Blind Reliance on Models: a Recipe for Trouble

 

We are delighted that Professor John Kay has allowed us to reprint this column, on the dangers of relying on models to predict what is beyond their power to predict.

 

As the global financial crisis began to break in 2007, David Viniar, then chief financial officer of Goldman Sachs, reported in astonishment that his firm had experienced “25 standard deviation events, several days in a row”. Mr Viniar’s successor, Harvey Schwartz, has been similarly surprised. When the Swiss franc was unpegged last month, he described Goldman Sachs’ experience as a “20-plus standard deviation” occurrence.

Assume these experiences were drawn from the bell-shaped normal distribution on which such claims are generally based. If I were to write down as a percentage the probability that Goldman Sachs would encounter three 25 standard deviation events followed by a 20 standard deviation event, the next 15 lines of this column would be occupied by zeros. Such things simply do not occur. So what did?

The Swiss franc was pegged to the euro from 2011 to January 2015. Shorting the Swiss currency during that period was the epitome of what I call a “tailgating strategy”, from my experience of driving on European motorways. Tailgating strategies return regular small profits with a low probability of substantial loss. While no one can predict when a tailgating motorist will crash, any perceptive observer knows that such a crash is one day likely.

Some banks were using “risk models” in which volatility was drawn from past daily movements in the Swiss franc. Some even employed data from the period during which the value of the currency was pegged. The replacement of common sense by quantitative risk models was a contributor to the global financial crisis. And nothing much, it seems, has changed.

It is true that risk managers now pay more attention to “long-tail” events. But such low-probability outcomes take many forms. The Swiss franc revaluation is at one end of the spectrum — a predictable improbability. Like the tailgater’s accident this is, on any particular day, unlikely. Like the tailgater’s accident, it has not been observed in the historical data set — but over time the cumulative probability that it will occur becomes extremely high. At the other end of the spectrum of low-probability outcomes is Nassim Taleb’s “black swan” — the event to which you cannot attach a probability because you have not imagined the event. There can be no such thing as a probability that someone will invent the wheel because to conceive of such a probability is to have invented the wheel.

But most of what is contingent in the world falls somewhere in between. We can describe scenarios for developments in the stand-off between Greece and the eurozone, or for the resolution of the crisis in Ukraine, but rarely with such precision that we can assign numerical probabilities to these scenarios. And there is almost zero probability that any particular scenario we might imagine will actually occur.

What Mr Viniar and Mr Schwartz meant — or should have meant — is that events had occurred that fell outside the scope of their models. When the “off-model” event was the breakdown of parts of the wholesale money market in 2007, their surprise was just about forgivable: in the case of the Swiss revaluation, to have failed to visualise the possibility is rank incompetence.

Extremes among observed outcomes are much more often the product of “off-model” events than the result of vanishingly small probabilities. Sometimes the modellers left out something that plainly should have been included. On other occasions they left out something no one could have anticipated. The implication, however, is that most risk models — even if they have uses in every­day liquidity management — are unsuitable for the principal purpose for which they are devised: protecting financial institutions against severe embarrassment or catastrophic failure.

First published in the Financial Times.

The Rise and Fall of BP

The tale of BP is a story of a sleepy British corporate, transformed by Lord Browne into one of the world's largest and apparently most successful oil companies, only to be cut down to size by a series of tragedies.

When it emerged that BP's apparent success was built on foundations of charisma, a flawed safety culture, cost-cutting and lost internal expertise, its reputation and its market value, were destroyed.  It became a pariah, publicly berated by a US President, downgraded to BBB by Fitch and discussed as a take-over target.  It was probably saved from takeover by its toxic litigation legacy, only recently resolved at a cost estimated at more than $50 billion.

Journalists have feasted on stories from the Texas City explosion and the Deepwater Horizon disaster.  We deconstructed the root causes from reports internal and external, to extract more lessons from these stories than from almost any other company in crisis.

But to our delight, Professor Andrew Hopkins has done better.  He taught the US Chemical Safety and Hazard Investigation Board, charged with investigating the Texas City refinery explosion, about culture, safety cultures and learning cultures.  His insider knowledge of the investigation and track record of thinking and teaching about oil industry disasters put him in a good position to write about both disasters.  But he also identified, which we had not, a treasure trove of material: depositions and internal BP documents on a US website devoted to the Texas City disaster by Eva Rowe in memory of two of its victims, her parents James and Linda Rowe. 

The result is two exceptional books.  The first, 'Failure to Learn' takes apart the story of Texas City with a confidence that comes from direct contact with the evidence of witnesses and other primary sources.  Based on these sources he devotes a chapter to the failure of BP's top leadership

'Disastrous decisions' the second of this pair of books, deconstructs the Deepwater Horizon disaster.  It is worth quoting its opening words, which we endorse:

The blowout in the Gulf of Mexico on the evening of 20 April 2010 caught everyone by surprise although it shouldn't have."

Before the Deepwater Horizon disaster, BP was sufficiently riddled with systemic behavioural and organisational risks and reputational risks that a bad accident was to be expected even it was not possible to predict timing or the precise accident.  This is not an uncommon situation: systemic risks typically lie latent for years, sometimes decades, before causing what can be catastrophic damage.  In the meantime, the absence of a catastrophe leads insiders, particularly leaders, to be complacent, believing that "it won't happen to us" because it hasn't - yet. Outsiders, and frequently lower level staff, know otherwise.  But no-one listens to them until luck takes a day off.

Whereas the special focus of 'Failure to learn' is leadership, Hopkins uses 'Disastrous decisions' to explain and illustrate the power of error management and root cause analysis to find out why accidents happen so that their root causes can be dealt with before they cause harm. He also focuses on decision-making by middle-mangers, using the community of engineers to illustrate his points.

Both books make striking contributions to the literature.  Their additional sources have reinforced our analysis with new and strong evidence. Both should be compulsory reading for business leaders, board members and everyone with risk responsibilities.

And unlike most required reading, they tell a captivating story too.

Anthony Fitzsimmons
Reputability LLP
London
www.reputability.co.uk

 Anthony Fitzsimmons is Chairman of Reputability LLP and, with the late Derek Atkins, author of “Rethinking Reputational Risk: How to Manage the Risks that can Ruin Your Business, Your Reputation and You”

Why Government Repeats Mistakes - and What to Do about it

We are delighted to be able to post, with his permission, an essay by Richard Bacon MP.   Richard is Member of Parliament for South Norfolk, Deputy Chairman of the Public Accounts Committee, its most long-serving member and, with Christopher Hope, the author of Conundrum.   Richard has probably been involved in the study of more governmental mishaps than any other parliamentarian. 

