RiskRewardNews recently sat down with Bill George, former Medtronic CEO, current Exxon and Goldman Sachs board member, best-selling author on leadership and a teacher at the Harvard Business School. In Part II of our interview Bill opines about risks we overlooked, failures of leadership, lessons not learned and the culture clash within business schools. Here is a sample of what he had to say:
"We’ve lost sight of the fact that it still takes just as long as it ever did to create a new microprocessor, a new car, a new drug, a new medical device."
"...either an incredible series of three Black Swans coming in simultaneously... or alternatively, the models are wrong."
"...either an incredible series of three Black Swans coming in simultaneously... or alternatively, the models are wrong."
"You should not let the process be dominated by people who think they're smarter than everyone else."
"There is a split or dichotomy in almost every business school between the finance faculties and the people (teaching business ethics)."
To read the entire interview, click on the link below. Part I of the interview is also available on this site.
Part II
RRN I’m curious. When you think about the last decade, starting with the accounting scandals at Enron, WorldCom, etc., moving to the dot.com melt down and exposure of bankrupt Wall St. research, and now with the recent financial meltdown. we’ve basically lived through a decade of destruction of trust...
BG Yes that’s a part of it, we’ve had a terrible decade, a decade of destruction of shareholder value as well.
RRN So, when you look back over the past decade -- it’s a huge question and it deserves more than a 30 second answer -- but what went wrong? What did we miss collectively, as a market, as a culture, as a society that allowed this to go on?
BG We became a society of instant gratification. We got caught up with short term money making and the creation of huge fee-based incomes. So, as (Vanguard founder) John Bogle says, we went from an ownership society to an agency society. We aren’t owning companies so much as we are holding a stock (and) for an increasingly short period of time. We’ve gone from five years -- at one time eight years -- average holding period, to less than six months. So we’re really just swapping assets. And that’s why there’s so much pressure to do more and more asset swaps rather than trying to build value.
We’ve lost sight of the fact that it still takes just as long as it ever did to create a new microprocessor, a new car, a new drug, a new medical device. But we’re trying to create much quicker results. And so that forces us away from science, away from basic research -- even basic engineering -- into a series of incremental improvements. Let’s put a few bells and whistles on the automobile and we think we’ve got a new car, except we don’t.
So that’s a fundamental concern for business. Going back to Michael Jensen’s theories at Harvard, I think business has been way too responsive to the mythical shareholder, and really basically responsive to the security analyst.
RRN Has your thinking changed about risk over the last twelve to eighteen months?
BG Risk? I’ve gotten a good education about risk -- at Exxon, at Novartis and at Goldman Sachs. But I’ve always been conscious of risk, conscious of the risks at Medtronic if we had a bad product. I knew what the risks were.
See, I’ve never believed in institutional risk, and you don’t’ see me sitting on any boards -- Goldman becomes the closest to it -- that’s taking significant institutional risk. I don’t believe in putting the institution at risk. I believe it’s a destructive act, not responsible, to put the whole company at risk.
So I think risk needs to be very carefully assessed: systemic risk, mega-risk. Think of the worst thing that could actually happen that could destroy the place. Like at Medtronic -- what if we had a software glitch?
That’s what I worried about in the 90’s when I was there. If we had a software glitch that went across all of our products, it could destroy the company and harm people dramatically.
RRN Were we lulled into complacency because we had these very bright PhD mathematicians creating these sophisticated products and models, saying ‘I can isolate the risk, put it over here.’ and we all said ‘OK.’? What risks weren’t we looking at?
BG Well, I would say we were lulled into a sense of irresponsibility to rely too heavily on mathematical models. I’ll give you an example.
We had three quant funds at Goldman Sachs go down 30 percent in the first week of August 2007. And as Gary Cohen, (President and COO of Goldman Sachs) said: ‘We had events that our models showed would happen once every 10,000 days. We had three of them this week.’
So a 1/10,000th chance! Obviously it’s one of two things come true: either an incredible series of three Black Swans coming in simultaneously, not just one but three! Or alternatively, the models are wrong. And I think we relied way too much on models and not enough on the assessment of people running enterprises.
And I don’t think the analyst community gets enough assessment of, and a look at, the people running enterprises.
RRN So the risk that we didn’t look at was the talent risk?
BG The leadership risk, the failure of leadership, the governance risk. The biggest risk corporations take is to have weak board governance and the wrong leaders at the helm. We thought we could take risk out, but we failed to assess the human risk and the fact the models didn’t reflect reality. The models reflect a time frame in history. Typically, they’re history-based, and the history was way too short, five to ten years.
RRN Models also have to limit their assumptions, take this factor out, take that factor out.
BG That’s right. Economists love that. I think it’s totally flawed. To me, judgment always has to come in. You can never rely entirely on models. But quant funds are all run off models. They don’t even allow human intervention.
