Everyone nods

Everybody nods.

In the years leading up to the collapse of the South Sea Company in 1720 there was an increased potential for foreign trade. Consumerism was on the rise. Wealth and luxury were no longer reserved exclusively for the aristocracy.

The company was promised a monopoly of all trade to the South American Spanish colonies.

Everyone agreed that the future was set fair. Everyone nodded.

But through a web of deceit, corruption, and bribery that included both company and government officials it was grossly oversold. The trading concessions barely materialized; the company had a very shaky commercial basis.

The company’s share price fell from a peak of £1050 at the end of June to £175 by September 1720, devastating institutions and individuals alike.

The bursting of the bubble, which coincided with the similar collapse of the Mississippi Scheme in France, ended – temporarily – the prevalent belief that prosperity could be achieved through unlimited expansion of credit.

In the later 1990s the new internet sector and related fields were the place to make your fortune. Everyone nodded.

A combination of rapidly increasing share prices, individual stock market speculation and widely available venture capital created an environment in which many of the internet based companies dismissed standard business models. They focused on increasing market share without regard to the bottom line. That would take care of itself.

These companies expected that they could build enough brand awareness to charge profitable rates for their services later. The motto "get big fast" reflected this strategy.

But the bottom line didn’t and the companies couldn’t. The dot-com model was inherently flawed.

Even if the plan was sound, there could only be, at most, one network-effects winner in each sector. Yet there were a vast number of companies all with the same business plan for the same respective sector. Therefore most companies with this business plan faced inevitable failure. In fact, many sectors could not support even one company powered entirely by network effects.

The dot-com bubble crash wiped out $5 trillion in market value of technology companies from March 2000 to October 2002. Add to this the write-downs by the venture capital community which, to name but three, include at least $280 million for kozmo.com, $160 million for boo.com and $65 million for MVP.com.

And so we come to recent times. The bankers announce they have found a way of lending the same money many times over and, even if it is lent where there is a high risk of default, it’s still safe. And everyone nodded.

However, these events and those like them down the years are merely the tip of the iceberg. These are just instances of high–profile, bizarre and reckless conduct. There is just as much perverse, incomprehensible and destructive business behaviour to be found in everyday dealings.

For example, a recent, cash-strapped client who offered 90-day credit to his customers because, “that’s what this industry does.” Everyone nods.

For example, a business acquaintance who cut back on his sales and marketing expenditure in anticipation of a fall in customer volumes (everyone nods) happily reporting that’s what actually happened.

For example, a company, anxious to have its employees engaged with the business (everyone nods), commissions a consultant to conduct a survey in order to discover what its people think.

For example, the business that is doing things in the same way as its competitors (everyone nods), yet expects a result that will show them as being exceptional.

The human animal is tribal. That is not the same as having a herd instinct. We can think independently if we chose; we are more likely to succeed if we do.

In 1841 Charles Mackay published his book "Extraordinary Popular Delusions and the Madness of Crowds", often cited as the best book ever written about market psychology.

In May 2004 James Surowiecki published The Wisdom of Crowds.

In the light of subsequent events, perhaps Mackay had it right after all.

Mining Facts and Missing the Point

Despite appearances bad decisions are rarely made because people don’t have all the facts. In the political sphere the Treasury will have been fully aware of the impact on taxpayers of abandoning the 10% tax band. The Treasury may even have alerted Ministers. Nevertheless, although the facts were noted, plainly they were not given sufficient weight.

In the run-up to the present ‘Credit Crunch’ the financial institutions were fully aware of what they were doing and, one hopes, so were the regulators. But merely knowing the facts proved insufficient. Clearly, they did not understand the facts and the whole unstable structure was allowed to plough on into the crash barriers.

The Burmese Government will be well informed about the consequences of Cyclone Nargis and how badly their population has been affected. However, here facts are equally useless because they are being ignored.

Business is subject to the same purblindness when it comes to facts. Too often when plans go awry Governments call for Royal Commissions or Parliamentary Committees; business calls for internal audits or additional research. More facts will not help them regain the perspective they have lost.

