Laurence Booth: Is It Finance Itself That is Broken?

Eight years ago I wrote a piece for Rotman Magazine on “The Responsibility Cycle.” My argument was straightforward: there are three basic stages to the business cycle. Stage 1 is the recession, when firms downsize. This is when firms cut costs, mainly period not production costs, and they lower their break-even point.  Mergers and acquisition activity drops off, and firms focus on survival. This is when the press is full of stories about ‘hollowing out’, downsizing and outsourcing. Stage 2 is when the inevitable recovery sets in and firms get a quick boost in profits, since they have lowered their break-even point, so that earnings dramatically increase even with minimal top-line growth. Stage 3 is the danger zone, when the quick earnings boost drops away and firms have to rely on organic or top-line revenue growth, which is much more difficult to generate.  

It is during this third phase that the seeds for the next recession are sown. This is when CEOs engage in M&A activity, convinced that they can manage someone else’s assets better than they can, or the CFO starts to resort to questionable accounting in moving assets off the balance sheet or triggering phantom gains to puff the income statement, or a firm simply expands too much since financing is easily obtainable as banks are flush with cash.  

When I wrote that article we were coming off of that cycle’s disasters: Enron’s use of special-purpose vehicles and WorldCom’s accounting fraud were the trigger for Sarbanes-Oxley and a raft of SEC measures designed to make financial statements fairer and information more available. The point was that these improvements in governance and markets were the direct result of the failures revealed by the recession. As I stated then, what the U.S. was going through in 2002 was similar to what we in Canada went through in 1994 with the Day Report (Where Were The Directors?). In both cases, the responsibility cycle was a direct reflection of the business cycle, where we were ‘closing the barn door after the horse had bolted.’

I concluded that governance and corporate responsibility should not be cyclical phenomena, and wrote that “As the cycle begins again and the economy strengthens, we are three-plus years away from a host of bad corporate decisions. Let’s hope that we put in place today the governance processes that insulate us from the next cycle’s Enrons.” Unfortunately that hope was misplaced: three years on from 2003 we had 2006, which was the peak in the US sub-prime mortgage disaster.

After every recession since 1982 I have repeated the same message: that bad loans and corporate disasters occur at the top, not the bottom, of the business cycle.  I am always asked what the next disaster will be; of course I don’t know, but no one would have predicted the almost total collapse in governance and responsibility within the U.S., and to a lesser extent UK, banking systems. By now the story is well told: cheap credit from lax monetary policy, a U.S. government push into making housing affordable, lax regulation during the era of the Bush cuts, and a change in the structuring of the mortgage market whereby each piece in the chain, from origination, credit evaluation, appraisal, servicing on to financing was sold off to specialized institutions with no-one taking overall responsibility. The result so far has been well over a trillion dollars in losses by banks who mostly never believed they had any exposure to start with and the worst recession in the developed world (apart from Canada and Australia) since the Great Depression.

In a Fall 2008 article in Rotman (“Saving Capitalism from the Capitalists”) I put much of the blame for the financial crisis on investment bankers (‘I-bankers’) and the fetish of liquidity. That is, that the process of securitization, which allowed the unbundling of a simple mortgage transaction, also meant that no one took responsibility for the underlying mortgage. As long as the package of mortgages met the rating requirements set by Standard and Poors and Moodys, individual mortgages could be packaged together and sold off as AAA-rated mortgage- backed securities. In this way the role of the relationship banker (commercial or ‘C-banker’) who stayed with the credit through the cycle was replaced by the I-Banker primarily interested in generating short-term fee income.  I concluded at that time that “Just as Enron lead to Sarbanes-Oxley, don’t be surprised if an angry U.S. Congress reinvents Glass-Stegal and puts some distance between I-bankers and the commercial banks they have come perilously close to destroying.”

Unfortunately, this prediction has also come true, and not just for the U.S. Congress.  In the U.S. the Volker Rule has put a barrier between proprietary trading by U.S. banks and traditional lending in the mistaken belief that it was proprietary trading that caused the U.S. problems, rather than basic lending (credit) mistakes. Similarly, in the UK the Independent Committee on Banking (ICB) has recommended that UK banks’ traditional lending operations be ‘ring-fenced’ or structurally separated not just from investment banking and proprietary trading, but also from lending in other parts of the world. The UK recommendations violate EU law and look more like a sop that the ICB knows will never be implemented, but the fact is that re-regulation is occurring throughout the world and when Basel III comes into place, the hope is that banking will be a lot safer and pose fewer systemic risks.

