The King is Dead! Long Live the King!

April 1st, 2009 — 9:51am

Night before last, I was watching AC 360, the Anderson Cooper news show on CNN. Anderson asked David Gergen, the former advisor to four presidents and current member of CNN’s team of political analysts, and two others, about the summary dismissal of Rick Wagoner. Mr. Gergen was generally supportive of the government’s position, but was critical of the fact that the government had forced Mr. Wagoner out, given that he had made progress in transforming GM.

Well, readers of this blog probably anticipate my reaction well: Firing Mr. Wagoner was not only necessary, but essential. So, let me take on the David Gergen’s argument. Imagine, for a moment, that a President of the US (whom I’ll henceforth refer to by the customary acronym POTUS) was at the end of an eight year tenure and he (think of Mr. Obama for now) had not been able to turn around the economy. Would you call him a failure? Sure you would!

Mr. Wagoner has been CEO for 8 years; prior to that he was GM’s CFO, President of North American Operations, and COO. A comparable track record in US national politics would have been Secretary of Treasury, (a hands on) Vice President and then POTUS. In effect, Mr. Wagoner had many more then 8 years to fix GM. Under the circumstances, the fact that he might have “made progress,” is simply not good enough! He has not delivered on the most important issues – GM’s culture, organization and strategy – and indeed, according to published reports chose to bypass these fearing that they would keep him from improving GM’s cost structure.

One of the other guests on the CNN program, an economist who supported the firing, pointed out that GM and Chrysler are so large that they account for almost 2% of America’s GDP. Consider this data point from a different perspective. We want our POTUS to turn around 100% of the GDP (while battling non-economic problems like wars, natural disasters,) and — by recent public criticism — do it in his first 100 days. Yet, we are OK with a very highly paid executive not being able to turn around a company in eight years that is only about 1% of the GDP?

Focusing an 8+ year role at the top on labor costs is leadership? Not in my books. Labor accounts for only about 8% of the cost of a car and on a global basis, as economist and journalist Ben Stein has pointed, even this cost is not wildly uncompetitive. But wait, he hired Bob “Mary Antoinette’s Soulmate” Lutz as Vice Chairman for Product Development and they turned out a few good cars, did they not? A few cars among how many? And what did GM do on core new technology? Oh yes, it caterwauled about unreachable mileage standards. Surely they were producing cars for Europe, where generally the laws are tougher and an End of Vehicle Life law already exists demanding near total recyclability?

No, the issues Mr. Wagoner chose to bypass – GM’s culture, organization and strategy – are the ones which could have saved the company. Had he broken down the Not Invented Here silos that existed within geographic and brand specific fiefdoms, he would have transferred innovations faster. Heck Saturn’s “no haggling” policy could have transformed the industry, instead of remaining a niche strategy. But that would have meant engaging with GM’s vast network of dealers in a new way. Think this does not matter? Then consider this: a couple of months back Hyundai came up with a brilliant idea to stimulate sales by addressing the fear consumers have about the economy. About the same time, I articulated a similar strategy in a radio interview I did that aired in the Boston market. How long did it take GM to do something similar? Until earlier this week!

The King is dead. I hope the new King – or kings, as I have argued earlier – come from middle ranks or better yet, from outside the industry. Ford’s Alan Mulally, after all, has been making faster progress and has so far, not had to reach for the begging bowl.

Comment » | Business Environment, Company Performance, Corporate Culture, Financial crisis, Leadership, Organizational structure, Politics

The Lessons of Camelot

March 19th, 2009 — 3:43pm

I have been trying desperately hard to stay away from politics. But the global financial crisis has made this impossible: virtually every business issue is singed, if not actually charred, by the blaze of the crisis. So, with the deepest of regrets …

Imagine President Obama, announcing at his press conference today that the US Special Forces had arrested Osama Bin Ladin. I would bet good money that the first question he’d get would be, “That’s great, but what about the AIG bonuses? Haven’t Americans been duped enough?”

Near the end Alan Jay Lerner’s musical Camelot, Guinevere and Lancelot offer to surrender and return to England to face justice. Arthur spurns them; his people no longer wanted justice, he says, they wanted revenge. Right now, the American people want revenge. They don’t want to be told about the contractual law, they want someone on Wall Street to feel real pain, just as they are feeling it. Bernie Madoff would have been a great fall guy, but he refused the part written so perfectly for him and pled guilty quickly. The people at AIG Financial Products Division, seen to be holding the country to ransom and getting away with it, have therefore become the focal point of public rage. They are making GM’s now departing Vice Chairman Robert Lutz (see my post “Marie Antoinette’s Soulmate”) look like a paragon of virtue. Which is why no one rebuked Republican Senator Grassley for calling on them to commit hara-kiri.

