Banks brought down by new Peter Principle

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It is particularly easy for those who work in financial institutions to make the mistake of believing that their success is the result of exceptional skill rather than good fortune. Until vanity is vanquished, I anticipate that diversification to the level of incompetence will continue to be a powerful element in business behaviour.

Forty years ago, Dr Lawrence Peter enunciated what he immodestly called the Peter Principle. Individuals would find their level of incompetence. If you were good at doing a job, you would be promoted until you were appointed to a job you weren’t good at.

The recent failures of financial institutions suggests an organisational analogue. Financial institutions diversify into their level of incompetence. They extend their scope into activities they understand less until they are tripped up by one they cannot do. It was almost refreshing when the Chelsea Building Society announced large losses because it had been a victim of mortgage fraud. The bank’s problems related to its core business. Most financial institutions that have come close to failure have done so as a result of losses in essentially peripheral activities.

The principle of diversification into incompetence applies from the largest financial institution to the smallest. AIG was America’s leading insurance company. The company did not just undertake credit insurance, but was the largest trader in the credit default swap market. That is how its financial products group, employing 120 people in London, brought about the collapse of a business that employed 120,000.

The very name of the Dunfermline Building Society evokes prudence, its base the home town of that canniest of Scotsmen, Andrew Carnegie. For more than a century, the society collected savings to lend to careful homebuyers. What were they thinking of when they decided that 2007 was the perfect moment for aggressive development of their commercial lending portfolio?

Hypo Real Estate was Germany’s largest property lender: it is hard to think of a duller but more profitable dominant position. So the bank bought a business that specialised in raising funds on wholesale money markets to lend to public authorities. No doubt its advisers offered an explanation of how you can make lots of money doing that. But whatever the explanation was, it was wrong, and led to Europe’s most costly bank bail-out.

The boredom factor is important. Much of traditional banking is quite boring. The desire to find new challenges is an admirable human trait. It is, however, very expensive for shareholders to allow their chief executives to indulge it.

Public sector bodies are usually constrained in their activities, so deregulation is often a trigger for expensive experimentation. In Britain, many of the efficiency gains from privatisation were squandered in diversification: I watched senior managers spending 80 per cent of their time on activities that generated 1 per cent of turnover and minus 10 per cent of profit. But it is more fun to go on jollies to Buenos Aires than to fix leaking pipes.

To win an auction when you don’t know what you are bidding for is often to lose. This winner’s curse is often behind bad acquisitions because the successful purchaser is the bidder most willing to pay too much. Hence the contest between Royal Bank of Scotland and Barclays as to which bank would court bankruptcy by buying ABN Amro. Ignorance of products may also be a problem. When you are the newcomer and know little, the business that gravitates to you will be the business no one else wants.

But the driving factor is hubris. Jim Collins’s well-timed study of How the Mighty Fall applies to every business I have mentioned. The financial services industry is particularly vulnerable to hubris because sections of it are not very competitive, and randomness plays a large role in the outcome of speculative transactions. It is therefore particularly easy for those who work in financial institutions to make the mistake of believing that their success is the result of exceptional skill rather than good fortune. What more natural to believe than that extraordinary talent will find pots of gold under other rainbows? Until vanity is vanquished, I anticipate that diversification to the level of incompetence will continue to be a powerful element in business behaviour.

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