Complete Blog 2 - Fred Goodwin - Shareholder Wealth Maximiser?
What is the goal of a firm?
Before I divulge my thoughts on the documentary "RBS: Inside the Bank that ran out of money", I feel it is worthwhile to provide an insight into why I believe the goal of the firm should be to maximise shareholder wealth, as this will provide the basis for the documentary discussion.
People may associate Adam Smith's 1776 'Wealth of Nations' book with a free market economy and limited government intervention. They would be correct to do so, however that is not the reason for its mention. Rather, it is the notion of enlightened self-interest, which Smith outlines in a rather convoluted way;
"It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest."
The connotation this has is that only by selling products consumers want, do firms make money. Therefore inadvertently, by looking out for oneself and focusing on profit, other stakeholder groups ultimately benefit too. This notion has been elaborated upon more recently by Friedrich Hayek and Milton Friedman, in 1960 & 1970 respectively and to whom the profit maximisation goal is often credited. Despite still being popular, in recent decades this goal has increasingly been replaced with long term shareholder wealth maximisation. This is because profit can be manipulated - as we have seen in scandals such as Enron and Tesco, accounting values can be manipulated to show a rosier picture than is true. This is a short term fix to an underlying problem which in the case of Enron was detrimental. Also, among other things, profits can be increased through the undertaking of projects, but this can be destructive from shareholder's perspective if the return is less than their opportunity cost of capital. Therefore, in looking out for the long-term and by using a market determined price as its measurement, shareholder wealth maximisation is superior.
Just when you thought all was agreed, Ed Freeman et al., argue for stakeholder theory, which states by pursuing a broader range of stakeholder needs beyond, but still including, shareholders, the competitive position of the firm will be enhanced. By having positive relationships with its stakeholders a firm is expected to generate more revenue and become more efficient. It is often argued, for example, that employees have a much larger stake in the firm because it is more difficult to find another job than for shareholders to sell their shares.
Cynical Calum: Although many firms have glossy aims which would imply a stakeholder theory focus, my belief is that these are largely marketing ploys to further the profit & shareholder wealth agenda. Therefore my view corresponds with Friedman's statement, such that, often Corporate Social Responsibility (CSR) schemes are actually profit seeking in disguise.
For me, when focusing truly on the long-term shareholder wealth and in a competitive market, such that suppliers have power, customers have options & alternatives, employees have mobility etc., it is not actually in the firm's interests to neglect these stakeholder group's as it will subsequently impact on the profitability and therefore shareholder wealth. This theory of enlightened self-interest resonates with me and negates Freeman's argument as other stakeholder group's are positively impacted. Additionally, organisations have a multitude of stakeholders each of which have differing and competing needs, the idea of whose needs should be prioritised comes into question. Thus, it can be said that stakeholder theory lacks clarity and can muddy the strategic decision-making water. It should be clear that in my opinion the goal of a firm should be to maximise shareholder wealth in the long term.
Despite my advocacy, this goal does have a clear limitation - agency. With the separation of management and ownership within firms, managers should work in the best interests of the shareholders. This however is not always the case and various agency-related costs are incurred by firms looking to mitigate conflicts by following a policy of goal congruence; whereby managers' goals are aligned to shareholders' through remuneration - e.g long term stock options. Nevertheless, this does not always work effectively, as I shall argue further below.
Even with this floor, I see this goal of shareholder wealth maximisation nowhere more important than the banking industry, because of the criticality of shareholders' capital by providing a buffer to impaired loans and write-offs. As I shall explore, however, it is evident that Fred Goodwin at RBS was pursuing a very different agenda.
Hopefully you have made it through the rather theoretical introduction, but it will be useful as background to help guide my discussion.
The Royal Bank of Scotland
A brief flick through the comments on any FT article relating to RBS confirms the public loathing of this once great and admired financial institution. So, where did it all go wrong for the Royal Bank? The documentary "RBS: Inside the Bank that ran out of money" sheds some pretty damning light on that question and allows one to comprehend the FT comments.
Prior to watching this documentary, I had a vague idea of what happened to RBS and others during the financial crisis. However, my reading on the subject had focused primarily on the HBOS / Lloyds Banking Group perspective of the UK financial crisis (note: Ivan Fallon's Black Horse Ride is an excellent read). I had largely neglected the detail of RBS, so it was very interesting to expand my knowledge of RBS and to draw comparisons between them and HBOS. This blog will not be used for this purpose, but instead to interlink shareholder wealth maximisation (or the lack of) to RBS's demise.
