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Are financial meltdowns inevitable?

In an interview with Paris Innovation Review, Claude Bébéar, the honorary chairman and former president of AXA, explains why he believes that financial crises, like the current meltdown triggered by problems in the mortgage and credit markets, are unavoidable because of basic human nature. He also argues for broad reforms in employee-compensations systems, including the remuneration of top executives. And he discusses his provocative views on a range of issues - shareholder voting rights and dividends, the speculative practice of short selling, leveraged buyouts, tax havens, and the nationalization of banks.

April 2010
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Paris Innovation Review - Can financial crises be avoided? Or are they simply an economic disease that can’t be wiped out?

Claude Bébéar - There are basically two constants in every financial crisis: greed and the loss of good sense. The two factors are somewhat related. The first is a mixture of both individual greed and organizational greed. Institutions have come to expect a return on investment, or ROI, of 15%, even when inflation might be 2% and when the return on money without risk is 4%. That’s a huge indication of dysfunction that should, on its own, serve as an alarm. Such a considerable disproportion between the degree of risk and margin used to cover that risk should immediately lead the people in charge to take urgent measures. But nothing of that sort happened during the recent financial meltdown. So, is man capable of keeping his greed in check? Is he able to maintain his good sense while others are losing theirs? I think not.

The financial industry has taken thoughtless risks and this includes insurers even though, theoretically at least, they’re supposed to be experts on risk. What’s your reaction?

An insurance company protects its clients against risks like accidents, fires, civil liabilities, and so on. Moreover, it manages a lot of money and invests in the market, thus assuming risks of a different nature. With respect to those investments, the insurance companies have certainly made mistakes like everybody else but we should remember that the problems of AIG did not arise from its insurance business; they resulted from the activities of its banking subsidiary.

When a system becomes corrupted, doesn’t a crisis present the perfect opportunity to take drastic actions to fix things?

You could argue that a crisis provides an excellent opportunity to overhaul a system and allow it to make a fresh start, but don’t delude yourself because that’s not going to happen. Remember the Mexican crisis of the 1980s, the crash of 1987, the Asian crisis of 1997, and the crisis of 2007-2008? After each of them, mistakes were acknowledged but what’s really changed since? Barack Obama is already reconsidering some of his proposed reforms even though they weren’t all that tough to begin with anyway. And how effective has he been thus far? He’s gently asked the banks that have benefitted from federal aid to curb their employee bonuses. So what did the banks do? They doubled or even tripled the fixed part of their employee compensation packages. And already we are seeing some American banks setting aside considerable funds for future bonuses that they will pay as soon as they’ve reimbursed the U.S. government for the federal aid. In Europe, there’s been some intervention but the measures are quite cautious. And with respect to currencies, accounting systems, and short sales, we do not see anything coming that will correct the problems of the past. That’s unfortunate because, thanks to increased globalization, we are currently living through a transition period that has brought unquestionable advances for many people but also indisputable risks.

Has the financial crisis camouflaged other major problems?

A badly managed financial industry drains talent that would be better utilized elsewhere. In France, the Ecole Polytechnique is a good example of that. A school that produces engineers and researchers was, until recently, suffering from the defection of 25% of its students who wanted to pursue careers in the financial industry. And what did those individuals do? They contributed greatly to the huge destruction of value that resulted from the financial meltdown. Let’s stop and think about what happened. Engineers, scientists, and technologists tend to have great faith in mathematics, but using math without understanding all the underlying assumptions can be extremely dangerous. In math, people establish postulates and deduce rules without ever questioning those postulates. That approach might be okay in a purely theoretical world but not in a real financial environment, where mathematical models can easily lead people astray if they forget about the postulates that those models are based on. And that’s exactly what happened. In retrospect, perhaps those models should have been developed more with the mentality of a physician, who starts from reality and comes back to reality as often as necessary in order to create models that work in the real world.

People have been calling for reforms in employee-compensation systems. Are such reforms an economic necessity, or is the debate driven more by populist sentiment?

Financial intermediaries are paid in ways that are out of proportion with their real economic contributions. Traders and investment bankers, for instance, deduct sums that do not make any economic sense. I propose that a permanent “claw back” system should be established, like in private equity, in which people have to return their commissions if they do not produce the expected results.

What salary does a top executive deserve?

The fixed portion of a top executive’s compensation must be in line with that of the board of directors. But the variable part can be very high depending on the long-term performance of the company because executives play an important role in adding value to an organization. That said, any executive’s compensation has to be accepted inside the company. Otherwise, employee morale and motivation will suffer. People in the U.S. and elsewhere often mistakenly believe that the French are against large compensations for good executives. That’s not true. The French become outraged only when bosses who have failed in their duty are rewarded lavishly. In a certain way, you could argue that good executives are always underpaid because their salaries are just drops in the bucket when you consider the value that those individuals are capable of bringing to their companies. But then you could also argue that bad and even mediocre bosses are always paid too much because they add little value to their businesses. In fact, they may even destroy wealth.