If President Obama does not display absolute, visceral rage – merely feeling angry won’t count – he seriously risks losing the people. Don’t believe me? Remember the effect on Michael Dukakis’s presidential campaign of his calm response to the question about what he would do if his wife and daughters were raped and murdered? His calmness, combined with his opponent’s blatantly racist campaign, doomed him. Today, similar conditions are present and the stakes are higher.

If Mr. Obama loses the people, the economy will slide into depression. This crisis in our networked world, as I have argued in earlier posts, was aggravated by a failure to manage as if the network matters. Ergo, resolving it will require tackling the ailings of the entire network, not just one of its nodes. Mr. Obama’s multi-sector bailouts and his plan to totally restructure multiple key sectors is exactly what is needed. But if the American people focus on only one node (AIG) of the network, he has no chance of succeeding. The good news is that as a master politician, he publicly repudiated Mr. Geithner’s position that the bonuses are a fait accompli. Now, he should take this repudiation to the next level and get some Hollywood types to teach him how to act furious on camera.

Substantively, Mr. Obama should outsource the work the AIG group does. These people are smart, but unlike Albert Einstein, they are not unique: The very products they used to peddle required them to work with equally smart people in other institutions. They are not unique! So, it is possible to fire them and simultaneously (this is key) introduce an outsourcing firm to take their place. The replacement firm could be one of the companies that participated in this market, but which currently have no (or minimal) such open contracts. If on top of this, the outsource firm were from a lower cost economy, so much the better: Wall Street can’t complain of being subject to the “market discipline” that they urge on others – and the American people would love the irony. (Incidentally, Wall Street already outsources a lot of work to India, albeit very quietly.)

Additionally, Mr. Obama should publicly and forcefully ask the organizations that provide the credentials job – CFAs, CPAs, NASD Series 7, JD, etc. – essential for a Wall Street to decertify (under morality clauses) those at AIG who brought disrepute to their profession. He should explain to Americans that this will deprive these people of their livelihoods in the world of high finance. Not quite Bernie Madoff’s fate, but definitely the equivalent of banishing Mordred from Camelot. Of course, if these people not only repaid this year’s bonus, but also contributed their entire last year’s bonus to charities that are working to help those who lost their jobs and homes, they might, just might, be able to retain their credentials.

I often tell executives that instead of battling a culture, they should focus on skillfully using the elements of the culture that can help them achieve their key goals. That’s what Mr. Obama must do now. In the final analysis, Arthur lost Camelot, as my teenager astutely told me the other day, because his knights saw peace as boring. He could not hold on to their passions and lost their support.

Mr. Obama must take steps that the Puritans of New England, the gun slingers of the Wild West, the Rhett Butlers and Scarlett O’Haras of the South and the flower people (yes, there are still many of them) of the two coasts appreciate. Stated differently, he must apply the lessons of why Camelot failed. Only then will he be able to fulfill his dream of taking the country back to Camelot for a sustained period of time.

Comment » | Business Environment, Financial crisis, Leadership, Politics

“I Wonder What the Ostrich Sees …”

March 13th, 2009 — 3:45pm

“… when he pulls his head from the sand? Probably a transport barreling towards him on the highway that was built while he wasn’t paying attention.” The Internet tells me that Stephanie Martin-Smith crafted this brilliant observation about the last US elections. It is an equally brilliant descriptor of Fortune magazine’s latest “The World’s Most Admired Companies.” Here’s why: 9 of the top 10, 19 of the top 20, 28 of the top 30 and 41 of the top 50 companies are … American!

I actually think very highly of many of the American companies on the list. I currently work with two of the top ten, and help (or have recently helped) several other companies – which rank high on the industry specific lists. I used to work for American Express and in my book, have praised Hewlett-Packard. But in the eighth year of the 21st century, to think that America has a monopoly on good management is short-sighted, if not ridiculous.

All such surveys have methodological biases. So I checked that out. Fortune essentially started with a list of 1000 large US companies and 400 large non-US companies. A bias no doubt, but minor. Then it asked “executives, directors, and analysts to rate companies in their own industry on nine criteria, from investment value to social responsibility.” This became the basis of the industry specific rankings. Finally, to create the list of the 50 most admired, it asked “4,047 executives, directors, and securities analysts who had responded to the industry surveys … Anyone could vote for any company in any industry.” Here’s one major possible source of bias: who ranked these companies? I could not find any description of their nationalities or domiciles or global experiences.

There are several reasons why this matters, but I’ll stick to the most important: Such biases give us a false sense of security about the quality of our businesses. While I think highly of many of the companies on the list, others simply don’t belong there. When one of them gets wiped out, the deliverer of the blow will be a foreign company whose position it had usurped. The wipe out will be a big surprise to many people because the judges, the editors and the companies themselves were not paying real attention to the lessons of Friedman’s Flat World or Zakaria’s Post American World. Think I’m exaggerating? Remember what Toyota and Datsun did to the US auto industry in the 1980s?

