What Could Stop the Next Madoff?
December 11 will mark 10 years since the FBI arrested the now infamous Bernie Madoff, who perpetrated one of the greatest financial frauds in U.S. history through an extraordinarily brazen Ponzi scheme that bilked his investors out of tens of billions of dollars.
What can prevent another Madoff from happening? Unfortunately, probably not the kind of fiduciary regulation the U.S. Department of Labor and the U.S. Securities and Exchange Commission have proposed over the past decade. As an Investment Advisor registered with the SEC – Madoff was already a fiduciary.
I recently authored a piece for On Wall Street sharing thoughts on what can prevent advisors with bad intentions from taking advantage of their clients' trust – and the good news is it's a rule that's already in place. I encourage you to check out the article.
Our Industry Should Be Invested in Diversity
Of the various challenges and risks facing the financial services industry, there is one I’m reminded of every time I look in the mirror.
The faces of our clients look different today than they did just twenty years ago. Even as wealth in our society is increasingly created and controlled by women and people with diverse ethnic or cultural backgrounds, our industry remains predominantly white and male – particularly its leaders.
If our talent doesn’t resemble or reflect the people we want as clients, is it reasonable to expect that they’ll believe we can understand the experiences, perspectives and backgrounds that shape their philosophical views and financial needs? Is it realistic for us to believe that a concentration of demographically similar people – many with similar backgrounds, experiences and educations – will be able to see situations from different perspectives and provide the best possible solutions?
I recently had the opportunity to share my thoughts on the importance of diversity and inclusion to the financial services industry with InvestmentNews. The article also explains why I chose to partner with a firm that shares my passion on this topic. I encourage you to check it out.
The Tip of the Iceberg: Financial Ethics vs. Ethos
While my most recent blog post highlighted the progress made by the financial services industry and the nation in the decade since the financial crisis, there is no denying that we still see examples of bad behavior in the financial services industry. Why might this be?
An iceberg graphic used by Dr. William Brendel at the Center for Ethical Organizations may help us understand. Brendel posits that, for any organization, “Ethics” are merely the visible part of the iceberg and reflect conscious behaviors. “Ethos,” an organization’s subconscious culture and values, are what lie beneath the water line and are much more important determinants of how an organization will behave over time.
Despite the actions taken by our government, monetary policymakers or financial regulatory bodies, the continued existence of bad behavior in our industry seems to indicate that some companies still have work to do on the ethos that drives what they do.
“Who’da thunk it?”
The Financial Crisis as a Stewardship Success Story
Never in my career has the ground under my feet felt as shaky as it did on September 16, 2008 when I got a call telling me the Reserve Primary Fund – a money market fund – had “broken the buck” and, more significantly, indefinitely suspended the redemption of its shares. That meant investors in the fund, including tens of thousands of clients at the wealth management firm I was then running, could not withdraw their money, could not get cash to pay their taxes, and could not pay their kids’ college tuition or their living expenses.
It was the mutual fund equivalent of a failing bank slamming its teller windows closed and locking its doors.
What triggered this was Reserve’s $785 million investment in Lehman Brothers commercial paper when Lehman declared bankruptcy. Overnight, the value of that investment fell to $0, meaning the fund could no longer return $1 to investors for every $1 they had invested.
As rumors of the Fund’s troubles hit the markets, shareholders staged the mutual fund equivalent of a run on the bank, asking for their money back en mass. Global confidence in the stability of the short-term money markets was shattered and our financial system came close to complete collapse.
The failure of a relatively small ($60 billion) fund was the bullet, unseen, that almost killed our economy.
That was 10 years ago. We survived. Thanks to a collective, coordinated and cooperative effort on the part of three US Presidents, Congress, the Federal Reserve, US Treasury Department, regulators and market participants – which I believe is one of the most successful stewardship undertakings of my lifetime.
