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Clearing the Bull: The Financial Crisis and Why Banks Need a Human Transformation

Clearing the Bull: The Financial Crisis and Why Banks Need a Human Transformation

by Jonathan Ledwidge


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The financial crisis shows that the banking industry requires a transformation, as its business model and practices are no longer sustainable. Even so, such transformation cannot be made without Clearing the Bull-moving beyond old and tired orthodoxies in order to properly diagnose the problem.

Drawing on more than twenty years of experience in banking, author Jonathan Ledwidge shows how the financial crisis exposed the industry's poor system of values, leaving it mired in conflict with its human environment. Specifically, this includes how poor leadership, virtually unmanageable organizations, dysfunctional suppliers, infuriated customers, alienated employees, and dissatisfied communities all arise from the inability of banks to understand that values are more important than valuations.

As a result there is now a total disconnect between banks and their human environment. That disconnect cannot be fully addressed by conventional solutions involving more regulations, more governance, and more controls. Banks have a very human problem, and thus by definition what they require is a human transformation.

Clearing the Bull provides both a clear diagnosis as well as a detailed and comprehensive roadmap for the banking industry's human transformation-and while doing so it remains totally engaging and accessible to bankers and non-bankers alike.

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Product Details

ISBN-13: 9781469700717
Publisher: iUniverse, Incorporated
Publication date: 02/10/2012
Pages: 340
Product dimensions: 6.00(w) x 9.00(h) x 0.76(d)

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The Financial Crisis and Why Banks Need a Human Transformation
By Jonathan Ledwidge

iUniverse, Inc.

Copyright © 2012 Jonathan Ledwidge
All right reserved.

ISBN: 978-1-4697-0071-7

Chapter One

Have We Been Here Before?

There is nothing new under the sun, and that includes a financial crisis. One could perhaps rephrase that by saying, "Most of all a financial crisis."

In order to better understand what happened during the subprime crisis that erupted in 2007, we need to take a walk down memory lane to see what exactly took place in the world of banking over the past four decades and some of the factors, motives, and thinking behind what transpired. History always provides a context and an understanding that enables us to better comprehend the events of today.

I deliberately chose this period because I am of an age where much of what happened during that time is within either my professional or personal experience/consciousness. We can safely assume that this is also true for the CEOs and senior executives of the banks that collapsed and faltered during the crisis.

The question is this: What might they have learned from this past? Is any of it relevant? How could it have informed their decision-making during the subprime crisis?

Let's see what we can find out.

Late 1970s and Early 1980s: Perverse Incentives and the LDC Debt Crisis

If you work in financial services for long enough, you will hear some very interesting stories, and I have heard quite a few. One of these stories, told to me by a friend who has spent even more time in the industry than I have, provides an interesting context for understanding the events that took place in the financial markets over the past few years.

My friend told me that, during the 1970s and early 1980s, the British bank he worked for was receiving very large amounts of petrodollars from oil- producing states—a not uncommon feature of the time. Now, if you are a bank and you are getting a lot of deposits on which you have to pay interest, then in order to make a profit, you have to take those deposits and turn them into loans at a higher rate. The "net interest margin"—the difference between the lending and the borrowing rates—is something that concerns all bankers; if they get it wrong then their business will be in trouble.

When the petrodollars started to flow, the sheer volume of deposits that the banks were receiving made it extremely difficult for them to find customers quickly enough to send the money back out the door and earn their net interest margin.

Rather than refusing deposits or taking drastic alternative steps (some suggested negative interest rates on deposits), the bank gave my friend and his colleagues in the loan department substantial rewards and incentives to make as many loans as possible. Further, in executing this diktat they were given license to completely disregard the concerns of the credit department—in other words, the people responsible for ensuring that loans were only made to creditworthy borrowers.

As it so happens, the biggest takers of these loans were the lesser developed countries (LDCs), and it came as no surprise that my friend and his colleagues in the loan department shoveled as many loans out the door as they possibly could to whichever country needed wanted them—making a lot of money for themselves in the process.

The real problem with this story is that it was not unique to any single bank; these actions were recklessly replicated throughout the banking industry. There is very little doubt that this course of action was, in many ways, fuelled by what became the accepted logic of the day. As expressed by the then CEO of Citibank, Walter Wriston, this logic holds that "countries don't go bust"—it is the diabolical equivalent of today's "too big to fail."