Sir Michael Barber once observed that the “How” question is relatively neglected in the writing of history and politics. A textbook would say of some medieval king that “he gathered an army and hastened north” without pausing to consider just how difficult that was to do. Yet when governments embark on anything  new, it is quite normal for things not to turn out as planned – and the problems are nearly always to do with the “How” question.

We have seen an NHS dental contract which left large numbers of people without a dentist; a new system for marking school tests where up to three quarters of the marking was wrong; a pension regulatory body which had no objectives; and an urban regeneration project which had no budget. People have died because flawed hospital computer systems meant they were not told about their next vital check-up until it was too late. Holidays have been ruined because the Passport Office couldn’t issue passports on time. Failed asylum applicants with no right to be in the country – who happened to be murderers, kidnappers and rapists – have been released from jail to wander free in our community because no one could be found to deport them.

Farmers have committed suicide because of the Kafkaesque horrors of the Rural Payments Agency. The NHS mismanaged its recruitment of junior doctors so badly that medics – whose training had been paid for by British taxpayers – were forced to flee abroad in search of work, only to be urged to return soon afterwards, at the highest agency rates, due to a government-induced shortage of doctors. Some failures are so infamous they have become household words – the Child Support Agency or the Criminal Records Bureau (CRB) – even surviving Orwellian rebranding efforts to stamp out memories of a fiasco; no one I know calls the CRB the “Disclosure and Barring Service”.

Ministers routinely enter office with no knowledge of why things have gone wrong so often in the past. Few civil servants are around long enough to tell them. After only eighteen months as an education minister in charge of academies policy, Andrew Adonis found he had been in post longer than any of the officials who were supposed to be advising him. The Department for Transport somehow managed to have four permanent secretaries in two years. Given the track record, one might expect the quality of government spending to be a matter of sustained national concern. One can’t say “Oh, that’s management” and expect someone else to do it. It turns out that the “How” question can seriously affect the “What” question or even “Whether” anything happens at all.

The case for examining much more closely the quality of what we are doing has never been stronger. In a rapidly changing world there is an almost perfect storm of problems. As we get better at keeping people alive longer, we face inexorable rises in the cost of pensions and healthcare systems. As our population gets older and the tax base shrinks, our need to invest in better infrastructure – including better broadband connections, roads, railways and airports – only grows more urgent. We have an ongoing skills crisis. Our people need to be more numerate, literate and IT-savvy. We need to produce more housing but we have a dysfunctional model that fluctuates between near-stasis and a market bubble. Across the globe we face a burgeoning population and the need to produce more food on less land with much less water. We also know that if we can’t help the world’s people in situ they will instead come to us, compounding the pressures we already face. And we grapple with all these problems while struggling under a growing mountain of public debt, because successive governments seem quite unable to live within their means.

Squeezing much more out of the lemon is simply essential. We know that our governments must cost us less while being much more efficient and effective, to help us to deliver the changes we need. All this is probably common ground among most political parties, but the truth is that we are very bad at learning from our mistakes. Many politicians, civil servants and journalists are more interested in getting on with the next policy initiative, the next project or the next story.

Who is responsible for all this failure? Many screw-ups are plainly the result of poor decisions by ministers, who either try to do things too quickly or who won’t listen. Officials advising ministers on the Common Agricultural Policy were explicit that using the “dynamic hybrid” method for calculating single farm payments would be “madness” and a “nightmare” to administer; ministers chose it anyway.

The big regional contracts in the NHS’s National Programme for IT were agreed at indecently high speed – and duly signed before the NHS knew what it wanted to buy and the suppliers knew what was expected of them – because of pressure from Downing Street; the result was an expensive catastrophe. Tax credits still cause misery for thousands of low income families who have been overpaid, because HMRC demands repayments they cannot afford; the policy was Gordon Brown’s from its inception.

But what about civil servants? When managers at the Learning and Skills Council failed to count the money for the FE Colleges building programme while handing it out – thus pledging billions of pounds which they didn’t have – the Innovation and Skills Secretary John Denham said grimly that “there was a group of people that we might have expected to know what was going on who did not themselves have a full grasp of it”. In the InterCity West Coast franchising competition, the officials in charge at the Department for Transport were unaware of advice from external lawyers that the Department’s actions were unlawful. And even in the case of the Rural Payments Agency, where decisions were very ministerially driven, the choice of the “dynamic hybrid” method for determining single farm payments was made – as Dame Helen Ghosh, the Permanent Secretary, eventually told MPs – because “ministers were being told it was possible when it was not in fact possible.”

The reality is that there is more than enough blame to go around. We need to spend less time blaming and more time seeking to understand what is going on. In recent decades there has been a whole string of attempts to reform the Civil Service, including Continuity and Change, the Citizen’s Charter and Taking Forward Continuity and Change. Then came Modernising Government and Civil Service Reform: Delivery and Values. Imaginatively, this was followed by Civil Service Reform: Delivery and Values – One Year on, which in turn was followed by the “Capability Reviews”, then Putting the Frontline First: Smarter Government and The Civil Service Reform Plan. Now we have The Civil Service Reform Plan – One Year on. That’s roughly one white paper or major initiative every two years for twenty years. And eight years after the Capability Reviews – more than the time required to fight the Second World War – the Government launched the Civil Service Capabilities Plan. A year later the new head of the Major Projects Authority identifies that there is “a lack of distributed capability around delivery across Government”. The problem is not a lack of "to do" lists.

For sure, it is down to the Civil Service and its accounting officers to make sure there is a system that works. As Richard Heaton, Head of the Cabinet Office put it: “It is our job, without ministerial pushing, to create a civil service that has the capabilities that the Government need”. But what should a civil servant do when a powerful minister is on the rampage and demanding the impossible? The epic scale of the failures should tell us that the problem is systemic. As the former Head of Tesco Sir Terry Leahy put it: “Management and democratic process are not a good mix”. But we will only solve the problem when we stop looking in the wrong place. As Bill Clinton nearly said: “It’s behaviour, stupid.”

