The financial crisis imposed immense costs on the nation and our financial system. Some 10 million families face foreclosure. Families have lost trillions of dollars of net worth since 2007. Almost a quarter of American households owe more on their mortgages than their homes are worth.
And it didn’t need to happen. Good management and governance could have saved our largest institutions (Citi, Fannie Mae, WaMu, Lehman, etc.) from failure. As a senior staff member of the Financial Crisis Inquiry Commission (FCIC), I interviewed CEOs, traders, risk officers, board members, and regulators to try to understand: What did successful firms do that kept them out of trouble?
Three core elements are culture, communication, and discipline. The culture of successful firms allowed for a respectful exchange of views – what can be called “constructive dialogue” – between the CEO and revenue-producing parts of the firm on the one hand, and the board of directors, an engaged management team, and risk officers on the other. CEOs at successful firms solicited feedback to gain a robust understanding of risk-reward tradeoffs. A gentleman at a successful company said proudly, “The CEO often asks my opinion on major issues,” adding, “But he asks 200 other people their opinions too.”
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 risks.
Where were the regulators? Especially after legislation in 1999, and reminded frequently by members of Congress, federal financial regulators felt that they lacked the mandate to supervise all parts of large complex bank holding companies and investment banking firms. And these firms were huge. Before the crisis, major financial firms had at least several hundred subsidiaries, eight had more than 1,000, and Citigroup had almost 2,500 subsidiaries.
Companies used a host of approaches to engineer around regulatory requirements and increase their leverage. High leverage was profitable while markets were good, but was deadly on the way down. Rigid rules and fluid markets meant that Stanton’s Law prevailed: “Risk will migrate to the place where government is least equipped to deal with it.”
But only a regulator could stop the race to the bottom as firms strove for market share, especially in 2005-2007 when financial markets hit a fever pitch. At a dinner with then-Treasury Secretary Henry Paulson in 2007, Citigroup CEO Charles Prince urged regulators to intervene. He asked about “whether given the competitive pressures there wasn’t a role for regulators to tamp down some of the riskier practices,” and “Isn’t there something you can do to order us not to take all these risks?”
Mr. Prince raised an important point: When markets overheat, they can singe all firms and not only those that are badly managed. Even well run firms have a stake in ensuring that less skilled or greedier firms do not cripple the entire financial system. Needed is a process of constructive dialogue between financial firms and their government regulators.
Edmund Clark, CEO of TD Bank, a firm that navigated the crisis well, 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.”
After the FCIC finished its work, I turned to nonfinancial firms to see whether the same patterns of success and failure prevailed. Major failures such as the BP Gulf oil spill, a major deadly accident at Massey Mining Company, the PG&E San Bruno gas pipeline explosion, and even hospital medical errors, show the same pattern: of management (or doctors) that fail to engage in constructive dialogue with risk managers (or nurses) and that often apply a variety of techniques to keep regulators at bay.
Needed now are statesmen in the financial services industry, and other sectors as well, who step forward and make good governance and management enough of a reality that we protect ourselves from mistakes of badly managed firms that are costly to us all.
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About the Author
Thomas H. Stanton teaches at Johns Hopkins University. He served as a lead researcher on governance and risk management at the Financial Crisis Inquiry Commission and is author of Why Some Firms Thrive While Others Fail: Governance and Management Lessons from the Crisis (Oxford University Press, 2012).