We’re all familiar with the extraordinary measures required: Hundreds of billions of dollars of emergency capital infusions and guarantees. Zero percent interest rates. Trillions of dollars of mortgage purchases by our central bank. The heroic decisiveness of former US Treasury Secretary Hank Paulson and former Federal Reserve Bank Chairman Ben Bernanke, both of whom, I believe, deserve Congressional Medals of Honor.
The bottom line is: it worked. By almost any measure, our government has earned a holistically positive rate of return on its investments over the past decade.
Today, the US financial system is the envy of the world. It is safer, sounder and more secure than it was going into the crisis. Core equity capital is double what it was.
Liquidity in the banking system (cash + deposits/total assets) is up 4x since the crisis. Most derivative transactions are now processed through central clearinghouses. And after the most comprehensive rewriting of financial regulations in our history, we now have a regulatory infrastructure that, while not perfect, reflects the learning of the 2008-2009 crisis, rather than the Great Depression of the 1920’s and 30s.
There are areas of concern. The growth of so-called “shadow banking”, for one. Where less-regulated asset owners, such as hedge funds, are making riskier loans that are no longer attractive to more heavily regulated banks. Or the enormous growth of ETFs including, in particular, ETFs reflecting portfolios of less illiquid assets. Or the decline in the number public companies (down almost 50% since 1996), the decline in capital raised through public markets, and the increased reliance on private debt and equity investors.
But (though you wouldn’t know it from the commentary in the media these day) relative to where this country stood 10 years after the crash of 1920, we are in far better shape. And we’re not close to being done.
Stimulated by the recent tax cut, corporate capital expenditures are starting to accelerate. Corporate cash is being repatriated and redeployed in the US. GDP growth continues to clip along at over 4%. Unemployment remains at historic lows.
In my 2012 book, Stewardship: Lessons Learned from the Lost Culture of Wall Street, I compared the stewardship failures that led to the financial crisis with other societal problems looming on the horizon: like climate change and income inequality, which can be addressed, but only if we rise to the occasion and behave like responsible stewards.
I also spoke on this topic during a recent appearance on Bloomberg Surveillance, which you can view below:
Remarkably, it turns out our response to the last financial crisis offers a roadmap for how we can collectively tackle other major threats to our well-being.
As one of my mentors, George Latimer, the former Mayor of St. Paul, used to quote his mother, “Who’da thunk it?” Our response to the financial crisis is a Stewardship success story.
We’ve accomplished a lot since 2008-2009. Let’s give ourselves credit, at least, for that. And let’s wisely apply the lessons we’ve learned to challenges ahead.
The Unintended Consequences of Post-Financial-Crisis Fed Policy
It’s been nearly ten years since the global financial crisis began, and I’m reading more reflections on this event and the way we responded to it. With the benefit of hindsight, it becomes easier to see where even the best intentions may have not yielded optimal results.
This interview by Bloomberg columnist Joe Nocera (All the Devils Are Here) with Karen Shaw Petrou, perhaps the leading expert on U.S. financial services regulation, makes the provocative point that U.S. monetary policy post the financial crisis may well have exacerbated income inequality. How? By imposing capital requirements that make it less attractive for banks to lend to middle class customers, or to make relatively riskier loans to small businesses. Although unintended, Petrou says, financial regulation “has concentrated more and more money in fewer and fewer hands.”
In a Distinguished Speakers Lecture earlier this year to the Federal Reserve Bank of New York, Petrou made a number of other related points:
* “Both wealth and income equality have gotten dramatically worse since 2010.”
* This is because financial assets (disproportionately owned by the top1%) have appreciated more than, say, housing and other assets owned by middle-class Americans.
* The savings accounts of middle-Americans “have been particularly hard hit by ultra-low rates.”
* Financial stability and economic equality are intertwined.
