Archive for December, 2009

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The New Normal

December 17, 2009

The rules of global commerce have changed profoundly; the events of the past few years have reminded everyone that predictable incremental growth is the exception, not the rule. We all hope that when the recession has passed that the economy will return to normal. Unfortunately there is no returning to business as usual, the ‘New Normal’ we’ll all be facing – although not unprecedented – will be significantly different from the recent past.

For instance, it was once possible to assume that the global financial system was stable and reliable; the reality today is we must adjust to a world of increasing financial instability. Former Barclay’s Bank CEO, Martin Taylor, has described Wall Street as incompetent at best, possibly fraudulent. He claims that this banking culture contributed materially to the 2008 crisis and is reforming rapidly. And although this is dangerous enough, it is being compounded by other troubling actions at the heart of the global financial system including massive quantitative easing and unprecedented levels of government debt.

We must also adjust to rapid technological and societal changes. No one knows what the outcome of Copenhagen will be, but the environmental tide is turning. The rules of the legal game are changing and changing fast: consider the implications of the recent judgment against IMAX for alleged misrepresentation in a press release. Investors have sued, that’s not unusual – but a few years ago this might never have seen the light of day – today Canadian courts are authorizing a ‘global class action’ against the company and its management.  

There is, of course, the now obvious volatility in the price of everything from basic commodities to real estate. Not only are prices volatile, the speed and global competitiveness of business is ratcheting up, with market opportunities opening and closing rapidly.

The ‘Age of Volatility’ essentially began just after the turn of the millennium, when Chinese growth finally tipped the supply/demand balance in many global markets. The impact has been felt most strongly in industrial commodities such as iron ore, metallurgical coal, copper, nickel, zinc and aluminium markets, but China has also impacted many related global markets, including global trade, shipping, currency and financial markets.

The extraordinary volatility going forward will present many challenges. The contrast could not be greater between the past 30 year period of slow, steady growth and the violent circumstances of today. Foundational assumptions must be revisited: for instance, using ‘rolling thirty year averages’ for commodity prices in capital projects was a useful and reliable planning assumption until recently: present circumstances have rendered it completely obsolete. Furthermore, the need for high performance planning, with real effective contingency plans in place, ready to go will be a survival necessity – not a luxury;  as will having a ‘strategic organization’ one that works together effectively as a team, can plan and move with speed when the inevitable changes in economic circumstances occurs. 

Things to Think About

  1. Giant forces, that have been at work for decades are beginning to impact your industry and company, learn how the rules of the game have changed
  2. The New Normal will challenge our leadership and management skills to the limit. Planning to succeed is vital.
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A Banking Bridge to the Future

December 11, 2009

This is an article I wrote for Risk Management Magazine back in June – seems like a lifetime ago! It’s relevant but somewhat dated. I’ve included it because many of the larger issues are still relevant and a continuing source of management angst.

Also, thanks for your comments, I’ve added a bit at the end – Things to Think About – section to help summarize the issues. 

A Banking Bridge to the Future, Robert McGarvey June 09

Although many new bridges are about to be constructed in this period of ‘stimulus’, the one bridge that is not under construction, nor even contemplated, is potentially the most critical infrastructure project of all: the risk management bridge that could connect the enormous mountains of savings and investment that are accumulating in our financial system and the productive (but under-capitalized) heart of the nation’s value creation engine.

Banker’s Dilemma

The collapse of Wall Street investment banking has unleashed a tsunami of unwelcome expectation on the conventional banking industry. At the same time that governments throughout the world are pressuring banks to be more active on the lending front, their world is falling apart: bank balance sheets are unraveling while entire arenas of bank profitability are vanishing before their eyes.  To compound the problem, bankers have suddenly awoken to the true – shocking – reality of their risk exposures. All in all, the speed of the economic collapse, coupled with bankers’ growing uncertainty around their fundamental business model has led to a kind of institutional paralysis.

