shareholder value: my background in finance meant that I took shareholder value for granted – a no-brainer: it was the orthodoxy when I was training, over twenty five years ago (that’s the late 1980s, in case you can’t do the maths!), and again, fifteen years later when I did my MBA. It struck me as being good to review my understanding of shareholder value.

“Shareholder value” – there are many definitions, but this one seems simplest:

the value that a shareholder is able to obtain from his/her investment in a company. This is made up of capital gains, dividend payments, proceeds from buyback programs and any other payouts that a firm might make to a shareholder

– is the be all and end all of management. It stems from the separation of ownership of an limited companies by shareholders from the management of those companies – the principal-agent problem. By focusing on shareholder value, managers should align their interest with shareholders.

I still think this is simply stating the bleedin’ obvious: managers of a firm should manage the firm in the interests of the owners (the shareholders). It is the same for all employees – if you behave in a way that is detrimental to the company whilst performing your duties, you are likely to be sanctioned.

In financial decision making, maximising shareholder value is often synonymous with maximising the net present value of future income streams – calculating the discounted cash flows of a company. That is essentially how the market prices of share are estimated (and they go up and down as the market reassesses those future values). Allegedly.

This gives a relatively simple way to estimate shareholder value, and companies regularly assess new projects to maximise shareholder value.

The duties of directors to act for the advantage of shareholders is set out in the UK Companies Act 2006 (and previous versions of it, too!). But CA 2006 goes beyond its predecessors by establishing “enlightened shareholder value”. Section 172 of the CA 2006 states

(1) A director of a company must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole, and in doing so have regard (amongst other matters) to—
(a) the likely consequences of any decision in the long term,
(b) the interests of the company’s employees,
(c) the need to foster the company’s business relationships with suppliers, customers and others,
(d) the impact of the company’s operations on the community and the environment,
(e) the desirability of the company maintaining a reputation for high standards of business conduct, and
(f) the need to act fairly as between members of the company.
(2) Where or to the extent that the purposes of the company consist of or include purposes other than the benefit of its members, subsection (1) has effect as if the reference to promoting the success of the company for the benefit of its members were to achieving those purposes.

So whilst the company is to be run for the benefit of its members [shareholders] (s172.1), it requires a long term view (s172.1.a), consideration of employees (s172.1.b) and other stakeholders (s172.1.c and d), and maintaining a reputation for high standards (s172.1.e). Shareholders come first, but clearly CA 2006 reckons that the best way to maximise the benefit for shareholders is through its relationships with others. And, though I’m not a lawyer, I reckon that s172.2 means that the directors have discretion to do things other than in the immediate interest of shareholders for a longer term benefit. (Like making contributions to charity, perhaps?)

In the US, corporate law is set at a state level; for historic reasons, though, the small state of Delaware has over 50% of company registrations, and they are determined by Delaware General Corporation Law ((DGCL). This doesn’t set out directors’ duties, which are governed instead by common law.

The key ruling seems to be Dodge v Ford Motor Co (1919): Henry Ford wanted to expand production the company (of which he was the major shareholder) for the benefit of employees and customers – cutting prices in the process. (A strategy of going for growth and market share at the expense of profits.) The Dodge Brothers objected, and the court ruled in their favour:

A business corporation is organised and carried on primarily for the profit of shareholders. The powers of directors are to be employed for that end.

Shareholders have primacy.

This might seem unequivocal, but of course it isn’t. There is a huge amount of discretion for directors.

In public companies shareholders will have a huge range of objectives. Some may want a stream of dividends to supplement their income now; some might want future capital growth; some might simply want to have a say in what a company is doing (like protester at BP’s AGM). The CA 2006 covers this in s172.1.f – “the need to act fairly as between members of the company”.

But most shareholders are shareholders because they want some form of their wealth to increase through income or capital growth. The UK stockmarket was, in 2010, owned 11.5% by individuals, 41% by financial companies and institutions (pension funds, unit trusts, insurance companies and banks) and 41% by “rest of the world” (overseas financial companies and individuals). Anyone with a pension plan or investment has a direct or indirect investment in listed public companies.

Those financial institutions are increasingly measured by their relative, often short term performance: fund managers (the people managing the share portfolios of those unit trusts, pension funds and insurance companies) are measured on their quarterly performance, and so they assess the shares in those portfolios on quarterly performance as well. Focussing on “shareholder value” allows them to do this.

Additional focus on shareholder value has come from the rise of shareholder activism – particularly from hedge funds. Activist shareholders are nothing new – the Dodge brothers in Dodge v Ford were activist shareholders: they wanted to influence the company’s strategy in a particular direction.