The documentary outlined a brief history of the Royal Bank of Scotland, describing it as "Prudent, Effective and Ambitious" - the latter at the expense of the former two as we shall see. George Matthewson was looking for a successor as CEO, and in doing so found Fred Goodwin. Goodwin had been notorious for cost-cutting in his career and acquired the nickname "Fred the Shred" to augment his uncompromising nature. I admire this aspect of Goodwin*. Banks receive negative publicity for cutting costs because of the job losses it usually entails. However, I see cutting costs as an integral part of remaining competitive. Cutting 2,000 staff may be a big deal for trade unions or the government in the short term, but should a bank become insolvent the bailout or cost to the economy should it go under is unthinkable. As the documentary goes, it was from this partnership, with Goodwin as CEO and Matthewson as Chairman, that started the idea Scotland was not a large enough banking playground for RBS and they subsequently started looking at international expansion.
*Note: this is the only thing I really admire about an otherwise despicable man.
NatWest Acquisition - The first nail in the coffin?
RBS, along with rival Bank of Scotland (BOS), were looking to expand and diversify beyond Scotland. In doing so, the logical next step was England and like a preying lion, they spotted the slowest gazelle in NatWest. RBS managed to acquire the much larger NatWest, along with it's significant deposit base, as a result of its promise to realise synergies.
While I agree this was a positive move for all involved at the time - it allowed RBS to realise its goal of expansion and removed the lackluster management at NatWest - with the luxury of hindsight, I see this as the start of RBS's demise. Goodwin was lauded for the success of the deal by the City and this enhanced his reputation and ego. In my view, this was the first step to Goodwin's self-confidence proliferating into a tameless beast. Further, I see this acquisition, because of the financial incentives for Goodwin being at the helm of a financial powerhouse, as the contributing factor to allow him to pursue an era of agency-motivated acquisitions.
Acquisition Spree - Death by 1000 cuts?
There is an insightful paper by Michael Jensen entitled "Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers" which outlines his cash flow theory. This states managers with cash in excess of that which is needed for operations, may not return it to shareholders even if there are no positive NPV projects available, but instead invest in projects which may be value destroying. Therefore, the ability to recognise when the company is at its optimum size and understand additional investment would stifle shareholder value is something that should be carried out if truly following a shareholder wealth maximisation agenda.
This links to RBS because as a result of the cash acquired from NatWest's depositors, during the period from 2000-2006 RBS embarked upon 25 acquisitions with Goodwin receiving many accolades in the process. In my opinion, the fact that shareholders of RBS were content during this period of acquisitions does not imply shareholder wealth maximisation as the goal. From the documentary, it appeared shareholder wealth creation was a coincidental consequence, as opposed to the motive for the M&As. To me, this acquisition spree evidences Goodwin's clear 'empire-building' approach; pursuing a strategy of size over value, with agency as his primary motive.
Goodwin appeared to be undertaking this M&A spree in order to become CEO of one of the worlds largest banks and subsequently boast the salary that comes with it. The lack of challenge Goodwin received internally and from shareholders leads me to believe these acquisitions exacerbated Goodwin's self-confidence, to his and RBS's detriment in the ABN Amro acquisition.
With access to this deposit base from NatWest, RBS embarked upon a transformational journey of acquisitions, rapidly expanding its investment banking and U.S divisions. This ultimately changed the cultural dynamic at RBS from a prudent Scottish retail bank into a risky Global financial conglomerate using retail deposits for investment banking gains. One of the key takeaways from this documentary, as I embark upon a career in Risk within Retail Banking, is to be aware of this cultural shift so as to ensure prudence. Despite there being little doubt in my mind that these acquisitions were damaging to the understanding of exposures, tainted the culture and made RBS a major player in the mortgage derivatives market, I feel reluctant to say it is anything other than the ABN Amro acquisition that is ultimately responsible for RBS's demise.
ABN Amro - The Final Nail?
Following a period of uncertainty with the U.S housing bubble bursting and the first tranche of sub-prime defaults in mid 2007, you may be forgiven for thinking RBS and other financial institutions would rein in their activity, take stock of their risks and look to mitigate impairments. This sadly was not the case, especially for RBS. The rapid expansion had led Goodwin and team to have only limited knowledge of their asset portfolio; they believed sub-prime defaults wouldn't impact their financials.
Perhaps I am blessed with the hindsight RBS would have craved at the time, but nevertheless it does seem inherently risky to acquire ABN Amro for £49bn (three times its book value!), with a consortium of two other large banks, at the time of a major economic change - property price declines and sub-prime defaults. Not only did the takeover go ahead, RBS did not conduct thorough due dilligence (significantly deviating from the Prudent and Effective narrative). This was arguably the most important factor in RBS's demise from my perspective. To follow a true shareholder wealth maxmisation goal, projects - and mergers & acquisitions are projects albeit large ones - need to be assessed using the present value of future cash flows. By not studying ABN Amro's loan book and balance sheet with a fine toothed comb, they were entering the realm of unknown - synergies could not be accurately predicted and therefore a true reflection of whether this acquisition would create shareholder wealth could not be adequately assessed.
