When the unexpected hits, have you ever heard someone ask, “How did this happen?” Or observe, “We never saw it coming!” Or cover their tracks by asserting, “We didn’t know!” Homo sapiens have engaged in this sort of dialogue ever since Adam and Eve were ejected from the Garden of Eden. When it happens in the C-suite and in the boardroom, we’re looking at a failure in the governance model. Such was the case with the derivatives fiascos over the last 20 years, Long Term Capital Management, the Enron era and the financial crisis.
The historical durability of the “How did this happen?” theme points to a valuable lesson in how success can create organizational blind spots. Simply stated, when stars and rainmakers are making money, they’re often left alone and encouraged to continue with whatever they’re doing, however they’re doing it. And why not? Success breeds enthusiasm. Stars and rain provide what everyone craves – growth, revenue, success stories and role models.
However, when circumstances change, losses start to mount, the waves of reputation hits surge onshore and fingers begin to point, it is interesting how often we hear the comment, “We had no idea what they were doing or what risks they were taking.” The specter of plausible deniability rears its ugly head. It’s a sad and telling picture to see.
Some illustrations are useful. Founded in 1762, Barings Bank was the oldest merchant bank in London until it collapsed in 1995 after one of its employees lost a fortune in its Singapore branch. This employee functioned as the Floor Manager for the institution’s trading on the Singapore International Monetary Exchange, served as the Head of Settlement Operations and provided oversight of the unit’s accounting records. This inappropriate concentration of responsibilities enabled the employee to hide mounting losses that were flagged by internal audit reports. However, the leadership for Barings Bank in London chose to ignore these reports because the employee was delivering outstanding results. The star continued to make rain and operate unchallenged. The rest is history.
At Kidder Peabody, the profitability of the government bond trading desk outperformed the market. The supervisor of the bond trader applauded and rewarded his shining star performer, even using him as the role model everyone should follow “if they were going to get ahead.” In reality, it was alleged the trader cooked the books, causing the CEO of the parent company to circle the wagons in damage control and, ultimately, sell the unit. The star was making rain, so the supervisor left him alone, even though industry observers knew the trader’s margins were impossible to achieve.
In the 1990s, the treasurer for Orange County, California, was portrayed as the role model of superior government finance. He consistently made a minimum of 100 to 200 basis points more than anyone else and received awards as one of the best municipal treasurers in the United States. When interest rates rose abruptly, several major municipalities placed calls to withdraw the operating monies they had invested in the Orange County fund to generate higher returns. When delays started to occur, rumors spread and a “run on the bank” began. That is when the truth surfaced. The treasurer had bet on declining interest rates by investing in very risky inverse bonds. The highly leveraged fund portfolio was earning over market, but no one asked the tough questions. Even the governing bodies of the governmental entities invested in the fund for many years knew that their investments were earning over market. And they, too, failed to ask the right questions. Why bother? Let the rainmaker work his magic!
The subprime lending crisis precipitated the 2007-2008 financial crisis. Its root causes are many, making it systemic in nature for an entire industry as opposed to a one-off situation in a specific company. Originators brokered financing of houses without regard to credit quality so they could get their up-front fees and walk. There was significant erosion of market discipline by those involved in the securitization process, including underwriters, credit rating agencies, investment firms, hedge firms and global investors demanding higher-yield securities. This erosion resulted from breakdowns in underwriting standards, failures to provide or obtain adequate disclosures and flaws in rating agency assessments of structured products, among other things. Why were such time-tested practices disregarded? Once again, we need only follow the cash trail. Too many people were having a good time making a lot of money. Those left standing when the music stopped paid the penalty.
Making money is fun. We all admire the star performers and rainmakers in our respective organizations. Their value-added contributions “grease the skids” for the enterprise. However, an appropriate level of oversight by the Board and executive management is vital to understanding how and why these individuals achieve their success.
The following are 10 suggestions on how to keep a watchful eye on star performers and rainmakers:
- Understand how and why you are making money – One way to achieve this understanding is to apply the time-honored 80-20 rule, i.e., a majority of a firm’s top-line success often comes from a much smaller segment of its activities. What are those activities? Who executes them? Who oversees them? Are they generating unusually high margins and returns relative to the market? Are those results sustainable? What are the risks inherent in these activities? Are those risks being managed effectively? How do you know?