How did banking, of all industries, get to such a place? Well, during the past three decades, the conservative world of banking has undergone some remarkable and quite radical changes. Since the elimination of restrictions on banking activities in the 1980’s many commercial banks have moved strongly into non-traditional (and higher risk) lines of business such as investment banking, securities brokerage, insurance, and mutual fund sales. In recent years banking profitability has become increasing dependent on a host of nontraditional banking services, electronic funds transfer fees, credit cards services and account management fees. Advances in securitization have certainly accelerated this trend, increasing banks dependence on newer non-traditional sources of profit, including loan origination fees and, until recently, fees associated with asset-based loan securitization.

All this banking ‘service’ growth has diverted public attention from a disturbing trend: the precipitous decline in a pillar of banking industry stability, commercial and industrial (C&I) lending. According to Cobas Mote, and Wilcox:  Probably the most important change in banking (in the last few decades) has been the “…reduction in banks’ role as a lender to non-financial corporation’s… the ratio of commercial paper outstanding to bank commercial and industrial loans, which was just over 10 percent in 1960, rose to about 30 percent in 1975 and to more than 100 percent by the early 1990s.”. This trend has accelerated in the last two decades. Between 1986 and 2003 Commercial and Industrial loans declined from 31.53% to just 18.9%  of overall industry loan portfolio, as large business borrowers began to bypass regulated banks for Wall Street financial institutions substituting commercial paper or high-yield debt for bank loans secured against collateral grade assets. 

The Asset Revolution

This transformation in the banking business model has been driven by many factors including advances in technology, the development of sophisticated credit-scoring models, new financial processes, the Internet and, of course, by cold-blooded financial pressures, the need to meet profit and growth targets in an increasingly competitive market. However, a significant, if underreported reason for all this change in banking strategy, is the persistent decline in the quantity of traditional bankable assets in modern corporations. According to the World Bank there has been a revolution in the underlying engine of growth in western economies; a precipitous decline in tangible industrial-type assets as a percentage of total market capitalization. Today, in most ‘post industrial’ economies market services and intangible assets dominate, contributing over three-quarters of GDP. 

 

What does all this mean in the conservative world of banking? Today as banks retreat from high yield financial derivatives and begin to search for solid collateral they are facing, head on, the transformation of the underlying asset foundation in western economies. Instead of the bankable assets of old, real property, plant or inventory, corporations in the modern economy are underpinned by host of non-traditional ‘assets’. These new assets include many of the ‘harder’ (potentially bankable) forms such as patented new technologies, copyrighted software, but they also include many new contractual based assets, not least those ‘sophisticated’ financial derivatives we’ve all read about, and a variety of unfamiliar relationship based assets such as ‘brands’, trademarks, social networks and related assets that are becoming more and more important in our economy.

The scale of this economic revolution and the immaturity of the actual assets (from the banking perspective) make it extremely difficult for banks to move quickly, to adequately fulfill the rising expectations of business, governments, regulators and an increasingly impatient public.

The Lesson’s of History

It’s been a long time since bankers have faced such a challenge. The last time western banking went through as profound an asset transformation as we are presently experiencing was at the dawn of the industrial revolution two centuries ago. The dilemma then facing bankers was described well by John Jay Knox, in his ‘History of Banking in the United States’ (1903). “Money banks… issued notes on the basis of obligation of merchants and manufacturers, in contrast to land banks which issued their notes on the basis of land and personal estates. The latter type of banking was considered (prior to the War of 1812) preferable to banking on mercantile credit because land banks were supposed to stand on solid ground and not to depend on the success of their borrowers as did the money banks.” The historic importance of American bankers of the time, according to Knox, lay in their recognition of the changes brought about by the industrial revolution and an appreciation of the changing focus of (intrinsic) value in an industrial economy. “Such were the ideas of the men who stood at the cradle of (modern) American banking, and their choice lay between banking on mercantile credit or banking on real and personal estates. It was in choosing the first possibility that they made history.”

