The United States has experienced in recent years the most significant failure of its financial system since the Great Depression. It could have been worse; looking back on events of 2008, Federal Reserve Chairman Ben Bernanke saw “Depression 2.0” just over the hill.1 But in any case, it was bad enough as it was. The numbers speak volumes.
Alan Blinder and Mark Zandi projected in 2009 that the total costs of the financial crisis would exceed $2.35 trillion, or about 16 percent of GDP.2 To name only the large-ticket items, these costs include: government activity as described by the stimulus package ($787 billion); government support for Fannie Mae and Freddie Mac (projected at $305 billion); the Economic Stimulus Act of 2008 ($170 billion); TARP (projected at $101 billion); and emergency unemployment benefits ($90 billion).3 All told, the Federal government committed more than $3 trillion in spending, loan purchases, loans and loan guarantees through the Treasury, Federal Reserve System and Federal Deposit Insurance Corporation to support financial institutions and auto companies, among other purposes.
Private-sector costs were even more immense. Perhaps ten million American households may lose their homes to foreclosure before the dust finally settles.4 Today almost one-quarter of homes across America are worth less than the mortgages on the property. Stock prices as measured by the Wilshire 5000 index fell 57 percent from their peak in October 2007 to the deepest point in March 2009 before rising again. The drop cost Americans and others trillions of dollars of value in their retirement and investment accounts. Median household wealth fell from an average of $125,000 in 2007 to $96,000 in 2009.5 The unemployment rate doubled, millions lost their jobs, and tens of thousands have remained unemployed or underemployed for so long that their return to the workforce in any capacity is unlikely.
It is fair to say that this calamity came upon the American people and their leaders as a surprise. Most people and even most experts thought everything was fine, until it wasn’t. It would therefore qualify as an unnatural act if, since September 2008, a great deal of forensic activity had not taken place to explain how and why all this happened. And indeed there has been a great deal of activity, from which many excellent narratives have emerged. Not least among these is the Final Report of the Financial Crisis Inquiry Commission (FCIC) of January 2011.
As a rule, however, analyses of the crisis have tended to fall into patterns dictated by the limited perspectives of their respective investigators. Economists apply the tools of their discipline as it is currently constructed and, predictably, reaffirm the utility of those tools. These analyses tend to downplay the social and political contexts in which the crisis occurred. Political and social analyses, contrarily, may neglect significant economic factors. Those interested in the longer-term cultural underpinnings of the crisis, such as the decay of thrift as a value, tend to find what they are looking for. All of this is perfectly natural, and much of it can be useful to our understanding. But it remains for the careful observer to assemble the parts of the puzzle and make of it what he or she can.
Too often missing from the amalgam of analytic perspectives is consideration of the disciplines of organizational design and management. Sometimes things go wrong not necessarily because people are greedy or present-oriented, but rather because misalignments arise over time between the way we are organized and the environment. Incentive structures and patterns of behavior can become dysfunctional without anyone intending that result.6 This is one reason among several that markets are not always self-regulating. Markets operate within frameworks ultimately established by political and social means. If those frameworks generate dysfunctional incentive structures, markets will fail to meet expectations for the common good. At the highest level of abstraction, then, the purpose of government supervision of business is to help prevent poor incentive structures from causing serious harm.
In the recent crisis many large private firms failed, but not all of them did. Fannie Mae, Freddie Mac, Countrywide, IndyMac, Washington Mutual, AIG, Citigroup, Merrill Lynch, Wachovia, Lehman Brothers and Bear Stearns failed. By “failed” I mean that they either went out of business, required massive amounts of government aid to stay afloat, or entered into mergers that ended their existence as independent companies. Other large firms, including JP Morgan Chase, Goldman Sachs, Wells Fargo and Toronto Dominion Bank (TD Bank), weathered the crisis, and some perhaps even emerged stronger from it. Is there anything to be learned by way of organizational design and management by comparing the financial firms that withstood the crisis with those that failed? Are there lessons that can be applied to the interrelated workings of public and private institutions, and can any of those lessons be generalized from the former to the latter?
