The Missing Ingredient

In this part of the module I have learned ethics for the finance professional. This subject is relevant for myself in three areas which is why I am really interested in it. Firstly, over the past 6 months, I have been writing a dissertation on how there is hope that new audit regulation will improve audit quality and I have looked into accounting scandals and what it means to be ethical in the audit profession. Secondly, I am going to be an auditor (far flung from when I wanted to be a fireman when I was a child) when I leave university, so I need to understand that ethics are really important. And finally, in semester 1 of this year, we learnt about ethics and normative ethical theories (Kant, Rand etc) and it is interesting to be able to apply that thinking to real case studies.

I myself have been aware of a lot of ethical scandals and news reports over the past few years and further into the past which really bring to light a couple of things. After each scandal, new regulation is passed to stop it from happening again (but it always does) and that business leaders are not learning from past mistakes. I have noted a few scandals below:

In the table above, you can see that scandals will happen, then a series of regulation will be passed, then it will happen again. This will continue to go like this probably forever. I did some investigation and it was clear to see what I am talking about. So, in 2001 (Enron) and 2002 (Worldcom) scandals happened, then the Sarbanes-Oxley (SOX) Act 2002 was passed. Then in 2010 (Lehman Brothers), the financial crisis was happening, more regulation e.g. Financial Services Act (FSA), and then a few years later we have more scandals. When will it stop?

Many columnists and accounting professionals who look into scandals report that scandals are still increasing year-on-year, with one saying that there was an increase of 46% in account fraud from 2013 to 2014. This is worrying because new regulation such as SOX was passed to try and protect stakeholders from accounting errors and fraud. I would like to ask a question to whether any regulation could be passed to stop it? or will businesses just try and find new loopholes?

What I found when doing my dissertation and which I have also learned from the lectures is that there are certain reasons to why accounting scandals happen between businesses and financial professionals. I have learned about the PIPCO acronym (Professional Behaviour, Integrity, Professional Competence, Confidentiality and Objectivity) which shows a few reasons (I am sure there are more) why finance professionals may fail their duty. The one thing I find when conducting my research was that Objectivity was the main reason into why finance professionals did a poor job. If they become to familiar with the client (known as lack of independence, such as going on holiday together or being 'mates' at the pub) then they are more likely to let things'slide' as it is said. I do believe that this is the biggest risk and probably the reason why a lot of scandals happen. 

For example, I read an article about how Arthur Andersen auditors of Enron were treated 'as if they were employees of Enron' and they were invited to company picnics and so on. If this is not a lack of independence then I do not know what it; and we all know how that turned out.

My belief is that being ethical in your role as a finance professional is the most important factor in being successful, and not about how much money you earn or how big your bonus is. If you cannot be ethical, you may be jepardising someones pension or rainy day fund which could cause a lot of harm and unhappiness. In relation to ethics being the missing ingredient, I think that the finance professional (a minority rather than a majority) sometimes misses thinking about ethical considerations.

One final note that I was really interested in when listening to this lecture was a question the lecturer mentioned was "should white collar crime be punished as harshly as murder?". This was interested and provoked a lot of thought because of a video of Dennis Kozlowski (former Tyco CEO) who for his crime may be in prison for 25 years (longer than some murderers). My thoughts to the question are that murders should obviously face more time in prison, but white collar crime can hurt people in different ways and can cause a lifetime a distress and suffering for some people, so definitely should be treated more harshly than it currently is. I feel CEOs of these companies are not put off because they see the rewards (bonus etc) outweighing the risk (prison).

Inside Job - A Culture of Dysfunction

This weeks blog will focus on my learning from the documentary 'Inside Job' by Charles Ferguson. What I like to do when watching something like this is identify a key theme of the documentary and then that is what I will talk about. The theme from this show was Culture.

The documentary went into detail about the dysfunctional behaviours of Wall Street and the Investment Banks in the US which led to the financial crisis (yes, again you have to hear about the crisis, sorry). These Wall Street bankers were selling sub-prime collateralised debt obligations (CDOs) to other institutions for their bonuses. This led to the collapse of Lehman Brothers and the need for Morgan Stanley to need bailing out.

What was really clear to see were people making terrible decisions and going for risky projects so that they could get their next bonus. This can be seen even after the financial crisis. For example, in 2012 RBS made a loss of £5bn and Lloyds a loss of £570m, but they both paid their top management bonuses of £607m and £375m. I just think that is absolutely ridiculous, how can you pay people bonuses for the losses they were making. Bloomberg made a nice quote that said that bonuses pre-2008 were incentivised for 'greed and risk'.

The second thing that was apparent was familiarity. You may ask why familiarity was a route cause of dysfunctional behaviour, but I think it is apparent. Familiarity between the CEO and Board, Leader of Country and Advisers or Investment Bank and Rating Agency (S&P, M, F) will create behaviours that will lead to bad decisions being made. I am currently doing a dissertation on audit quality and new regulation and I have found in my results that familiarity is one thing that reduces audit quality and this was another cause of the 2008 crisis. I don't think you can do a good job if you are supposed to be independent but also 'good mates' with the person who owns the company.

I am going to be an auditor after university (so exciting I know), so I have to be independent, I am sure subconsciously my opinions would change if my best friend owned to company rather than someone I did not know, I would place more 'trust' in what he said or did than a stranger. But it was clear to see in the documentary that people were not independent and making an ex-Goldman Sachs CEO Secretary of the Treasury helped benefit Goldman Sachs by $14bn in the bailout (yeah so independent right?).

