HBS’s Bill Sahlman on the Financial Crisis: Why it Happened, How to Fix It

Few people are more qualified to explain what went wrong in the financial industry than Harvard Business School’s Bill Sahlman.  His resume covers just about every aspect of the industry.

In an HBS Working Knowledge paper titled Management and the Financial Crisis (We Have Met the Enemy and He is Us …)  he gives us a very special view of what happened—broad and deep, and holistic to boot. He also gives us an idea of what should be done.

He gets an A+ for the explanation; for the recommendation, maybe not so much.

My summary cannot do his paper justice; but to whet your appetite, I’ll touch a few bases.

Managerial Incompetence Was the Driving Factor

Black swan theory fans notwithstanding, Sahlman argues this meltdown was not unique except in scope and scale. What we had was a massive failure of five largely managerial systems: Incentives, Control and Information Technology, Accounting, Human Capital, and Culture.

Sahlman also flatly says “Greed played a role but the bigger problem was incompetence.” What he means by competence largely comes down to managers. I find this hugely commonsensical, and rare at the same time. In other words, I think he’s very right.

He is inclined also to give a bye to some of the usual suspects: accounting firms, boards of directors, and regulators, to some extent. His reasoning is hard to argue with: the complexity of the products engaged in ran far beyond the relatively meager abilities of those in the aforementioned roles.

Sahlman singles out Goldman Sachs and JPMorgan Chase’s Dimon as examples of good managers who clearly avoided most of the damage caused by their inept competitors.
His diagnosis, refreshingly, puts the blame squarely at the feet of business itself—particularly management. A management that runs the company through over-leveraging and over-optimism is a management team that is grossly incompetent. Even they wouldn’t have generally wanted the results they ended up with.

What I also like about Sahlman’s view is that it treats impersonal tools like incentives not as exogenous dehumanizing variables, but as things completely within the realm of management—and he makes management squarely responsible for their use. As far as I’m concerned, this is the best of HBS talking; the old-school HBS that assumes managers have a responsibility to run organizations holistically, for the long run, and in the interest of stakeholders–not slavishly to a few slanted metrics.

The Solution–an Overseer?

After such a great analysis, I’m left a little cold with Sahlman’s solution. It is to have a sort of outside observer—not a government interveener, since Sahlman is not sanguine about government intervention, but a new kind of monitor. This monitor would have a scope to cover the five broad areas Sahlman outlined at the outset.

The problem is not with having a holistic view; I’m all for it. And while Sahlman is rather vague about the statutory authority of the “monitor,” I figure that could be figured out.

My concern is that, in the end, Sahlman sounds like the consummate insider; his specific knowledge of the situation runs the risk of blinding him to the system’s flaws.
In this case, the one flaw that worries me is the belief that one more systemic overview will finally get it right. It’s the idea that our problem is the lack of a comprehensive enough model; that if we just had a little more data and a better model, we could finally model the world.

Here I have to agree with Taleb’s Black Swan theory: the problem with models is that they never model what hasn’t been envisioned. And while you won’t get a better dose of commonsense in business than what Sahlman serves up, I’m still sceptical about this part.

A Different Idea: Management by Values

So do I have a better idea? Well, I do have another idea. And it lies in the one area Sahlman puts least emphasis on—culture. While Sahlman talks about ethical cultures, he seems generally to mean a focus on long-term risk management and an aversion to illegality. Necessary, but not sufficient, for a good culture.

Those traits are jacks for openers. We need to be cultivating belief systems, not just management control systems.  We need mental models that talk about relationships, that actually live out the idea of long-term relationships instead of relegating them to the thin air of risk management managers.

We need baked-in beliefs about the role of business in society, that get promulgated not by monitors and smart managers, but by high school teachers and b-school profs, by bloggers and journalists and marketing managers and bankers alike, and in the most mundane areas of business. That’s a culture: a set of beliefs that people unconsciously share about ‘big’ things like fairness, relationships and the value of one’s word.

One of the best insights I ever got from HBS could easily have been articulated by Sahlman himself, I suspect: as things get more complicated, you’re better off managing by values than by policies.