Of course, history records that countries did go bust, and they did so in spectacular fashion. In what became known as the LDC debt crisis, countries in Latin America, Asia, and Africa took on far more debt than their economies could handle.

Eventually, almost all of these countries had to have their borrowings restructured and many, most notably those in sub-Saharan Africa, are still struggling with this debt some several decades later—all because of the perverse incentives given to a handful of bankers.

Naturally, the banks did not get off lightly, either. Many suffered huge losses, and Citibank was one institution that almost folded as a result.

Mid-1980s: The Artificially Inflated Market in Junk Bonds

This was an era best summed up by Gordon Gekko's famous line in the movie Wall Street (1987): "Greed is good."

In the early 1980s junk bonds was the name given to sub-investment grade debt securities issued by corporates. In many instances these securities had initially been issued as investment grade by creditworthy organizations, but subsequently declined to junk when the fortunes of the organization deteriorated. Thus junk bonds were also known as "fallen angels."

In many respects, junk bonds were the corporate equivalent of subprime lending to individuals.

Investors who bought such bonds expected to receive a high rate of return on their investment in order to compensate them for the risk they were taking. In the beginning junk bonds only represented a small proportion of the market.

If the indebted organization managed to restructure its finances and/or operations, its debt would return to being investment grade. Those who had invested in these bonds would be handsomely rewarded. They could either sell the debt, since it was now worth more than the discounted price at which they had bought it, or continue to earn a higher yield on a bond which was no longer risky.

Michael Milken of the investment bank Drexel Burnham Lambert realized that junk bonds, while providing a higher yield, did not, in the longer term, represent significantly more risk than their higher grade investment counterparts. So he came up with what he thought was a marvelous idea. Rather than waiting for bonds to fall in quality and become junk, why not persuade companies to issue junk bonds simply by taking on levels of debt much larger than would normally seem prudent?

Thus, it came to pass that junk bonds became the currency with which small companies or even small groups of investors could borrow enough money to take over their much larger counterparts. It was as if the financial world had been turned upside down.

Milken and his colleagues at Drexel led the way in flooding the market and, thus, artificially inflating and literally "supersizing" what had hitherto been a small and relatively quiet section of the market. That market reached stratospheric levels, and soon, others jumped in to get their piece of the action. Investment banks, investors, and the senior management of the target companies (who had to sign off on the deals) all made a lot of money. Drexel in particular made billions, and Milken was said to have made over US$1 billion in a three-year period.

At the peak of the feeding frenzy, the buyout firm KKR used junk bonds to purchase RJR Nabisco for US$26 billion. The CEO of RJR, Ross Johnson, walked away with US$53 million, a fact that exemplifies a particular feature of buyouts with junk bonds. The boards of the takeover companies had every incentive to agree to the deal, given the sweeteners (you might call them perverse incentives) that were on offer. Further, as an inflated junk bond market induced inflated share prices, shareholders of target companies were also motivated to sell.

Then there were the arbitrageurs, led by the flamboyant Ivan Boesky. Arbitrageurs were supposedly able to predict which company was next in line for takeover, amass a position in its shares, and then profit from any increase in the share price once the impending takeover was confirmed.

There are no prizes for guessing what happened next.

The problem with financial markets is that they are a very strange beast. They will appear to be moving along with not a care in the whole world, and then the very next second they can collapse and fall off a cliff. Unfortunately, the junk bond market followed that script to perfection, and shortly after KKR's bold buyout of RJR Nabisco, the junk bond markets ceased to defy gravity, and Milken and Boesky, among others, were arrested and charged with insider trading. Drexel collapsed and was no more.

Many companies that had been purchased using junk bonds struggled under the crippling levels of interest brought about by their increased debt burden. Some companies had to be restructured, some broken up, and others simply liquidated. Thousands of people lost their jobs and the string of failures devastated America's corporate landscape.

The junk bond crisis was made possible because of perverse incentives, which acted to create an overinflated bubble in a market that could not be sustained.

