In recent years, performance of AllianceBernstein’s $500 billion asset management business lagged competitors.  This, in turn, has led to significant investor redemptions that continued even as performance improved last year. With fewer assets under management and continuing fierce competition for assets that put pressures on fees, the firm’s profits dropped by a little more than half.  An adjustment to the business model was clearly in order.

According to CEO Peter Kraus’s Wall Street Journal interview, the firm’s updated strategic vision intends to leverage “first-class global research” in new businesses. AllianceBernstein has already begun raising money to buy troubled bank assets within Treasury’s Public-Private Investment Partnership program. It also started a business that invests in distressed commercial real estate properties.

Of particular significance, the firm is also re-entering the capital-markets business – helping companies to raise money in the public markets – a business it had abandoned seven years ago.  A good example is their recent participation in the IPO for retailer Dollar General IPO largely owned by private equity firm Kohlberg Kravis Roberts & Co. AllianceBernstein was brought into the offering and shared a portion of the $8.5 million underwriting fee, re-establishing itself as a credible player in the IPO market and adding to the bottom line.

The connection between research and capital markets business on Wall Street is particularly noteworthy: publishing research reports establishes a relationship with a client that subsequently can be used to solicit capital markets business. For years the two went hand-in-hand. Then in 2003, following landmark corporate fraud and defaults, Federal regulators imposed an enforcement agreement on ten banks that were alleged to have pushed their research analysts to issue favorable reports on IPOs. AllianceBernsetein was not among the accused, and has marketed the benefits of independent research to clients ever since. However, faced with competitive and earnings pressures, AllianceBernsetein has apparently concluded that running a research business without capital markets business may not be sustainable.

Response to competitive and earnings pressures speaks volumes about a company’s financial and cultural DNA. Some firms respond to pressures by taking more risk, the extent of which is often misunderstood and mismanaged. Others embark on business model transformations that leverage their brand and core competencies to make the business model more robust and performance more sustainable and non-cyclical. At least in terms of intent, AllianceBernsetein seems to be on the right path.

More rigorous, more consistent, and internationally-coordinated regulation will certainly help.  But it will not address the fundamental behavioral dynamic at the core of the recent financial crisis. The fact is,  executives in financial services  are compensated based on ROE, P/E, and other such performance metrics – in absolute terms and relative to peers. Meanwhile, equity analysts and investors look for companies to deliver consistent and growing accounting earnings – irrespective of the prevailing economic and market environment. The net result? Vicious circles that lead to bad decisions and destroy value.

Suppose a publicly traded financial institution – having just witnessed the collapse of Lehman Brothers, Bear Stearns, and AIG stemming from excessive risk-taking – decides to pare down risk and grow less volatile businesses, like wealth management, advisory services, market making, or commercial banking. Meanwhile, its peers are back into the swing of things, loading their balance sheets up with risk in every way imaginable. How strong is the resolve of the firm’s executives to follow their vision before the competitive pressures to deliver short-term earnings force them into excessive risk taking? How long before boards of directors run out of patience and replace these executives?

As this moment, financial institutions are having a heyday. After years of margin pressures preceding the latest financial crisis, the underlying economics of financial businesses has dramatically improved during the crisis, with yield curves becoming steeper, bid/ask spreads widening, underwriting fees and sales commissions increasing, and so on. But déjà vu is just around the corner.  Soon enough, calming markets and competitive pressures of fully-commoditized financial businesses will compress margins and fees – if not to the 2006 levels, then close to it. As a result, many financial institutions will go straight back into risk taking, the extent of which will often be misunderstood and mismanaged. The same vicious circle that created today’s financial crisis  will be repeated.

If this grim prediction comes true, such future crisis – just like the most recent one – will not be a failure of risk management. It will also not be a failure of mathematical models, rogue rocket scientists, or normal distributions, as the Church of Black Swan would like you to believe. It will be a crisis caused by the continuing disconnect between strategic decisions and risk management. In other words, risk practitioners fully understand pros and cons of different risk management models – and what these models can and cannot do. The problems arise when senior financial decision-makers and institutional investors misunderstand or misuse those models as they try to keep up with competition or fight earnings pressures.

The regulatory reforms now being mooted can’t easily address these realities.  There are a million different ways in which financial institutions can take on risk. Moreover, given the continuing lack of risk-based transparency and departure from mark-to-market accounting, financial markets, investors, and regulators will remain blind to the true riskiness of the balance sheets of financial firms until too late.