Of course, influencing behaviour is almost a new Holy Grail among policymakers. We are told it will help us reduce crime, tackle obesity, ensure environmental sustainability and make sure people pay their taxes on time. It works – and it’s not that new. Making unleaded petrol cheaper than the leaded stuff sees more people buying it. Making it easier for people to recycle achieves better results than moral hectoring.

But what about the behaviour of civil servants and ministers? And the behaviour of Parliamentarians? What about the behaviour of suppliersto government such as big IT firms, who – unsurprisingly – have a preference for large IT projects regardless of what might actually be best for taxpayers. What if you have a civil servant running an IT project whom no one dares challenge? Or a team of civil servants foisted on a project without the right skills? What should you do when you have a permanent secretary and a Cabinet minister who barely talk to each other for months? Just as in Margaret Atwood’s novel The Handmaid’s Tale, this has all actually happened, somewhere, sometime.

As HM Treasury’s Permanent Secretary, Sir Nicholas Macpherson, has observed: “I have worked under Tory governments where Chancellor and Chief Secretary weren’t really speaking to each other. I have certainly worked under Labour governments where that was the case”. Many billions of pounds have been squandered this way. If we really want better outcomes, then understanding this – and changing it – is much more important even than policymakers’ efforts at “influencing” the behaviour of citizens.

Economics has seen a big shift towards studying how people actually behave, rather than how they are supposed to behave. We need a similar shift inside government and politics. The London 2012 Olympics showed we can get it right. The outstanding feature of the Olympics, as Head of Programme Control David Birch put it, was that “we worked hard to generate and recognise one source of truth”.

The world’s most successful organisations, whether in manufacturing or in services, spend a disproportionate amount of time and effort developing people. Our governments need to do the same. MPs are among the most determined people you will meet – otherwise they would rarely have become MPs – but as a class they need much better preparation for ministerial office. In the British Civil Service we have one of the world’s best talent pools but we don’t get the best out of them. Instead of incessant exhortation, we need to think harder about what makes people tick. Sir Ken Robinson, a teacher renowned worldwide in the development of creativity, wrote that “human resources, like natural resources, are often buried deep. In every organisation there are all sorts of untapped talents andabilities”. Don’t we need every hand on deck in order to get out of the mess we have landed ourselves in? It is always sensible to make the most of what you have. The answer is to look more closely at ourselves and our nature – and to act on what we find.

This essay was first published by Reform in "How to run a country: a collection of essays".  

You will find our blog on the competence of civil servants here

 

First Lessons from Volkswagen

Volkswagen, scion of German industry, has fallen off its pedestal after revelations that up to 11 million of its diesel cars were fitted with software designed to deceive regulators about levels of toxic NOx emissions. 

It all began to unravel last in May 2014 when Virginia University's Center for Alternative Fuels, Engines & Emissions (CAFFE) discovered that NOx emissions from two of three diesel-powered cars it was testing produced between 5 and 35 times more than the official emissions standard, though in laboratory conditions they complied.  This was the first whiff of rat.

According to a Californian Air Resources Board (CARB) letter of 18 September, CARB took up the case and pursued investigations.  Discussions ensued with VW, who solemnly carried out tests and provided fixes, which did not work when CARB tested them.

As CARB relates in its letter, on 3 September, after a year's prevarication, VW confessed.  As the world now knows, large numbers of VW's diesel-powered motor cars were "designed and manufactured with a defeat device to bypass, defeat or render inoperative elements of the vehicle's emission control system" whilst meeting official testing procedures.

When the news became public, on 18 September, it was met with a mixture of incredulity and a drop in the VW share price of about 25%.  After defending an almost indefensible position for almost five days, VW's Chief Executive Martin Winterkorn resigned.   Some began asking whether VW would survive.

Beyond VW there was collateral damage.  The share prices of other car makers dropped, though less than VW's.  A discussion began as to whether diesel technology, held responsible for large scale health problems, was a wrong turning that should be abandoned.  And questions were asked whether, after a long string of governance failures in Germany, German industry was really the paragon represented by its good reputation. 

But the intriguing question is: why did this happen?

We do not yet know what happened but it is not unknown for major corporate scandals to have their genesis in the board room.  Think of the Olympus and Toshiba scandals.  That said there is no evidence of active boardroom involvement and Mr Winterkorn's protestations of surprise imply that he first learned of the problem very late in the day.  But the composition of the supervisory board, which does not seem to have been chosen with skill sets as its primary concern, has echos of the boards at Airbus at the time of the A380 crisis and at the UK's Co-operative Group when it almost collapsed.

If that is so, he must have been in the dark, unaware of what seems to have been a piece of deliberate skulduggery going on under his nose - but without his knowledge.

This sadly is a very common state of affairs.  We call it the Unknown Knowns problem.  There are things that leaders would dearly love to know - but they cannot find out until it is too late.  In our research, 85% of leaders were taken by surprise when a serious crisis engulfed their company. Yet most of these crises were caused by systemic failures that had lain unrecognised for years, sometime decades.

The most telling example is that there have been at least 14 rogue traders, averaging one every eighteen months, since Nick Leeson broke Barings in 1995: most recently the London Whale, who breached in 2012.  JP Morgan sustained losses of $6 billion on positions said to amount to about $160 billion.  All the rogue traders operated in an environment where risk teams are huge: JP Morgan's risk team ran to thousands but they didn't spot the Whale; nor did the astute Jamie Dimon - until an even more astute hedge fund spotted his problem from the outside and began to trade on his misfortunes.

What seems to happen is that some combination of character, culture, leadership, targets, incentives, corner-cutting, complexity, groupthink - and the slippery slope from gently bending rules to breaking them - leads an individual or team to start doing something that, as Warren Buffett put it, you "wouldn't be happy to have written about on the front page of a national newspaper in an article written by an unfriendly but intelligent reporter."  It doesn't help if regulators are not robustly independent.

Once the wrongdoing has begun, it is very hard for participants to confess - doing so will probably lead to unpleasant sanctions - so it continues.  The hole gets deeper.

The wrongdoing is rarely known just to the participants.  Others usually know, but are unwilling to rock the boat.  This may be because the wrongdoer has higher status; or it may be because they are in the same 'tribe', but as time passes unwillingness becomes tacit complicity.  Many may know things are wrong but they won't tell anyone above them.  Often the root causes are visible to the thoughtful, perceptive outside observer, such as a hedge fund or professional investor.  We call these companies 'predictably vulnerable'.