There may well be. We served on the staff of the Financial Crisis Inquiry Commission (FCIC) from 2010 to 2011. The FCIC was careful to ask questions about the relative resilience of private institutions and the way that government institutions relate to them. I reviewed four financial firms that withstood the crisis and eight that did not. I interviewed numerous present and former officials of government supervisory agencies to get their perspectives. When the Commission finished its work, it put many of those interviews and numerous public documents on the public record (available at www.fcic.law.stanford.edu). This represents a sea change in attitudes: Before the crisis, unquestioning faith in markets often drove out efforts to improve the interplay between public and private institutional structures. Now we are beginning to understand better that repair of our institutions, especially in the financial sector, is a major national imperative as the country emerges—hopefully without a double dip—from the recession and tries to deal with our changing global economic status. Unfortunately, the legislation that has so far passed the Congress pays only limited attention to institutional design. We have a long way to go.
From Black Swans to Constructive Dialogue
My study within the aegis of the FCIC spotlights one overarching conclusion about financial firms’ organization and management: The quality of preparation a firm made to hedge against low-probability events—what Nassim Nicholas Taleb famously called “black swans”—was crucial to a firm’s fortunes during the crisis.7
In general terms, it is true but not particularly useful to say that managers must take the possibility of black swans into account even when times are good. Far more useful is to ask what specifically taking the possibility of black swans into account means in terms of organization, governance and management.
Organization. Organizational design refers to the way that the development and evolution of organizations can be shaped with respect to critical elements such as their capacity, flexibility, accountability and life cycle. As with all organizations in the U.S. constitutional system, law frames the attributes and activities of private companies. Some firms, such as many state-chartered finance companies, may engage in all activities except where prohibited by law. Other firms—such as commercial banks, thrift institutions, insurance companies and government-sponsored enterprises—may undertake activities only when authorized by law. Some firms are hybrids: Rating agencies, for example, are free to organize themselves as they wish but with eligibility and functions that have been shaped by law. Each organizational form has financial and operational advantages and disadvantages.8
A firm’s organization shapes its incentives and behavior. This occurred in the savings and loan debacle of the 1980s, when thrifts fundamentally changed their behavior after converting from mutual to investor ownership, and as occurred with Freddie Mac when it became an investor-owned company in 1989 and started taking more risks. Similarly, the behavior of firms in the financial crisis could often be traced back to the form of their ownership and control, such as when investment banks turned their partnerships into investor-owned companies and thereby increased their propensity to take large risks.
Large, complex financial institutions pose special organizational problems. Often consisting of a thousand or more distinct organizational elements, these firms need to devote substantial effort to managing the company as an integrated unit. Otherwise, as in the case of Citigroup, one part of the firm may be trying to reduce exposure to a troubled market while another is increasing its exposure. This is more than just a management issue; it is ultimately an organizational issue for most of the largest firms.
Furthermore, the United States is perhaps in a category of its own with regard to the organizational complexity of financial supervision and regulation. Financial firms can often choose the particular laws that govern their organizations. A commercial bank or thrift institution may select whether it desires a Federal or state charter, and which state’s laws it wishes to be subject to. Before the financial crisis, firms could even choose which Federal regulator they preferred. For firms such as AIG, Washington Mutual, IndyMac and Countrywide, the Office of Thrift Supervision (OTS) seemed to be the most congenial regulator. The OTS had emerged from the old Federal Home Loan Bank Board, an agency that had been mandated by law to promote the industry it regulated; although the Congress dropped that part of the law, the Bank Board’s weak supervisory culture seems to have survived.
This excessive flexibility created a race to the supervisory bottom. Firms could select the most amenable regulator, and regulators worried that, if they tightened up supervision, a firm would simply leave and place itself under authority of a more lax regulator. This deterred regulators from taking steps they otherwise might have considered appropriate. Creating a level playing field with regard to regulatory scope is not really as simple as it seems. There will always be new ways of doing business with the potential to move financial activities from better-supervised firms to those that are not. This is what I call Stanton’s Law: Risk will migrate to the place where government is least equipped to deal with it.9
While some policymakers and supervisors were alert to and concerned about the problem of regulatory arbitrage, their voices were muffled by organizational complications that made effective financial supervision difficult at best. Fragmentation of authority among multiple organizations created substantial governance problems for financial supervisors, not only with the distribution of authority but also with the flow of information. Fragmentation made governance difficult among supervisors and even within the Federal Reserve System itself. Supervisors described a process of trying to work around obstacles so that they could do their jobs, but when workarounds are required to be effective, it indicates that the organizational design itself needs attention.
The credit bubble and apparently benevolent economic conditions of the early 2000s also created problems for supervisors. How does a supervisor tell a company to refrain from activities that appear to be so profitable? Sometimes supervisors would wait until losses appeared before pressing a firm to improve its governance or risk management, but waiting until losses appeared often meant waiting until mistakes finally crippled a firm.