A Feel-Good Story About Responsible Finance
If you, like me, are weary of reading headlines about continued bad behavior in financial services firms, there’s at least one thing you can do to make yourself feel better about the future of finance:
Go to the website of a not-for-profit organization called Scholars of Finance (“SOF”): www.scholarsoffinance.org. SOF was recently founded by students at the Minneapolis-based Opus College of Business at the University of St. Thomas and the University of Minnesota’s Carlson School of Management to “inspire integrity and stewardship among the financial leaders of tomorrow”.
SOF’s vision is “a future where all financial leaders are stewarding the world’s capital for the purpose of serving the greater good”.
Their mission is to “provide educational and mentorship opportunities that inspire… integrity and an ethos of capital stewardship among students aspiring to be leaders in finance”.
To date, the group’s Minneapolis Chapter has sponsored four annual symposiums attended by almost 1,000 students and finance executives. Speakers have included former US Bank CEO Richard Davis, Target CFO Cathy Smith, Piper Jaffray Chairman Andrew Duff and famed equity analyst Ralph Acampora.
They formally became a non-profit less than a year ago, and since then they’ve raised more than $100,000 in funding. Co-founders Ross Overline and Ryan Quinlivan are contributing $10,000 a year each, on a monthly basis from their salaries, even though they are just a few years into their careers.
With an all-volunteer team of five directors and 20+ members of its Minneapolis Chapter, SOF is mapping out a strategy to open chapters in Chicago, San Francisco, and New York City. They’re even hiring their first full-time CEO.
Sound almost too good to be true?
Overline and Qunlivan don’t feel that way. They radiate an infectious enthusiasm and optimism about their group’s ability to effect change in finance.
“We really believe Scholars of Finance has the potential to impact the way trillions of dollars are spent and invested on a day-to-day basis,” Overline told me. “We’ve already seen students flourish and grow in their careers in ways that they directly attribute to their experience with SOF.”
“Students tell us there is nothing else like this on campus, nothing that focuses as much on values as SOF does,” says Quinlivan. “SOF gives students the chance to actively learn about the importance of strong values in financial services directly from top executives, face to face, which can be inspirational. At first we started with just the yearly Symposium, but the finance and educational community kept encouraging us that the world needed what SOF is building.”
Raj Singh, Curtis L. Carlson Chair of the Finance Department at the Carlson School, describes himself as a “cheerleader from the sidelines” and says “it’s remarkable what they’ve been able to accomplish – much more, frankly, than I thought they would.”
“Ethics are, or should be, a very big part of the profession of finance,” Singh says. “But it frequently becomes too mercenary and loses its sense of purpose. This group is a very big part of the conversation on campus of why and how to keep that from happening.”
“Scholars of Finance is quite impressive, says St. Thomas’ Finance Chair Kathy Combs. “It brings industry people into academia and connects students up with executives doing the kinds of jobs they will be doing one day. It also makes them go outside their comfort zone – to raise money and ask big names for help.”
Full disclosure: I have contributed to SOF and serve on its advisory committee. I can’t imagine a better way to invest in the future of finance.
Finance for the Greater Good
As I have traveled across the country writing and speaking for the past decade, my recurring theme has been the idea of Responsible Finance.
Or call it Enlightened Finance. Finance based on the core principle of Stewardship. Finance as a contributor to positive social outcomes. Finance as a means to greater ends, rather than an end unto itself. The language may vary, but the point is that Finance should serve a higher purpose.
Financial capitalism is the dominant socio-economic system in the world today. Underpinning it is a metaphorical contract between society and financial institutions. A social compact. It isn’t explicit. It isn’t static. It evolves over time to represent society’s evolving expectations of the role the financial services industry, and indeed the entire financial system, should play.
At the simplest level, Finance matches people who have money (investors) with people who need capital (corporations, governments, not-for-profit organizations) while managing the many risks involved and, hopefully, enhancing our collective standard of living.
But Yale Economist and Nobel Laureate Robert Shiller articulates a more expansive vision of finance’s role in society when he writes:
“Finance, suitably configured for the future, can be the strongest force for promoting the well-being and fulfillment of an expanding global population – for achieving the greater goals of the good of society.”