There may be a potential whistle blower; but anyone who researches whistle blowing as an activity will discover that it is commonly terminal if not merely frustrating.  It takes courage and determination to blow the whistle; and it takes an exceptional leader to listen and understand what a whistle blower is alleging with an open mind.

This is one of the ways in which leaders find themselves in the dark.  Breaking this silence is difficult.  It takes an insider-outsider, as anthropologists term it, armed with trustworthiness, skill and understanding of human behaviour to learn what insiders think and know but won't tell.   A sensitive investigation should uncover the root cause behavioural and organisational risks that lead to Unknown Knowns so that leaders can fix at least the root causes before they can cause more harm.  And as our research also shows, they usually do have some time.

An investigation may uncover things you wouldn't be happy to have written about on the front page of a national newspaper.  If so, you should listen and learn; and be grateful for the opportunity to deal with them before they blow up and destroy your personal reputation as well as that of your organisation.

Anthony Fitzsimmons
Reputability LLP
London
www.reputability.co.uk 
@Reputability

You can get a 20% discount when you buy Rethinking Reputational Risk - How to Manage the Risks that can Ruin Your Business, Your Reputation and You through this link by using the code RRRF20

The Silo Effect

Like our primate forebears, we humans have long organised ourselves into social groups and it is only natural that we form teams at work too.  Trust, a common purpose, shared culture and social norms are likely to develop within the family, tribe, group or team, along with a sense of identity that defines who is an insider and who is not.

As organisations grow so do teams.  The work of Robin Dunbar, an evolutionary psychologist and anthropologist suggests trouble starts as group size extends beyond about 150.  As teams grow and multiply, so do team identities and purposes.  Those in one team can easily come to see those in another as outsiders and rivals.  Cooperation becomes more difficult as their interests increasingly conflict.

When we examine the entrails of crises, persistently asking the question “why?” we often find that the root causes were well known at mid-levels of the company.  Sometimes the actual crisis was predictable, even predicted, from what one individual knew – but for a variety of reasons no message arrived in the consciousness of someone sufficiently senior to take action.   Frequently, key information known at mid-levels was spread among individuals who did not share it - so the information was never joined up. We have dubbed this the 'Unknown Knowns' problem.

We analyse causes of failure such as these by reference to factors such as culture, incentives, structural silos and the resulting non-communication of information.  Risk, psychology and sociology inform the analysis, but we have long suspected that anthropologists could enrich the analytical framework – if only they were interested in the business world. 

As a postgraduate level anthropologist turned FT journalist, some of Gillian Tett’s most perceptive writing has taken an anthropological look at business life.  Her latest book, ‘The Silo Effect’, explicitly brings her anthropological training to bear on it.  As you would expect of an experienced journalist, it is engagingly written.

Tett begins by introducing anthropology and summarises a few core anthropological insights.  Three are crucial:

• Human groups develop ways of classifying and expressing thoughts, and these become embedded in their ways of thinking;
• These  patterns help to entrench patterns of behaviour, often in a way that reinforces the status quo;
• These mental maps are partly recognised by group members but some parts are subliminal whilst others are ignored because they are thought “dull, taboo, obvious or impolite”, leaving some subjects beyond discussion.

These three explain much about how silos work and provide a useful additional perspective. They also imply an important corollary: it is in practice impossible for an insider to gain a reliable view of the world in which insiders live.  Only an outsider can achieve the necessary detachment to see ‘inside’ life as it truly is. 

But the outsider typically lacks crucial information that is available to an insider.  Tett describes how anthropologists attempt to become ‘insider-outsiders’ with access to inside information whilst retaining the relative objectivity of the outsider.   It is no accident that our methodology has much in common with what she describes.  We face the same challenges: except that we also aim to help insiders to understand what outsiders can see when given access to insiders’ knowledge.

The balance of the book consists of case studies, written in Tett’s usual lucid style.  Two of her studies of failure are built on her extensive knowledge of the financial crash of Noughties.  She dissects how UBS, the Bank of England and the host of financial market regulators, experts and economists managed not to see the crash coming.  A third tells how Sony, then a world-leader, reorganised itself into a series of separate business units, each with its own objectives.  By creating what became silos, Sony lost internal cooperation and its way.

Tett tentatively develops her theme to suggest an anthropological approach to mastering silos, from the outside as well as from within.  She begins by describing how, with advice from Robin Dunbar, Facebook has set out to build structural bridges of friendship and trust between what might become silos; and a culture that encourages experiments and cooperation across what might be frontiers in a culture that treats mistakes as opportunities to learn. 

Tett’s second, contrasting tale tackles breaking down long-established silos. Her story concerns one of the most tribally structured professions: medicine.  Structured around disciplines, there is a wasteful temptation for every doctor to try to apply their particular skill to your symptoms rather than beginning with an objective diagnosis and only then prescribing treatment perhaps by another doctor.  Tett tells how a perceptive question led Toby Cosgrove, CEO of Ohio’s Cleveland Clinic to question and dismantle the Clinic's disciplinary silos to deliver care centred on the patient’s need for a dispassionate diagnosis before prescribing the most appropriate treatment. 

But for me, Tett’s third tale was the most telling.  She relates how a detached but interested outsider, a hedge fund, was able to deduce that JP Morgan’s Chief Investment Office was placing huge bets on credit derivatives – at a time when JP Morgan’s leaders and risk team were completely ignorant of what was going on under their noses, let alone the scale.  The hedge fund, BlueMountain, profited from the insight when the London Whale breached.  The episode cost JP Morgan more than $6 billion in losses on a series of holdings with a value Tett estimates at approaching $160 billion.

This story resonates with our experience.  We regularly find that external analysis can identify organisations that seem blithely to be living on the edge of a cliff.  As with real cliffs, it is rarely possible to predict when they will fail.  But it is possible to predict why and with what consequences they will fail.

Leaders who seek what can be an uncomfortable foresight will usually have time to deal with the issues and avoid disgrace since consequences usually take time to emerge.

Astute long term investors can use such insights to avoid or improve vulnerable investments.  And in those rare cases where the timing seems imminent, there may be opportunities to profit from another’s risk blindness.