There is no time-frame for shareholder value, which is what makes it rightly subjective: focus on the short term profit, like many hedge fund managers, and you’ll stuff future value. Focus on customers, employees, suppliers and (erm…) the broader community – focus on relationships, if you will – and your business will grow for the future but perhaps at the loss of those short term gains.

For instance, Starbucks may have maximised its current shareholder value by legally minimising its corporation tax liability, but at the expense of its reputation once the story broke and, if customers act on this knowledge and choose to buy someone else’s coffee, future profits.

I know which I prefer.

Where I Stand on Scottish Independence

Much of my last post on “A Just Scotland” concerned the constitutional settlement for Scotland, and in particular the outcome of the proposed referendum in 2014 on Scottish independence.

I rarely post here about overtly party political matters, though much that I write about is “political”; but the arguments for and against independence go beyond (or, at least, ought to go beyond) party politics, and I thought it only right that I should explain where I stand on Scottish independence.

I have already made up my mind how I’ll vote (though of course I have plenty of time to change it – and if I do, I’ll post about it!).

I am against independence.

My decision stems from three arguments, any one of which I think would stop me voting “yes” to independence.

The first is the outright uncertainty in what we are voting for. Fortunately, the recent “Edinburgh agreement” restricts the referendum to a single question on independence. (The precise wording is being overseen by the Electoral Commission – the wording of the question may make a big difference to the outcome.) But quite what a “yes” vote may mean is unknown: in the EU or not, in NATO or not, contributing to UK armed forces or not, in sterling or the euro (or neither) or not, the amount of debt UK national debt that will be allocated to Scotland… The list of unknowables is long. Some of these might be decided – or at least a policy decided – before the referendum, but much which be decided as part of negotiations should there be a “yes” vote. Which of course means that we won’t know what we’re actually voting for in 2014.

The second factor is the complexity. Scotland and the rest of the UK have been so closely linked since unification in 1707 that common institutions are intricately tangled, and untangling them will be difficult. Rebuilding these from scratch would be costly. One of the advantages of union is the economies of scale resulting from being part of a larger whole. At its most basic, having the infrastructure for tax collection in place is a huge boon. (Imagine the economic hiccup in switching from one tax collection system to another: just as when one changes jobs, the Scottish government would need to build up a reserve to tide the country over the gap.) It might be possible to outsource much of the bureaucratic infrastructure – I’ll bet the UK government would happily do the job (for a cost). Or maybe not: HMRC might just laugh at us, and not hand over their share. Scotland would have minimal leverage. And no representation. Even if the Scottish government were able outsource the bureaucracy for so much of our day to day lives back to London, what then would be the benefit of independence? Nothing would have changed.

The difficulty for business would be immense: the large number of cross-boarder businesses which would, one way or another, need to account for their Scottish and other UK operations separately would make this a vast, and expensive, task. (I recently had a conversation with a friend who had been working on the transfer of over 300 RBS branches to Santander – a deal that has subsequently fallen through. Both organisations had large teams working on this, and the complexity of the process was mind-boggling.) Separating two countries that have been so tightly linked would be several times more complicated – an enormous and costly task.

It is also possible that there could be a large number of talented people who migrate from Scotland to greener grass south of the boarder if Scotland gains independence, leaving the country financially and culturally poorer.

The last, and frankly killer, argument is economic. Scotland’s economy is inextricably tied up with England’s. Excluding oil and gas, Scotland exports goods and services (excluding oil) worth £45bn (2010) to the rest of the UK (ie England), more than twice the £22bn it exported overseas [pdf]. (Of the £22bn of international exports, £10bn went to the EU, £4bn to the USA and £2bn to Asia.) For business reasons, it would make sense to keep sterling: the costs of transacting in another currency could be very large.

There are at least two other options: Scotland could join the euro (though it is doubtful that could take immediate effect – the Maastricht criteria for joining the euro have a minimum of a two-year lag period, during which the nation’s currency must be in ERM II (which sterling would not be, of course); or Scotland could issue its own currency (like Irish punts before Ireland joined the euro). Given the current state of the euro and the stringent economic conditions being set by the European Central Bank, it is unlikely the Scottish government would chose that path. And the costs associated with establishing its own currency (which would have no value in the money markets and which would impose large transaction costs on business) would, I believe, make this a non-starter.

(The SNP states that “…on independence day … the pound will be our currency“, but there are many views which dispute the workability of this.)