“The goals served by finance originate with us. They reflect our interests in careers, hopes for our families, ambitions for our businesses, aspirations for our culture, and ideals for our society.”
“Finance is not about ‘making money’ per se. It is a functional science in that it exists to support other goals – those of society. The better aligned a society’s financial institutions are with its goals and ideals, the stronger and more successful the society will be.”
Better alignment between Finance and the goals of society is the foundation upon which the future of the financial industry must be built. Particularly in a world where, as Shiller puts it, “financial institutions and financial variables are as much a source of direction and an ordering principle in our lives as the rising and setting sun, the seasons, and the tides.”
The threat of a systemic meltdown in our global financial system has receded since the financial crisis of 2008.
But society faces other potential train-wrecks-in-slow-motion which could seriously and negatively affect the quality of our lives and those of our children and grandchildren. Like climate change. Or dangerously high levels of government debt. Or income inequality. Or population growth coupled with resource scarcity.
The financial services sector – including asset management firms, retail, private, commercial and investment banks, wealth management firms, mutual funds, insurance companies, hedge funds and private equity investors – all can and must play a critical role in preventing these problems from becoming full scale crises.
The purpose of this blog is to talk about how we as an industry and a part of society can help ensure that Finance truly does serve the greater good.
What Doing the Laundry Can Teach Us About Investing
One of the most enduring tenets of finance may have passed its prime.
Throughout my career in the financial services industry, the concept of the efficient frontier, first developed in 1952 by Nobel Laureate Henry Markowitz, has underpinned and informed portfolio management and asset allocation – as much, if not more than any other intellectual breakthrough of the last half century.
Conceived as part of Modern Portfolio Theory, Markowitz’s efficient frontier represents the combination of assets that, at any given point of time, will produce the highest investment returns per unit of risk.
“Because Markowitz’s effort was so simple and powerful, it attracted a great number of followers and is still widely used today,” wrote two admirers in a recent academic paper. It became the central tenets of what might be called the golden age of asset allocation, a decades-long period when advisors of all stripes and colors could get paid, and paid well, for the alchemy of constructing portfolios that, at least on paper, promised to outperform less scientific approaches to investing.
But today, new entrants such as “robo-advisors” are disrupting asset management and using low cost efficient frontier algorithms to turn asset allocation into a commodity. Investment professionals are responding by looking for things they can do for their clients that no one else can do (including computers). Helping clients identify life goals and achieve desired outcomes is replacing the construction of investment portfolios as a driver of value. “Goals-based wealth management” and “solutions” are superceding asset allocation and portfolio construction as the future building blocks of wealth and asset management.
In the process, Markowitz’s 1950s version of the efficient frontier is being eclipsed by another kind of efficient frontier – call it the next generation efficient frontier -- the objective of which is to optimize portfolios not in terms of returns per unit of risk, but in terms of the certainty of achieving desired outcomes.
Here’s one way to think of it.
When a consumer walks into an appliance store and buys a washing machine, they expect that washing machine will turn dirty clothes into clean clothes 100% of the time. In fact, they can buy a warranty that more or less guarantees that.
When a consumer walks into a money manager, however, they are asked to accept the investment equivalent of a washing machine that may or may not work as expected. Our industry tells them: “Combine the optimal mix of detergent, water temperature and clothing type and you will have a 50% chance your clothes will come out clean, a 25% chance they will come out dirty, 20 % chance they will be turned a different color, and a 5% chance they will come out shredded.”
Who would buy a washing machine like that? No one.
Yet, in many ways, that’s what advisors and manufacturers of investment solutions have been asking their clients to do for years.
No doubt some readers of this article will question the validity of the washing machine analogy. Investing, they will argue, is a lot more like sailing a ship across open water than doing the laundry. Knowing where you want to go is the first step. Buying the right kind of boat is the next (preferably one with a heavy keel) Equipping it to withstand all kinds of weather and hiring an experienced captain are also important.