Anthony Fitzsimmons
Reputability LLP
London
www.reputability.co.uk

Anthony Fitzsimmons is Chairman of Reputability LLP and, with the late Derek Atkins, author of “Rethinking Reputational Risk: How to Manage the Risks that can Ruin Your Business, Your Reputation and You”

Admitting Mistakes Shows Intelligence

We are delighted that Professor John Kay has allowed us to reprint this column, on how admitting to doubts and mistakes shows intelligence and good leadership, not stupidity.  

When I was much younger and editing an economics journal, I published an article by a distinguished professor — more distinguished, perhaps, for his policy pronouncements than his scholarship. At a late stage, I grew suspicious of some of the numbers in one of his tables and, on making my own calculations, found they were wrong. I rang him. Without apology, he suggested I insert the correct data. Did he, I tentatively enquired, wish to review the text and its conclusions in light of these corrections, or at least to see the amended table? No, he responded briskly.

The incident shocked me then: but I am wiser now. I have read some of the literature on confirmation bias: the tendency we all have to interpret evidence, whatever its nature, as demonstrating the validity of the views we already hold. And I have learnt that such bias is almost as common in academia as among the viewers of Fox News: the work of John Ioannidis has shown how few scientific studies can be replicated successfully. In my inexperience, I had foolishly attempted such replication before the article was published.

It is generally possible to predict what people will think about abortion from what they think about climate change, and vice versa; and those who are concerned about wealth inequality tend to favour gun control, while those who are not, do not. Why, since these seem wholly unrelated issues, should this be so? Opinions seem to be based more and more on what team you belong to and less and less on your assessment of facts.

But there are still some who valiantly struggle to form their own opinions on the basis of evidence. John Maynard Keynes is often quoted as saying: “When the facts change, I change my mind. What do you do, sir?” This seems a rather minimal standard of intellectual honesty, even if one no longer widely aspired to. As with many remarks attributed to the British economist, however, it does not appear to be what he actually said: the original source is Paul Samuelson (an American Nobel laureate, who cannot himself have heard it) and the reported remark is: “When my information changes, I alter my conclusions.”

There is a subtle, but important, difference between “the facts” and “my information”. The former refers to some objective change that is, or should be, apparent to all: the latter to the speaker’s knowledge of relevant facts. It requires greater intellectual magnanimity to acknowledge that additional information might imply a different conclusion to the same problem, than it does to acknowledge that different problems have different solutions.

But Keynes might have done better to say: “Even when the facts don’t change, I (sometimes) change my mind.” The history of his evolving thought reveals that, with the self-confidence appropriate to his polymathic intellect, he evidently felt no shame in doing so. As he really did say (in his obituary of another great economist, Alfred Marshall, whom he suggests was reluctant to acknowledge error): “There is no harm in being sometimes wrong — especially if one is promptly found out.”

To admit doubt, to recognise that one may sometimes be wrong, is a mark not of stupidity but of intelligence. A higher form of intellectual achievement still is that described by F Scott Fitzgerald: “The test of a first-rate intelligence,” he wrote, “is the ability to hold two op­posed ideas in the mind at the same time and still retain the ability to function.”

The capacity to act while recognising the limits of one’s knowledge is an essential, but rare, characteristic of the effective political or business leader. “Some people are more certain of everything than I am of anything,” wrote former US Treasury secretary (and Goldman Sachs and Citigroup executive) Robert Rubin. We can imagine which politicians he meant.


First published in the Financial Times.
© John Kay 2015 http://www.johnkay.com

Shareholders and Short-termism

Are shareholders responsible for slowing corporate growth?

Andy Haldene is bothered that as dividends have risen, profits retained by quoted companies for reinvestment have fallen from 90% in 1970 to about 35% today, leaving firms with far less money for growth-boosting invetment and risking "eating themselves".  This is bad for the long term health of UK Plc.

As Terry Smith lucidly explained in a recent FT article, a firm with a 20% return on capital that reinvests 100% of profits will grow by about 4000% over 20 years.  If the same firm reinvests only 10%, its 20 year, growth will not even reach 1000% over the period.  This matters to long term investors such as the many saving for a pension in 20 to 40 years.  It also matters to governments since a growing economy means more money to spend without increasing tax rates.

It is a subject that Anthony Hilton raised in 2012.  He aired Andrew Smithers' concern that the 'craze' for trying to align CEOs' incentives with their company's interests by paying 'massive' bonuses linked to measures like earnings per share and return on equity gives CEOs corresponding incentives to cook the books by using share buy-backs as a quick-and-easy way to improve earnings per share.  Reinvesting earnings to promote longer term growth takes time to produce results and tends to depress share prices in the short term.  So CEOs with short term bonus schemes (and in this context three to five years is short term) are systematically tempted to shun what is better for the long term good of the company in favour of the short term good of their wallets.

You might think that boards are to blame for this.  After all, they design and set bonus systems with 'long-term' targets including relatively short-term returns on equity.  This despite (in the UK) the Corporate Governance Code, whose opening words are:

"The purpose of corporate governance is to facilitate effective, entrepreneurial and prudent management that can deliver the long-term success of the company."

But things are not that simple.

Incentives set for professional asset managers are usually mis-matched to the decades-long horizons of the many future pensioners investing their funds; and investment managers can be influential in the appointment of boards.

These managers' incentives usually mean they get bigger bonuses if boards deliver short term gains.  Anthony Hilton recently reported the egregious case of an otherwise successful chief executive who was told by a senior shareholder that an unexpected rights issue and subsequent share-price drop had robbed him of his performance bonus and he would have his revenge. The CEO was out soon after. 

This mis-match is widely recognised.  In his review of UK equity Markets, John Kay wrote that:

"short-termism is a problem in UK equity markets, and that the principal causes are the decline of trust and the misalignment of incentives throughout the equity investment chain."

But Con Keating has recently pointed out that there is another layer of complexity.  As he puts it:

"Shareholders are not a homogenous group; their motivations and strategies can vary significantly. Some have even developed strategies, such as the “washing machine”, where engagement and activism seek to achieve short-term gains before the manager then moves on to the next. Heterogeneity among shareholders will tend to reinforce collective preferences for the short-term. In times of corporate action, such as hostile take-overs, groups of activist short-term shareholders, often hedge funds, do have a tendency to arise naturally, through self-interest, without any formal co-ordination or collusion. By contrast, when engagement is concerned with the long-term, formal co-ordination through bodies such as the Investors Forum is deemed advisable or even necessary"

With such a range of shareholder motivatations, Keating believes the short-termists win; and since the long term is a series of short terms, long-termists are also likely to lose in the long run.