What could be guaranteed with this acquisition, however, is RBS would become the largest bank in the world by assets, further supporting the evidence for agency related motives - Goodwin and team could be sure to earn a hefty bonus, if not a pay-rise. Yet, agency is only a secondary reason for this acquisition in my opinion. The reputation and accolades Goodwin had received from the City as a result of this acquisition spree inflated an already popping ego. As he had integrated NatWest and many other companies into RBS, ABN Amro would just be another one to the list - or so he thought. This self-confidence, or hubris, led Goodwin to become complacent in his own ability; overpaying for ABN Ambro and neglecting the paramount due diligence process and ultimately failing to realise synergies coupling with acquiring toxic assets. Of course, RBS would still have incurred huge impairments and losses because of their prevalence in the mortgage derivatives market, the ABN Ambro acquisition compounded the situation and drastically reduced the time RBS had to act to (unsuccessfully) shore up its balance sheet. Thus, it is this acquisition which I feel constituted RBS's self-inflicted downfall primarily, but notwithstanding the earlier acquisitions mentioned. As we all know, what then followed was a Governmental bailout at the expense of 72% stake in RBS.
Summary
While I have outlined why I believe shareholder wealth maximisation should be the goal of the firm, it is evident from the case of RBS that this is not what occurs in reality. From the documentary, it is my understanding that Fred Goodwin acted in his own self-interest at the expense of his shareholders' wealth in the long-term and played a tremendous role in the financial crisis and recession that followed. It is therefore evident there is always the chance organisational goals may be manipulated or corrupted and this only outlines the importance of a solid corporate governance structure to mitigate potential harm from arising issues. A further takeaway is the importance of due diligence in the M&A process. It is integral for this to be completed thoroughly to ensure a successful integration and realisation of synergies.
So, an inspirational message for all of you current or future business leaders; regardless of the goal your organisation pursues, please don't be a Fred and let your own self-confidence and personal gains jeopardise the fiduciary duty you have to shareholders.
Before I divulge my thoughts on the documentary "RBS: Inside the Bank that ran out of money", I feel it is worthwhile to provide an insight into why I believe the goal of the firm should be to maximise shareholder wealth, as this will provide the basis for the documentary discussion.
People may associate Adam Smith's 1776 'Wealth of Nations' book with a free market economy and limited government intervention. They would be correct to do so, however that is not the reason for its mention. Rather, it is the notion of enlightened self-interest, which Smith outlines in a rather convoluted way;
"It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest."
The connotation this has is that only by selling products consumers want, do firms make money. Therefore inadvertently, by looking out for oneself and focusing on profit, other stakeholder groups ultimately benefit too. This notion has been elaborated upon more recently by Friedrich Hayek and Milton Friedman, in 1960 & 1970 respectively and to whom the profit maximisation goal is often credited. Despite still being popular, in recent decades this goal has increasingly been replaced with long term shareholder wealth maximisation. This is because profit can be manipulated - as we have seen in scandals such as Enron and Tesco, accounting values can be manipulated to show a rosier picture than is true. This is a short term fix to an underlying problem which in the case of Enron was detrimental. Also, among other things, profits can be increased through the undertaking of projects, but this can be destructive from shareholder's perspective if the return is less than their opportunity cost of capital. Therefore, in looking out for the long-term and by using a market determined price as its measurement, shareholder wealth maximisation is superior.
Just when you thought all was agreed, Ed Freeman et al., argue for stakeholder theory, which states by pursuing a broader range of stakeholder needs beyond, but still including, shareholders, the competitive position of the firm will be enhanced. By having positive relationships with its stakeholders a firm is expected to generate more revenue and become more efficient. It is often argued, for example, that employees have a much larger stake in the firm because it is more difficult to find another job than for shareholders to sell their shares.
Cynical Calum: Although many firms have glossy aims which would imply a stakeholder theory focus, my belief is that these are largely marketing ploys to further the profit & shareholder wealth agenda. Therefore my view corresponds with Friedman's statement, such that, often Corporate Social Responsibility (CSR) schemes are actually profit seeking in disguise.