Taglines like “Guides for the Journey” - starring the advisor as captain of a seaworthy ship, who can’t control the wind or the waves, but knows how to batten down the hatches in a storm – captures this kind of positioning, which wealth management firms have been offering up for decades.
But today’s consumers of investment advice want more certainty and dependability than that.
They have financial goals, which they often need help articulating, such as generating steady, reliable monthly income to support their chosen lifestyles. Or growing the value of their savings so they have enough money to retire and/or to pay for their children’s education. Or preserving the value of their savings when interest rates rise and stock markets correct.
They want their advisors and investment managers to provide investment and wealth management strategies that offer them a high likelihood of achieving those goals. The Next Generation Efficient Frontier represents in theory the combination of assets, risk management overlays and dynamic tweaking that best accomplishes that.
It’s not nearly as simple or as straightforward or as easy to execute as the risk/return efficient frontier of the 1950s. But then, neither is the world we are living in today.
Quitting Retirement… Because I Missed Clients, Culture and Being on a Team
I am going back to full-time work.
A year and a half after retiring as CEO of RBC Wealth Management, I have been offered one of the most exciting opportunities of my 35-year career in financial services – to join the executive team at Baird as Vice Chairman.
I can’t think of a better fit. Baird, an international wealth management, capital markets, asset management, and private equity firm, embodies everything I have cared about throughout my career: Strong values. Ethical business practices. A client-focused, employee-centered culture. A long history of quality and excellence.
I am joining Baird because I believe they are ideally positioned to succeed. There is really no other firm quite like it in America today. Employee owned and, therefore, in control of their own destiny. Well capitalized. Diversified across several businesses. Small enough to be intimate, but with scale enough to invest for the future.
The US wealth management and investment advisory business continues to split into two competitive camps. In one camp are scale players and aggregators. They tend to be publicly owned. They also tend to be highly regulated. They have a particular view of the world. They believe in a centralized advice model. They believe client relationships belong to and should be managed by the institution. Clients should be segmented into “homes of best fit”. Investment strategies should be developed in the home office, packaged and delivered out through relationship managers whose compensation is tied to corporate priorities.
In the other camp are independents. They tend to be employee owned. They, too, are regulated but (unless they own a bank) aren’t subject to the kind of onerous oversight imposed by the Federal Reserve or the Comptroller of the Currency. They also aren’t beholden to the short term financial pressures imposed by public shareholders.
These types of firms practice a decentralized advice model. They believe client relationships belong to advisors. They believe decisions about what kinds of clients to work with, what advice to provide, and what investment products and services to offer should be left up to advisors.
The result is two entirely different types of client experiences. And two entirely different types of employee cultures.
I’ve worked in both.
I’ve been a client of both.
And in my experience, there is absolutely no question that the independent, employee-owned, decentralized advice model offers the opportunity for better client outcomes and the opportunity for a better employee culture.
Which isn’t at all surprising. Because in wealth and asset management, client experience and employee culture are interrelated. Wealth and asset management are people businesses. In people businesses, employee engagement translates directly and immediately into client satisfaction. Get culture right, and anything is possible. If not, then nothing else matters.
As an example, a couple of years ago, I posted an article on LinkedIn titled “The Long Haul” about a successful advisor-client relationship that had lasted more than 40 years. That kind of continuity is critical to effective wealth management. But it just doesn’t exist at big, complex, highly regulated financial service firms any more.
Instead, at big firms, a soul-crushing combination of top-down risk management and profit-maximizing imperatives leads to the kinds of initiatives you’ve read about recently, such as “cross-selling,” or transferring smaller clients to “robo advisor” services centers or threatening to sue employees if they move to other firms.
All this is driving out the best financial advisors and investment advisors who don’t want to be told what to do, who don’t want to be manipulated, and who don’t want anything to stand between them and doing what they believe is the best possible job for their clients.