History has raised the bar again. The value creation engine in our economy is migrating, moving rapidly into new asset forms that need institutional support of all kinds, including banking. If there is to be a significant role for banks in the post industrial economy some things must change and change quickly. To begin with banking risk management standards and risk tolerances will certainly need to be developed internally, predicated on first principles, and not simply outsourced to credit rating agencies. Secondly risk must be identified and managed, not veiled behind statistical models or blindly hedged with credit default swaps etc, and – most importantly – thoroughness, diligence and openness need to be guiding principles for managers.

It is no longer possible to support the fiction that the new engines of growth in our economy are simply Good Will, ‘services’ that can escape rigorous analysis. Fortunately the risk management profession has just the right mind-set and tool kit to deal with all these problems. One of risk management’s most attractive attributes is its formal disciplined treatment of assets. Risk management processes seek quality verification of assets at discrete stages: (1) identification of the assets, what exactly is the asset, how does it deliver value to the company? (2) the current state of the assets, what does the company ‘own’ and what is its condition? (3) performance criteria, what level of performance or service are required, how is performance measured, how do these asset fail? (4) life of the asset determination and (5) what is the strategic ‘best use’ of the asset, are there alternative uses of this asset?

Adapting to New Assets

Nontraditional assets need to be identified and given the same rigorous treatment as traditional assets. Where this is presently being done quantitative valuations of intangibles (software, patents, trademarks etc.) are beginning to show up on financial statements, strengthening corporate balance sheets. Software, despite its obvious attraction as an asset has only been treated as such since 1999 under GAAP. But intellectual property based assets are not the only, nor the most productive new assets: brands, customer equity, employee know-how (human capital) and other key stakeholders contribute significant value to corporations, and are beginning to appear on the radar screen of major accounting bodies as ‘potential’ capital assets of the future. 

 The question is will we, standing at the cradle of another new era, have the vision, the creative imagination and the strength of character of our forbearers? Are we prepared to engage once more in an historic act of social invention, to do the hard work necessary to unleash an era of new prosperity?  Or will we continue to wring our hands, and hope that the Humpty Dumpty of 20th century banking can be put back together again? History is calling, are we prepared to answer the bell?

Things to Think About:

  1. If it’s not an asset for you, don’t expect your accountant to capitalize it! (or your banker to bank it) Management should be asking themselves the question “what are the real value drivers in our organization“,  presuming you can identify the newer nontraditional sources of value, ask yourself if you’re doing everything you can to treat them like a formal asset.
  2. Thanks to the rest of us pulling out all the stops, banks are recovering, but they still have difficulty identifying and managing risk in an evolving economy, and show no willingness to begin capitalizing the new engines of growth in our economy.
  3. Expect more uncertainty and volatility to emerge from a shaky financial system. Its belts and braces time for the CFO’s: have a plan, have a back up plan and work diligently to ensure that you’re prepared for any eventuality.  
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Copenhagen, and the Age of Unreason

December 9, 2009

According to the press Alberta’s Environment Minister is going to get on his horse, ride into town and show them foreigners (in Copenhagen) a ‘thing or two’. “I’m going to Copenhagen as a proud Albertan…Alberta can hold its head high as a responsible major global energy producer already acting to make real greenhouse-gas reductions.” The Environment Minister is going to the Climate Change Summit armed – no doubt – with the latest policy initiatives of the Alberta Government, the latest scientific evidence and a cupboard full of rational arguments in support of the oil sands development being no more damaging to the planet than other less high profile developments. He is assuming that these rational arguments will win the day and save the oil sands as an economic development resource in Alberta.

