Stick to what you know

05.26.09
By Randy Johnson

When I started my business career some 46 years ago, there were banks, savings and loan associations, stockbrokers, investment banks, insurance companies, and so forth. Each type of company stuck to its business. Banks took in depositors’ money and lent it out to individuals, companies, and the like. Savings and loan companies financed residential housing and stockbrokers sold stocks and bonds. Each stuck to its own business. You see what I mean.

There were a couple of reasons for this. First, leading up to the Great Depression, banks and other types of financial institutions had become too intertwined.  This resulted in the passage of the Glass-Steagall Act, technically the Banking Act of 1933. This law separated the banking and investment businesses.

The other reason is that each of those types of institutions did a pretty good job at its main business. But there is this funny thing about human nature. Somehow it often seems that some other guy’s business looks easier and more profitable than yours. This happens on an individual level too – the “grass is greener on the other side” syndrome.
 
The grass-is-greener syndrome also happens to people running big businesses. Some guys running a bank look at how much money is being made by the investment bankers and think, “We can do that just as well as those other guys. We do the banking for these companies – why not be their investment banks too?” 

At the same time, investment bankers look at how much money the bankers are making and they want that profit too. They say, “We can pick of their largest customers and finance their short-term credit needs by issuing commercial paper for them.”

Fast forward to the present day. Before long, all of these aforementioned companies got into each other’s businesses and transformed themselves into “financial services” companies. The story they told was that they could manage all of these businesses well and that the diversification reduced risk.

While all this was going on, there was a change in the political climate as well. It was the era of deregulation. All across the spectrum of government, laws and regulations were changing. Regulatory bodies and their rules were being dismantled. It didn’t make any difference whether Republicans or Democrats were in the White House. Deregulation was in the air.

Finally in 1999, the Gramm-Leach law passed, which effectively eliminated the last vestiges of Glass-Steagall. What happened? This allowed banks to get into businesses like trading in and investing in mortgage-backed securities, collateralized debt obligations, and structured investment vehicles that were at the heart of the collapse of the credit markets less than ten years later – the current financial crisis we are living right now.

Bottom line: These guys did not know how to run these businesses, they didn’t know how to measure or contain risk, and they got drunk using other peoples’ money. I can remember the CEO of Wells Fargo stating that they were in 129 separate businesses. I imagine that outfits like Citicorp were in even more. It’s doubtful that all of these businesses were operated as well as the core businesses. 

What is perhaps more important was whether the top management even knew what some of their smaller businesses and sister companies were doing. Consider that one single rogue trader in Singapore managed to sink Barings PLC, one of England’s oldest and most respected investment banks. One single Sumitomo Bank trader cost his firm over $2.6 billion through unauthorized trading.

Executives at AIG Insurance, a company with over 100,000 employees, had a subsidiary in London, AIG Financial Products. It created and traded credit-default swaps that ended up sinking the country’s largest insurance company. The company’s core business was well managed, but this small group of people managed to sink the entire ship. The shareholders have virtually been wiped out and the government has invested almost $100 billion dollars in the company. 

As bad as this crisis is, there are going to be a lot of things that we will never know. But of one thing I am sure: A lot of managers led their companies down a dark road where they should have never gone. Combined this with too much leverage because they under-estimated the risks, and you have a prescription for the disaster in which we find ourselves. 

I cannot but think that one solution is to tell every Board of Directors: “Pick ten businesses that you want to be in and stick with those. Sell every other subsidiary to people who know something about those businesses.”

More Experts Articles | News Home | Discuss in our Forum

Are big banks spreading themselves too thin?