And who should decide the salary of a top executive?

That’s the task of the board of directors, which is appointed by the general assembly of shareholders. In addition, I also recommend asking for the advisory opinion of the general assembly. That approach, which is used quite frequently in Great Britain, would be a good change. Recently, Shell shareholders contested the proposed increase of a manager’s salary and the raise was denied.

Speaking of shareholders, what’s their true role?

Of course, shareholders must always exist. But I’m referring to genuine ones! By that I mean shareholders who are willing to share in the company’s future over the long term. That is, investors should be encouraged to think about the long term because that’s the kind of perspective that companies need. To accomplish that, the right to vote could, for example, be multiplied (in some cases even more than doubling it) according to the duration of the possession of the share. The same thing could be done for dividends, which today are ridiculously limited to just a 10% premium. The goal is to discourage investments that demand short-term results because those types of investments tend to harm a company.

There’s been considerable debate over the best way to measure the performance of a company. What’s your take on the issue?

One thing is clear: the quarterly report has no real economic validity. (And, quite frankly, you can’t accurately judge the performance of a company even over a full year.) But the current obsession with quarterly results traps managers into near-sighted thinking. It prevents them from making desirable investments that might harm short-term objectives but be profitable over the long course. And that doesn’t make sense because, really, companies should be judged on their long-term performance, not their quarterly results

Given how you feel about short-term investing, what’s your view of leveraged buy-outs, in which acquisitions are financed through considerable debt, with the assets of the acquired company used as collateral for the borrowed capital?

LBO activity is necessary because it helps eliminate bad executives and can result in the creation of viable businesses. But the geared debt that is currently in vogue is often excessive, draining companies of their substance and destroying real value. Of course, some geared debt has its virtues because it can motivate managers and encourage them toward greater efficiencies, but too much is too much.

Recently, the market has certainly been criticized a lot, but what’s more effective than the market?

Ah, that’s the eternal question: Should you follow the market? Is it gifted with some sort of immanent wisdom? True, there would be no effective economy without the market. But, at the same time, we should realize that the market is always wrong in the short term. It spins around; it follows all the trends. And that’s exactly opposite of the kind of guidance that a company needs. Of course, over the long term the market eventually returns to reality because it doesn’t have any choice but, meanwhile, the damage it can wreak! People forget that stocks were never intended to be a measure of the instantaneous value of a company. Remember Vivendi? About 10 years ago, the group launched its Vizzavi portal with great fanfare and the market reacted with frenzy. But the product was unsound, the launch premature, and the success a fantasy. So the market had been intoxicated and it intoxicated itself as well. I am happy to have protected AXA against that kind of irrational, herd behavior.

To keep markets more in line with reality, even over the short term, what are the most serious issues that need to be addressed first?

It all has to do with speculation, which is the deadly enemy of the economy. For example, we need to better regulate short sales -- the selling of a security that one does not possess in hopes of buying it back later at a lower price. In other words, the investor is betting that the value of the security will fall in the future. This is a speculative activity that goes against the interest of companies. Short selling can kill a company by making its market value collapse.

Governments have been talking a lot about tax havens. Is that just propaganda?

In my opinion, tax havens are not an important crux of what’s wrong with capitalism. The problem is not that tax havens exist, and we shouldn’t fight for their elimination. Instead, we should strive for their transparency, because then they would not be considered to be havens anymore!

And what about the nationalization of banks?

Let’s not make that a blanket taboo. We shouldn’t be afraid of nationalizing those banks that need it in order to carry out their work, which is to loan money. In Sweden in the 1990s, for example, the government nationalized the banks in order to stabilize their balance sheets, which then permitted the country’s financial system to work again. But, after intervening, governments should then denationalize those banks as soon as possible.

Can membership in the European Union provide any protection against the crisis?

It certainly can. The strong European countries can help save the weak ones. But Europe also makes bad mistakes. The EU has, for instance, established accounting rules that are disassociated with economic reality. In particular, the “mark to market” rule only tends to intensify a crisis. If for any reason the values of the market are running low, then the mark-to-market accounting will automatically lead to a decrease in the value of assets. This will then result in some companies encountering great difficulties, even facing bankruptcy, while in reality they are in a perfect state of functioning. That’s why the mark-to-market rule needs to be changed immediately.

Claude Bébéar
Honorary Chairman of AXA, Chairman and Founder, Institut Montaigne