Convince yourself if you don’t believe me. If you are a world traveler and have stayed in top tier (highly profitable, innovative, socially responsible, high quality … use Fortune’s nine criteria) hotels, make your own list of the top five chains. If you fly around the world a lot, try ranking airlines. If you know much about the IT industry, do the same. You’ll end up with several European, or Asian companies (I confess I don’t know much about African or South American ones) that do not appear on Fortune’s lists. Your analysis won’t be statistically rigorous, but it will probably give you greater insights than Fortune’s will.

Comment » | Business Environment, Company Performance

Oh What a Tangled Web do Politics Weave …

February 28th, 2009 — 2:55pm

A few days ago, I read a newspaper article on Secretary Clinton’s Asian trip. In China, she urged the Chinese to buy American debt, arguing that if they did not, China itself would be badly hurt: The recession-bound US economy would not be able to absorb Chinese exports. I found Ms. Clinton’s argument refreshing from one perspective: she eschewed the typical diplomatic mumbo-jumbo, admitting the US was in deep trouble. How the Chinese will react is an open question, particularly given President Obama’s budget. They may see merit in Secretary Clinton’s logic or may consider it as an invitation to throw good money after bad.

If American debt is a good investment, so are real estate and companies. National Public Radio recently ran two stories about organized groups of ordinary, albeit wealthy, Chinese who are visiting the US to buy real estate. So, that raises the question: how will the broader American political establishment react? For long, instinctive xenophobia has greeted investments from outside Western Europe. In the 1980s, the Japanese were demonized. More recently, the Chinese and Arabs were. Even Indians – who, like the Japanese, don’t pose obvious political problems for America – are attacked; a trivial example: The Taj Group’s purchase of Boston’s Ritz Carleton Hotel produced in the Boston media opinions that made me cringe. Never mind that Taj’s CEO is an American and its luxury hotels are among the best in the world!

Every economy should protect itself from harm. At the Darden School, I silenced Ayn Rand capitalists in a managerial economics class by pointing out that objective data showed that semi-open countries with mixed economies outperformed the US. Shouldn’t the US follow suit? Indeed, today, the semi-open, mixed Indian economy has (so far) escaped the worst ravages of this recession. So my concern is not with anyone questioning the worth of a foreign investment. I just want such questioning should to be based on objective criteria, not irrationality. Today, all of us should take on to ourselves the responsibility of injecting such objectivity into discussions we participate in.

The biggest challenge to our doing so is that we just don’t know enough about how the rest of the world thinks. Fareed Zakaria’s book, The Post-American World, (which I mentioned in my first post) can help. Mr. Zakaria brilliantly describes why America no longer dominates a unipolar world. While it still leads on virtually every important metric economic, technical and social metric, the rest of the world has risen. So, today world has other poles anchored on China, EU, India, Japan, Korea, Brazil and Russia. Americans should embrace and celebrate this, because it creates tremendous opportunities and indeed makes the world safer. This argument is well supported by multi-faceted – economic, political, social, technological and cultural – data and anecdote and is therefore very compelling. Unfortunately, Mr. Zakaria does not go far enough. He needed several more chapters addressing how each of the new “poles” see the important issues of the world. Where can the various poles agree? Where do they differ sharply? What principles, if adopted, could help the poles collectively resolve our huge challenges?

So, if you are a Chinese politician, bureaucrat or business person, what do you think of Secretary Clinton’s challenge? Why? This inquiring mind wants to know.

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Marie Antoinette’s Soul Mate

January 20th, 2009 — 6:41pm

I’m back! I hadn’t meant to be away for five weeks, but life intervened. In my defense, I didn’t notice anyone actually breaking my door down asking about my whereabouts …

I am wondering if you heard the recent Robert Siegel interview of GM Vice Chairman Bob Lutz on NPR’s All Things Considered a few days ago. If not, it is definitely worth listening to (http://www.npr.org/templates/story/story.php?storyId=99253055), for it gives a unique insight into the travails of the US auto industry.

Mr. Lutz showed great restraint; he waxed eloquent about the stupidity of the average consumer, without actually using the word. GM produces great cars, he said, but only a handful of experts really know this. It will take time for the experts’ opinion to filter down to the great unwashed masses and GM had no choice but to wait this out. Asked about the effect of the government bailout on the workings of his company, he said, “I’ve never quite been in this situation before of getting a massive pay cut, no bonus, no longer allowed to stay in decent hotels, no corporate airplane. I have to stand in line at the Northwest counter. I’ve never quite experienced this before. I’ll let you know a year from now what it’s like.”

If anyone has any doubts about why GM is really flirting with bankruptcy, Mr. Lutz comments should have clarified the issue. The Vice Chairman of a company which went with a begging bowl to Congress acted as if he was Marie “Let them eat cake” Antoinette’s soul mate. CEO Rick Wagoner and GM’s Board should have repudiated his statements by publicly firing him, but in my heart of hearts, I knew that my life would long be over before any good sense emanated from those quarters. But hope is what keeps the world spinning, does it not?