- Source the risks inherent in your business model – In the financial crisis, the institutions that reported fewer losses from subprime lending shared quantitative and qualitative information more effectively across the organization. In fact, according to a Senior Supervisors Group (SSG) report, some firms identified “the sources of significant risk as early as mid-2006” and “had as much as a year to evaluate the magnitude of the risks and to implement plans to reduce exposures or hedge risks while it was still practical and not prohibitively expensive.” Blind spots spawned by high profits can preempt the healthy skepticism needed to prompt such risk assessments.
- Make sure the risk takers don’t get a “free ride” – It’s dangerous when risk-takers play with someone else’s money with no cost to them or their compensation. Some of the firms avoiding the significant challenges faced by their less fortunate peers in the subprime market debacle established more discipline by charging business lines for building contingent liability exposures to reflect the true cost of obtaining capital and liquidity in a more difficult market environment.
- Push back on the “smartest people in the room” – Avoid presuming these individuals know what they are doing because they are making a lot of money and talk a great game. If you do not understand the risks they’re taking, what they’re doing and why they’re doing it, ask the necessary questions until you do.
- Make sure your risk measurement and management reporting are up to par – The SSG reported that best performers in the financial crisis had more effective management information systems, meaning executive management was more aware of the speed and severity of changes in the fundamental variables driving the market. These tools included stress testing, sensitivity analysis and scenario analysis by a function independent of the business lines that could review and interpret the results objectively and report them to executive management and the Board. Although value-at-risk techniques were used, these firms recognized the limitations of such measures in terms of evaluating the degree of market volatility they may face. By combining quantitative rigor with qualitative assessments, these firms were able to apply the brakes and reduce exposures when they determined the risks outweighed expected rewards.
- Beware of the impact of complexity on risk culture – Complexity obscures the big picture and provides a breeding ground for smart people to “game the system.” Conversely, transparency is critical to recognizing prudent risk-taking, providing risk-based communications, facilitating independent validation and enforcing risk limits, encouraging timely escalation, supporting effective enterprise risk assessments that impact business planning and conducting periodic scenario analyses to reality-test the strategy. In and of itself, complexity should be viewed as a red flag.
- Recognize that executive management and the Board of Directors represent the final line of defense – The parties in the C-suite and the boardroom are ultimately responsible for making sure that opportunity-seeking behavior is undertaken responsibly, risks are understood, appropriate competencies are brought to bear and the longer-term interests of shareholders are preserved.
- Identify and manage your trust positions – Pay attention to the people whose actions and/or inaction can expose your organization to significant risk events. Who are these people? Where are they? What are they doing? Who oversees them? These positions are not limited to financial-related risks. They include such areas as environmental, health and safety, among many others.
- Pay attention to how your organization’s incentive compensation structure and culture drive behavior – Are there potential unintended consequences that management and the Board would want to avoid? Are there “heads I win, tails you lose” compensation structures in place in which a manager taking significant risks stands to receive significant compensation irrespective of how his or her bets play out? Alternatively, are effective clawback and deferred compensation provisions in place to balance short- and long-term perspectives?
- When taking on risks, be careful of relying exclusively on outsiders – Skeptical of rating agency assessments during the period leading up to the financial crisis, some financial institutions developed their own in-house expertise to assess credit quality and even tested their assessments by selling a small percentage of assets to obtain pricing data points in selected markets.
No risk management process is bulletproof. As Alan Greenspan noted in a March 2008 op-ed published by the Financial Times, the financial risk-valuation system failed under stress. He wrote:
“Asset-price bubbles build and burst today as they have since the early 18th century, when modern competitive markets evolved. To be sure, we tend to label such behavioral responses as non-rational. But forecasters’ concerns should be not whether human response is rational or irrational, only that it is observable and systematic.”
The point is deceptively simple. No matter how hard we try, we cannot model the future perfectly. There always will be uncertainty, and human behavior is part of the equation.
Therefore, if certain business activities are generating unusually high rates of return, Boards of Directors and executive management must understand why. Just because some people are generating significantly superior returns does not mean what they are doing is sustainable or not heading toward a disastrous dead end. In short, management had better be sure the underlying economics are understood. If the picture is so complex that no one understands it, someone has to take a step back and ask, “What are we doing and why are we doing it?”
My advice: If you do not understand the risks, ask the necessary questions until you do. Further, if superior returns are being generated off of a high-risk strategy, remember the old adage, “What goes around, comes around.”
Jim DeLoach, a founding 
