Banks, regulation and hindsight

Last evening, once again the BBC reported Gordon Brown telling us that the banks need better regulation:

"Gordon Brown has reiterated his call for a clean-up of the financial system to ensure what he called "banking responsibility" in the UK and abroad."

Yet of course he was the artchitect of the regulation scheme that has been in place in the UK since 1997.

Government ministers have objected to those that point this out that "well, neither you nor anyone else saw the problems coming" as if it would have been impossible for anyone to foretell of the banks failures. It's as though the banks were unquestionable rock solid institutions until the shock of Northern Rock in 2007. But this simply is not true.

I've been reading an excellent book that collates the opinions of Warren Buffett taken from the annual reports of his company, Berkshire Hathaway Inc. Buffett is, as you will know, an American investor, businessman and philanthropist. His investment activities have made him the world's richest man. Yet he's achieved that mostly without borrowing to invest and by avoiding what he perceived to be high-risk enterprises. And one area of business that he has generally avoided has been banks.

His annual reports offer a tutorial in both investment and business. While he is not going to tell you which business he intends buying next, he's quite open about his methods, philosophy and understanding of the ways of the business world.

And here are two quotes from his annual reports that struck me as especially interesting.

Firstly, on why business managers frequently do not take decisions on rational grounds:

My most surprising discovery: the overwhelming importance in business of an unseen force that we might call "the institutional imperative". In business school, I was given no hint of the imperative's existence and I did not intuitively understand it when I entered the business world. I thought then that decent, intelligent and experienced managers would automatically make rational decisions. But I learned over time that isn't so. Instead, rationality frequently wilts when the institutional imperative comes into play.

For example: (1) As if governed by Newton's First Law of Motion, an institution will resist any change in its current direction; (2) Just as work expands to fill available time, corporate projects or acquisitions will materialise to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) The behaviour of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever will be mindlessly imitated.

Institutional dynamics, not venality or stupidity, set businesses on these courses...

So here, Buffett has recognised that business leaders don't always decide issues on rational grounds - they allow themselves to be driven by other forces. And we know that -we've all been witness to some pretty bizarre decisions and many of us have made a few ourselves. But for most of us, the resulting cost affects us, our colleagues and families - not the whole of the world's economy. Mistakes in banks have the potential to do more harm. And so what they do needs watching.

But surely banks have always been considered low-risk investments? Bufett's partner this time:

The banking business is no favourite of ours. When assets are twenty times equity - a common ratio in this industry - mistakes that involve only a small portion of assets can destroy a major part of equity. And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failing that we described [above] when discussing the "institutional imperative": the tendency of executives to mindlessly imitate the behaviour of their peers, no matter how foolish it may be to do so. In their lending, many bankers played follow-the-leader with lemming-like zeal; now they are experiencing a lemming-like fate.

Now the two quotes here are not recent - the first dates from 1989, the second - which was written by Buffett's partner Charles Munger - from 1990. So risks recognised by Buffett and Munger twenty years ago were apparently ignored by the UK government and its regulator the FSA.

Lloyds Banking Group was formed by the merger of Lloyds TSB and HBOS with the active encouragement of Gordon Brown. I have just received the half-yearly report on the M&G Recovery Fund where I read this:

In terms of disposals, we sold the portfolio's holding in Lloyds TSB because of our loss of faith in the company's management team following the merger proposal with HBOS...

Subsequent events have demostrated the wisdom of that sale and the folly of the merger. Things can only get better?

The passages quoted above come from "The Essays of Warren Buffett' by Lawrence A Cunningham - available from Amazon. The latest Berkshire Hathaway annual report is available from their website.