So, did Mr. Lutz change my mind about the auto industry bailout? No! If anything, his words are proof that the bailout is needed to preserve the company until more drastic steps can be taken.

An argument – also made by a handful of others – is that without the bailout, the industry’s second and third tier companies will be irreparably weakened. This will harm the broader industry’s stronger companies, for they rely on many of these companies too. Ideologues don’t understand this is the unfortunate logic of networks: As I’ve written elsewhere, it is hard to succeed if your network is failing.

The more important, and thus far unmade, argument is: bankruptcies will not reform these companies. In the best case scenario, they would file for pre-packaged bankruptcies (in which creditors back the financial restructuring plan) without scaring customers (even though buying a consumer durable is a riskier bet than buying a ticket from a bankrupt airline). Who will manage GM through this process? People like Mr. Lutz will represent the companies. Across the table from them will be their creditors. What will the negotiations focus on? The executives will argue they can fix the problems – if everyone else makes large concessions. The creditors – rightfully – will be trying to get back their money as quickly as they can. No one will be focusing on changing the culture that allow people like Mr. Lutz to be top dogs. And without changing culture – encouraging collaboration, being open to others’ ideas, being willing to take considered risk, managing learning every day, etc. – these companies will stumble from one disaster to another. Changing culture takes great effort, committed leadership and time. All three will be in short supply during the negotiations and during the tightly choreographed marches towards tough milestones that will follow.

I hope the Obama administration’s Auto Czar, backed by the bills that Congress must pass (to provide additional funding) by March, will be able to force change. As I wrote in an earlier post, I would like to see appointees to the Boards, an orderly departure of people like Rick Wagoner and Bob Lutz, and a shifting of power to less jaded executives running smaller companies created by splitting up the behemoths. The ideologues will probably not let this happen, but extraordinary times call for extraordinary steps. Nevertheless, I’ll even take smaller steps along the lines I have proposed while hoping for more. Hope, as I said, is what keeps the world spinning, does it not?

Comment » | Business Environment, Company Performance, Corporate Culture, Financial crisis, Leadership, Organizational structure, Politics

“There’ll Be Spring Every Year Without You”

December 5th, 2008 — 5:01pm

At this week’s Senate auto industry hearing, Senator Christopher Dodd noted that a death sentence focuses the mind. It does, but for the US auto industry, it took a humiliating public whipping of its CEOs for this to happen. In my last post, I took Rick Wagoner to task; in The Spider’s Strategy, in a chapter I mostly wrote two years ago, I expressed extreme pessimism about the industry and called Chrysler “the canary in the coalmine.” I can only shake my head in disbelief at Boards of Directors which trust executives who lack basic common sense: You don’t go begging for alms wearing Armani suits and flying corporate jets!

I have had the good fortune to work with several C-level executives, including CEOs and Board members. The common trait across the very best of them: they are astute politicians, who understand how to build coalitions, not just of the like-minded, but of those whose interests are not aligned with theirs. Detroit’s top executives, in contrast, did not see this in political terms. That they publicly displayed such naïveté speaks volumes about their companies’ culture: Imperialistic, with CEOs as monarchs who believe that the world would be truly worse off if they were not around. No wonder they are isolated from the real world!

In contrast, a very successful Chairman of the Board of a global company I’ve worked with had an office with glass walls which was about half the size of typical bedroom. It was located next to the operating area of a key business unit. It is not unusual for the CEO to walk into the company’s break room to pick up his own coffee. He had lunch with small groups of new hires. When I reported that a long-time employee had asked when old timers would be similarly invited, he immediately asked his secretary rectify his error; he invited his critic and a few other long-timers whom the critic thought he should know. If this CEO ever had to go to Capitol Hill and ask for help (I doubt he’d ever have to), he would not make the errors the Detroit CEOs did. Oh, by the way, this gentleman is probably as rich as, if not more than, them.

In Lerner & Leow’s My Fair Lady, Eliza Dolittle sings to Professor Henry Higgins, “There’ll be spring every year without you/England still will be here without you/ …/And without much ado/We can all muddle through/Without you.” Perhaps Mr. Wagoner, Mr. Nardelli and Mr. Mulally should play this snippet of the movie a couple of times a day on computer/video screens in their offices. It might induce them to leave the rarefied atmosphere of their sanctums and visit the real world more often. Who knows, that might cause them to rebuild their companies with policies more suited for a networked world and so create cars people want to buy. Ironically, of course, there may not be much of a spring for the American economy if these companies are not saved, despite their incompetence.

In the next post – which I promise will be soon – I’ll comment on the substance of the plans and the hearings.

Comment » | Business Environment, Corporate Culture, Financial crisis, Leadership

“What’s Good for General Motors is Good for America”

November 13th, 2008 — 1:49pm

The Federal government’s denial of the $10 billion bailout for the now aborted GM-Chrysler merger took my thoughts back to the Darden School of Business, 1981-1983. There, I first heard the saying, “What’s good for General Motors is good for America,” justified by the fact that 10% of Americans worked in the auto industry (and still do). Somehow, I was not convinced.