When facts have failed to register, the continued pursuit of yet more facts painfully echoes Dickens’ Thomas Gradgrind in ‘Hard Times’. Gradgrind worships facts and figures. He puts his faith in abstract theories rather than direct observation of real people and real needs. The asymmetrical approach to human life of early industrial England, the denial of some of the basic needs of human beings, is being repeated in what some are pleased to call our post-industrial age. The structure of the economy may have changed. Too many of the attitudes live on. The cost in human happiness is great.

In Dickens’ Coketown, the needs of the factories dominate everything else. The factory hands work long hours in oppressive conditions, and they live in cramped houses. Their lives are monotonous; every day is exactly like every other day, just as all the houses and streets look alike. In Coketown, there is a strict uniformity in everything. The workers have little time off to relax and enjoy themselves. Does that sound familiar?

Employees and those running their own businesses will recognise the close parallels. Today we still struggle with long hours, astronomic housing costs, poor diets and an existence where evenings and weekends are nothing more than the exercise yard of our own imprisonment.

Each business, each day, has the opportunity to step back and take a clear-eyed view of the workplace we have built for ourselves. If it is not as we would wish it, then we can change. If you think it isn’t as easy as that then you will be setting yourself up to fail as a self-fulfilling outcome. Give real change a try. Take action. You may surprise yourself.

Clinging to the Wreckage

UBS, Switzerland's largest banking group, has just written off $37bn (£18.7bn) of its sub-prime investments.

Following an internal investigation demanded by the Swiss Federal Banking Commission, the Swiss version of our own dear FSA, it admitted a series of mistakes including inadequate supervision, poor risk management and a failure to react quickly enough when the sub-prime market started crumbling.

UBS was so focused on racking up ever larger profits that it “forgot” every silver lining has a cloud.

This is its first full-year loss (Sfr4.38bn for 2007) since its came into being 10 years ago following the merger of Swiss Banking Corporation and Union Bank of Switzerland. Planned job cuts are rumoured to run to more than 3,000 people.

As one might expect of the Swiss, those in charge have shouldered their full share of the responsibility and suffered the inevitable consequences. The Chief Executive, Peter Wuffli, was ousted in July last year, followed by the CFO, Clive Standish and the Head of Investment Banking Huw Jenkins. This month it was announced that the Chairman, Marcel Ospel, would not seek re-election.

Meanwhile, here in the UK, RBS came up with a further £5.9bn of write-offs on bad debts yesterday having already declared a £1.7bn write-down of sub-prime investments in December. However, you would search in vain for any admissions of abject personal failure by top management, let alone a principled resignation. In any industrial company the chairman and chief executive would both have been fired and forgotten by now. Not so with RBS.

Apparently RBS's has two excuses: (1) things have changed, and (2) it didn't foresee quite how bad things would become. Well, isn’t that what leaders are paid to do? Doesn’t leadership imply vision – the ability to see and foresee, rather than stumbling over the truth, picking themselves up and hurrying off as if nothing had happened (Churchill). And if they fail to uphold their end of the contract should that contract not be properly terminated?

According to Sir Tom McKillop, the RBS chairman, the board is unanimous: the current team is the one to take the bank forward. On what logical basis should that be the case? Those that have engineered dramatic expansion are rarely adept at managing either a holding operation, or retrenchment. Those call for very different skills. Endangering the ship when it’s in stormy seas, based solely on your capacity in calm waters, constitutes reckless conduct in anybody’s book.

Marianne Jennings, Professor of Legal & Ethical Studies at Arizona State University has identified the belief by management that they are so brilliant and innovative that the mundane rules of accounting, corporate governance and even basic economics do not apply to them as one of the seven signs of ethical collapse. RBS fits the bill.

Of the five leadership traits identified by Kouzes and Posner’s research that was done for the book ‘The Leadership Challenge’ namely:

~ Honesty
~ Forward-Looking
~ Competency
~ Inspirational
~ Intelligence

RBS seems to fall short on the first three.

If the Swiss banking fraternity have the principled leadership qualities needed to do the right thing then those privileged individuals on this side of the Channel should exhibit the same qualities.

First Cloud Cuckoo of Spring?

Andrew Oswald proposes that to cope with possible bank collapses we should devise an effective insurance solution in which governments are only minimally involved (Independent on Sunday, 30 March 2008). He sees this as a cast-iron guarantee. I beg to differ.

