Business pioneers in finance
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James Madison, the fourth US president, had a view of banks that was uncompromising. “The money changers have used every form of abuse, intrigue, deceit and violent means possible to maintain their control over governments by controlling money and its issuance,” he said in the late 18th century while trying to stop the creation of the First Bank of the United States.
A century later John Pierpont Morgan’s double rescue of the US government’s finances was taken by many as evidence that Madison was right. When Morgan, founder of the eponymous bank, made immediate fat profits by selling on the government bonds he received, he was accused of a “sinister complot” to control the country, and subjected to a Congressional investigation.
In finance, little seems to change. Morgan built his reputation on trust and his fortune on smart trading tactics — what would now be called market manipulation — before using his wealth and power as a banker to dominate the railway industry.
Like many other great financiers, Morgan was a businessman, not an innovator. His initial advantage came from exploiting the big financial trend of the early 19th century — the flow of money from wealthy Europe to opportunities in the US. Later he was lucky to avoid the 1870s railway bubble, leaving him the money and connections to mop up the pieces on the cheap.
The same is true in many industries: Bill Gates did not invent the computer, John Rockefeller did not invent the oil refinery. Even so, some innovators do make a success of business, and finance is no exception. Warren Buffett is one — his success comes from great stock-picking skills but also the innovative idea of using an insurance company structure to secure high leverage without the risk that highly geared hedge funds face of having their debts called in.
In any case, financial innovation has a dire history. From note discounting to bills of exchange for silver, from fractional reserve banking to collateralised debt obligations, almost all the innovations in modern financial history have been about expanding credit and debt — fuelling booms and busts in the process.
The history of finance is of a battle between the industry’s efforts to expand credit and government attempts to clamp down on them, as Charles Kindleberger points out in his magisterial documenting of the boom-bust cycle, Manias, Panics, and Crashes. One theory is that those who invent a new form of credit typically underprice the risk they are taking, leading to a boom. Only after the bubble bursts do their successors work out how to make money on a sustainable basis.
International banking, for example, was not invented by Mayer Rothschild, founder of the banking dynasty. Versions of it had been around since the Phoenicians, at least, and the great medieval banking families of northern Italy made large loans to kings and merchants across Europe. But Rothschild solved a large part of banking’s trust problem by having his children set up in the leading capital cities, as well as being a highly capable businessman.
Financial innovation seems to be all around us today. From cash machines in the 1960s and credit cards in the 1970s to today’s internet banking, computer-facilitated peer-to-peer lending and high-frequency trading measured in microseconds, technology has transformed finance. Will history decide the next great finance pioneer is one of today’s entrepreneurs? Investors certainly have high hopes: online payments and peer-to-peer are valued at dotcom levels.
Yet the lesson of the past is that this time is never different. The technology may be new, but the basic principle of banking is immutable: lending money is easy — the trick is to be able to get it back. Still, if entrepreneurs can find a way to provide the same service more cheaply, they could be expected to take a fat reward, just as they would from selling any other productivity-boosting innovation.
Thomas Philippon, professor of finance at New York University’s Stern school of business, has found little evidence of such a boost to productivity, at least for the finance industry as a whole. His research suggests the costs of finance to society remain fairly static, at about 1.5-2 per cent of the total amount being intermediated.
Rather than cutting the overall cost, technology seems to be used to draw previously hard-to-reach groups of customers into finance, maintaining the total cost of the industry at the same level. Bringing banking to the unbanked can make a big difference, as Grameen Bank, Muhammad Yunus’s microfinance initiative, showed in Bangladesh, but extending financial services is not unambiguously good news — the world economy is still recovering from the 2007 subprime mortgage disaster.
Exactly 100 years before the stock market peaked in October 2007, a failed attempt to rig the market in United Copper shares threatened to bring down the US financial system. Morgan again rode to the rescue — and again emerged substantially richer, having persuaded the trust-busting US president to waive anti-monopoly laws to allow him to expand his steel empire as part of Wall Street’s bailout.