Keating toys with weakening the power of shareholders.  This is a tricky approach since if shareholders are unable to hold a board to account, who is left to prevent a malign or incompetent board from wreaking damage?

To escape this conundrum, Keating asks whether a system that discriminates between short- and long-term shareholders might give boards greater practical power to put the long term interests of the company ahead of the shorter term interests of shareholders.  France has attempted to do this with the Loi Florange part of which may have made it easier for shareholders who have held a company’s shares for more than two years to claim double-voting rights. 

States have a huge interest in promoting the long term health of enterprises in their economies.  They have also given enterprises the precious ability to limit their liability, invest collectively on huge scales and overcome mortality.  Is it unreasonable for States to insist on measures that discourage short-termism from ovewhelming the long term succcess of enterprises on which long term national prosperity depends?

And if it is reasonable, what is the best solution?  Loi Florange is one approach that has gained some support, but Sherlock Holmes would recognise this another three pipe problem. 

Anthony Fitzsimmons
Reputability LLP
London
www.reputability.co.uk

Anthony Fitzsimmons is Chairman of Reputability LLP and, with the late Derek Atkins, author of “Rethinking Reputational Risk: How to Manage the Risks that can Ruin Your Business, Your Reputation and You”

Structural Weakness at the FCA Board

Writing about the departure of Martin Wheatley, the Chief Executive of the Finanical Conduct Authority, Anthony Hilton, the renowned city columnist recently suggested that the FCA board shows signs of being dysfunctional.   As he put it:

"No FCA board member has uttered even the feeblest cheep of protest, let alone done the honourable thing and resigned.

Yet if directors were happy with Wheatley, they should resign in protest at this external interference; if they were unhappy with Wheatley, they should have done something themselves to improve his performance or secure a replacement.

Either way, the board appears dysfunctional."

That is certainly an explanation of the conduct he observed but there is a deeper issue.

The FCA's corporate governance framework confirms that:

"The FCA is governed by a Board with members comprising: a Chair and a Chief Executive appointed by HM Treasury (Treasury); the Bank of England Deputy Governor for prudential regulation; two non-executive members who are appointed jointly by the Secretary of State for Business, Innovation and Skills and the Treasury, and at least one other member appointed by the Treasury. The majority of the Board members are Non-Executive Directors (NEDs)." (1.5)

In other words if a board member takes a line that offends the Treasury, they risk not being re-appointed.

In my experience this is sometimes a real fear of NEDs who enjoy the status or the money that flows from their appointment; and there is an additional aversion to risking 'failure' to be reappointed if the non-reappointment may be given publicity, as in the case of Mr Wheatley.

This government-imposed structure is inherently likely to make a board dysfunctional.

First, minsters like appointees who will be compliant and not rock boats. For a minister, an appointee who enjoys the status or wants the money, and preferably also lacks the character to take a public stand against the minister, is an ideal appointee.  From the perspective of the board and its organisation, such an appointee is a disaster waiting to happen.

Second, board composition matters.  An effective board needs an NED team with not only intelligence but also the knowledge, skills and experience to understand every aspect of the organisation's business.  Unless the board has the spine to spell out the characteristics it seeks in a new board member, and resign if they don't get them, the board will lack essential skills leaving it functionally incompetent and blind to risks that matter. A NED team with significant gaps in its knowledge, skills and experience is also a disaster waiting to happen.

When a government agency fails, an adroit politician, supported by the government's media machine, will deflect blame to the agency and its leaders.  This has already happened at the FCA following a botched press briefing that released a maelstrom of criticism, much of it well deserved.  The FCA chairman has said that the board has learned lessons from the experience.

But the fundamental problem remains.  The seeds of the next disaster may already have been sown by the Treasury's wish to maintain control of its progeny through selecting the FCA's board members.  The FCA board should confront the issue. 


Anthony Fitzsimmons
Reputabilty LLP
www.reputability.co.uk

Anthony Fitzsimmons is Chairman of Reputability LLP and, with the late Derek Atkins, author of “Rethinking Reputational Risk: How to Manage the Risks that can Ruin Your Business, Your Reputation and You”

Loyalty - Virtue and Risk

Cultural differences around the world represent substantial organisational risks with severe reputational risk implications.   The Toshiba accounting scandal provides yet another example of just how badly things can go wrong even in an advanced economy.  These risks can only be addressed by leaders of multinationals if their scale and significance are first understood.

In his introduction to the Official Report to the National Diet of Japan into the Fukashima nuclear accident,  Kiyoshi Kurokawa, a former President of the Science Council of Japan sorrowfully wrote:

"How could such an accident occur in Japan, a nation that takes such great pride in its global reputation for excellence in engineering and technology? This Commission believes the Japanese people – and the global community – deserve a full, honest and transparent answer to this question.

Our report catalogues a multitude of errors and wilful negligence that left the Fukushima plant unprepared for the events of March 11. And it examines serious deficiencies in the response to the accident by TEPCO, regulators and the government.

For all the extensive detail it provides, what this report cannot fully convey – especially to a global audience – is the mindset that supported the negligence behind this disaster.

What must be admitted – very painfully – is that this was a disaster “Made in Japan.” Its fundamental causes are to be found in the ingrained conventions of Japanese culture: our reflexive obedience; our reluctance to question authority; our devotion to ‘sticking with the program’; our groupism (sic); and our insularity."

Accounting scandals are found worldwide, but Toshiba provides the latest in a series of Japanese financial scandals that seem to stem from Japanese culture.  About $1billion of losses have been hidden by overstating profits over many years.  The report of the Investigation Commission is not yet available in English but Toshiba website states that nine directors, including the Chief Executive have resigned, and newspapers carry pictures of those resigning bowing long and deeply in shame. The report apparently spells out “systematic” and “deliberate” attempts to hide losses by inflating profit figures.

As to why, it describes a culture that made employees afraid to contradict their leaders when they demanded unrealistic earnings targets.  Within Toshiba, there was apparently a corporate culture in which one could not go against the wishes of superiors.  Loyalty can be a virtue but not if it becomes blind to reality.  In this case loyalty meant cooking the books. The report apparently states that both Mr Tanaka and Norio Sasaki,  knew that profits were being over-stated but took no action to end the improper accounting.  This is despite the Toshiba Standards of Conduct which states: 

"Directors and Employees shall:

1. maintain proper and timely accounts in accordance with generally accepted accounting principles;
2. promote the prompt release of accurate accounts; and
3. endeavour to maintain and improve the accounting management system, and establish and implement internal control procedures for financial reporting."