Good luck! I’m not sure the Minister is remotely aware of the scope and scale of forces lining up against him in Copenhagen. This is not a rational scientific debate about carbon emissions and government policy; it’s a framing and public relations battle that Dirty Oil has already lost. More importantly it’s a debate that has become deeply entangled in global politics. Consider that the scandal de jour in Copenhagen is not whether or not we should be more environmentally responsible, reducing green house gases (that’s pretty well agreed) but who should pay the bill and why. The debate has moved on to the point where many global activists are concerned that the ‘Rich’ countries are not prepared to reduce their green house gases, and then compensate the developing world (including China and India) with ‘reparations’ for centuries of uncontrolled development and flagrant imperialism.

Into this maelstrom the Minister will ride a rugged but lonely voice of ‘reason’.

As a Canadian, he should have seen this coming. For it was in Vancouver in 1970, that Marie Bohlen and a group of friends launched a small boat and, with it, a global environmental movement. The small boat, The Greenpeace, sailed north to protest a US nuclear test at Amchitka, a small island near Alaska. With this seemingly innocent act an environmental cause célèbre was born. Right from the beginning the founders of Greenpeace, Bohlen and friends Brian Davies, Paul Watson, Robert Hunter, Patrick Moore (et al) combined environmental passion and moral righteousness with extraordinary public relations savvy. “We may have just looked like a little old fish boat but in fact we were cranking away at our typewriters and with our tape recorders,” said Hunter. “In a sense, we were a media war ship.”

And let’s not forget, the reasoned, scientific approach has been tried before. Consider the media fiasco associated with the 1970’s seal hunt protest. After several years of disrupted hunts, the Newfoundland Government attempted to counteract the growing influence of Brigitte Bardot and Greenpeace by commissioning an ‘expert’ panel. They brought together a host of scientists, fisheries experts and local fishermen, and mounted an international media campaign to tell their side of the story. The pivotal moment came at their televised news conference in the Savoy hotel in London. As the panel was soberly presenting their ‘scientific’ evidence, Greenpeace founder Brian Davies rose in the gallery and violently disrupted the proceedings, loudly denouncing the panel as puppets of barbarism and cruelty. Reasoned arguments soon got buried under shouts and abuse – the news conference rapidly reduced to chaos. The British press, needless to say, had a field day. After the smoke cleared the government panel retreated, the battle lost.

Alberta has a lot of catching up to do. For a variety of reasons the government, the oil industry and Albertans in general have operated with a studied indifference to the environmental impact of oil sands development. It’s the ‘way things are’ in Alberta. The economic imperative of the industry has always been the compelling argument, which was fine as long as the eyes of the world we’re not focused on Alberta. They are now and we’d better be prepared for the consequences.

We should perhaps take heed from Satya Das, revisit his thoughtful recommendations. A more responsible, sophisticated Green Oil approach, where Alberta leads the world in stewardship of our shared heritage might start to redress the balance, anything less will simply be drowned in the flood.

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Sovereign Debt, the new ‘Sub-Prime’? Robert McGarvey

December 4, 2009

You may have heard in the news recently of the debt crisis in Dubai. At issue is a potential default of the outstanding loans ($59 billion) of Dubai World, a state owned development entity situated in the prosperous Persian Gulf Emirate. The Dubai department of finance has requested a ‘standstill’ on all Dubai World debt repayment, particularly on bond payments due December 14th.

Unfortunately, although not technically a sovereign debt, Dubai World is perceived by its lenders (and may have been represented) as having the backing of the Government of Dubai. Sheikh Mohammed bin Rashid Al Maktoum the ruler of Dubai has however disavowed any government liability in the matter. Speaking to the press last week he said:  “this company (Dubai World) is independent of the government, they (international investors) do not understand anything”.

You may wonder what this has to do with your business, Dubai is a small micro state a long way away; unfortunately this in another of those ‘over the horizon’ problems that could come rebounding back to haunt us all. The Dubai World problem is not just a local problem; it raises unwelcome questions about the stability of ‘sovereign debt’ around the world, and that strikes fear into the heart of our present financial system, potentially threatening recovery in the rest of the world.   