The Panic of 1907 led to the creation of the Federal Reserve, the institution that did most to save the banks after Lehman Brothers collapsed. But some things stay the same: Buffett made chunky profits on the money he injected to support Goldman Sachs during the latest crisis.
If Rothschild or Morgan were around today, they would surely be filling their wallets from the money that continues to flow through the financial industry. But it is not obvious they would be leaping on the latest innovations, at least until they had been seasoned by a crisis.
Warren Buffett stands as a reproach to almost everyone else who has tried to make a living from investing, writes John Authers. Indisputably the greatest investor ever, the scale of his achievement is hard to comprehend.
Berkshire Hathaway, the struggling textiles company he bought 50 years ago, is now the third-largest company in the US by market value, and the world’s biggest conglomerate.
Buffett’s fortune has placed him among the world’s two or three richest men. And this has been backed by the investment performance of Berkshire Hathaway: since 1980, the S&P 500 — the most widely used measure of the US stock market — has gained 1,850 per cent, compared with Berkshire’s growth of 84,000 per cent.
How did he do it? Buffett’s annual letters to investors, and his frequent loquacious appearances in the media, give plenty of hints. A student of Benjamin Graham, who invented value investing — a system for beating the market by buying stocks when they are cheap and out of favour — Buffett applied the technique to successful companies. If a company had a “wide economic moat” — a sustainable competitive advantage — he would buy it, even if it did not look a complete bargain.
He also grasped that great performance was possible only if he did not diversify too widely, stuck to companies and industries he understood and held stocks for many decades. In all of these respects, Buffett looked utterly unlike most investment management products sold to retail investors today.
He was also opportunistic. As Berkshire grew bigger, Buffett sought out deals that took advantage of its size, buying companies outright, or operating as a lender of last resort — at high interest rates — during the crisis of 2008 when banks were unwilling to lend. He is not always long-termist, sometimes making short-term killings on the foreign exchange or commodities markets.
There are other criticisms. Berkshire’s companies tend to be well-entrenched operators in traditional industries, rather than bold innovators. Berkshire manages its taxes as aggressively as anyone — despite its founder’s folksy populism. And there is the question of who can possibly succeed Buffett, now in his 80s.
But the greatest question is how he did it. His simple-sounding ideas are almost impossible to implement in practice, yet he has managed to do so.
If anyone can claim to have brought banking to the middle and working classes, it was Amadeo Giannini, writes John Authers. The founder of Bank of America revolutionised banking in the US, and left behind him the biggest commercial bank in the nation.
Seven decades after his death, the bank continues to provide the backbone of the biggest consumer banking franchise in the US. But the positive image he created of the banker as a pillar of the community is long gone.
The son of Italian immigrants who arrived in California in the 1849 gold rush, Giannini left school young to work as a trader of agricultural produce. He only entered banking when he set up the Bank of Italy in San Francisco in 1904, at the age of 34. His idea was to serve migrant workers who could not find financing anywhere else.
The migrants turned out to be very disciplined and focused workers, and excellent credit-risks — a combination of attributes that would also spur the growth of microcredit in the developing world many decades later.
Giannini achieved national fame after the San Francisco earthquake of 1906, when he set up a temporary bank to help ease citizens’ desperate straits. According to legend, he funded this with $2m he had retrieved from the rubble of his bank’s headquarters. He then built Bank of Italy branches throughout California, servicing different migrant communities. This dispersed model was a radical departure in the US.
In 1930, Bank of Italy became Bank of America, and took on a new heroic role financing infrastructure projects (including San Francisco’s Golden Gate bridge) as the US tried to weather the Great Depression. It was also in on the birth of Silicon Valley, seeding the business that would become Hewlett-Packard.
In 1998, Bank of America was bought by North Carolina’s NationsBank, led by buccaneering chief executive Hugh McColl, in one of the biggest bank deals in history. The new bank keeps the BofA name, but it is based in Charlotte, North Carolina, and no longer maintains the Giannini populist ethos.
