How Banks (and Companies) Diversify Their Way Into Incompetence
Today’s Daily Angle comes from Wikinvest Wire member Yves Smith of Naked Capitalism. You can read the full article on NakedCapitalism.com
Flash Player 9 or higher is required to view the chart Click here to download Flash Player nowI read my first management book at the age of 11, not because it was a management book, but a best seller at the time, And it may have been imprinted by it more than I realized. The Peter Principle says that managers are promoted until they reach their level of incompetence. The classic example is promoting the best salesman to be a sales manager. The joke (all too true) is that you both lose your best salesman and gain a lousy supervisor.
That pattern says that organizations as a whole are not very capable (if they recognize this danger, they should try to manage against it, but the popularity of The Peter Principle did not change corporate practice one jot, at least as far as I can tell). And of course, it explains why there are so many crappy managers and executives.
John Kay of the Financial Times applies this idea to financial firms, arguing that they diversify their way into incompetence: Financial institutions diversify into their level of incompetence. They extend their scope into activities they understand less…
The principle of diversification into incompetence applies from the largest financial institution to the smallest. AIG was America’s leading insurance company. The company did not just undertake credit insurance, but was the largest trader in the credit default swap market. That is how its financial products group, employing 120 people in London, brought about the collapse of a business that employed 120,000.
Citigroup is another example. It isn’t so much that Citi made a disastrous acquisition as it dedicated itself to massive reach as a corporate imperative: be as global and be in every conceivable product niche. That is a prescription for being unable to manage yourself, which is the essence of the big bank’s problems. Back to Kay:
The boredom factor is important. Much of traditional banking is quite boring. The desire to find new challenges is an admirable human trait. It is, however, very expensive for shareholders to allow their chief executives to indulge it.
Public sector bodies are usually constrained in their activities, so deregulation is often a trigger for expensive experimentation. In Britain, many of the efficiency gains from privatisation were squandered in diversification: I watched senior managers spending 80 per cent of their time on activities that generated 1 per cent of turnover and minus 10 per cent of profit. But it is more fun to go on jollies to Buenos Aires than to fix leaking pipes.
To win an auction when you don’t know what you are bidding for is often to lose. This winner’s curse is often behind bad acquisitions because the successful purchaser is the bidder most willing to pay too much. Hence the contest between Royal Bank of Scotland and Barclays as to which bank would court bankruptcy by buying ABN Amro. Ignorance of products may also be a problem. When you are the newcomer and know little, the business that gravitates to you will be the business no one else wants.
But the driving factor is hubris. Jim Collins’s well-timed study of How the Mighty Fall applies to every business I have mentioned. The financial services industry is particularly vulnerable to hubris because sections of it are not very competitive, and randomness plays a large role in the outcome of speculative transactions. It is therefore particularly easy for those who work in financial institutions to make the mistake of believing that their success is the result of exceptional skill rather than good fortune. What more natural to believe than that extraordinary talent will find pots of gold under other rainbows? Until vanity is vanquished, I anticipate that diversification to the level of incompetence will continue to be a powerful element in business behaviour.
With all due respect, I think Kay has the essence of this wrong. First, deals are engrossing and sexy. They are very intense, the top executives are the focus of Big Decisions, and they have a horde of high priced talent catering to them (well actually, leading them by the nose, but they are usually so adept at it that the client often does not realize he is no longer in control).
But the big driver is that bank CEO pay is correlated with the size of the institution. And it is much easier to get big fast by acquisition than organically. Big deals are a wallet-lining activity, and the advisors understand that very well.