Governance. Governance is the ability of a firm to guide its activities effectively. Governance relates to the flow of information to appropriate decision-makers both up and down the corporate hierarchy and across the firm, the ability to assess and act on that information, and devising incentive structures relating to people and units within the firm. Governance thus relates to the distribution of power and authority among different parts of the organization.
Weak governance compounded organizational shortcomings at many firms. Overbearing CEOs too often dominated weak boards that failed to uphold the duties of respectfully challenging management to provide feedback and probing the limitations of proposed management initiatives. Former senior U.K. Treasury official Paul Myners charged, “The typical bank board resembles a retirement home for the great and the good: there are retired titans of industry, ousted politicians and the occasional member of the voluntary sector.”10 Such people, he noted, are unlikely to have the knowledge needed to provide guidance for a large complex financial institution in today’s global economy.
Many firms couldn’t provide adequate information to top management or the board to support sound decision-making. For example, Martin Sullivan, AIG’s CEO, testified to the Commission that he had not realized the degree of financial exposure created for AIG by its London-based subsidiary, AIG Financial Products (AIGFP). An excerpt of the transcript from the Commission hearing June 30, 2010, reads:
CHAIRMAN ANGELIDES: So you had a book of $78 billion of exposure by 2007 and you didn’t become aware of it until then?
WITNESS SULLIVAN: What I was receiving was regular reports from not only [AIGFP’s CEO] Mr. Cassano on his business, but also from [others] on AIGFP’s business in its totality, including the credit default swap portfolio. But to the best of my knowledge, I never recognized that portfolio, and there were no issues raised in the correspondence that would have given me cause for concern.11
When such damaging information is not making its way in a clear fashion to the top decision-makers of a firm, weakness in governance can threaten a firm’s very existence.
Management, meanwhile, has to do with the way that leaders guide an organization, shape its culture and ensure sustainable ways of doing business. The cultural gap between well-managed financial firms and those that failed in the crisis was large. Information systems at successful firms captured enterprise-wide risks, allowing them to manage those risks; those at unsuccessful firms did not. Creating strong and effective systems was expensive and time-consuming for firms but was deemed essential for risk management as well as effective management more generally.
By contrast, at firms that failed to tie risk management integrally to the organizational culture, it often became a pro forma exercise in which company officials went through the motions without actually enhancing the company’s capacity to address potential risks. Officials at unsuccessful firms complained that they could not have been expected to foresee a drop of 30–40 percent in housing prices. They missed the basic point. Resilient firms did not foresee this either, but their company leaders preemptively took defensive positions by maintaining strong balance sheets, avoiding risky products or becoming alert to early signs of a troubled market and reducing risk.
Given these realities, what advice can we give about organizational design and management? Is there any single major recommendation that, if well implemented, could help bring weaker large financial firms up to the level of their more successful peers and at the same time help government regulators do a better job? It is useful to think about the private and public aspects of this problem together since, as a practical matter, they relate to one another in basic ways.
The literature on decision-making in large organizations actually yields an answer. Sydney Finklelstein and his colleagues at Dartmouth’s Tuck School of Business found that bad decisions required two key elements: first, an initial flawed decision that the CEO or another influential person made and, second, a poorly structured decision process that failed to provide facts and input to correct the mistake.12 In the felicitous phrasing of organizational development expert Jack Rosenblum, “feedback is a gift.” Critical input must be understood as a means to rethink a preliminary decision before it causes harm.
One of the critical distinctive factors between successful and unsuccessful firms in the crisis was the presence or absence of what can be called constructive dialogue. Successful firms managed to create productive and constructive tension between those in the firm who wanted to do deals, or offer certain financial products and services, and those who were responsible for limiting risk exposures. By creating a respectful exchange of views among the proponents of these divergent perspectives, successful firms enabled themselves to attain outcomes that took the best from each point of view. Instead of simply deciding to do a deal or not, successful firms considered ways to hedge risks or otherwise reduce exposure from doing the deal. They created opportunity for constructive dialogue between CEOs and their boards, between CEOs and their top managers, and between revenue-producing units and risk officers.
