Failed Leadership Caused the Financial Crisis

We need to do more than fix the crisis; we need to fix the mindset that got us into it.

By SHARE
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The devastating financial crisis of 2008 has claimed another casualty: trust in leaders of America's most important financial institutions.

Gaining the trust of the people is essential for every leader. Leaders cannot be effective without full confidence of the constituencies that grant their institution its legitimacy, nor can capitalism function without trust. Trust is "the coin of the realm."

According to the just-released 2008 survey taken by the Center for Public Leadership at Harvard's Kennedy School, an astounding 80percent of the American people believe we have a leadership crisis in the country today. Unless we get better leaders, 79 percent feel that the United States will decline as a nation.

Business leaders rank near the bottom of the list, with only 45percent reporting confidence in them, down from 59percent last year. Only Congress and the President fare worse. In contrast, military leaders have the confidence of 71percent of the people surveyed, making it the highest group in the survey.

This decline in confidence in business leaders is extremely worrisome. Not surprisingly, given the current fiscal crisis, the trust issue is most acute among leaders of financial institutions. If we can't trust in the people who invest our life savings, who can we trust?

For many leaders, the criticisms are well deserved. The heads of failed institutions like Lehman, AIG, Bear Stearns, Countrywide Financial, Fannie Mae, Freddie Mac, Wachovia, and Washington Mutual have done a great disservice to their clients, employees, shareholders, and the nation. It is a disgrace that the U.S. government has had to bail out so many firms to keep the financial system from unraveling.

To their discredit, many of these leaders opposed mark-to-market accounting rules, regulation of credit default swaps, greater transparency for hedge funds, or insistence that mortgage bankers obtain financial statements before granting mortgages.

These failures were not caused by complex financial instruments. They result from failures in leadership. Heads of the failed firms forgot two basic principles of business: To sustain success, firms must serve their customers well for the long term and contribute to ensuring healthy markets.

These principles have been central to successful Wall Street leaders for generations. Former CEOs Walter Wriston of Citigroup and John Whitehead of Goldman Sachs always believed clients' interests and sound capital markets were essential to their firms' success. So did Treasury Secretary Henry Paulson in his investment banking days. Warren Buffett has consistently spoken out about the problems financial firms were getting into, but few were listening to him, in spite of the enormous success of his firm, Berkshire Hathaway.

In recent years, financial firms engaged in a mad rush to justify high fees for managing clients' money by producing outsize short-term returns. This caused many leaders to lose sight of the importance of protecting their clients' long-term investments and their financial security. In the scramble to make money for themselves, the failed firms underpriced risk and relied on excessive leverage--in excess of 35 times as much debt as equity. Gambling with their firms' futures, these failed leaders created massive short-term gains, followed by even greater losses, and wound up putting their firms out of business.

No wonder the public has lost confidence in business leaders.

The wisdom of President-elect Barack Obama—who said about the war in Iraq, "I don't just want to get our troops out of Iraq. I want to change the mindset that got us there in the first place"—applies here as well. In Wall Street's case, it's not sufficient to get out of the mess we're in. We need to change the mindset that led to these problems, so we don't repeat them in the future.

Correcting the system's immediate shortcomings, as hard as that will be, is insufficient. We need leaders who can envision the way 21st century global financial markets must function to maintain stability and serve all participants fairly. Wall Street leaders must work with their government counterparts to put in place institutional rules and oversight to guarantee that markets function smoothly in the future, even under the most extreme circumstances.