Many books and articles have now been written to explain the causes of the credit crisis of 2007–2008 and the broader upheaval in the financial services industry that followed.
This “failure of management” in investment banking is far more than the story of a few CEOs losing control of their organizations; it is the story of a deeply flawed model of management that encouraged bankers to pursue opportunities without regard for their long-term consequences, and to put their own interests ahead of those of their employers and shareholders.
Consider Lehman Brothers
Of the investment-banking giants, Lehman Brothers (Lehman) perhaps suffered the greatest loss of value in the shortest period of time. What were the underlying causes of Lehman’s failure? While CEO Dick Fuld’s take-no-prisoners management style certainly didn’t help, we need to dig deeper into the company’s underlying management model to understand what happened.
Here are some contributory factors:
• The company’s risk management was poor: Like most of its competitors, Lehman failed to understand the risk associated with an entire class of mortgage-backed securities. But more importantly, no one felt accountable for the risks they were taking with these products. By falling back on formal rules rather than careful use of personal judgment, Lehman made many bad decisions.
• It had perverse incentive systems: Lehman’s employees knew what behaviors would maximize their bonuses. They also knew these very same behaviors would not be in the long-term interests of their shareholders – that’s what made the incentive systems perverse.
• There was no long-term unifying vision: Lehman wanted to be “number one in the industry by 2012,” but that wasn’t a vision – it was simply a desired position on the leader board. Lehman did not provide its employees with any intrinsic motivation to work hard to achieve that goal, nor any reason to work there instead of going over to the competitors
Of course Lehman Brothers was not alone in pursuing a failed management model. With a few partial exceptions such as Goldman Sachs and JP Morgan, these practices were endemic to the investment banking industry. It was the combination of Lehman’s model, its fragile position as an independent broker-dealer, and its massive exposure to the sub-prime meltdown that led to its ultimate failure. A management model is the set of choices we make about how work gets done in an organization. One of the well-kept secrets of the investment banks is that their own management systems are far less sophisticated than those of the companies to which they act as advisors. For example: people are frequently promoted on technical, not managerial, competence; aggressive and intimidating behavior is tolerated; effective teamwork and sharing of ideas are rare.
General Motors – Same or Different?
From a market share of 51% in 1962, General Motors (GM) began a long slide down to a share of 22% in 2008. New competitors from Japan, of course, were the initial cause of GM’s troubles, but despite the fixes tried by successive generations of executives, the decline continued. The financial crisis of 2008 was the last straw: credit dried up, customers stopped buying cars, and GM ran out of cash, filing for bankruptcy on May 31, 2009.1
As is so often the case, the seeds of GM’s failure can be linked directly to its earlier successes. GM rose to its position of leadership thanks to Alfred P. Sloan’s famous management innovation strategy – the multidivisional, professionally managed firm. By creating semi-autonomous divisions with profit responsibility, and by building a professional cadre of executives concerned with long-term planning at the corporate centre, Sloan’s GM was able to deliver economies of scale and scope that were unmatched. Indeed, it is no exaggeration to say that GM was the model of a well-managed company in the inter-war period.
Two of the best-selling business books of that era – Sloan’s My Years with General Motors and Peter F. Drucker’s Concept of the Corporation – were both essentially case studies of GM’s management model, and the ideas they put forward were widely copied. So where did GM go wrong? The company was the model of bureaucracy with formal rules and procedures, a clear hierarchy, and standardized inputs and outputs. This worked well for years, perhaps too well – GM became dominant, and gradually took control not just of its supply chain but of its customers as well.
This model worked fine in an industry dominated by the Big Three. But the 1973 oil-price shock, the arrival of Japanese competitors, and the rediscovery of consumer sovereignty changed all that. At that point, all GM’s strengths as a formal, procedure-driven hierarchy turned into liabilities – it was too slow in developing new models, its designs were too conservative, and its cost base was too high.Former US presidential candidate Ross Perot, when he sold EDS to GM in the 1980s, sized up GM in this way: “At GM the stress is not on getting results – on winning – but on bureaucracy, on conforming to the GM System.”
This story is now well known. GM’s bankruptcy was caused in large part by a failure of management just as Lehman’s was. But the mistakes made by GM were completely different from the mistakes made by Lehman. To wit: Lehman motivated its employees through extrinsic and material rewards, and used incentives to encourage individualism and risk-taking. GM paid its employees less well, it hired people who loved the car industry, and it promoted risk-averse loyal employees. Lehman used mostly informal systems for coordinating and decision-making. GM emphasized formal procedures and rules. Lehman had no clear sense of purpose or higher-order mission. GM had a very clear and longheld vision – to be the world leader in transportation products.
Like Lehman, GM’s demise can be explained by any number of factors. Some of these are purely external, such as Japanese competitors and rising oil prices in the case of GM, and poor regulation and policymaking in the case of Lehman. A management model is, simply put, the set of choices we make about how work gets done in an organization. A well-chosen management model, then, can be a source of competitive advantage; a poorly chosen management model can lead to ruin. And Lehman and GM illustrate nicely – but in contrasting ways – the downside risk of sticking with a management model that is past its sell-by date…