Credit Suisse Must Have Forgot 'The Great Winfield’
(Bloomberg Opinion) -- The business model of banking is under assault, from ultra-loose central bank monetary policies that pinch profits to inroads made by new wave financial technology companies taking market share. Of all the challenges, staffing issues could prove to be the most problematic, as laid bare by Credit Suisse Group AG’s board report into how the bank lost about $5.5 billion from the implosion of Archegos Capital Management.
The report concluded that Credit Suisse failed to properly monitor its exposure to the hedge fund, but the real takeaway is the widespread “de-skilling” that has taken place in the banking industry, with experienced managers replaced by younger and cheaper hires. This “juniorization” of the business should be shareholders’ most immediate worry. With risk taking at all-time highs and the end of a long bull market beckoning in most financial assets, shareholders are likely to find they will be paying for a very expensive education as the new generation of bankers confront the realities of a bear market.
The Credit Suisse report revealed that in the run up to the Archegos debacle, 40% of the senior risk managers had been let go by the bank with the aim of reducing staffing costs. In fairness to Credit Suisse, the juniorization of finance jobs is widespread on both the sell- and buy-side and has three key causes.
First, there is the unintended consequences of poorly considered regulation such as the European Union’s new capital requirements for banks, known as CRD IV, which reduced flexible compensation but bumped up base salaries, thereby increasing cost bases. Secondly, there are the long-term toxic effects of zero interest rate monetary policies and extended quantitative easing by central banks, which has crushed profit margins. Finally, there is a certain type of behavior that usually accompanies an extended bull market.
The final part is not new. In his classic book “The Money Game,” the author and economics commentator George Goodman (pseudonym Adam Smith) wrote about a hedge fund manager called “The Great Winfield” in the 1960s tech-driven bull market who found he was underperforming because “his memory kept getting in the way.” His solution was to “fire all the old guys” and bring in young hires that were more open to taking risks because they hadn’t been scarred by the experience of a bear market. Predictably, it didn’t end well for The Great Winfield.
Some staff turnover is healthy. It brings fresh ideas and the dynamism that is necessary for keeping up with rapidly changing market conditions and the demanding requirements of investment banking. Then again, a firm entirely comprised of very experienced hires isn’t very optimal. It was no accident that some of the biggest blow-ups during the financial crisis had the most ossified managements.
Another subtle problem identified in Credit Suisse’s report is culture. The new people the firm put in risk management roles were not only more junior, but also increasingly from a sales and marketing background, because the chief risk officer (who also had limited risk experience) wanted to make the department more “commercial” and therefore aligned with client-facing activities.
This should be familiar to anybody with experience at a large financial firm over the last five or so years. As financial markets have become more stretched, senior positions are increasingly being filled by those who have either taken the most risk -- whether well considered or not -- or sufficiently politically adept but lacking the skill or entrepreneurial drive to go elsewhere. The latter is where you’ll find heavy use of “moating,” which is when substandard managers remove all potential competition for their jobs, making it harder to be replaced. This is the opposite of the bull market practice of “layering,” which is when weak managers can afford to place additional staff between them and potential rivals. Either way, it makes for inefficient process and risk control. Finance firms are also too often focused on the revenue from deals perceived to be successful. There is far less introspection of the increasing asymmetry of the risk connected to “successful” deals and the “near misses.”
There are several things the finance industry can do to prevent the type of situation faced by Credit Suisse, starting with culture. Once a poor culture is entrenched, change is difficult. But compensation that is properly aligned with long term outcomes can help effect change for the better. As Berkshire Hathaway Inc. Vice Chairman Charlie Munger once said, “show me the incentives and I will show you the outcomes.”
The better managed banks these days are making greater use of technology, such as artificial intelligence, to improve oversight. But perhaps the best solution can be found buried in the notes to the Credit Suisse report: the use of independent experts. Given the vast complexity and conflicts of interest inherent in investment banks, maybe part of the risk management function needs to be outsourced. This approach has several advantages, namely that senior management gains an independent opinion by experts outside the realm of office politics.
This ability to source additional operational capacity at short notice is important, The Great Winfield’s plan was to rehire experienced staff when a bear market looks imminent. But hiring takes time and by their very nature bear markets are usually surprises to most market participants. It certainly was a surprise to the Great Winfield, as his firm failed in the great bear market of the 1970s.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Ben Ashby is a Partner at Good Governance Capital. He was previously a Managing Director at JPMorgan Chase & Co.’s Chief Investment Office & Treasury.
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