Unsuccessful firms frequently pursued revenue-producing ventures without constructive dialogue with those concerned about risk. In 2005–07, major firms jumped into the market by expanding market share, acquiring increasing volumes of risky assets and avidly pursuing profits without regard to risk, just as housing prices peaked and declined. They pointedly disregarded input from their risk officers. Freddie Mac’s CEO fired his chief risk officer in 2005, just as the company greatly increased its risk-taking. Lehman’s CEO sidelined his chief risk officer in 2007.13 By contrast, because of their application of constructive dialogue and a robust sense of the risk-reward tradeoff, successful firms sometimes retained more capital than their competitors and many times refrained from lucrative but risky types of financial products or transactions that appeared to be making so much money for their competitors.
Here lies an ideal point of private-public engagement: Government supervisors should require effective, constructive dialogue in firms that lack it. In making major decisions (and supervisors can review these), can the company point to changes it made because of input from the board, from an engaged senior management team or from risk officers? If not, supervisors likely have found an unsafe and unsound condition in the company’s culture that deserves prompt attention. This is a test supervisors can apply long before losses materialize as a result of poor decisions.
Constructive dialogue also should apply more generally to relations between large, complex financial institutions and their government supervisors. The crisis and its immense costs suggest that companies need to view feedback from their supervisors, too, as a gift and not as part of an avoidance game. That means listening respectfully and accepting supervisory feedback before it becomes a formal enforcement action. While regulators may not have the depth of expertise available to large complex institutions, they do have the ability to ask simple questions, such as about the amount of capital a firm has reserved against potentially risky activities, whether a firm is pursuing market share or profitability goals without taking account of risks involved, or whether a risk officer is contributing usefully the decision-making process. The record of major firms that survived the financial crisis reflects the power of simple questions to expose problems for correction before they cause major losses. Feedback from supervisors can improve decisions, sometimes merely by posing the right questions.
Constructive dialogue is of course a two-way street. Supervisors need to be open to input that examiners are merely “checking the boxes” in rote compliance drills without understanding the real risks of the company’s business, or that there are too many examiners from multiple regulators on site without a focus on the most important issues, or that particular examiners are not open to fruitful discussions. Constructive dialogue can thus improve decision-making all around—at supervisory organizations and at the firms they supervise.
A caveat is in order: Constructive dialogue between a company and its government supervisor must rest on constructive tension between their perspectives. The supervisor must maintain what some call “principled intimacy” with those it regulates.14 Without the tension, a supervisor can essentially be captured by regulated firms.
Constructive dialogue is certainly a superior alternative to destructive dialogue. Attacks on the capacity of regulators—such as happened with the Office of Federal Housing Enterprise Oversight, the former supervisor of Fannie Mae and Freddie Mac and happens periodically with the Securities and Exchange Commission and Commodity Futures Trading Commission—are examples of destructive dialogue. Large, complex financial institutions can benefit from recognizing their interest in improving rather than diminishing the quality of feedback they receive from their supervisors.
Constructive dialogue is not the early trajectory of the new Consumer Protection Financial Bureau (CPFB). The CPFB has become subject to extreme partisan contention. The Dodd-Frank Act designed the bureau to be funded from fees, outside of the appropriations process that controls funding of most governmental organizations, in a manner similar to Federal bank regulators. Opponents of the bureau’s creation now seek to withhold approval of any candidate to head it unless the law is changed to subject the bureau to political control through appropriations, a tactic that has often prevented a supervisory organization from building the strength needed to do its job. The logic is simple: If we lack the political power to prevent the CPFB from coming into existence, the next best option is to hamper its operations.
Is there a way to replace the current destructive dialogue with a constructive one? It would help if the new CPFB focused on building capacity with its current funding mechanism and at the same time pushed for strong economic analysis to help ensure that the benefits of any regulations or guidance it issues would likely outweigh costs. In other words, a constructive political dialogue would ensure that the new bureau builds constructive dialogue into its own processes to reduce the risk of costly and potentially ineffective interventions into the financial system.
Given the large-scale origination and securitization of low-quality mortgages to borrowers unable to repay them, one way the CPFB can reassure skeptics is to adopt high-quality standards that could help the financial system reduce its own future vulnerabilities. One example is Alex Pollock’s proposed one-page mortgage disclosure form. A June 2007 Federal Trade Commission survey of mortgage borrowers indicated that about a third could not identify the interest rate on their mortgage paperwork, half could not correctly identify the loan amount, two-thirds did not recognize that they would be charged a prepayment penalty, and nearly nine-tenths could not identify the total amount of upfront charges.15 Pollock’s concept, now under consideration by the CFPB, can help fix these problems. Financial institutions that want to adopt a sustainable approach to profitability should welcome the help. It is only by setting common minimum standards of conduct for all competing firms that we can avoid the destructive race to the bottom that felled so many companies in 2008.