The burden on developing a strategic vision for the organization – one that explicitly incorporates risk management and makes use of the lessons learned from this crisis – remains squarely on the shoulders of boards of directors and executives.  For them the key challenge is  to foster corporate cultures that give risk management an equal seat at the table where strategic decisions are made. Financial institutions – and many non-financial companies – must explicitly acknowledge that risk plays a central role in their business models. Risk is already the key determinant of their ROEs, P/E ratios, earnings volatility, and more broadly, their value creation or destruction over time. The ways in which decisions are made on the most senior levels of financial institutions – and the ways that these organizations are structured and managed – must change to reflect that reality.

Crafting a sound strategic vision for financial service firms will be exceptionally difficult. It will take genuine leadership and resolve. It will need broad systemic knowledge as well as collective openness to new ideas. It will demand a longer-term horizon that fights the focus on short-term accounting earnings. Last but not least, it will require dynamism in the broadest sense of the word. All of this is hard work. But as difficult as these endeavors may be, they are far less painful than the alternative – a Darwinian failure to evolve followed by financial ruin.

This article has originally appeared in Harvard Business Review online.

The announcement sure seems to describe something awfully similar to a static business model, where a typical response to recent losses or an unfavorable market outlook is to scale a business down or exit it altogether. Is there a better response, the one that does not mechanically exit businesses at the bottom only to lose market shares, reopen these same businesses at the top of a cycle, suffer losses, and exit them again? Is there no value in being in real estate and securitization and structured products businesses going forward?  Or in municipal bonds, proprietary trading and commodities businesses?  The answer to these questions is a resounding “no.” Is retrenching to highly commoditized “red oceans” of equity trading and underwriting, merger advice and foreign exchange trading a better strategic decision? Highly debatable.

Static business models have been at the core of many ills that got financial institutions in trouble in the first place.  Following losses, they exited businesses, exposing themselves to loss of market share and opportunity costs. When the perception of the environment turned favorable, abandoned businesses were re-entered and existing businesses were scaled up. Throughout, the risks underlying these businesses always remained the same. Importantly, this latter feature is responsible for yet another highly undesirable and dangerous properly of static business models: the fact that they tend to respond to earnings pressures and low return environments with blind leverage and excessive risk taking.  The ongoing financial crisis is, in many ways, a manifestation of static business models in action.

UBS’s response poses a sharp contrast to other financial institutions that seem to be transforming their business models in the spirit of Financial Darwinism.  The Blackstone Group, for example, has been using its natural expertise in analyzing and advising companies to shift focus from leveraged buyout to advisory businesses. Note that it is not exiting private equity business altogether; it’s just supplementing it with other sources of revenue in an area where its natural expertise and competitive advantages can be leveraged.  As a part if its adaptive evolution, Blackstone has already advised Procter & Gamble Co. on the $4.5 billion sale of its Folgers coffee unit to J.M. Smucker Co. and worked with Microsoft Corp. on its proposed takeover of Yahoo! Inc. 

In all, according to Bloomberg, Blackstone earned fees from clients on 18 deals worth $12.3 billion in recent months.  The group’s profit almost tripled to $61.1 million in the third quarter of 2008 compared with a year earlier.  “The problems at all the major banks and securities firms are causing widespread cutbacks, distraction and personnel defections,” one of the firm’s executives said.  “This turmoil at our major competitors is clearly benefiting our advisory business.”

No one claims that organizational change is easy, but firms like Blackstone have shown that the effort can mean not only survival but long-term prosperity. Such actions are clearly a superior alternative to typical knee-jerk behavior of institutions with “static” business models .

However, at this time of economic crisis, natural selection in financial institutions has not been entirely “natural” – and not solely from the viewpoint of government bailouts of failed institutions. More generally, governments around the world have assumed the role of “facilitating” evolution, interfering with the historical patterns of institution survival.  

Consider the diverging fortunes of two Cleveland banks, as described by David Enrich and Damian Paletta in a recent Wall Street Journal article, “Regulators Fell One Bank, Spare a Rival.” Last fall, National City Bank was forced to sell itself to PNC Financial Services Group, while AmTrust Financial Corp was allowed to survive.  Both were banks on the brink of failing due to real-estate loans made before the housing market crashed.  Both pleaded for a financial lifeline from the government.  But although National City appeared better suited for survival with a stronger balance sheet and better-known brand, it was AmTrust that was allowed to live on. In a seeming contradiction with the quote from an OTS official in the article – that suggested that as long as the banks have liquidity and the capital to work down the risk they have, the government should not have a hand in shutting them down – the government allowed a seemingly weaker bank to survive. Was that a case of picking winners and losers? 

