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Stanford Business magazine

 

Dean's Column

A Call for Back-to-Basics Bankers

By Robert L. Joss

Since mid-2007 the news has brought nearly daily reminders about risk in the credit and financial markets. So, when I was invited to give a lecture to Australia’s Melbourne Centre for Financial Studies last December, I decided to address “Modern Finance and Its Leadership Challenges.” In many respects, it took me 35 years to prepare the lecture Dean Robert Jossbecause so much came not just from gathering my thoughts but also from my long banking experience. After all, the current subprime problem is only the latest in a series of excessive credit extension cycles that have included commercial real estate (twice), agriculture, shipping, oil and gas, developing nations, and leveraged buyouts (twice) since I graduated from the GSB.

In the age-old business of providing affordable loans to creditworthy borrowers we used to have one institution that found the borrower, priced and committed to make the loan, funded the loan from its own resources, held the loan on its balance sheet, and serviced and collected the loan. Now as many as a dozen separate entities might get involved in making that same loan. This brave new world has given people better access to credit, but financial products have become mind-numbingly complex, even to the experts. Risks are split, shared, and redistributed, making it hard to track who is actually bearing what risk. Relentless daily market pressure and competition drive new products into the market faster than they are understood.

But the more things change, the more the basic “truths” stay the same. The subprime mortgage mess illuminates nine lessons for financial leaders:

  • Borrowers need to repay loans. No lender does a borrower a favor by making a loan that can’t be repaid. It is easy to make loans but hard to make good loans—lenders must keep their eye on underlying credit risk.
  • Investors need their money back with a return. No one does savers any favors by selling them investments whose risk they either don’t understand or can’t bear. Some inappropriate investors ended up holding instruments containing subprime mortgage-backed securities when they should have been invested in other assets.
  • If it looks too good to be true, it probably is. AAA-rated securities with higher than AAA returns signal trouble. There is no alchemy in finance—junk can’t be turned into gold.
  • Not all assets and liabilities are on the balance sheet. After Enron, this lesson should have been learned, but history has repeated itself in short order with structured investment vehicles (SIVs).
  • Not all funding is created equal. Borrowers need to remember the difference between dealing with markets and wholesale funding sources (which can be impersonal, unstable, and uncompromising) versus dealing with institutions and retail funding sources (where the borrower can find someone to talk with and work things out).
  • If it is too difficult to understand, don’t buy it, trade it, or underwrite it. In the securities alphabet soup of CDOs, CPDOs, CDSs, and “synthetic CDSs,” it is not clear that investors, underwriters, or traders fully understood what they were dealing with. Just ask the former CEOs of Citibank, Merrill Lynch, and Bear Stearns.
  • So-called “normal” distributions exist only in statistics textbooks, not in financial markets. Many describe recent events as “unprecedented” and “unforseeable,” which is not the case. Fat tails on distribution curves are a fact of life in financial outcomes.
  • Borrowing in one currency and lending (unhedged) in another can lead to trouble.
  • The short run and the long run are not the same. Strip away the complexity and you often find people engaged in that old recipe for disaster of borrowing short and lending long.

As Ron Sandler, MBA ’76, (whom the British government recently named to turn around the failed Northern Rock bank) and other executives try to right the ships of modern finance, it is essential to focus on enterprise leadership. The test of enterprise leadership is whether the firm is stronger 5 or 10 years after the leader departs. This can be measured along 5 dimensions: strategy, people, culture, risk management, and long-run value. Change the firm for the better, and stay focused on long-term value. This is the only sure path to a successful financial institution for all—customers, staff, shareholders, and the broader community.