For me, when focusing truly on the long-term shareholder wealth and in a competitive market, such that suppliers have power, customers have options & alternatives, employees have mobility etc., it is not actually in the firm's interests to neglect these stakeholder group's as it will subsequently impact on the profitability and therefore shareholder wealth. This theory of enlightened self-interest resonates with me and negates Freeman's argument as other stakeholder group's are positively impacted. Additionally, organisations have a multitude of stakeholders each of which have differing and competing needs, the idea of whose needs should be prioritised comes into question. Thus, it can be said that stakeholder theory lacks clarity and can muddy the strategic decision-making water. It should be clear that in my opinion the goal of a firm should be to maximise shareholder wealth in the long term.
Despite my advocacy, this goal does have a clear limitation - agency. With the separation of management and ownership within firms, managers should work in the best interests of the shareholders. This however is not always the case and various agency-related costs are incurred by firms looking to mitigate conflicts by following a policy of goal congruence; whereby managers' goals are aligned to shareholders' through remuneration - e.g long term stock options. Nevertheless, this does not always work effectively, as I shall argue further below.
Even with this floor, I see this goal of shareholder wealth maximisation nowhere more important than the banking industry, because of the criticality of shareholders' capital by providing a buffer to impaired loans and write-offs. As I shall explore, however, it is evident that Fred Goodwin at RBS was pursuing a very different agenda.
Hopefully you have made it through the rather theoretical introduction, but it will be useful as background to help guide my discussion.
The Royal Bank of Scotland
A brief flick through the comments on any FT article relating to RBS confirms the public loathing of this once great and admired financial institution. So, where did it all go wrong for the Royal Bank? The documentary "RBS: Inside the Bank that ran out of money" sheds some pretty damning light on that question and allows one to comprehend the FT comments.
Prior to watching this documentary, I had a vague idea of what happened to RBS and others during the financial crisis. However, my reading on the subject had focused primarily on the HBOS / Lloyds Banking Group perspective of the UK financial crisis (note: Ivan Fallon's Black Horse Ride is an excellent read). I had largely neglected the detail of RBS, so it was very interesting to expand my knowledge of RBS and to draw comparisons between them and HBOS. This blog will not be used for this purpose, but instead to interlink shareholder wealth maximisation (or the lack of) to RBS's demise.
The documentary outlined a brief history of the Royal Bank of Scotland, describing it as "Prudent, Effective and Ambitious" - the latter at the expense of the former two as we shall see. George Matthewson was looking for a successor as CEO, and in doing so found Fred Goodwin. Goodwin had been notorious for cost-cutting in his career and acquired the nickname "Fred the Shred" to augment his uncompromising nature. I admire this aspect of Goodwin*. Banks receive negative publicity for cutting costs because of the job losses it usually entails. However, I see cutting costs as an integral part of remaining competitive. Cutting 2,000 staff may be a big deal for trade unions or the government in the short term, but should a bank become insolvent the bailout or cost to the economy should it go under is unthinkable. As the documentary goes, it was from this partnership, with Goodwin as CEO and Matthewson as Chairman, that started the idea Scotland was not a large enough banking playground for RBS and they subsequently started looking at international expansion.
*Note: this is the only thing I really admire about an otherwise despicable man.
 |
| Fred Badwin, former CEO of RBS |
NatWest Acquisition - The first nail in the coffin?
RBS, along with rival Bank of Scotland (BOS), were looking to expand and diversify beyond Scotland. In doing so, the logical next step was England and like a preying lion, they spotted the slowest gazelle in NatWest. RBS managed to acquire the much larger NatWest, along with it's significant deposit base, as a result of its promise to realise synergies.
While I agree this was a positive move for all involved at the time - it allowed RBS to realise its goal of expansion and removed the lackluster management at NatWest - with the luxury of hindsight, I see this as the start of RBS's demise. Goodwin was lauded for the success of the deal by the City and this enhanced his reputation and ego. In my view, this was the first step to Goodwin's self-confidence proliferating into a tameless beast. Further, I see this acquisition, because of the financial incentives for Goodwin being at the helm of a financial powerhouse, as the contributing factor to allow him to pursue an era of agency-motivated acquisitions.
Acquisition Spree - Death by 1000 cuts?
There is an insightful paper by Michael Jensen entitled "Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers" which outlines his cash flow theory. This states managers with cash in excess of that which is needed for operations, may not return it to shareholders even if there are no positive NPV projects available, but instead invest in projects which may be value destroying. Therefore, the ability to recognise when the company is at its optimum size and understand additional investment would stifle shareholder value is something that should be carried out if truly following a shareholder wealth maximisation agenda.