We certainly hope not, and the WSJ article provides a supporting hint: apparently during negotiations with the regulators, AmTrust executives articulated a vision for the bank. Nat City executives did not – which apparently was enough to spell the end of a 164-year old franchise. After being handed the gift of survival, AmTrust still had to raise capital through such actions as the sale of some of its branches, and its 2009 first quarter results that were mixed at best. But, unlike Nat City, it will live to fight another day.

Financial Darwinism argues that it is critical for executives to craft a clear strategic vision that integrates business decisions with risk-taking – in pursuit of business survival, economic performance, and growth. Therefore, it would not come as a surprise that in the aftermath of dramatic events of the past two years, financial executives and their advisors are spending an enormous amounts of time, trying to figure out if their organizations have the requisite “selfish genes,” and if they don’t, what kind of financial “gene therapy” may be in order.

We hope that the time when the governments’ interpretation of a firm’s strategic vision determines its survival shall pass. This would allow financial institutions to focus their attention where it belongs: redesigning their business models, revamping their risk management functions, and positioning themselves for benefiting all stakeholders through real value creation – in the new world order.

John M. Patti contributed to this article.

Responding to earnings pressures with risk and leverage.

In a globalized world, basic financial services have become increasingly commoditized, with their margins and fees declining. At least it has been the case for decades prior to the current financial crisis. Thus, the earnings of large and stable insurance companies have declined precipitously.  Embarking on business model transformations while controlling risks – a response advocated by Financial Darwinism – may have been the right remedy, but it required leadership, vision, right people, and risk management discipline, certainly not an easy feat. It appears that AIG followed a different path, taking on huge contingent liabilities via structured products and credit default swaps. A $60 billion loss in one quarter speaks for itself.

The inadequacy of inconsistent, charter-based regulation.

According to Bernanke, “There was no regulatory oversight because there was a gap in the system.” AIG’s insurance unit was subject to stringent state regulation but the riskiness of other units fell through the cracks. Overall, obviously, the entire firm’s capital and oversight were not congruent with its inherent risks. Going forward, risk-focused regulation, where capital and other regulatory characteristics are commensurate with the nature and magnitude of risks of a company – not its charter! – is desperately needed. The danger is, of course, that over-regulation that leads to narrow-line financial institutions would be enacted instead.

Lack of transparency

In what has become a motif across our publications, the risks that AIG was taking were not visible to outside observers. In fact, its standard financial disclosures and accounting earnings were not capable of properly describing its exposures, with the subsequent losses genuinely surprising stakeholders, regulators, and – what appears to be the case – its executives and the board of directors. The insurance unit may have been large and stable, but the Financial Products unit apparently was not.

* * *

A basic tenant of Financial Darwinism is that risked-based transparency in the financial system is needed both for the purposes of regulation as well as to inform the stakeholders about business models and risks of financial firms. Risk-based transparency involves direct, clear, and comprehensive descriptions of their sources of economic revenues, risk exposures, and the mechanisms by which they generate economic value.  Had AIG conformed to these requirements the investing world would have realized just how exposed it was to almost unfathomable risks.  Such disclosures would have forced the company executives to formulate a clear understanding and explanation of why these exposures were desirable and prudent, potentially resulting in a better strategic direction for the company.

The view on AIG as a “hedge fund” is bound to fuel additional arguments for the need to constrain the activities of “too-big-to-fail” financial firms. While we continue to argue for a balance between risk-based regulation and risk-based transparency, all signs point to overregulation as a more likely scenario. Unfortunately, stifled financial innovation and risk-taking that is delegated to smaller financial institutions are likely to follow, negatively impacting real economies and capital markets for years, if not decades, to come.

As part of the ongoing bailout of Citigroup, it was recently announced that the government’s investment of about $25 billion in preferred stock would be converted to common shares, increasing the government’s ownership from 8 percent to about 36 percent. This move was designed to remove a large amount of expensive preferred stock from Citigroup’s balance sheet, shoring up the firm’s tangible common equity and hopefully calming down the continually deteriorating financial markets. As a result, the government became by far the largest shareholder of Citigroup stock, while stopping short of a full-blown “nationalization,” according to a popular view. Are we on a path to a nationalized the banking sector?