On the one hand, several of my classmates were GM managers on leave with full scholarships. They did not have to return to GM, but not one was even interviewing elsewhere. Surely a company that inspired such loyalty was well managed? On the other hand, a case we discussed documented years of mismanagement of GM’s Tarrytown New York plant; we had to decide whether to try to fix it or shut it down (and open a brand new plant). Moreover, Toyota had just begun thrashing the industry. A top GM executive spoke at a doctoral seminar I was auditing. He said GM had considered, and then abandoned, the idea of making small cars because it couldn’t be done profitably. That decision – and similar ones at Ford, Chrysler and AMC – made Toyota’s task a cakewalk. (The executive’s talk led me to undertake the independent research study on financial risks analysis I mentioned in a prior post on the global economic crisis.)

The more things change, the more they remain the same. In 2001, The New York Times published an article on production outsourcing at GM. The existing GM plant was rundown, filthy, and struggling; the proposed outsourcing vendor operated a computerized, almost “cleanroom conditions” plant. In more recent years, we’ve heard caterwauling from GM – and the broader industry – about the inability to anticipate the need for hybrid technology.

Should such executives be trusted with a share of the $25 billion in modernization funds they are still seeking? Over a close to 30 year period, two generations of GM executives have failed to strategically manage their company. I’ve briefly cited two virtually identical stories of factories run into the ground and lack of investment in next generation products. I don’t know about you, but I don’t get the warm and fuzzies they know much about modernization. Two epochal changes (see the very first post in this blog for a definition) and these people blow them both.

GM’s problems are not its labor or its infrastructure; they are endemic in the culture of management practiced there. It was apparent in the sheer audacity – chutzpah is a better word – of CEO Rick Wagoner comparing the denial of the $10 billion to the Treasury’s not bailing out Lehman Brothers. Did he ever consider saying, “I’m sorry America, my entire management team and most definitely I, blew it. We will tender our resignations in an orderly manner so as not to do more harm. In the meantime, please do not take out your anger at us by punishing the people and communities GM operates in.” Perhaps it is the water in Detroit … I’ll remember not to drink any next time I visit that city.

Nevertheless, I would hold my nose and give GM the money. In this networked world, the failure of this large a company will bankrupt many suppliers and dealers and most importantly – as I had mentioned in a prior post – will tank the still-struggling financial markets. However, recognizing that this company cannot be trusted to reform itself, I would insist on the following conditions:

One, the Feds get to appoint a couple of Board members who must be on GM’s Finance committee. (Some people may rage about this taking us closer to “socialism,” but surely that is preferable to the brand of capitalism practiced by Mr. Wagoner?) Two, Mr. Wagoner and his top lieutenants must resign in an orderly fashion, without their golden parachutes (If a company can seek to break binding legal contracts with its suppliers through a bankruptcy court, there must be at least 10,000 lawyers who can figure out ways of getting GM to rescind its contracts with it its executives). Three, the Fed appointees should have veto rights on the replacements for Wagoner and his associates. Four, over the next five years GM (and Ford and Chrysler) must be reduced in size, so they are no longer “too big to fail.” This will require mandatory spin-offs of relatively independent businesses (as some analysts have suggested). Five, no one in the top spots in any of the restructured companies should come from the senior-most ranks of these companies; fresh blood that is willing to be boldly rethink how to operate in a networked world, is essential.

What may be really good for GM is definitely no longer good for America. And what is good for America will most definitely not be good for GM’s management. National policy makers must make incompetent executives pay without destroying the economy. If they pull-off this balancing act, the people will cheer them on to re-election. If not, we will have to bail out many others in the years ahead.

1 comment » | Company Performance, Financial crisis, Leadership

What’s $700 Billion Among Friends? – Part 2 of 2

September 28th, 2008 — 5:07pm

Like the last one, this lengthy (sorry!) post is also written jointly with Sanghamitra Dutt.

Even if the Administration got a $700 billion blank check, no one could guarantee a resolution of today’s crisis. Network effects can still bring down others. For example, so far GM has only wanted a few measly billion dollars of a separate bailout to make investments that it has ignored for decades. If the financial crisis hits GMAC (see the last post), that amount will quickly become a few measly tens of billions. Add a few more incidents and we’ll be in “We don’t remember ever saying $700 billion would be enough” territory.

The question we should discuss in depth is whether a successful resolution of this crisis will automatically forestall another similar one. Not by a long shot! Irrational exuberance is not rare (think of the 17th century “tulip mania” and the tech bubble a decade ago). Indeed, given our networked world, new crises will emerge much more often and with devastating effect unless we strengthen the role of our financial regulators by explicitly making them responsible for managing negative network effects.

