This guest post was contributed by Lawrence Baxter, a member of the faculty at Duke Law School and formerly a divisional executive in a large banking organization. He takes a look inside the large mergers that created the behemoth financial institutions we know today, and the assumptions that encouraged and allowed those mergers.
A friend recently observed to me that he had maintained zero interest in banks and banking all his life—until the past year. Now everyone is engaged in a swirl of emotions and punditry as we focus as experts, taxpayers or consumers on almost every dimension of the financial crisis, from bailouts to complex executive compensation schemes. Yet throughout the commotion we have not lost our faith in one quintessential American value: bigger is better. How quickly we forget such disasters as Daimler Chrysler and Travelers-Citicorp, even as we hail Chrysler-Fiat.
True, a consequence of great scale has informed the public policy debate on banks: what do we do with a financial institutions that is “too big to fail”? Yet answers to this question have, for the most part, turned on whether a particular company should be allowed to fail, or be propped up by government action. The underlying pathology receives only passing attention. Why do we let these institutions get so large in the first place? Is it not likely that many of the institutions requiring massive injections of public capital and other forms of subsidization and public assistance are, and have been for some time, simply too big to manage?
America’s obsession with bigness has led us to assume glibly that organizational growth, vertical and lateral, is a natural consequence of business success and must be respected, even celebrated. Armies of consultants, lawyers and investment bankers devote their businesses to the science of corporate enlargement, encouraged by economists who celebrate not only economies of scale, but even “economies of super scale.” Ken Thompson, then CEO of one of the most venerated banks in the United States, Wachovia, spoke for an industry when he declared in 2006, at the very moment the company was making its fatal acquisition of Golden West Financial, that ““[c]onsolidation continues to make economic sense. Done right, size enhances competitive power. With economies of scale, a company can better afford the technology and longer branch hours that customers demand.”*
Mr. Thompson was not saying anything controversial. His own company had enjoyed years of success in the wake of several large acquisitions and scores of smaller ones. The entire industry was reveling in size. Regulators, from the Fed to the Justice Department, were approving almost every M&A in sight. The stock market was on a veritable sugar high after the brief setback of 2001 and 2002. A college of academic theorists was urging US adoption of the universal bank idea. Great engines of technology seemed capable of automating almost anything, from back office processing to customer relationship management. Large-scale offshoring offered enticing opportunities for global labor arbitrage. The nirvana of rising revenue and declining costs seemed tantalizingly close to reach. Who could object to rewarding handsomely the corporate superstars who were making this exquisite success possible? Few questioned whether the logic of financial consolidation actually made sense, even as ominous clouds gathered on the horizon. In its 2009 outlook The Economist accepted, albeit gloomily, that “Western finance will be increasingly dominated by a few huge universal banks, with a new aversion to risk”—as if such institutions could, let alone would, actually be able to avert risk.
America’s financial institutions grew at brisk pace once the first spigots of deregulation began to open in 1980. Consolidation not only aggregated assets and capital at stupendous rates; it also meant that the people and systems of each of these organizations had been ramped from relatively small operations into gargantuan ones that many bank employees had never dreamed of. Many a small town banker suddenly found himself at the helm of a business line or operating unit far larger—sometimes four or five times larger—than had been those of the great major money center banks of 1980. And many a customer experienced an involuntary re-introduction to a rapidly growing bank that hardly knew them anymore. Bits and pieces that did not fit the vision were sold off into an even further removed world of outsourced services.
Nor did these big new adventures feel all that scary. For those in control, compensation escalated to match the bold new responsibilities such executives had now acquired. The word “leadership” was substituted for “management” as the new corporate big leaguers learned the art of articulating grand vision while delegating detail. A reassuring chorus of supporting consultants produced reams of PowerPoint highlighting challenges and providing scientific graphs and charts filled with solutions. Boards enjoyed their exciting Sunday meetings to approve new deals that would enhance prestige and stun Monday morning markets. Beamingly confident CEOs assured credulous investment analysts and reporters that their big new adventures would render amazing efficiencies by exploiting technological scale, juicy new customer bases in “fast growth regions,” and cost redundancies (i.e. employees). Brand experts eagerly made travel reservations from Madison Avenue to victorious headquarters where they would compete breathlessly for assignments that would anoint new companies with visionary logos and stunning customer value propositions.