This links to RBS because as a result of the cash acquired from NatWest's depositors, during the period from 2000-2006 RBS embarked upon 25 acquisitions with Goodwin receiving many accolades in the process. In my opinion, the fact that shareholders of RBS were content during this period of acquisitions does not imply shareholder wealth maximisation as the goal. From the documentary, it appeared shareholder wealth creation was a coincidental consequence, as opposed to the motive for the M&As. To me, this acquisition spree evidences Goodwin's clear 'empire-building' approach; pursuing a strategy of size over value, with agency as his primary motive.
Goodwin appeared to be undertaking this M&A spree in order to become CEO of one of the worlds largest banks and subsequently boast the salary that comes with it. The lack of challenge Goodwin received internally and from shareholders leads me to believe these acquisitions exacerbated Goodwin's self-confidence, to his and RBS's detriment in the ABN Amro acquisition.
With access to this deposit base from NatWest, RBS embarked upon a transformational journey of acquisitions, rapidly expanding its investment banking and U.S divisions. This ultimately changed the cultural dynamic at RBS from a prudent Scottish retail bank into a risky Global financial conglomerate using retail deposits for investment banking gains. One of the key takeaways from this documentary, as I embark upon a career in Risk within Retail Banking, is to be aware of this cultural shift so as to ensure prudence. Despite there being little doubt in my mind that these acquisitions were damaging to the understanding of exposures, tainted the culture and made RBS a major player in the mortgage derivatives market, I feel reluctant to say it is anything other than the ABN Amro acquisition that is ultimately responsible for RBS's demise.
ABN Amro - The Final Nail?
Following a period of uncertainty with the U.S housing bubble bursting and the first tranche of sub-prime defaults in mid 2007, you may be forgiven for thinking RBS and other financial institutions would rein in their activity, take stock of their risks and look to mitigate impairments. This sadly was not the case, especially for RBS. The rapid expansion had led Goodwin and team to have only limited knowledge of their asset portfolio; they believed sub-prime defaults wouldn't impact their financials.
Perhaps I am blessed with the hindsight RBS would have craved at the time, but nevertheless it does seem inherently risky to acquire ABN Amro for £49bn (three times its book value!), with a consortium of two other large banks, at the time of a major economic change - property price declines and sub-prime defaults. Not only did the takeover go ahead, RBS did not conduct thorough due dilligence (significantly deviating from the Prudent and Effective narrative). This was arguably the most important factor in RBS's demise from my perspective. To follow a true shareholder wealth maxmisation goal, projects - and mergers & acquisitions are projects albeit large ones - need to be assessed using the present value of future cash flows. By not studying ABN Amro's loan book and balance sheet with a fine toothed comb, they were entering the realm of unknown - synergies could not be accurately predicted and therefore a true reflection of whether this acquisition would create shareholder wealth could not be adequately assessed.
What could be guaranteed with this acquisition, however, is RBS would become the largest bank in the world by assets, further supporting the evidence for agency related motives - Goodwin and team could be sure to earn a hefty bonus, if not a pay-rise. Yet, agency is only a secondary reason for this acquisition in my opinion. The reputation and accolades Goodwin had received from the City as a result of this acquisition spree inflated an already popping ego. As he had integrated NatWest and many other companies into RBS, ABN Amro would just be another one to the list - or so he thought. This self-confidence, or hubris, led Goodwin to become complacent in his own ability; overpaying for ABN Ambro and neglecting the paramount due diligence process and ultimately failing to realise synergies coupling with acquiring toxic assets. Of course, RBS would still have incurred huge impairments and losses because of their prevalence in the mortgage derivatives market, the ABN Ambro acquisition compounded the situation and drastically reduced the time RBS had to act to (unsuccessfully) shore up its balance sheet. Thus, it is this acquisition which I feel constituted RBS's self-inflicted downfall primarily, but notwithstanding the earlier acquisitions mentioned. As we all know, what then followed was a Governmental bailout at the expense of 72% stake in RBS.
Summary
While I have outlined why I believe shareholder wealth maximisation should be the goal of the firm, it is evident from the case of RBS that this is not what occurs in reality. From the documentary, it is my understanding that Fred Goodwin acted in his own self-interest at the expense of his shareholders' wealth in the long-term and played a tremendous role in the financial crisis and recession that followed. It is therefore evident there is always the chance organisational goals may be manipulated or corrupted and this only outlines the importance of a solid corporate governance structure to mitigate potential harm from arising issues. A further takeaway is the importance of due diligence in the M&A process. It is integral for this to be completed thoroughly to ensure a successful integration and realisation of synergies.
So, an inspirational message for all of you current or future business leaders; regardless of the goal your organisation pursues, please don't be a Fred and let your own self-confidence and personal gains jeopardise the fiduciary duty you have to shareholders.
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