RRN And that blinds people, as you say, to the institutional risk? Or were they willing to bet the house?
BG No. I think they were blinded to the risk and deregulation didn’t help either, because that allowed people to do egregious things.
RRN Can you expand on that a little bit?
BG Sure! They took basic, sound regulations off of Wall St. So you had people just playing the game. And so there was no sound risk management.
Take a Citigroup. They didn’t manage the risk. They didn’t even assess the risk! I know it’s complex, but you’ve got to do it! I remember once we had an Exxon board meeting where we spent ten hours assessing risk, all the way from a refinery blowing up, to a tanker going aground, to employees getting killed, to drilling for oil and not finding any, to someone violating business practices -- which doesn’t really happen very often at Exxon. But I think that risk assessment is a whole emerging field that’s got to be done well, all the way up to, and including, Boards of Directors.
RRN You’ve also said that we didn’t learn the lessons of Long Term Capital management. Can you expand?
BG We didn’t learn (the lessons of) systemic risk and excessive leverage. We didn’t learn that you can’t rely on models. And the fourth thing we didn’t learn is that you should not let the process be dominated by people who think they're smarter than everyone else -- arrogance, hubris, call it what you like. It was the same thing at Enron.
RRN So it’s not sufficient to have lawyers do compliance training and your risk management process become a check the box exercise?
BG Right Absolutely! That’s a good way to take your company under. The leadership’s got to be out with its people all the time – assessing risk, talking about it, seeing both opportunities and risks. How do you do that? You've got to be out and talking to people.
RRN What’s the role of the board in all of this?
BG Boards should also be assessing risk. The CitiGroup board was not assessing risk. Goldman never spent less than two hours on risk assessment at a board meeting. On the compensation side, if you set compensation to drive people to short term performance, you’ll get short term performance. And you may destroy the place. The board has to be very careful that the incentives they put in place are consistent with the long term best interests of the enterprise.
RRN So the whole compensation discussion cannot be separated from the discussion of risk?
BG Right! Because you’ve got to live with the outcomes! Enron’s the extreme case, but then Wall St. replicated it in the form of CitiGroup and AIG. At Enron, they paid people for putting deals together, agency fees. And they didn’t make them stick around to see how the deals paid off. Why would you let traders do that? At Goldman, we’d withhold the compensation.
I’ve taught Enron cases (at Harvard) so I feel like I know it. Talk about arrogance... three things came together. Absolutely there was fraud, but there was also incompetence and arrogance. The way I teach the case, incompetence preceded the illegality. They were incompetent first, then they engaged in fraud to cover up their incompetence.
RRN That’s a great segue to my next question. You teach future leaders at the Harvard Business School. So how does the values discussion play out in that environment?
BG Let me say there are a wide range of motivations and of peoples’ values there. I went there to teach leadership and corporate accountability – a post-Enron course. It’s still being taught as a required first year course focused on just these topics we’re talking about: the values of organizations and how they get in trouble and how leadership fails. And I now teach a course called Authentic Leadership Development which is very values-based.
RRN Should business schools explicitly try to create more of an ethical business culture, or is that not their role?
BG Absolutely they should! OK?
RRN Are they?
BG They’re trying. Post Enron, there’s been kind of a reawakening, but I can say there is a split or dichotomy in almost every business school between the finance faculties and the people doing this work. You aren’t going to get any of that in finance class. So that’s a big concern, this split.
What I’m saying is, not everyone comes with the same motivation, not everyone has the same set of interests. So you have a mélange. It’s not a top down thing, there’s a split… the values course is over here, the finance course is over there and never the twain shall meet. For the people wanting to go to work at private equity or hedge funds, I get a few of them, but for the most part they want to learn analytical tools so they can get that huge compensation when they get out, you know?
I don’t’ worry about the people going into the corporate side, going to work for Procter and Gamble or General Mills. They’re of far less concern to me. I worry about people motivated by short term gratification to make a lot of money. I think we’ve seen a growing percentage (of graduates) going into financial services. It’s gone from 25 percent to around 47 percent in Calendar 2008. I’m sure it dropped off (since then); I haven’t seen new the figures.
But I think this will be a wonderful crucible experience for this new generation of business leaders… to realize the world is not about picking up gold lying in the streets. We’ve got to get people to realize that models or the latest financial techniques aren’t everything. You’ve got to build yourself to be a leader. To paraphrase (GE CEO) Jeff Immelt; there’s no way you can truly prepare to become a CEO. What you’ve got to do is learn how to learn from your experiences and quickly adapt.
RRN Again, what role can or should the business schools play in trying to have a common conversation across this divide?
BG Well I think clearly there could be more leadership from the top. Look, I’m not an academic but the way academic institutions come together, they tend not to have very strong leadership at the top. The deans are out raising money and thinking about future initiatives and new buildings. But the faculties don’t have a really good way of coming together to talk about things. Too many of the finance faculty have never worked in business. They’re not even finance trained. They’re PhD’s in economics. They want to run economic models…but they didn’t work in business.