Meanwhile, back at the office, the games would begin. Systems would be identified for selection or elimination—a magical opportunity to take the best of each world. Employees, locations, operations and lines of business would be analyzed to ensure that overlaps would be eliminated and customers served better than ever. HR consultants would be brought in to hasten the adoption by employees of new cultures. Generous severance packages and retention bonuses—all surely offset in their expense by the seductive efficiencies of the merger—would be secretly prepared and offered to surplus employees. This was American bio-corporatism at its finest.
Where were the regulators? We talk of deregulation as if this was a phenomenon introduced by the Bush Administration in 2002. Yet the deregulation movement had been building for twenty years or more on many fronts. In the financial world it was represented by a number of iconic developments, beginning with the deregulation of interest rates in 1980 and accelerating with the demise of restrictions on geographic expansion by banks (1979–1994), the repeal of the Glass-Steagall Act (which tried to separate commerce and banking, and investment and commercial banking) in 1999, and the emergence of a gigantic “shadow financial system” that cast itself well beyond the traditional balance sheets of banks. Potentially tough regulation developed in the wake of the S&L Crisis with legislation in 1989 and 1992 was itself offset by a growing deregulatory philosophy based on deep faith in the discipline of market mechanisms. The federal deposit insurance funds were so flush in the absence of bank failures and the rapid growth of assessable deposits that banks were relieved of the need to pay insurance assessments altogether.
And the truth is that much of the modernization was needed. The rickety structure of bank regulation in America was not only odd by comparison to some foreign competitors, but the system of “non-bank” finance companies, securities and insurance companies purveying credit and other “bank-like” products had reached a scale that all but rendered the traditional framework of banking regulation a farce. It is hard to gainsay the wisdom of many actions taken by the deregulators, at least as far as well established and well understood financial products were concerned, and at least as far as deregulation sought to break down the very real barriers to competition that genuinely archaic restrictions provided.
The net effect of all of this progress was a rapid expansion in the scope of “banking” activity and a remorseless expansion in size of the players engaged in such activity. All the while it was also largely assumed that the large-scale management of such financial activities was itself not a problem. Far from creating the potential for concern, bigger had to be better, particularly if such non-American behemoths as HSBC, Deutsche, ING, and others were dwarfing our own. American bank consolidation became a veritable patriotic duty and a merger spree began.
Sadly, a lot of things happen inside mergers that no one likes to talk about.
First, the best technology systems are not always chosen. Far from it. Unless the larger partner to a merger is at the point of collapse, an inevitable dynamic in most mergers is that the larger company wins. Even where it is recognized that the smaller company has better technology (as is often the case because the larger company tends to have older systems), the possibility of damage to the larger customer base during system and database conversions leads risk-averse IT executives to choose the inferior systems. Intense management might sometimes produce acceptable results, but usually it will be years before problems created by a downgrade to inferior systems can be fixed. The connection between the original merger and later, consequential expense is therefore hard to discern.
Another thing that happens is that a lot of expertise gets thrown out the door. Industrial researchers have warned of the damaging loss of intellectual capital resulting from the recent trend to earlier retirement. Add to this the sheer intellectual devastation wrought by the elimination of hundreds of thousands of longtime financial employees, conveniently dismissed as “redundancies” (or, more quietly by the survivors, as corporate “deadwood”). This loss of institutional memory and knowledge is an important yet hidden cost of many mergers, in which the elimination of real people is treated for investment purposes as an elimination of “headcount” expense.
Then there is the awkward problem of culture. Anyone who has worked in a genuinely high performance culture (and not just one like Lake Wobegone whose children are “all above average”) will know that people provide much more value to an organization when they are motivated and develop effective relationships within and beyond the organization. Motivation itself comes from various sources, including raw compensation, but one of the sources large entities rely upon more than they even recognize is a culture of performance, itself generated by a sense of shared commitment. Walk into and Apple store if you aren’t following me.
