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17 Sep. 2012 | Comments (0)

We seem to have a new crop of banking scandals every week, and every time a new scandal occurs, somebody responds by saying, “… the culture is broken…” but that begs the question of how the culture became broken. In this series of blogs, I’m going to offer some views on how multiple causes, all of them well-intentioned, came together to create a “broken culture,” and I suspect the lessons from the financial sector can be applied more widely. For me, it all seems to be a story of unintended consequences, which makes our current situation more of a tragedy than a conspiracy. The factors that caused the decline in the financial sector, which I will further elaborate on throughout this series, include:
  • The rise of the “shareholder value” movement
  • Changes in the nature of finance sector
  • The impact of benchmarking approaches
  • The rise of stock based compensation plans
  • The rise of the “superstar” CEO
  • Why regulation on it’s own doesn’t work
  • Enterprises as educational institutions
  • How it all fits together
I’ll also give my take on what could be done to mend the culture. To begin this discussion, I’d like to nominate the rise of the “shareholder value” movement in the 1980’s as a tipping point in the resulting financial sector crisis. The rise of the shareholder value movement correlates well with the rise of the increasing value of CEO compensation relative to “typical” workers in the U.S., and the increase in the proportion of CEO compensation arising from share options (and similar vehicles). This movement arose in the early 1970’s at a time when U.S. companies were losing out to more efficient Japanese enterprises. It was suggested that an important issue for U.S. companies was an “agency” problem, where “managers’” interests, which were not subject to “market mechanisms,” were in conflict with those of shareholders, and that managers would tend to pursue objectives in their own interests, rather than those of the owners of the enterprise. The proponents of the shareholder value approach argued that, since share price growth was the point at which “…the result of all management actions come together…”, commercial success led inevitably to higher shareholder returns. They argued that a takeover of under-performing companies and the replacement of “under-performing” management was the way forward. Jensen & Meckling’s “agency theory” paper in 1976 provided an academic underpinning and institutional investors enthusiastically supported the idea of “aligning managerial and shareholder interests”. Jack Welch’s speech in 1981 (“Growing fast in a slow growth economy”) and his successful efforts to improve efficiency by reducing bureaucracy and trimming inventories, which led to an improvement in shareholder returns, kick-started the wide adoption of “shareholder value” as the most important measure in business. Share prices and returns are clearly critical to shareholders, but the share price itself doesn’t provide useful guidance to managers on how to create sustainable share price growth. In fact, even Jack Welch stated, in March 2009, that focusing on quarterly profit and share price gains “…on, the face of it, is the dumbest idea in the world…” and that “…shareholder value is a result, not a strategy?.?.?.?your main constituencies are your employees, your customers and your products…” However, “shareholder value” was almost universally adopted as the primary measure of management success in “long term incentive plans,” and two consequences of this theory were of particular importance:
  • The prevalence of stock option plans, which rewarded share price growth, increased rapidly in the bull markets of the late ‘80’s and provided significant earning potential growth to executives. A kind of “arms race” developed with companies, offering ever more generous packages to compete for executive talent
  • Managements began to focus more on the short-term management of the share price and less on the long-term management of the business. As Peter Drucker can be paraphrased as saying, “People don’t do what’s expected, they do what’s inspected.”
Please tune in next week for my second blog on this topic, Banking scandals - Causes and Cures, where I will focus on the results of adopting “shareholder value” as the principal gage of management success, and how it led to a series of unintended consequences and the current breakdown of the U.S. financial sector. About the Guest Blogger:
Guest Blogger: Yonat Assayag, ClearBridge Compensation Group

Guest Blogger: Christopher Bennet, Senior Fellow, Human Capital, The Conference Board

Christopher Bennett is a Senior Fellow, Human Capital at The Conference Board. In this role, Chris supports the Human Capital Practice which includes The Conference Board Human Capital Exchange™, research, conferences, webcasts, and programs in a broad spectrum of human capital areas. Chris teaches, writes, and advises on Human Capital in the Boardroom and ‘C’ suite and related governance issues. He served as Managing Director, Singapore & Malaysia, for Watson Wyatt Worldwide, and headed the Board and executive compensation team in ASEAN. Previously, Chris has served as the Country Manager and Executive Compensation and Rewards Practice Leader for Towers Perrin, Singapore & Malaysia. Prior to his consulting career, he served as the Regional Director for Asia Pacific based in South East Asia in a subsidiary of a major British plc, where he held both line executive and fiduciary responsibilities in many areas/countries around the world. This post originally appeared on The Conference Board Human Capital Exchange Blog on July 19, 2012.  
  • About the Author:Marcel Bucsescu

    Marcel Bucsescu

    Marcel Bucsescu is a Co-Program Director of The Conference Board Chief Legal Officers Council. Bucsescu has also served Executive Director of the Ira M. Millstein Center for Global Markets and Corpora…

    Full Bio | More from Marcel Bucsescu

     

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