So they’re trying to teach young people the most clever ideas; what’s going to come after credit default swaps, securitized instruments. They’re going to create all these esoteric instruments that everyone gets all excited about and no one really understands.
RRN But maybe, the starting point for a common conversation is around this expanded notion of risk.
BG Yes, I think so. If they’ll own the fact that their models, rather than eliminating risk, actually created it and put the institution at risk. A third of hedge funds close up every year, because their idea is: ‘Well, if it doesn’t work I’ll walk away and go somewhere else.’
Do you really want to close up Procter and Gamble? We closed down General Motors. We closed down Chrysler. We closed down CitiGroup. We closed down AIG. We closed down Merrill Lynch. I’m mean, you just keep going? That’s not a healthy situation. No one really had a model of Citigroup that would ensure its survivability for the long term and I think people lost sight of that. That’s why I say it goes to sub-prime leadership. Shame on the leaders who let that happen.
And by the way, these problems have long roots. So you can’t look at Vikram Pandit at Citigroup, you can barely look at Chuck Prince. You have to go way back. Sandy Weill’s the one who created this culture. He’s not a bad guy, but he didn’t create a culture of sound risk management. He created so many legal deviations, and so many regulatory deviations, he put a lawyer in charge to succeed him, who has to spend all his time doing what? Cleaning up the messes, instead of managing risk!
RRN Weill stepped into a culture that was very accepting of that. In fact he was lionized for it.
BG We lionize people in the short term. We lionized Hank Greenberg. This is very worrisome. And the street does too. We’ve got a guy coming in now, (Robert Benmosche) he’s going back and catering to Greenberg, and the street loves it and no one can figure out why AIG stock is up. It’s crazy!
RRN Thank you, Bill.
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1 Comment:
Excellent interview. A few comments and questions…
Bill George’s bottom-line assessment of the corporate and financial disasters of the last decade is as clear and compelling as a classic morality play. He makes a strong case for short-term-ism as the root (evil) cause of all such catastrophes, from LTCM to Enron to AIG. His plea is unassailably reasonable: Why can’t we all – investors, CEOs, boards of directors and IROs alike – think more like Warren Buffet?
Mr. George also feels that there is a generational aspect at work. No doubt, public displays of impatient greed have reached new depths in recent times, but in my opinion the issue is as old as the hills. Before Warren Buffet, I recall Peter Lynch in the 80s and 90s decrying the focus on quarterly results and preaching essentially the same mantra of long-term value creation. And I’m sure he was not the first. Before folks in the current generation started craving “instant gratification,” their parents and grandparents were often sucked in by “get rich quick” schemes going back to the turn of the last century (and earlier, of course).
Nor is the problem geographic. The debacle of mortgage derivatives on Wall Street has been paralleled on Main Street by U.S. auto executives who mortgaged their companies’ future on the equally risky, now toxic SUV markets. The problem is as ancient and widespread as the human condition itself. It’s the lesson parents try to teach their children by insisting they finish their vegetables before they eat dessert. It’s the simple wisdom that says, if it seems too good to be true, it probably is.
Mr. George sums up neatly and cogently what when wrong. The real debate begins, however, when we ask the obvious follow-on questions: What could we have done about it? How can we prevent it from happening again on such a grand and scary scale? How do we all get long-term religion and stick to the straight and narrow? How do we deter risk taking when there is simply too much is at stake?
In the area of investor relations, many of us have held at least faint hope that the recent rise of shareholder activism might shift the focus toward the longer term. But isn’t it somewhat naive to expect CEOs, boards and investors to rock the boat when stellar quarterly results are driving the stock to record highs? Or to ask these same folks to do or say nothing when the stock is tanking due to quarterly disappointments?
Obviously we need more than elucidation. We need some combination of initiatives, regulations and incentives to help us resist temptations that can lead not only to self-destruction but to mass systemic damage. And this is where it gets messy and tricky and political. What can we do and how far will we have to go? A renewed emphasis on teaching ethics at business school? Well, that’s a start. A return to 1930s style regulation of the capital markets? Probably necessary in one form or another. New disclosure and reporting requirements for greater transparency in all trading and investing activities? Certainly makes sense, especially when the trader is not betting his own money. The resurrection of anti-trust enforcement to prevent entities from becoming too big to fail? In the real world that might be tough, both practically and politically. Criminalization of bad corporate governance? Now perhaps I’ve gone too far. Or have I?
Assuming such measures are implemented, will they do enough to reduce our collective risk to an acceptable level? And even if they do, will they also create other significant problems, as we’ve seen with the unintended consequences of SOX on so many small cap companies? It’s not clear cut. But one thing we should know by now: Doing nothing is not really an option; that would be too risky.
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