The reality, however, is that it takes a long time to evolve a culture. Trust is the bedrock of culture and trust is earned through repeat engagement. Once a culture emerges, all kinds of “efficiencies” start to occur. Employee interactions become efficient ongoing relationships. Insecurities recede and so does destructive territoriality. People start to cooperate with each other. With such cultures some companies have proven that they can become genuinely high performing, outstripping competitors and adding real shareholder value.
Alas not so for rapid mergers. Employees caught up in merger situations often tend to become deeply suspicious of their new associates. Territoriality escalates, driven by a justified belief that this is necessary for survival. Employees start to under-perform or, sometimes, even to act directly contrary to the interests of the new combination. Reliable information about what is actually happening becomes increasingly difficult to uncover, even for the most assiduous of managers.
A very salient aspect of the Financial Crisis is the failure of risk management. Not only do risk managers appear to have been asleep at the switch in many instances. It is also evident that even when they were aggressively trying to manage risk they did not know what they were managing. Scientists of risk management have explanations for why this has been the case. Whatever the theoretical explanations, there is also one very simple but frequently overlooked additional element: our faith in technology has lulled us into believing that highly diverse metrics could be correlated if only good systems are in place.
Yet systems, no matter how good they might be in conception and even implementation, are merely engines that convert input into output. If people load garbage in, garbage always comes out. This is not because those who provide input are dishonest: in complex environments such as those created by “efficiencies of scale and scope” (i.e. rapid combinations of lines of business with clashing cultures and denuded of the institutional memory of recently laid off employees and relying on patchwork quilts of uneven technology) the providers of input, no matter how diligent, cannot properly understand what it is they are being asked to put into the pipeline.
For technologically illiterate executives, bored by risk management at best and frustrated by its necessary impediment to revenue generation at worst, complex systems render an illusion of control. “Dashboards” coded in red, yellow and green suggest that scientific management is afoot, that IT systems have worked their wonders in processing right data. The output presents a familiar, manageable set of executive decision points. Perplexed regulators feel reassured that the organization has a handle on things—after all, the company has put so much effort into developing a scientific system for measuring and managing its risk.
What does this mean for public policy?
At the very least we ought to re-examine our assumptions about letting banks, or any financial institution the actions of which generate systemic concerns, grow to whatever size they desire. Antitrust analysis has taken a back seat to “market discipline.” Yet it is not at all clear that markets have the information or power necessary to ensure that the discipline of the market will prevent the growth of institutions that are too big to handle. Optimal size assumptions, ones that do not rely upon surreptitiously externalized or postponed risk and costs, ought to be an important yardstick in antitrust analysis.
Secondly, we should not assume that corporations are internally coherent. Employees operate in large divisions, frequently strangers to each other; sometimes they even have to operate in environments fragmented by cultural misalignment and division. Incentive structures are widely different and do not necessarily ensure that everyone acts for the good of the shareholder. Conflicts of interest remain even after complex formal controls are imposed—indeed these controls often create more opportunities than ever for inimical arbitrage within the organization. It is quite possible that something like the re-imposition of some Glass-Steagall type constraints is needed to prevent unnatural combinations and impose structural curbs on the risk-taking that has created the present crisis.
Third, when corporate executives claim that they can live large safely, directors, shareholders, analysts and reporters should apply healthy doses of skepticism. It would be more effective to require executives to account, without excuses, for their success in actually delivering and preserving what they already promised the last time than to accept promises of future performance.
America has always celebrated competition. Our recent experience suggests that our obsession with size has diverted the focus from this critical element of our economic strength and it is high time to question whether it is how corporations can really perform, not how big they can get, that should be the foundation for sound merger and acquisition policy.
* “Wachovia Chief’s Vision: A Handful of Dominant Firms,” interview with Barbara A. Rehm, American Banker, May 19 2006.