Mr Oswald’s idea is that when depositors open an account they should be offered insurance deals that, for different levels of premium, would guarantee different amounts of their funds. Those customers who wish for complete security will have that option, but only at the cost of a substantial premium.

Those slightly less worried will be able to opt for a smaller premium and a larger "excess" where, in the event of a bank collapse, they will forgo the first X hundred pounds of their savings.

This wheeze seems to overlook the existence of The Financial Services Compensation Scheme. The FSCS is the UK's statutory fund of last resort for customers of authorised financial services firms. It pays compensation if a firm is unable, or likely to be unable, to pay claims against it. In general this is when a firm has stopped trading, and has insufficient assets to meet claims, or is in insolvency. The service is free to consumers.

The FSCS protects deposits, insurance policies, insurance broking (for business on or after 14 January 2005), investment business, and mortgage advice and arranging (for business on or after 31 October 2004).

As a statutory fund of last resort there are limits to the protection FSCS can provide. The maximum levels of compensation are:
· deposits: 100% of the first £35,000.
· investments: £48,000 per person (100% of the first £30,000 and 90% of the next £20,000).

Other levels govern insurance and mortgage provision.

The point being that 100% cover was in place for most small depositors of Northern Rock. It made no difference. People wanted their money out. Demonstrably, offering guarantees is wholly ineffective in such circumstances. People want to avoid the turmoil ahead of a collapse and the interregnum following a collapse when everything is sorted out at some other institutions’ leisure. Substituting commercial insurance cover for the Government-backed provision offered by the FSCS is unlikely to work.

Andrew Oswald also holds a somewhat rose-tinted view of the insurance industry. He believes that the large institutions who might offer this kind of saver insurance have assets spread widely enough, across many nations, to survive even major financial shocks within a single country. And, moreover, insurance companies are better placed than government inspectors to keep an expert eye on any profligate lending practices inside banks.

This is serious cloud cuckoo land. Maybe Mr Oswald is too young to remember the collapse of Lloyds. Let me remind him.

Between 1940 and 1970 many Lloyds syndicates took on enormous amounts of excess insurance business for leading asbestos companies. Underwriters ignored the medical evidence of the risks they were running, even though insurance companies had been refusing to sell life insurance to asbestos workers since 1918. The syndicates were enticed by the lucrative stream of premium and investment income which such business produced.

In 1992 the Yale School of Organisation and Management predicted 200,000 asbestos-related deaths over the next quarter of a century at a cost to asbestos manufacturers and their insurers of $50 billion. The combined book value of their 45 primary and excess insurers was estimated at only $50 billion, before allowance for all other types of claim likely to arise and make a call on those assets.

Many Lloyds Names were ruined financially. Some went bankrupt. Some committed suicide.

It doesn’t end there. On January 10, 2001 Chester Street Insurance Holdings Ltd., formerly Iron Trades Holdings Ltd was declared insolvent. Financial uncertainty over the escalation in asbestos liabilities led Chester Street’s directors to propose a run-off of the company’s business. The High Court approved the Scheme on February 28. Within ten days, the Scheme Administrators, in consultation with the Creditors’ Committee, set an initial payment percentage of just 5%. The likelihood of obtaining insurance-backed compensation for many UK victims of asbestos-related diseases evaporated.

The woeful record of the insurance industry is not confined to asbestos. In August 2001 the business of the Frontier Insurance Company was seized by officials of the New York State Insurance Department in a move designed to avoid insolvency. Harry W. Rhulen, the group's president and chief executive, said that the company's collapse had been caused by unsound underwriting and pricing of medical malpractice policies in the early and mid-1990's. “We did a poor job of determining which were the good doctors and which were the bad”.

In the same year the HIH Insurance Group collapsed and the NSW Supreme Court placed it into provisional liquidation. HIH insurance is now in run–off, which means it is managing its outstanding claims and not writing any new business. This could take several years to complete; some have suggested as long as 10 years.

Also in 2001 Independent Insurance, based in the UK, collapsed. The business consisted mainly of home contents insurance for council tenants, which involves the regular payment of small premiums. An initial valuation of the company's assets ran into "tens of millions", while estimates of its liabilities ranged as high as £1bn. The liquidators described the disaster as the worst “since Maxwell”.

Saver insurance is not the answer. It merely hands the hot potato to an industry no better placed to moderate risk and mitigate disaster than the banks themselves.