Herd Mentality of the 1980s and 1990s: The Japanese Bubble Economy

Nothing so epitomizes an overpriced market as the herd mentality that drives it. The first recorded speculative bubble in the modern era was the early seventeenth-century tulip mania in Holland, where the price of a single bulb would sell for several multiples of an average person's annual wages. People piled in with their entire life's savings, only to see it suddenly evaporate when the bottom fell out of the markets.

After three hundred years, apparently not much has changed.

In the late 1980s, Japanese stocks were all the rage, and the Nikkei index reached almost incomprehensible levels. The theory was that Japan was on its way to global domination and, therefore, Japanese equities were going to be on a constant upward trend. Based on this apparently indisputable fact, one had to either invest directly in Japanese stocks or do so in a more cost- efficient manner by buying options (derivatives) on those stocks. Further, you had to do it as soon as was humanly possible, or you would miss out on the opportunity of a lifetime.

In addition to buying Japanese equities, the accepted norm was that one should learn the Japanese language and culture. The assumption was that, since Japan was going to dominate the world, one's future success in virtually any endeavor would be very dependent on having these skills. At every conference or forum I attended during that time, I could be sure that at least one speaker would echo this sentiment and others, including such things as instructions on how to bow at the correct angle.

In those days, I was working in the internal audit department of Continental Bank in London, and I remember asking someone in the finance department, the person specifically responsible for valuing the bank's Japanese equity options portfolio, why that market was so high. I was particular curious to get an answer because at that time the price of Japanese stocks as compared to a year's corporate earnings, known as the P/E ratio (essentially the number of years of earnings priced into the value of a stock) was much higher than it was for western companies.

His response was basically that it was the market, and that the market was always right and thus whatever value the market assigned to a product it should always be considered correct.

I was puzzled. It seemed strange that the P/E ratio of Japanese companies was over 100 —in other words, it would take a hundred years of earnings to recover the purchase price of a share, while those of western companies were showing a P/E ratio of around 20.

Later, when I visited the Continental branch in Tokyo, I found out that the Japanese also had hundred-year mortgages. Come to think of it, it made total sense that corporate P/E ratios of 100 were matched by hundred-year mortgages (of course I am being sarcastic). Yet, this is what happens in over- inflated markets—everything becomes overpriced and affordability goes out the window.

The paper profits on Japanese shares were being used to buy property. That property could then be used as collateral to undertake even more borrowing, and that borrowing would make its way back into the stock market, and so the merry-go-round went on. It was said that, at the peak of the bubble economy, the value of land in Tokyo alone was worth more than the entire value of land in United States.

In late 1989, the Nikkei peaked at around 40,000 and then dropped—precipitously. It never recovered, and these days it can be found hovering below the 10,000 mark. There is no underestimating the severity of the pain that this financial meltdown has caused the Japanese economy. Property prices collapsed, and so too did Japanese banks, which eventually had to be bailed out by the government or merged with other banks.

The Japanese economy remained mired in recession and the 1990s became known as the Lost Decade.

As a final word of caution, I would say that those who believe in the inexorable rise of China should take note—now it is being claimed that the total value of land in Beijing is worth more than the Gross Domestic Product (GDP) of the United States.

'Nuff said.

Late 1990s to Early 2000s: From Dot-coms to Dot-bombs

One could be forgiven for thinking that, given the collapse of the Nikkei in the early 1990s, investors worldwide would take some time, or at least pause for breath, before plunging into another overpriced stock market. You would have thought that, at the very least, they would wait another couple of generations before being suckered into staggeringly overpriced stocks.

Hell no.

As a general rule, it seems that, every time a market becomes overinflated, bankers and investors develop new theories and invoke new paradigms explaining why this time it is or has to be different—why, this time, gravity will be defied and why we should unlearn everything we have ever learned so that we can enter this particular new paradise.

In the dot-com era, the new paradigm read as follows: Current sales levels are of little or no consequence; no earnings, no profits, no problem—don't worry; they will come in time. In fact, all you need is a business prospectus stating that you have a dot-com address and that you are going to use it to generate (or to use an even better term, aggregate) very large and unheard of economies of scale in cyberspace.

As wonderful as all of this sounded to those who were ready to defy gravity, it could only drive the markets so far and so fast. In order to turn a herd into a bunch of rampaging bulls one needed to invoke the concept of time and what I call the "immediacy imperative"—do it now or forever live with the pain and regret of your unfortunate inaction.