The problem is that the banking crisis was not caused by traditional investment banking: there were no huge losses on a derivatives desk, at least not in the banks, and no large bet that broke a bank. Instead the losses stemmed from normal credit losses, where the lenders concerned did not believe there was any significant risk, partly due to the outsourcing of credit risk analysis to the rating agencies. The U.S. Controller of the Currency, the major bank regulator, was surely thinking of Citibank when he stated “There is really no excuse for institutions that specialize in credit risk assessment, like commercial banks, to rely solely on credit ratings in assessing credit risk.”

However, whenever there is a major crisis, there is also a hunt for a smoking gun or a villain on whom the blame can be laid. After the 2002 crash it was the Enron gunslingers and Bernie Ebbers of WorldCom who were the villains; and after the financial crisis the blame has been put on the banks and the incentives for ‘excessive’ risk taking that presumably led to the $140 billion in losses at Citibank. The fact that Citibank never realized it was taking any risks is quietly brushed under the table. Instead critics point to the very high salaries earned by top financiers: surely, the argument goes, the fact that bankers made so much money means they were only in it for the money and short-term gains? Doesn’t this mean that it is finance itself that is to blame? As a result, we have seen a return to the perennial criticism that finance is short-term oriented, that Finance education is a part of the problem and that there is something fundamentally wrong with the idea of creating shareholder value (CSV).

As a professor of Finance I have to admit that some of this thinking is correct: some of the basic ideas of finance have been abused in practice. Take executive stock options (ESOs) for example. When the late Rotman Professor Emeritus Myron Gordon, inventor of the Gordon Growth Model, was at the University of Rochester with Michael Jensen, they both observed the conservative financing of U.S. companies by well-paid executives with little equity stake in their firms. Ikew explained how Gordon interpreted this in terms of a managerial focus on survival and growth for which he is famous, whereas  Jensen drew the conclusion that there were ‘agency’ problems and managers were not acting in the best interests of their bosses, the shareholders. Since shareholders own the company and vote-in directors to hire the senior management to act in their interest, it was important to align the interests of the managers with the shareholders, which is all that creating shareholder value (CSV) involves.

The tool to align these interests was executive stock options, where due to the development of the Option Pricing Model by Fisher Black and Myron Scholes at the very time that CSV become important we had a tool to value the incentive contracts needed to implement it: neither could have succeeded without the other.  However, like every other tool, if you leave it to managers to implement it, they do so for their own benefit, which is what Jensen would have predicted from agency theory. So instead of aligning shareholders and managers, we have seen ‘option backdating’, whereby the exercise price of the option was set at a lower historic price and was already ‘in the money’ when granted; or option re-pricing, where when the stock price falls, the board re-sets the exercise price so it continues to incent managers. However, the result is that rather than incent managers, executive stock options have all too often been used to allow managers to ‘rob the shareholders,’ since ultimately it is the shareholders who lose as a result of the dilution caused by more shares being outstanding.

These problems are well known, but they are not a problem either with Finance or CSV, but with governance. In 2003 I argued that the only way to incent managers is not to give them ESOs exercisable against the company, but to change the laws surrounding both their granting and how they are taxed. Currently if ESOs are granted at the current stock price, there are no immediate tax implications either for the executive or the company. However, any introductory Finance textbook will tell you that the pure option value is highest when the exercise price of the option is the current stock price.

What I recommended in 2003 was that the laws be changed such that on the date of the option grant, the firm has to buy the options from an investment bank; the value of the options should then be included as executive compensation and written off for tax purposes by the company, just as if the executive had been given a new Roller.  As executive compensation it would then be subject to U.S. restrictions on tax-deductible salary, the shareholders would not be at risk due to dilution and the compensation committee of the firm and shareholders would know the true value of executive compensation.  What’s more, if the firm then does well and the options are exercised, they have no impact on the firm and do not skew tables of executive compensation. In this way the abuse of ESOs is minimized and we know by the design of the compensation package how much executives really value their ESOs.

As in 2003, the basic issue today is one of governance. At that time I was worried that governance was a cyclical phenomenon and that we had to act immediately to avoid the same problems repeating themselves through the next cycle. Unfortunately, this was not done and we are again at the same stage of complaining about incentives faced by managers, with the added problem that this time, they have struck at the core of the economic system, which is the banking sector.

Finance has provided the tools to solve these problems, but it requires boards of directors and the government (through taxation rules, etc.) to put in place the governance to implement them. By my count, this is the fourth time I have observed the very same phenomenon through the business cycle. I am an eternal optimist, but somehow I doubt it will be the last.  As I first said eight years ago, the seeds of the next crisis will be sown in about three year’s time; or as Yogi Bera might have said, “It is déjà vu all over again but squared.”

Laurence Booth is the CIT Chair in Structured Finance and professor of Finance at the Rotman School of Management. Rotman faculty research is ranked in the top 20 worldwide by the Financial Times.

[This article has been reprinted, with permission, from Rotman Management, the magazine of the University of Toronto's Rotman School of Management]