Throughout most of history bankers have tended to be disliked; Giannini gave Americans a banker they could love.
Walk into the airy offices of KKR overlooking New York’s Central Park and one might be forgiven for thinking one has arrived at a venture capital firm, given the edgy modern art on the walls, writes Henny Sender. The message is clear: better to look forwards than backwards.
The former Kohlberg Kravis Roberts may be the most venerable private equity firm around. Other firms may have more money under management and a better track record, but no single founder of any of the big alternative investment firms has the brand name or star quality of Henry Kravis the co-founder of KKR.
It is not just that Kravis and his cousin George Roberts were the pioneers who survived as others, such as Forstmann Little, failed to adapt to changing times. It is that the two men have presided over the institutionalisation of a firm that is far more closely identified with its founders than any of its peers such as Blackstone or Carlyle.
Along the way, they have fostered a culture that remains both entrepreneurial and collegiate. For example, Joe Bae was only 33 and not even a partner when he was sent by the firm to Hong Kong to kickstart its Asian business. Today, that business is so highly regarded by investors that KKR Asia raised $6bn in record time for its second fund for the region. (Bae is now a partner and is likely to be one of the successors when the two founders finally decide to step aside — which they show no sign of doing.)
Kravis hates the description of KKR as the original barbarians at the gate, also the title of the bestseller describing KKR’s (highly) leveraged buyout of RJR Nabisco in 1988, at the time the largest takeover in Wall Street history. Indeed, the cover of the book describes RJR Nabisco as the “victim of the ruthless, rapacious style of finance in the 1980s”. Perhaps it was. But at the same time, the executive management of RJR Nabisco was all about entitlement, and contempt for shareholders. KKR executives were just as much the original activist investors as they were the enfants terribles of finance at that time.
Today, Kravis appears to relish the respect in which he is held. He has presided over initiatives to improve the lives of workers, softening the adversarial relationship with the unions at companies in the KKR portfolio such as HCA, the hospital chain. He has made sure that KKR-owned companies are committed to the best environmental practices, such as recycling the cardboard at retailer Dollar General.
And without much fanfare, he is one of the great philanthropists of New York. The former enfant terrible has become an elder statesman of the industry.
John Pierpont Morgan
For better or worse, John Pierpont Morgan shaped the modern American economy and the financial services industry that serves it, writes John Authers. The most powerful banker who ever lived, his legacy lives on a century after his death — although in some cases, this is because politicians and regulators have deliberately changed the rules to ensure that nobody can ever again amass the same power enjoyed by the original JP Morgan.
Morgan took over what was already a flourishing transatlantic banking business from his father, shortly after the end of the US Civil War. In his early years, he was a pioneer of international banking, persuading Europeans to finance explosive US growth as the growing nation rebuilt after the war, and constructed its continental infrastructure — a phenomenon only since matched by the growth of China in the past few decades.
He used his powers as a banker to become a corporate matchmaker, spotting that the interests of bankers and shareholders were best served if companies could be combined into large trusts, thus cutting costs — and eliminating competition. US Steel and other monopolistic titans emerged from his work.
Morgan also became the world’s first financial firefighter, leading attempts to quell several financial panics throughout the late 19th century, culminating in his masterly performance averting disaster during the Panic of 1907. He was the convenor of negotiations, and the financier of last resort. Crowds watched in awe as he strode along Wall Street between crisis meetings.
Largely in response, the Federal Reserve was created — politicians realised it was dangerous to leave such critical public policy to a private individual. Subsequently, legislators tried to thwart such an accumulation of power by splitting investment and commercial banking with the 1933 Glass-Steagall Act, meaning Morgan’s empire has ever since been represented by both JP Morgan and Morgan Stanley. Those names still adorn two of the world’s most powerful banks. The antitrust battle against the monopoly power that Morgan abetted also continues to this day.
Some critical aspects of the way Morgan did business have gone. The consummate relationship banker — “insider” to his critics — Morgan believed in judgment and in dealing only with people he trusted. Asked about the importance of collateral, he said character was far more important: “A man I do not trust could not get money from me on all the bonds in Christendom.”