The problem of speaking truth to power is widespread and driven by a mixture of incentives and culture, but the cultural dimension seems particularly deeply rooted in Japan. Why?  I am no specialist in Japanese culture but in reading the Analects of Confucius recently I came across the following, written in about 500 to 400 BC:

"The Master said, in serving his father and mother a man may gently remonstrate with them. But if he sees that he has failed to change their opinion, he should resume his attitude of deference and not thwart them; may feel discouraged but not resentful." (IV.20)

"The Master took four subjects for his teacing: culture, conduct of affairs, loyalty to superiors and the keeping of promises." (VII.24)

 "The Master said, first and foremost be faithful to your superiors..." (XI.24)

A Japanese travel guide says:

"According to early Japanese writings, [Confucianism] was introduced to Japan via Korea in the year 285 AD. Some of the most important Confucian principles are humanity, loyalty, morality and consideration on an individual and political level.

This may explain why loyalty is given special emphasis in Japanese society.

But as Andrew Hill points out in a post subsequent to the original publication of this post, it is important that boards everywhere do not think 'it couldn't happen here'.  A long string of European and US corporate scandals demonstrate that Confucianist loyalty is not the only route to board-led failure.  Complacency is deadly everywhere.


Anthony Fitzsimmons
Reputability LLP
London

Anthony Fitzsimmons is Chairman of Reputability LLP and, with the late Derek Atkins, author of “Rethinking Reputational Risk: How to Manage the Risks that can Ruin Your Business, Your Reputation and You”

A Contrarian Approach to Groupthink

Groupthink is a  well-recognised psychological phenomenon in which people strive for consensus within a group. People may set aside their own personal beliefs or adopt the opinion of the rest of the group.  Groupthink is found wherever people collaborate, and this includes boards and leadership teams, especially if they embrace collegiality. 

Groupthink happens for many reasons.  The group may recruit in its own image.  Members may conform because job security depends on conformity; or for more subtle reasons, such as group culture or well-recognised psychological biases such as status quo bias, confirmation bias, herding and the availability heuristic. And that is before considering the effects of the individual's character and the effect of a dominant or charismatic person in the group.

Modern corporate governance requires boards to include 'independent' directors but this does not necessarily mean that independent directors will think independently.  A recent McKinsey report found that only 14% of almost 700 directors surveyed included "independent thinking" as a selection criterion for choosing a new director.  This is not a propitious starting point.

Add the ability of groupthink to lead 'independent' directors to lose their ability to think and reach conclusions independently and it is no surprise that many of the corporate failures analysed in 'Roads to Ruin' the Cass Business School report for Airmic, included groupthink among their causes.

Whilst some bad decisions remain latent vulnerabilities for years, our research suggests that about half will manifest into a crisis within 5 years.  When it becomes apparent that the board has made a bad decision, the Chief Executive is often the board's first sacrifice, and this is probably one reason why average CEO tenure seems to stick below 5 years.  In bad cases, it is not unusual for the Chairman to be next in line.

Since ignominious ejection from office often terminates careers, it should be important to CEOs and Chairmen to reduce the risk of avoidable bad decisions.

In her prize-winning essay, Siobhan Sweeney, a Judge business School MBA candidate, has suggested a solution: companies should combat groupthink by appointing a "Contrarian Director" (CD) whose explicit role is to be an independent source of critical thought and analysis for the board.  The concept is a development of the roles of Roman Catholic Church's 'Devils Advocate' and the Advocate General of the European Court of Justice.

Ms Sweeney's proposal includes the following elements:

• The CD's main role is to analyse and report formally to the board on any important proposal;
• CDs are full voting board members with long experience in independent analytical thinking and the character required to deliver unwelcome views should this be necessary;
• An 'Institute of Contrarian Directors' (ICD) should be established with robust governance to set standards for CDs and devise a standard Charter under which CDs can operate effectively, including rights to seek information;
• The ICD will, on request, recommend a suitable CD from a pool of people who have never been directors other than in a CD role and have not departed from the ICD charter;
• Such CDs are appointed for a single, non-renewable 3 year term and are paid as professionals;
• Where an ICD-nominated CD is appointed, the ICD Charter is to be incorporated into the company's governance regime and the CD specifically instructed by the board to act in accordance with the Charter, and
• Where a CD finds the company obstructing his or her effective operation, the CD is required to resign, making a public statement that she or he was unable to operate effectively.

The concept will appeal most to companies whose self-critical leaders embrace success in the long term, measured in decades, as a corporate goal.  Such leaders are keen to avoid avoidable errors.  It will be an anathema to leaders who are insecure, egotistical, arrogant or dominant, especially those whose personal goals share the much shorter time horizon of their incentive plans.

Given patterns of corporate failure, it is the latter's companies who would arguably benefit the most, but they are the least likely to adopt the concept.  Regulators may wish to take note.

We would welcome your comments on the merits and weaknesses of Ms Sweeney's proposal as well as your thoughts on how it might be improved.


Anthony Fitzsimmons
Reputability LLP
London

Anthony Fitzsimmons is Chairman of Reputability LLP and author of “Rethinking Reputational Risk: How to Manage the Risks that can Ruin Your Business, Your Reputation and You”

Are Regulators Damaging UK Productivity?

Are actions by regulators a partial cause of the UK's productivity problem? Anthony Hilton, the eminent City columnist, thinks that the UK's Chartered Accountants may be onto something here.  If so, should the FRC, FCA and PRA adopt a new line in their values statements:- "Do no Harm".

We are delighted to reprint Anthony's recent column in the London Evening Standard with permission.

 Britain has a severe productivity problem.

Output per employee and value added per hour of work are directly linked to the quality of the kit the employee has to hand to help do the job — be it machinery, software or market information.

Our companies do not invest enough in any of these things.

We lead the world in corporate governance and have a fully-developed overarching code supported by subsidiary codes for different sectors — like shareholder engagement, private-equity reporting or how auditors should behave.

Nowhere else in the world are companies so actively supervised, managements so closely monitored and boards so concerned about what shareholders think.

Perhaps the two are connected — some FTSE 100 chairmen of my acquaintance think so. In their view, corporate governance has made company boards excessively risk averse because no one wants to make a mistake and directors are, with obvious good reason given what has happened in recent years, fearful of the consequences to their reputation if they do.