The recent economic recovery (OK, stabilization) is very welcome for all, but it has been purchased in part by a massive government intervention in the economy. According to the Bank of England, state intervention ‘just to support banks’ in the UK, USA and euro-zone during the present crisis amounts to US$ 14 trillion and that, of course, does NOT include the trillions more of ‘stimulus’ spending that has taken place in all developed economies over the past 18 months. All of this amounts to a massive explosion in state indebtedness – sovereign debt.

Consider the following sovereign debt warning from Edward Harrison of Credit Writedowns:

From Dubai to Iceland, Ireland, Greece, Hungary, Italy, Portugal, Spain, Japan, France, the UK and the USA, the sovereign debt burdens have been at current levels during peacetime only on the way down from even higher public debt burdens incurred during wars.  Watching the public debt to GDP ratios rise to levels likely to reach or exceed 100 percent of GDP by 2014 is deeply worrying, especially with structural primary (non-interest) deficits as high as they are. 

How could this impact you at home?

Well consider that your local bank is just finally getting its self back in order after the financial crisis. It has finally cleared out all those nasty securitized sub-prime mortgage assets and other high risk derivatives, replacing them – at government request – with ‘rock solid’ government paper, particularly attractive are US treasury notes which are considered the world’s most secure investments, almost risk free.  

Today the capital base of many banks is stuffed with sovereign debt, and they therefore depend upon a continuing faith in the stability of those government debt assets -in fact the stability of the global financial system depends upon it.  

Having learnt the lessons of the past few years, however, banks are touchy these days.  Let’s face it, even AAA credit ratings are no longer simply assumed to be solid. So if market sentiment were to suddenly turn against sovereign debt, then the perceived value of the sovereign debt assets would diminish. In other words the capital base of most banks could take another hit. Heaven forbid that a larger state (California?) or government should default.

What will the banks do? Of course the banks would react (panic) – by jacking up fees and reducing exposure. Both of which could present serious problems for you – right here at home.

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Monetarism as a Source of Volatility Robert McGarvey

December 2, 2009

In a landmark New York Times article (September 13, 1970), Dr. Milton Friedman laid out the case that managers in fulfilling their corporate duties should focus their attention on profits: “…there is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits….” Given Professor Friedman’s standing as one of the world’s leading economists; head of the Chicago School of monetary economics, his article carried great weight and authority. Ultimately it turned out to be more than just an interesting article; it was a pivotal moment in the history of capitalism, changing the course of American business management profoundly.

The Chicago School

The Chicago School was on a roll in the late 60’s, it had risen phoenix like in the post War era, providing a substantial challenge to the ruling Keynesian orthodoxy. In the Chicago School was born a new, hard minded economic fundamentalism. The new set of assumptions that Professor Friedman and the Chicago School brought to economic thought is fairly straightforward; in addition to the normal neoclassical assumptions (Rational Expectations Hypothesis and others) monetarists assume for a variety of reasons that markets are frictionless, essentially perfect. In other words markets are considered to be in equilibrium (the so called Efficient Markets Hypothesis). In these circumstances market signals are assumed to be accurate, essentially objective realities. And given the parallel assumption that all relevant phenomena are ultimately translatable into market signals, it follows that complex human systems are best managed by identifying and controlling a few key financial variables.

In respect to the larger economy, strict monetarists believe that simple manipulation of the money supply is the key to managing the boom and bust cycles in the economy. Translated into a corporate context, monetarism manifests itself in the belief that a business enterprise is best managed through manipulating key variables on the financial statements: cash flow (generally in the form of EBITA), bottom line profits and (indirectly) the company’s stock price.