It is important that the CPFB and the objects of its regulatory ambit get off on the right foot. A destructive dialogue, of which Washington has seen far too many in recent years, could lead instead to the usual high-tension regulatory interventions, followed by political attacks on the regulator, with resulting costs to the financial system. This is another way of saying that beyond the technical aspects of regulation are the attitudes that regulators and those regulated take toward one another. It is a cultural issue as much as it is a strictly legal one. And as a cultural issue, the source of success lies in accepting that mutually respectful feedback can be a source of strength for both private companies and government regulators.
In a very real sense, then, financial institutions and their government regulators are engaged in a standard collective action problem. Regulation properly administered can save private firms the futility of trying to gain competitive advantage by engaging in high-risk ventures only to see others do the same, resulting in more danger for everyone and for the system as a whole. Upon reflection, we can see that it is in everyone’s interest to avoid such futile and reckless pursuits. In such circumstances, unreasoned attitudes toward regulation generate their own penalties, as the financial crisis has shown.
Constructive dialogue is no panacea. But it can be a valuable adjunct to other regulatory improvements, such as better capital and liquidity standards, transparency and strengthened supervision. Improving governance and risk management at weaker firms could improve their reliability as counterparties and reduce the incidence of panic. This would be far superior to having to rely on government once again to bail out the AIGs of the world and, in return, imposing difficult restrictions on major firms such as those specified in the Dodd-Frank legislation. Perhaps the Federal Reserve Chairman or someone of similar stature can work with industry statesmen to determine where and how to apply constructive dialogue to the relationship between major firms and supervisors. Implementing this dialogue will not be easy given the current atmosphere in Washington, but it would seem to be well worth the effort.
1David Wessel, “Inside Dr. Bernanke’s E.R.”, Wall Street Journal, July 24, 2009.
2Blinder and Zandi, How the Great Recession Was Brought to an End, monograph, July 27, 2010.
3The Blinder/Zandi forecast on TARP turned out to be wrong, as it happened: The government made money on TARP in the end.
4Congressional Oversight Panel, “A Review of Treasury’s Foreclosure Prevention Programs”, December Oversight Report, December 14, 2010, p. 4 (“8 to 13 million foreclosures expected by 2012”).
5Jesse Bricker, Brian Bucks, Arthur Kennickell, Traci Mach and Kevin Moore, “Surveying the Aftermath of the Storm: Changes in Family Finances from 2007 to 2009”, working paper, Board of Governors of the Federal Reserve System, March 2011.
6Here the work of Diane Vaughan is instructive. See Vaughan, “Organizational Rituals of Risk and Error”, in Bridget Hutter and Michael Power, eds., Organizational Encounters with Risk (Cambridge University Press, 2005).
7Taleb, The Black Swan: The Impact of the Highly Improbable (Random House, 2007).
8See, generally, Thomas H. Stanton, “Nonquantifiable Risks and Financial Institutions: The Mercantilist Legal Framework of Banks, Thrifts and Government-Sponsored Enterprises”, in Charles Stone and Anne Zissu, eds., Global Risk Based Capital Regulations, vol. 1 (Irwin Professional Publishing, 1994).
9Thus, in testimony before the Senate Banking Committee in a hearing on The Safety and Soundness of Government Sponsored Enterprises, October 31, 1989, I observed that increases in stringency of capital requirements and government supervision for thrift institutions after the savings and loan debacle would drive many billions of dollars of mortgages from the portfolios of savings and loan associations to Fannie Mae and Freddie Mac because their capital standards and government oversight were much weaker.
10Myners, “Reform of banking must begin in the boardroom”, Financial Times, April 24, 2008.
11Financial Crisis Inquiry Commission, hearing transcript, June 30, 2010, p. 151.
12Finkelstein, Jo Whitehead and Andrew Campbell, Think Again: Why Good Leaders Make Bad Decisions and How to Keep It from Happening to You (Harvard Business Press, 2008).
13Financial Crisis Inquiry Commission, interview with Richard Syron, August 31, 2010; Financial Crisis Inquiry Commission, interview with Madelyn Antoncic, July 14, 2010.
14See Malcolm Sparrow, The Regulatory Craft: Controlling Risks, Solving Problems, and Managing Compliance (Brookings Institution Press, 2000).
15Pollock, “Introduction to a Conference on Improving Mortgage Disclosure”, American Enterprise Institute, June 15, 2007.