Had the House Republicans objected to the bailout because of the lack of such regulatory measures, I would have sympathized with their position. (Strengthening these as a part of the conditions attached to the bailout bill would have been easier than trying to get these adopted once the crisis fades from public view.) Instead, their finding religion after facilitating the dismantling of existing regulations (see, “S.E.C. Concedes Oversight Flaws Fueled Collapse” in The New York Times, 27th September), is nothing but a cynical election ploy.

Simply restoring the status quo will not help; the problem with how our financial networks operate is that individual players have very little visibility across it expanse. So no one sees problems arising early enough and even innocent bystanders get dragged down. To correct this situation, Congress should authorize/enable five critical steps, which are based on my “Design Principles” for networked organizations:

1. Unify the structural relationships among the myriad of regulators. Some time back, recognizing that the lack of cooperation among intelligence agencies was problematical, Congress unified the intelligence agencies under one national office. Though the execution was flawed, the idea was sound. We need a similar step now. If one financial regulator has weaker standards than the others, in a networked world, all financial institutions will still be exposed. I am not recommending centralization of all regulators; I am arguing in favor of legally mandating a coordinating structure that can drive the next four steps.

2. Require regulators to create processes to identify possible emerging crises and empower them to mandate proactive corrective action. In a networked world, seemingly local events traverse great distances rapidly and strike with devastating power. No one pays them attention initially, and even when some get affected, others consider themselves safe. Chairman Bernanke identified (“sensed”) this crisis a year ago; earlier this year, their was much wider awareness of the sub-prime crisis, but most people did not expect AIG to go bankrupt. Today GMAC and others are still at risk.

Assembling coherent corrective actions (“respond”) to head off a growing crisis is even harder. No individual company can do so; collectively many can, but few CEOs would be gutsy enough to expose their own companies if they did not have to. JP Morgan Chase bailed out Bear Sterns only because the Treasury protected it against losses. It is anyone’s guess whether its acquisition of WaMu without similar government protection will help or hurt it.

Moreover, and this is critical, in a networked world, responding to a specific effect of a crisis does little to stop it. That is why the rescue of Bear Stearns, Freddie Mac, Fannie Mae and AIG did not calm the markets. WaMu got liquidated calmly, but now Wachovia looks like the next domino. Stopping the entire crisis cold requires enormous power. That is the real value of the $700 billion. It is large enough to send a strong signal that the government is ready to tackle not AIG or Freddie Mac or Fannie Mae, but the whole enchilada.

To prevent future crises, we need regulators armed with strong sense-and-respond capabilities. Which is why in the last post, I took Secretary Paulson and Chairman Bernanke to task; they sensed (how?), but did not respond (why not?). The how must be analyzed and turned into a robust, replicable process not dependent on the Chairman’s brilliance; that process should be used by all regulators. The why not may have embedded in it serious policy and legislative implications, which must be addressed. For example, if the regulators had no authority to order AIG or Freddie Mac or Fannie Mae from acting in ways that put everyone at risk, they should be given such authority. Note also that the other “safety net” built into the system – the rating agencies like A.M. Best, S&P and Moody’s – also missed the emerging crisis. Were they all asleep at the switch, or were there fundamental underlying issues to which no one paid attention?

3. Require the Treasury and the Fed to immediately begin negotiations with major foreign regulators to create a consistent set of ground rules. The media has reported that European governments are demanding cooperation from the US and the Fed is responding. (E.g., it helped the European Central Bank and others, contributing to a $60 billion liquidity injection to ease the tightness in the LIBOR market.) The real question is: what should the Treasury and the Fed do proactively for the future? America’s financial networks don’t end at its borders. So, it will be difficult to sense the next emerging crisis without the collaboration of foreign regulators. Recent media reports have indicated foreign regulators, even from other G7 nations, grate their teeth at the patronizing behavior of senior US officials. Without a sea change in attitude among US officials, we will continue to be at risk. We must negotiate with them rules and regulations that are consistent across national boundaries. We have to ensure that robust, replicable processes are adopted by everyone. And we have to ensure that knowledge of impending crises are passed on to other regulators quickly. When UBS earns a huge chunk of its revenues and profits in the US, it is no longer a European bank. When Bank of America earns a huge chunk of its revenues and profits outside the US, it is no longer an American bank.

4. Create new analytical tools to better predict effects of market events. National Public Radio reported on the 27th that when he was a professor at Princeton, Chairman Bernanke, co-developed a computer simulation (“Financial Accelerator”) with the type of analytical capabilities mentioned in the last post. If Princeton has this, I sure hope the Fed and the Treasury do too. And yes, let’s share this knowledge with foreign regulators – or adopt their tools if they have better ones. Equally importantly, we need to authorize the regulators to mandate the adoption of such tools by every major financial institution. We have to get past the “one lender – one borrower/one lender – one sector of borrowers” mindset criticized in the last post. I am mindful of the fact that in the post “Beware the Model All Logic,” I cautioned against blind reliance on models; nevertheless, not using essential decision-making tools is equally bad.