Without an independent currency, in what way could an economy be independent? Any economic decisions made by an independent Scottish government would be subject to decisions on monetary policy decided in London or in Frankfurt – that is, fundamental decisions on interest rates and monetary supply. Fiscal policy – tax raising and spending powers – would be determined in Scotland, but it is fair to assume that the yield on Scottish government bonds (the rate of interest charged by the money markets) would be higher than that on UK government bonds, if only because the market would be so much smaller (and hence less liquid). It would therefore cost more for the Scottish government to borrow money to fund its activities.

Either way, the Scottish government would have its hands tied – by the Bank of England, the European Central Bank – or even by the financial markets. It would be independent in name only, and at great cost.

And that is why I am against independence.

Other sources I looked at when trying to set out my views include

“Caring Capitalism”?

There was a bit of an unintentional theme running through a couple of events and conversations I’ve been to over the past few weeks regarding the future of capitalism and corporations, and then last week Ed Miliband’s speech at this year’s Labour conference continued his emphasis last year on “predatory capitalism“.

Miliband was talking about aggressive capitalism which he saw as damaging the economy, and I doubt anyone could really disagree right now.

Last month I went to a talk on “caring capitalism” – perhaps the antidote to Miliband’s “predatory capitalism”. Focusing on social enterprise – as the speakers pointed out, a broad term with no real definition (though Wikipedia has a go) – as a means to create a more just society, a few different models were explored: though frankly none of them seemed particularly new.

For Helen Chambers and Mary Duffy, a social enterprise is one which exists specifically for social purposes, working within a commercial, for profit model – with a commnon principle “to do good”. Two specific organisations – Haven Products and Rag Tag ‘n’ Textile – were used as examples though the latter is a registered charity (and hence a not-for profit – although presumably just as many charities run retail, for profit operations, it does too). Both these organisations work largely for the benefit of their employees, providing opportunities to those who might otherwise not find employment.

Other objectives for social enterprises include working for the benefit of employees more generally, suppliers (such as fairtrade), the environment, and the wider community.

Whilst social enterprises might explicitly have such objectives, I can’t help thinking that most commercial corporations implicitly act in a similar fashion: a business which works against customers, suppliers or the community should not prosper, at least in the long term: if you work against customers, they will move (that’s what competition is about). Many commercial, profit-seeking organisations make large donations to charity – including banks such as the near-collapsed RBS. The rising interest in corporate social responsibility has focused investors, managers, employees and other “stakeholders” on organisations’ governance, ethics, ways of working and their internal and external relationships. (Much of this may be mere window dressing, though…)

Much of the talk was about social investment. It sounded like a wall of philanthropic finance was pouring into a small, undeveloped and fragmented sector: this could distort the economics and lead to imperfect allocation (one of the things markets are supposed to be good at – though the economic crisis has clearly dented that particular claim). But the amounts of money are still chickenfeed compared to the amounts spent by governments.

Nor is philanthropy anything new – Andrew Carnegie distributed his large wealth, endowing libraries, museums and universities; other “robber barons” such as Frick, Rockefeller and Vanderbilt did the same. Indeed, contrite financiers such as Michael Milken have tried to make amends through charitable donations and work, though the rich have long been using the gains – ill-gotten or not – to buy forgiveness.

Most social enterprises are small: perhaps it is easier of small organisations working outside the usual constraints of (non-social) investors “to be good”. Certainly large, international corporations seem to suffer from much of the criticism – perhaps because they are further from their suppliers, customers and communities: and of course one of the main advantages of large organisations – the ability to leverage economies of scale – means that someone, somewhere is paying more or getting less than smaller firms.

I still believe that outside a few industries – tobacco, arms and extractive industries, perhaps – all businesses benefit from “doing good”, if they want returning customers. Perhaps some organisation structures are better fitted for this than others – cooperatives, employee-owned firms or mutuals, perhaps. With businesses focused on customers, employees and suppliers, all organisations would be “social enterprises”: exploitation of one or oanother of these key groups would be to the detriment of the business.

Or what am I missing?

Trying to Understand the Financial Crisis…

Some time back, someone shared a new acronym with me: GFC. For those, like me, not in the know, this is apparently the hip shorthand for the global financial crisis – the economic mire that engulfs us all. It has been going on, more or less, for five years now, with every indication that it will get worse. It is its evolution from a banking crisis to a sovereign debt crisis – at least within the Eurozone – that gives me my optimistic outlook. I’ve been trying to write this post for ages, but every time I do, the story gets bigger and and seem to be constantly changing. It still is.

I have written this in an attempt to understand how we got here. I must stress that, whilst I have taken a couple of classes in economics, I am not an economist. I am sure I am missing large chunks, and I look forward to being corrected by people who have a greater understanding of these matters than I have.
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