When I retired from RBC in May of 2016, my plan was to build a portfolio of activities that would sustain me through the next chapter of my professional life. I joined the Board of the Columbia Threadneedle Funds as an independent Director. I became a Senior Advisor to Deloitte and Touche, LLP. I was slated to join a second corporate board in January.
In short, I achieved what I set out to do. But I wasn’t fulfilled.
To use a sports analogy, it turns out I missed being on the playing field. Serving on boards and in advisory roles is like sitting in a booth atop a football stadium with offensive and defensive coordinators, watching the game through a plate glass window and communicating with coaches and players through headsets.
I missed being close to the game. I missed wearing a jersey. I missed being part of a team.
That’s what I have again at Baird. I can’t wait to get down to the field again to help my new team win.
Our Modern Day March of Folly
When I published Stewardship: Lessons Learned from the Lost Culture of Wall Street (John Wiley & Sons) in 2012, I intended it to be a case study in what can happen when we lose touch with the core principle of stewardship. Stewardship is defined as “responsibly managing what others have entrusted to our care.”
Stewardship failure contributed to the near collapse of our financial system, the enormous loss of asset value and the ensuing Great Recession.
But the very same dynamic underlies and is contributing to other challenges facing society, such as:
· Climate-driven environmental changes (such as global warming);
· Growing levels of public sector indebtedness; and
· Income inequality.
These are all train wrecks in slow motion that have the potential to make the financial crisis of 2008-2009 look like child’s play. If the financial crisis was the Ghost of Christmas Past, these are the Ghosts of Christmases Present and Future.
The good news is that all these crises-in-the-making could be mitigated and possibly averted if we were collectively to act like responsible stewards and demonstrate more consistently the behaviors I describe in my book: purposefulness, humility, accountability, foresight, integrity.
The bad news is that we haven’t come anywhere close to behaving more responsibly in the years since Stewardship was published. In fact, we’re performing worse by almost all measures of Stewardship than we were in the years leading up to or during the financial crisis.
Hurricanes are flooding major cities and destroying entire islands, fires are burning down millions of acres in the state of California, yet the United States has withdrawn from the Paris accord and top elected officials are calling climate change a “hoax.”
Congress just passed a tax cut bill that will increase by $1.5 trillion dollars the public indebtedness of the United States, taking us far beyond the debt/GDP ratio where nations have historically spun into irreversible debt spirals – in which the cost of servicing the national debt leads ultimately to a decline in standards of living and social chaos (think Greece or Venezuela).
In the United States, income inequality has increased since drum-beating Occupy Wall Street rallies denounced “The 1%.” Our economic system – the most dynamic, efficient version of market capitalism in the world – is devolving beyond crony capitalism towards something that resembles outright oligarchy, where elected office is viewed as an opportunity for self-enrichment rather than public service.
Everywhere we look, near-term greed is trumping long-term stewardship. We are playing out the title of Barbara Tuchman’s classic, The March of Folly, in real time. And the ominous predictions of The Fourth Turning, (Steve Bannon’s favorite book, reportedly) today look prescient:
“A spark will ignite a new mood … it will catalyze a crisis [tearing] at the civic fabric at points of extreme vulnerability – problem areas where … America will have neglected, denied or delayed action. Anger at ‘mistakes we made’ will translate into calls for action, regardless of the heightened public risk.”
Stewardship failure is leadership failure. Somewhere over the course of the last half-century, we lost touch with and stopped valuing the notion that those who occupy a leadership position in society have an obligation to help improve society in ways that benefit everyone.
Stewardship begins with a shift from self to others. It begins with the realization that we have all been put on this earth for a reason – to leave the world a better place than we found it.
Stewardship is a choice for service as a moral activity.
And stewardship is the flip side of community. When we see ourselves not just as individual actors but as members of communities, we define our purpose not in terms of self-interest alone, but in terms of improving the well being of others.
Unfortunately, every day we seem to be moving further and further away from the Stewardship ideals on which our nation was founded and on which our collective future depends.