5. Use modern information technology to cross link approval structures. As our financial institutions are becoming larger, lending silos make approval decisions about risks in their market niches without talking to each other. Consequently, it is not unheard of for different arms of an institution to offer the same creditor different types of debt with inconsistent legal rights and responsibilities. As such the institutions are losing the ability to see and understand their total exposure across their networks. When crises loom, they can’t tell how they could be affected. (This is a manifestation of a problem that affects all networks: distribution of work across time and space compromises visibility.) This confusion is mirrored externally by the existence of a myriad of (albeit defanged) regulatory bodies with overlapping jurisdictions.

To assure better visibility and to facilitate analysis of complex decisions, we must use modern technologies more effectively. For example, technology can flag problems that could arise from inconsistencies far more quickly and more thoroughly than a human can. Being forewarned, decision-makers can now act – or be held accountable for not doing so. Regulators should be empowered to demand the implementation of modern IT both within their own bailiwicks and also to transfer critical information on a timely basis to regulators. The regulators should be able to use the information to question executives about actions that could threaten the network – and force them to cease-and-desist.

Implementing this guideline will raise all sorts of difficult policy questions about protecting proprietary information, the governance responsibilities of Boards and the like. But that is the fundamental conundrum we are not wrestling with today: modern technologies have created the networked world. We have embraced the networks with both arms because of the benefits they offer, but we have not re-thought how our laws, strategies, processes, values, analytical tools and yes, even technologies, must be updated to function within them.

There’s no question that many executives involved in the present crisis were rapacious and deserve to be penalized. There is also no question that many policy setters are ideologues who would like to do nothing better than demonize each other rather than solve problems. But unless we actually reform the underlying mindset, processes, tools and technology, we – and other major economies –will be doomed to shelling out trillions of dollars of pocket change ever so often.

Comment » | Business Environment, Business Tools, Company Performance

Looking for Risk in All the Wrong Places! Part 1 of 2

September 23rd, 2008 — 1:21pm

I was trying to avoid writing about the financial crisis since it is hard to say anything substantive briefly and in order to stay away from politics. However, since my book’s subtitle refers to averting crises, I cannot. So, here is the first of two posts. This one expresses three ideas: (1) We need a mindset change from a bilateral to a multilateral (or networked) perspective in business. (2) Unless work practices change, such crises will recur. (3) The (regulatory) culture must change, for it affects perceptions of risk.

20+ years ago, I was a junior banker at an American owned international bank. Today, I understand finance from a strategist’s perceptive, but am not an expert. So, my wife and business partner, Sanghamitra Dutt, has co-authored these posts. Before we co-founded Ishan Advisors, she was a Managing Director at a “money center commercial bank.” In the 1990s, the US Office of the Controller of the Currency recommended that other major banks adopt the information and analysis packages she had designed for use by her bank’s top managers and Board.

Let’s understand that financial innovation did not cause this crisis. Financial innovation has been with us ever since Europeans reshaped the world centuries ago by creating the first stock market. Nor is the complexity of innovations the problem. As an MBA, I had considered doing a Ph.D. in Finance and had learned risk analysis at levels beyond those taught to my peers. So, when my bank entered the new commodities lending business, I got tasked to understand the credit issues – and these to teach others, including my bosses. That fact did not depress our stock price or sink the markets! Blaming innovation for the crisis is akin to blaming Edison for destroying the livelihoods of candlestick manufacturers.

Now consider a simplified description of how financial institutions assess risk. Let’s say Bank A asks an analyst to evaluate whether AIG is a good credit risk. She would study its financials (including confidential information) and pass a judgment. However, unless Lehman Brothers was also A’s client, no one would analyze its financial statements in depth. If both were clients, any direct interactions between them would be looked at, but no one would necessarily evaluate how a failure of a partner of a Lehman client could affect AIG. To address such broad issues, an analyst would be asked, “Given our capital structure, should we be comfortable with our exposure to all financial institutions in this particular sector?” He would perform “what if analyses” (or “stress tests”) and posit an opinion. A group of senior executives would debate these analyses and reach consensus on policy, keeping in mind the revenues A was earning (no risk, no reward). A’s board might provide oversight over this decision (by mandating “portfolio limits”) but would not delve into details. It could not; look at a few annual reports to see for yourself how many Board members of financial institutions actually have deep financial expertise.

If you asked any executive involved, “Can you precisely describe a situation that could cause every financial institution in the market to implode over a matter of a week?” they would probably answer “No.” The idea would seem irrational, given this type of analysis and decision making. Scientists have established that humans are notoriously bad at estimating, understanding and acting on probabilistic information.

The root cause of the crisis, then, is the limited ability of financial institutions to estimate risk that arises from sources beyond their immediate trading partners. In the past, they operated as relatively isolated organizations linked loosely to each other by specific transactions. Today, they form a global network that is constantly managing flows of monies; here, any institution’s failings can affect every other institution it touches.