At some time in the ordinary course of our lives, we have all been subject to sales tactics and inducements of one form or another, telling us to do something now or we will lose out. The most interesting of such pitches tell us that, if we spend some money now, we will actually be saving money, even if we're spending on an item we never needed in the first place.

The immediacy imperative causes us to lose both the context and concept of what is truly valuable, and this is precisely what happened with the "dot- coms." The argument was that, because Internet time was literally not of this world (it's cyberspace, remember), every day that one delayed the launching of an investment in an Internet-related business would be critical to one's future existence.

People fell for it, and as the bubble grew, so too did the number of overnight millionaires. At one time, Yahoo had a P/E ratio of 571. Japan, eat your heart out!

Then shock, horror! Paradise was lost. Dot-com shares crashed to earth. Investors suffered huge losses, and so too did some of the banks who underwrote the many public offerings of the fledgling Internet and technology companies. And the name dot-bomb was born.

The tragedy of the aftermath was described by Investopedia as follows: "Many argue that the dotcom boom and bust was a case of too much too fast. Companies that couldn't decide on their corporate creed were given millions of dollars and told to grow to Microsoft size by tomorrow."

Alas! Another strategy for turning base metals into gold had been proven a mere fantasy.

Blinded by Science and the Nobelity

If all else fails, blind them with science!

For bankers, economics and economic models are a weapon of choice. Unfortunately for bankers, economics is, at best, an imprecise science, and its application played a very important role in the failures we have looked at so far.


Excerpted from CLEARING THE BULL by Jonathan Ledwidge Copyright © 2012 by Jonathan Ledwidge. Excerpted by permission of iUniverse, Inc.. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

Table of Contents


Introduction: Ready or Not, Change Comes for Us All....................1
A Few Helpful Definitions....................7
1. Have We Been Here Before?....................14
2. Déjà Vu All Over Again....................26
3. Exposing the First Fallacy....................36
4. Trapped in the Confines of a Belief System....................44
5. A Fiendish Orthodoxy....................46
6. Regulators Getting Jiggy with It....................54
7. Central Bankers and Governments Add Fuel to the Fire....................64
8. What We Have Learned Thus Far....................78
9. The Impact of Structural Issues Within the Industry....................82
10. To Really Screw Things up, You Need a Computer....................84
11. The Challenges of Product Complexity....................89
12. The Organizational Labyrinth....................96
13. The Interconnectedness of Banks and the Globalization of Liquidity....................100
14. What Have We Learned So Far?....................104
15. The Behavioral Aspects of the Crisis....................108
16. A Few Bad Men and the Banks They Got into Trouble....................125
17. Is It More Than Just Egotistic Men And Bad Logistics?....................141
18. Time for Some New Thinking....................146
19. The Importance of Values in Sustaining Organizations....................148
20. Determining Intrinsic Values....................154
21. Extrinsic Values and the Human Imperative....................161
22. Gratuitous Self-Indulgence....................172
23. The Overdependence on Financial Analysis and Assessment....................178
24. How Should We Move On from Here?....................182
25. Gauging the Response of Governments, Regulators and Banks....................188
26. Limitations of the Government and Regulatory Response....................189
27. Response by the Banks: Crisis? We Had A Crisis?....................200
28. The Answer to the Failings of the Past in a Single Word: Enough....................213
29. A Gazpacho Moment....................218
30. A Model for Transformation....................222
31. How Poor Human Assets, Mission, and Values Wrecked the Banking Industry....................234
32. Mission and Values with Real Meaning and Purpose....................240
33. Leadership and Management: Totally Live the Mission and Values....................246
34. The Individual Employee: Make Them Proud!....................254
35. Employees: Make Them All Jedi and Expand Their Universe....................262
36. Organization: Simplify, Standardize and Make Transparent....................264
37. External Knowledge and Environment: Breaking Out of the Fiendish Orthodoxy....................266
38. Customers: Make a Commitment and Keep it....................270
39. Suppliers: Have Them Embrace Your Mission and Values....................275
40. The Community: Listen! Make the Transformation!....................277
41. The Human Asset Bank....................282
42. Banks Have a Clear and Present Choice....................285
43. The Era of Realinvestment....................287
44. Governments and Regulators Must Put Their House in Order....................289
45. Debt and Democracy....................291

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