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When I started at Goldman Sachs as a young trader, I never imagined that 30 years later I would be arguing for clear, enforceable and enforced risk management rules. I did not believe such rules were necessary.
However, I am not an advocate of detailed regulations and prescriptions aimed at preventing every mistake or misjudgment. Micro-management strangles enterprise and innovation, and encourages the behaviour it is intended to stop.
Bank regulators are currently making this error. The detailed regulations being put in place on both sides of the Atlantic to prevent another bank-led crisis are destined to fail because our financial institutions will find a way around them. Their real impact will be to prolong the crisis by making it more difficult for businesses and entrepreneurs to borrow money for expansion.
Instead, a complete separation of investment and commercial banking is needed to prevent any repeat of the recklessness that brought the global economy to its knees. That way investment banks would pay the price for mistakes they make and commercial and retail banks could be as safe and dependable as utilities are meant to be. Banks, though, would not be able to make the returns they are used to, which is why they have campaigned so aggressively against separation. Mixing assets and activities across the bank meant that in the good years bankers won, and in bad years shareholders and ultimately the public lost.
Mervyn King, governor of the Bank of England, observed during the Libor scandal that the riskier culture of investment banking had seeped into our commercial banks and ultimately into our high streets. Many heads of international banks came originally from proprietary trading – where I began my own career. But being a fiduciary manager of a government-backed institution requires a very different mindset.
When I criticised the way banks were being run five years ago, I was forcefully told by the head of a major international bank that “only through using the money we raise through our retail deposits for our investment banking activities can we continue to make the returns that justify what we get paid”. He is no longer in his post.
We need people in charge who can stand up to the rest of the firm to protect the bank’s balance sheet and customers. They are not the risk-taking investment bankers and traders I admired in my earliest days at Goldmans.
It was there that I began to see the dangers of having only a few rather unclear boundaries. On taking over the London Eurobond desk, I proposed strict limits on the amount each trader could invest and that any trader who breached these limits would be fired.
I was overruled by my senior US bosses who argued traders needed the freedom to increase their positions to boost returns. That freedom appears fine in a healthy market but is disastrous in a crash. In good times, such boundaries ensure that people do not over-reach and can resist the pressures that success brings. This lesson applies to both the private equity industry as well as the banks. After Terra Firma’s experience with EMI, the music group, in which we were the biggest investor, there are few better placed to share the lessons than me.
In the days before 2008, money poured into the private equity industry and the pressure was on to find ever larger deals. Even those with plenty of experience found this difficult to resist.
At Terra Firma we believed EMI presented a great investment opportunity, which is why we committed to it in May 2007 and underwrote such a high exposure to a single deal across two of our funds. We were confident that we would be able to sell down part of our investment to co-investors. No one knew that credit conditions would change so quickly and disastrously. We were not the only firm caught out by the crash but, because it was large and colourful, EMI became the poster child for failed deals.
The irony is that EMI could have been a good deal if the debt and equity market conditions had not changed so dramatically. Our problems stemmed from the timing of the transaction not the strategy. Our view of the music industry’s overall market decline proved to be largely correct.
As EMI’s subsequent performance has shown, our plans for transforming its operations were effective. Under our ownership, EMI moved from having an annualised negative cash flow of £150m a year to a positive cash flow of £250m a year, while at the same time EMI’s market share increased 13 per cent in an industry that declined by 15 per cent.
However, the timing of the closing of the deal, in the second half of 2007, meant we were unable to syndicate or refinance the transaction, and Citigroup eventually took over the business.
Although I stand by the deal, the responsibility for what went wrong is mine. I had the chance to veto it but did not. We should have had in place strict rules restricting our exposure to individual deals and preventing cross-fund investment – as we do now.
EMI demonstrated to me the importance of having firm boundaries in place, irrespective of your experience. We are fortunate that we were strong enough to learn from our mistakes. It is crucial that regulators now ensure that the banks do the same.
Guy Hands is the founder and chairman of the private equity group Terra Firma Capital Partners