It is not a semantic technicality to say that the answer depends on the definition of “nationalization.”  The term typically stands for an action by the government where assets, companies, or entire industries are taken into public ownership. In the process, stakeholders are typically wiped out, and the government assumes all of the attendant risks and debts.

Nationalization has historically been a feature of socialist countries where the government wanted to control economies, reallocate resources, redistribute wealth or income, or to pursue certain public policies. An important feature of the nationalization is that the government intends to run companies for long periods of time, if not indefinitely. In this sense, it can be argued that happened to Fannie Mae and Freddie Mack was true nationalization. In this regard, the resignation of Freddie Mac’s CEO, David Moffett, after just six months on the job is noteworthy. “The resignation resulted partly from Mr. Moffett’s frustration over the need to consult with regulators on all major decisions and follow public-policy mandates that he didn’t necessarily see as food for the company,” according to the WSJ.

U.S. Stance So Far

In the case of U.S. banks, according to Government and Fed officials say, it is not their intention to take over these institutions and run them indefinitely, under the belief that the government can do a better job than the private sector or that such actions are needed for public policy purposes.  On the contrary, they have repeatedly affirmed their belief that properly incentivized and accountable bankers are better able to manage banks than government officials.  Therefore, too-bid-to-fail banks are likely to be taken over by the government only to prevent a Lehman Brothers’-style spillover into capital markets and real economies. Such nationalization, therefore, would be more akin to a government-led orderly liquidation. The only caveat here is a scenario where the government fails to find buyers for various parts of an institution, as it appears to be the case with AIG. In this case, the government may end up owning and running a company for a long time – a strange hybrid of nationalization and orderly liquidation, as “buy-and-hold strategy” of sorts, as aptly summarized by a WSJ headline.

The Goal: Preserve Economic Dynamism

There are benefits, uncertainties, and dilemmas related to such interventions as we have recently observed. Among the reasonable and perhaps desirable aspects is the government’s say in dividend policy, executive compensation, and accountability – the government is an important stakeholder (think of a board member) after all. The danger arises when the government gets involved in strategic decisions of financial institutions, for instance, by dictating that economic rationale should be sacrificed for the sake of public policy objectives.

The discussion on bank nationalization is part of a wide-ranging debate on the future of capitalism. Arguably, improperly incentivized and inadequately regulated animal spirits of “unfettered capitalism” must be addressed while maintaining vigilance against protectionism and overregulation. Even though, as observed by Nobel Laureate Edmund Phelps in his Foreword to Financial Darwinism, “capitalism has been disgraced in the area of its greatest competence – the knack for profitable innovation,” it remains the premier economic system whose advantages need to be continually preserved and enhanced. True nationalization impairs economic dynamism – the ability of a capitalism system to discover, finance, and bring to market viable commercial innovations. From this viewpoint, nationalization of financial institutions should be resisted at all costs.

Aren’t there interesting parallels here with the lethal impact of Golden West on Wachovia?

One of the mission-critical objectives of this program should be the  re-establishment of a market for structured products. Currently these complex instruments are barely traded and are quoted at fire sale prices. It is the absence of a liquid market that both fuels concerns of a continuing asset price deterioration and  prevents banks from leveraging the government-provided capital, defeating the whole purpose of the bailout.

Of course, significant uncertainties related to pricing of these assets remain. While an argument can be made that “intrinsic” prices for these securities (based on conservative assumptions about consumer defaults and other macroeconomic factors) are above the quoted fire sale prices, it is unclear where the banks are currently marking these assets .
Given this uncertainty, one answer that seems persuasive is that fiduciaries (such as professional money managers or analysts) should help the government determine the asset prices, and then the government should buy the assets and hold them until maturity or dispose of them when the market environment improves. The taxpayers would have an opportunity to benefit from any price recovery, and over time the entity that holds them may turn out to be a worthwhile investment. As an added benefit, the government’s mere willingness to buy distressed assets at “intrinsic” values may encourage other investors to enter the market as well, becoming a self-fulfilling prophesy.

This does not, however, seem to be the path under consideration. Instead, the establishment of the public-private investment fund may potentially create a monopoly that both prices assets and invests in them – with lots of room for errors with highly adverse consequences. The stakes are extremely high: a suboptimal implementation of the Financial Stability Plan may potentially hamper bank capital further and expose tax payers to undue risk and a limited upside.  To make it work for all parties, the devil – as always – will be in the details.