Business school graduates preparing to take their place in the working world should rely on critical thinking, integrity and their strength of character to shape their business success. These attributes will always be more important than blind faith in financial models, according to former chair of the Commonwealth Bank and chair of the Future Fund Board of Guardians, <i>David Murray,</i> OA.
Murray was addressing the UTS Business graduation ceremony on 12 May. He took the opportunity to consider what failures in business leadership contributed to the devastating financial crisis, the ramifications of which are still spreading across the globe.
According to Murray, current business education is still influenced by the pre-financial crisis environment. Post-crisis thinking is yet to fully emerge. A business degree awarded today has been earned in a world which had come to revere the power of mathematical modelling, and hold firmly the belief that any risk can be quantified and traded – even when market signals inferred an extreme risk.
True leaders need more than the ability to model outcomes – they need thinking skills, judgement, and a moral code that relies on more than ego or popularity. Business graduates must ask themselves: Have we learned how to think, or have we learned how to model?
Murray used three examples of failures in leadership thinking that, in his mind, contributed to the financial crisis.
#1: Government bonds are not risk-free
Government bonds are not risk-free. Governments can go bankrupt, default and find themselves unable to pay. Even governments underwritten by the power of the robust and wealthy European Union. Just ask the holders of Greek bonds. Yet a key assumption behind the capital asset pricing model (CAPM), the mathematical model that underpins the valuation of assets today based on future cash returns and which determines the rate at which cash flows are discounted is that government bonds are risk-free.
We hold this belief in risk-free government bonds because sovereign governments have the power to raise revenue and/or reduce expenditure if faced by the prospect of default on their bonds. Even if they refuse to act, there has been a belief that another government will bail them out, and because they will need future funding, they will see the error of their ways and fall into line. In human terms, people forget that those who lend their savings to others are entitled to be repaid.
The implications of this misplaced assumption are considerable. If you do your maths based on an incorrect set of figures, the outcomes will be unreliable. If you calculate investment risk, based on an arguably false sense of security that the CAPM model offers, then you will not have an accurate picture of the risk you are taking.
#2: Rating is not an exact science
When a ratings agency rates a bond or mortgage as triple A, the model assumes a probability of default of 4 in 10,000. That figure gets input to the computer program, on the assumption that the rating is an exact science. If a subsequent rating is lower, many large institutional investors in the world are forced to sell the lower-rated assets because their portfolio model requires that they only invest in triple A rated assets. This can set in motion a downward spiral in prices.
#3: Loss + declining ratings + mathematical models + leveraging = dangerous spiral
Banks incur a probability of loss on loans from the day they fund them. Yet, the ‘mark to market’ model which underpins accounting standards, does not allow banks to build reserves in good times for future losses. Thus the huge losses brought to account during the crisis had the affect of exacerbating it. Even worse, the declining market prices reflected a market momentum driven by the ratings, the mathematical models and super leverage – a dangerous spiral.
How could our financial leaders (public and private) allow spirals to develop with such serious cosequences both now and for many years to come?
Outcomes flow from inputs and systems. Without examining the nature of systems, it is impossible to assess likely outcomes. This requires critical thinking because every system is governed by people who need and respond to leadership, symbols and signals – all of which will affect the systems.
Leadership requires the exercise of judgement, and this relies on the values and beliefs of leaders.
Successive Greek generations have come to believe that tax avoidance and government indebtedness are okay. Greek leaders thought it was acceptable to lie to the rest of the world about their fiscal position – and they weren’t telling small lies. The outcome is that people have been killed in riots in Greece, as the size of the adjustment is so large and people try to get to grips with what it will mean in terms of their personal financial security.
In Britain’s case, a hung parliament coming after an enormous budget deficit means that firm fiscal action will probably be deferred, and an early next election may still not produce a clear mandate and decisive action. This is not about credit default swap prices, it is about people, their political systems, beliefs and behaviours.
How then do our graduates of today – the leaders of tomorrow – think about their role in the future?
In Australia, 16% of school leavers earn a university degree and only 4% a postgraduate degree. Because leaders need thinking skills to operate at higher levels of complexity of work, we should assume most will come from the graduate cohort.
Imagine our future if our leaders think everything can be modelled, and that the models are flawless.
No doubt, every graduate is thinking about promotion. At UTS, history tells us that business graduates acquire substantial skills and are more likely, on average, to get good work and get on the experience curve. But this leaves the exercise of judgement which requires exposure to critical thinking and an understanding of people and human systems.
Pre- financial crisis, two large systemically important banks in the United States had the same strong credit rating. They were both SEC- (US Securities and Exchange Commission) and Sarbanes–Oxley-compliant. They both complied with the Fed’s supervisory requirements and were capital adequate. Their PE ratios were similar.
Why is it that one virtually failed and the other did not? Clearly the leadership of one bank made some superior judgements about what they would and would not do. Not only that, the people in this bank trusted their leaders and had confidence in their judgement. This culture of trust and confidence turned out to be more important than all the regulation.
Leaders require an additional dimension – a moral code and strength of character which is not based on neediness, ego or popularity. There is no textbook on this but there is one good way to get on the path to good leadership.
Remember that ultimately, reputation is all you have. It can only be nurtured and be preserved by integrity of behaviour.