The Impact 

The publication of Professor Friedman’s article and the subsequent rise of monetarism as a school of economic thought contributed significantly to radical changes that were then taking place in American management practices. The late 1960’s saw the rise of an aggressive and much more numbers-biased managerial class, many with MBAs. Their arrival on the business scene completed the ascendancy of a narrowly focused, Wall Street inspired, ‘financial’ theory of the business; its fundamental premise (relatively new at the time ) was – a business exists to return on shareholder equity; its measure of corporate success or failure, the company’s quoted stock price.

It all went relatively smoothly until recently, then the world changed profoundly and the rosy assumptions simply got overwhelmed by reality. For example, central bankers, idealizing the efficiency of markets, began to overestimate their power; many came to believe they could directly influence macroeconomic outcomes from their central bank desks. Consider Federal Reserve Chairman Ben Bernanke’s statements (September 17, 2008) about commodity prices: “We have lost (monetary) control…we cannot stabilize the dollar. We cannot control commodity prices.” The Federal Reserve could only control, or even remotely influence global currency and commodities markets, if we accept the most extreme forms of market efficiency and purism; it was a gross oversimplification for which we are now paying a very heavy price. Unfortunately for the rest of us, these biases in economic thought are carried forward blindly into the world of business theory and management decision making.

Bounded Thinking in the ‘C’ Suite

From a management point of view, over-focusing on the ‘numbers’ is an equivalent class of error. This critical error has the unintended consequence of elevating a company’s financial statements to previously unimagined heights; today they are the management equivalent of ‘Tablets from the Mount’. The problem with the numbers is they don’t tell the whole story; presently constituted, financial statements don’t come close to quantifying the ‘guts’ of the business. There are a host of ‘soft’ issues that are critical to business success, that because (at present) they’re not quantifiable don’t appear on the balance sheet or the financial statements, and as a result tend to get lost in the shuffle.

Let’s face it many of the most important value drivers in a business today are essentially invisible on management’s present radar screen. As such, when a CEO huddles with their CFO and the hard decisions are made valuable assets are largely ignored (at our, particularly shareholder’s peril).

For example, management’s decision to improve profitability through the adoption of lean manufacturing processes and just-in-time supply chain management (carrying only the minimal product inventory) will almost certainly improve the bottom line. All to the good according to traditional financial management principals, until you discover that those new lean processes have the unintended consequence of lengthening the order and delivery timelines for customers, undermining customer loyalty (i.e. impairing the customer equity asset) and increasing customer defection rates. Or consider the rush to outsourcing, many organizations these days are lowering operating costs by outsourcing software development, customer relationship management and basic accounting functions to lower cost service providers in India and other parts of Asia. Although this makes sound bottom line sense, it carries a variety of associated risks to key nontraditional assets. In outsourcing software development, for example, valuable market insights, technological advances and trade secrets are often inadvertently bundled with the process and sent half way around the world into economies where no legal protection of intangible assets is possible; ironically many of these advances and innovations reappear almost instantly in the form of new ‘lower’ cost competitors.

Assets are the Source of Earnings

The causal agents of corporate earnings are assets. Indeed assets are not only the sources of earnings it is clear from sub-prime mortgage crisis that, they are the root sources of risk as well. If management is to both build and sustain shareholder value more attention will have to be focused at the ‘asset’ level. Furthermore, a larger more balanced asset perspective, including awareness of both traditional and the newer non-traditional assets will open management’s eyes to the many hidden sources of value within their organization and, ideally, alert managers to the historic transformation going on under their noses: the migration of the western economies from their established industrial foundations to newer intangible knowledge-based ‘engines of growth’.

Balanced Decision Making

It is clear that foundational assumptions concerning the primacy of shareholders, key financial metrics and stock market valuation need to be supplemented by a broader perspective. These traditional metrics are not wrong, but are insufficient, to ensure stable long term growth in shareholder value. Like economists senior manager’s today are over focused on effects (cash flow, share prices etc.) not causes (healthy productive assets). A broader perspective and a more balanced set of priorities could certainly help managers see the ‘big picture’ and with a bit of luck, deliver sustainable shareholder value in future.

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