Yet, they lack the management mechanisms essential for this changed world. Their standard risk approval mechanisms, anchored on an “one lender, one borrower” and “one lender, one sector of borrowers” mindset, are outdated. Their standard tools of risk analysis focus on individual institutions or sectors and cannot reveal risks buried in the network. The data they have available to do any analysis is weak: these are usually, but not always, available in the US and less so in Europe; they are usually unavailable or unreliable for institutions from the rest of the world. So, without being the demons they are being made out to be, financial managers have for long been on the edge of today’s crisis.

The loosening of regulatory requirements, particularly under the present administration, exacerbated this weakness by encouraging a culture tolerant of imprudent risk. We can recall saying “There goes the neighborhood” when investment banks abandoned the partnership model and became common stock companies. When their partners’ personal wealth was at risk, they were more cautious. Even when risks were apparent, important people looked away. Consider The New York Times report (“A Professor and a Banker Bury Old Dogma on Markets” September 21) that Secretary Paulson praised Chairman Bernanke for identifying the possibility of today’s crisis a year ago. He meant to praise Chairman Bernanke’s brilliance; we were outraged. Messers Paulson and Bernanke, what did you do over the last year to head off the crisis before it occurred? If you did nothing, why not? If you did act behind the scenes, what caused you to fail? Congress should ask these two gentlemen these questions before giving them a blank check.

Keep in mind that the paucity of financial information about ‘Rest of the World’ institutions suggests the possibility of a widening crisis. Think of this not as the falling of “another” shoe, but in terms of a well shod millipede! Foreign banks with exposure to Lehman could be grossly weakened by its bankruptcy. Their weakness could precipitously weaken other US banks that are (thus far) healthy. Some European banks have already lobbied for their share of the $700 billion and in principle, Secretary Paulson has already acquiesced to their request.

Moreover, what about the “non-bank banks” in the US economy? GE and GM get more than 50% of their profits from their financial arms. GE might be financially sound, but will the meltdown be the straw that breaks GM’s back? Trickle down network effects can reach pension funds, state and local governments and the like.

Networks at their best, are wonderful. Networks that are not managed appropriately are deadly. Nokia and Ericsson tried to teach us these lessons. Too bad we haven’t learned them yet.

1 comment » | Business Environment

Pyromaniacal managment

September 14th, 2008 — 7:09am

My wife considers me a workaholic; naturally, I disagree. On our European vacation, I did not work at all. I read The European Wall Street Journal only twice — and that too because when the blazing Milanese afternoons forced us to retreat repeatedly into our hotel room, I had run out of books and the hotel’s management treated all weekday guests as business people.

An August 12 article (“Sounds like a combined position? It is”) caught my eye. It reported: “Call it a sneaky way to get more work for less money. U.S. companies in some sectors that are cutting back on manpower aren’t eliminating positions entirely, bur rather have taken to melding a midlevel position with a more junior one – then advertising it as a junior slot, offering a low salary.”

I have to confess that the article left me dumfounded. Does anyone actually think that this is a smart way of doing business? Consider the logic inherent in the idea: “We have a managerial/executive position that is important enough to preclude its elimination, even in these tough times. However, it really does not matter if we offer it to an unqualified person.”

Let’s take this logic into another field – how about surgery? “Doctor X assisted in 15 (pick an appropriate number) heart surgeries while completing his internship. Let’s make him the Chief of Cardiovascular Surgery of this hospital, since we can’t afford to hire an experienced surgeon with management experience.” Or, consider a parallel to the specific example (of a contract manufacturer) in the article, “Doctor X has assisted in 15 heart surgeries. Since we cannot hire both a cardiovascular surgeon and a gastro-intestinal surgeon, we will combine the two jobs and have him do both. We should be OK, since a senior surgeon will check in on him occasionally.”

Would you go to such a hospital for a surgery? If the logic sounds asinine in medicine – or engineering or professional team sports or a dozen other fields – why is it not asinine in the running of a complex business? All these years, I had believed that the only field of human activity in which you could (routinely) find such sheer stupidity was politics. I guess the good news is that I am still living and learning.

Near the end of the article, the Journal quoted experts saying that such measures “… tend to backfire in the long run …” and “… when jobs are poorly combined, the strategy can also be bad for the firm …” because the company may be “… cut(ting) into the bone, into the things that are really adding value to your customers …”

The house can burn down and the experts are worried about the possibility of a long term decline in real estate values? Here’s what I would have said, had I been asked, “If you are a customer of such a company, immediately conduct an quality audit of everything you got from them. Also, find a replacement provider immediately. Then you won’t be singed when your provider crashes and burns.” To the Board of the provider company, I’d say, “Would you give a match and lighter fluid to a pyromaniac? No? Then fire the person who made the hiring decision. That’s an executive you can do without, particularly during tough economic times.”

Comment » | Leadership, Organizational structure

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