If nothing else, this should provide food for thought for the International Corporate Governance Network meeting in London tomorrow.

Investment is often risky in that, however well-prepared the case, it requires a leap into the unknown. Corporate governance responsibilities that weigh heavily on their shoulders stop boards from taking that leap.

So Britain falls further and further behind its international competitors.

It is a point of view that is not aired as much as it should be, if only because whatever they may say in private, few company directors will come out publicly about the way governance distorts boardroom decision-making.

They do not think it would be career enhancing. In fact, it would be the kiss of death to their hopes for any further board appointments.

Unconstrained by that problem, Professor John Kay tried four years ago in his report for the then Industry Secretary Vince Cable on the functioning of the equity markets.

He suggested that we look more closely at whether existing systems of governance facilitated “effective entrepreneurial and prudent management that can deliver the long-term success of the company”.

One organisation, the Institute of Chartered Accountants in England and Wales, has also tried. In the past two years, it has published a series of papers as part of what it calls a thought leadership initiative. The aim is to promote a debate about corporate governance.

What the papers outline is an alternative approach to the one currently promoted by the Financial Reporting Council, the body responsible for supervising the operation of the current code.

Relations with the FRC have apparently become somewhat strained as a result.

Yet the Institute makes a powerful case that, however well-intentioned it may be, the current code does not address the world in which we now live. It is, for example, primarily focused on relations between companies and their shareholders, and is driven by the paramount principle of shareholder value — that the responsibility of boards is to deliver the best possible return to investors.

This narrowness may explain why shareholders and non-executives, far from holding bank executives to account in the run-up to the financial crash, appeared instead to be egging them on to greater excess.

In today’s world, companies are no longer financed by shareholders alone — most employ a range of financial instruments some of which have the characteristics of both debt and equity.

All sorts of different groups have the ability to influence a company and a voice that demands to be heard. Bondholders can be every bit as demanding as shareholders, particularly for a company in difficulty.

Financial market regulators tell companies who they can and cannot have on their board, whether they can pay a dividend and whether their business plan is acceptable.

Pensions regulators can seek to block a takeover or disposal or lay down financial terms that will make it acceptable.

There is vagueness in the way these codes apply in practice as opposed to theory in the boardrooms of some of the overseas companies that have a London stock market quotation. And that is before we get to taxpayer involvement via state aid and bailouts and the complications they cause.

Shareholders are different too. Foreign and domestic investors have different priorities, hedge fund and long-only investors are different and there is nothing in common between a passive investment house that replicates indices and promotes exchange-traded funds and an algorithmic trader buying, holding and selling shares for just a few seconds at a time.

This implies that one of the main legs of the British approach to governance, that shareholders take an interest, is as honoured in the breach as in the observance.

Nor does society think that shareholder value should be paramount or that companies have to live in, and be part of, society. In society’s eyes, corporate governance has clearly failed in curbing pubic company executive pay, which most people think of as excessive, unnecessary and undeserved.

It has failed too in curbing aggressive tax avoidance. It is poor in making boards aware of society’s norms about fairness — witness the Thomas Cook row.

Thomas Cook has been criticised over its handling of compensation over the deaths of two children who were holidaying with the firm.

Basically the Institute’s case is that these controversies and other factors are not one-offs which are here for a moment but will vanish like the winter snow.

Rather, the accountants believe there is a fundamental misalignment between today’s markets and the corporate governance frameworks.

What these rows underline is that there is no longer a shared belief about what constitutes good governance, and the structures within the market reflect this confusion and do not, therefore, give the code the backing it needs to work properly.

They believe that the current code does not reflect how companies have to operate in today’s world if they are to survive and prosper in the long term. The original idea of the code was as a high-level set of principles that applied equally to companies and investors.

We need to reinvent this ideal, the accountants say, and produce an over-arching code based on an understanding of what companies are for in today's world, what values they are expected to have, and how they should behave.

Board Risks in Financial Institutions

Once upon a time, it was widely thought that banks and insurers basically failed because they ran out of money.

The UK's Prudential Regulation Authority has decisively rejected the notion that financial failure is, fundamentally speaking, a money problem.  Its Chief Executive Andrew Bailey, and others, now seem convinced that whilst financially focused regulation remains essential, much more attention needs to be paid to boards.  As he put it in recent speech:

"[it] is uncommon and rare to find a problem in the capital or funding or business model of a firm which cannot be traced back to a failure of governance."

We agree.  In 'Deconstructing failure' we focused on the role of leaders in failure.  We discovered that of the nine prominent categories of board weaknesses investigated, six were influential in the majority of corporate failures.  Three were present in more than 70% of failures.  Even the least frequent factors were present in almost 40% of failures.

The role of leaders in failure, taken from 'Deconstructing failure' © Reputability LLP

This does not mean that board members are 'bad'.  What matters is their influence.  Boards are, or should be, the most influential people in any company.  This means that their activities, whether good or not, are likely to have big consequences. 

Our work confirmed earlier findings by William McDonnell and Paul Sharma, in two much-neglected pieces of research published in 2002 by the Financial Services Authority and the European Conference of Insurance Supervisors.  As McDonnell put it in the former:

"Management problems appear to be the root cause of every failure or near failure, so more focus on underlying internal causes is needed."

The conversion of the PRA to the view that management matters is corroborated by their recent Consultation Paper  CP18/15 on board responsibilities and corporate governance.  Whilst these proposals need refinement to meet best practice, they make it clear that the PRA is putting greater emphasis on individual and collective human behaviour as the 'underlying' cause of failure, with boards seen as an important source, arguably the most important source, of such risks.

The message for boards and risk professionals in the financial sector is clear.  Behavioural and organisational risks matter to your regulators.  Risks emanating from boards are top of the list, which should include risks from all layers of management.  For insurers, the ORSA will develop into the tool through which you will have to confirm to regulators that these risks are under analysis and management.

Boards across the sector need to understand and find these risks before working out their potential consequences and how to mitigate them.  Since they too are run and led by people, that includes the boards of central banks and financial regulators.

Anthony Fitzsimmons
Reputability LLP
London

Anthony Fitzsimmons is Chairman of Reputability LLP and author of “Rethinking Reputational Risk: How to Manage the Risks that can Ruin Your Business, Your Reputation and You”