Culture

Culture is so important in any firm, and is usually more of a reason why it is successful or a failure than any other in my opinion. Take Morgan Stanley for example, they had around 50,000 employees but a culture which was only looking for achievement of their next bonus which made them act so dysfunctional they were having cocaine and going to strip clubs every night.

Culture is important if you are wanting to undertake a merger or acquisition too. If I was a CEO and we found out that all the employees were really unproductive or taking high risks, this could cost us a lot of money and make the acquisition fail. But I think that it is so hard to actually think of how to measure the culture in a company unless you are there.

As a student and not having a full-time job before, I got the opportunity to undertake a placement. I could have tried to apply to a Big 4 accounting firm, but instead chose to go for Grant Thornton (who are number 5). The reason I did this was because I got told their 'culture' was a lot better (thank god is was a really great culture). But if the company has a horrible culture then I would have not succeeded in what I wanted there, and that would be the same with an acquisition.

Failures can be seen through recent history where companies have acquired others and have failed or had problems due to culture clashes:

• AOL - Time Warner
• Daimler - Chrysler

I think that a business leader in the organisation needs to set the tone for organisational culture. I believe this will help increase shareholder value by not putting it at risk, which would also be the case for a successful merger/acquisition as successful culture integration is said to be the most important factor for M&A success.


I just want to touch lastly as what my optimal culture I believe would be for a firm. I think a firm where you are recognised for things you do well, even a simple 'thank you' I found helped motivate me. Secondly, I think openness when explaining what I have done wrong, I hate when someone says 'oh, [this guy] said he didn't like you doing this', why didn't he just tell me? What is your optimal culture?



Empty Vaults - The RBS Collapse

The Royal Bank of Scotland (RBS) which found notoriety in 2008 when it was apparently '2 hours away from running out of money' and losses of £24.1bn (I can't even comprehend this figure). It was clear from my own viewing that I could conclude RBS had serious problems which included to rate of acquisitions, due diligence of these acquisitions and Fred Goodwin's leadership. As you can see below, this is the result of RBS management decisions.

RBS Share Price (Yahoo! Finance)

Acquisitions
RBS I feel really fell down on their rate of acquisitions, I think they over expanded too quickly and this can't be good as they ultimately had 'a finger in too many pies'. They were involved in Insurance, Hospitals, Airports, second-hand cars and asset finance (I can't see where some fit into banking). I thought that these acquisitions were a waste of money and there was no need to diversify from their core business of banking. The acquisition of ABN-Amro was obviously their biggest downfall. They had no idea about the level of sub-prime mortgages ABN held and therefore I do feel I can reach a conclusion that this was why they failed.

Fred Goodwin said "we don't do acquisitions for fun", but I thought that them buying a second-hand car company, this did not seem like it was done to 'better the core business'. RBS was not the only company undertaking failing acquisitions; HSBC's acquisition of Household (2003) fell victim to the sub-prime collapse and AOL's acquisition of Time Warner took less than 2yrs to fail.

Due Diligence
Watching the part where Fred Goodwin said that there was no real scrutiny of ABN-Amro's books really made me annoyed. I would have thought someone with all that business knowledge wouldn't have gone with the 'we did Natwest well, so this will be fine' mentality. Even myself, a final year business student looks into everything I buy; if I purchase a TV, I will be looking into it for a week at least to see if it is worth it (and that only costs £300 not £49bn).

Due Diligence is key when acquiring a business. It makes sure you're not buying 'junk' and will reassure you that you are not paying over the odds. I am currently looking to buy a car for work, I wouldn't want to pay £10,000 for something that is actually worth £6,000 or a car that has been written-off in the past. This is why you undertake due diligence. Anglo American mining is another example, they have really underestimated the challenges they would face when going to Brazil in 2009 and other projects where now their share price has dipped below 1999 listing level and have been given 'junk' bond status by credit firms such as Moody's (FT, 2016) (would they have been more successful if undertaking more due diligence?).

Leadership
One thing that was apparent when watching the documentary to me was Fred Goodwin's management style. Morning meetings were called 'morning beatings' and managers were intimidated to say if they believed something was wrong. I don't think you can run an organisation like that. Listening to others is the most important thing, especially when dealing with a public interest sector.

When I was in my placement working in the audit department, listening to what I was doing wrong and what I could do better was important to help me do a quality job and make sure every part of the audit was correct. This helped shareholders/stakeholders base decisions on true and fair information. If not, I could have been misreporting values and making wrong decisions which may have lost people money. This is exactly what Fred Goodwin did with RBS and definitely I believe another reason for their demise.

A Final Note
I think what really hit me the most when watching the documentary was that ordinary people (which I probably know a few) who have saved for years and were unfortunate enough to invest in RBS (where they thought their money would be safe) lost around 90% when RBS collapsed. These are the people who I really feel for.

References
Financial Times. (2016). Anglo American’s credit rating downgraded to junk, retrieved from http://www.ft.com/cms/s/0/1f989c28-d409-11e5-829b-8564e7528e54.html#axzz40cHUmspG 
BBC. (2011). RBS - Inside the Bank that Ran out of Money (documentary).