Mayer Amschel Rothschild
Mayer Amschel Rothschild founded the greatest of all banking dynasties, and one that enjoyed what was possibly at one time the greatest of all fortunes, writes John Authers. He also defined the concept of the international banker, creating for the first time a power that might even be able to contend with nation states themselves.
The patriarch of the Rothschild bankers, he was born in the Jewish ghetto of Frankfurt am Main in 1744. After a brief apprenticeship at a bank he went into business as a dealer in rare coins. The business naturally expanded into the difficult area of foreign exchange, in those days fraught both by the lack of the deep and liquid market that exists today, and by the wars and revolutions that split Europe during his lifetime.
He rose to be the personal banker for the Landgrave of Hesse-Kassel, one of the electors who selected the Holy Roman Emperor, a position that added greatly to Rothschild’s power. He could then issue his own bonds, using capital from the Landgrave.
Perhaps his unique insight was to see the importance of an international dimension to banking, and to plan deliberately for an international banking dynasty. He sent his sons to Vienna, Naples, London and Paris, as well as Frankfurt, where they would all set up their own powerful new outposts of the Rothschild empire. These “five arrows” of banking gave a vital source of advantage. If his clients had difficulty gaining access to funds, his international network could do it for them.
Famously, the Rothschilds raised money to allow the British to fight the Napoleonic wars, in a lucrative undertaking that led to the aphorism that you should “buy when there is blood in the streets”.
From there, Mayer Amschel’s sons moved on to dominate 19th century European finance, to build what at its apex might have been the greatest fortune ever assembled, and to spark myriad conspiracy theories. Perhaps no family has ever suffered more and wilder accusations, as a quick internet search for the words “Rothschild” and “Illuminati” will show.
The family remains powerful to this day, although the model of keeping tight control through a family has long been superseded. Governments, now wise to the fact that the power to control the money supply can make bankers more powerful than politicians, have tried to ensure international bankers can no longer wield so much power. But seven generations on, Mayer Amschel’s descendants still run many businesses across the world, and they have branched out into new areas, notably fine wine.
Muhammad Yunus may not have invented microfinance, but he is the man most closely associated with it in the modern world, writes Andrew Jack. His championing of small loans to the poor in Bangladesh — and the related idea of social business — has spread around the world. At home the same socially responsible values are very much in evidence in BRAC Bank, for example.
Born in Chittagong, then in East Bengal, in 1940, Yunus pursued research in economics, moving to the US to study for a doctorate. But the war that led to the independence of Bangladesh in 1971 drew him home. Within three years, at a time of famine and persistent poverty, he grew frustrated with university teaching and focused on working directly with the poor.
In 1976, he began offering very small loans without security to the poor, notably women, to bypass loan sharks, initially extending the money interest-free and then underwriting bank loans himself, while insisting on immediate and regular repayments by instalment.
That became the basis for Grameen Bank (“the bank of the village”), which in 2013 made 7m loans totalling $1.6bn. Its model has since been exported to many other countries, even the US.
His efforts won Yunus and the bank a joint Nobel prize in 2006 — for peace rather than economics. “Yunus’s long-term vision is to eliminate poverty in the world,” the jury concluded. “That vision cannot be realised by means of microcredit alone. But Muhammad Yunus and Grameen Bank have shown that, in the continuing efforts to achieve it, microcredit must play a major part.”
Microfinance has faced growing criticism, however, with accusations that in many countries the interest rates are usurious and that it misallocates finance at the expense of mid-sized and larger enterprises while doing little to alleviate poverty.
A study in Hyderabad in India in 2015 by Esther Duflo of Massachusetts Institute of Technology concluded it had made little difference to lifting households out of poverty. “Microcredit may not be the ‘miracle’ it is sometimes claimed to be, although it does allow some households to invest in their small businesses,” she concluded.
Grameen came under criticism, with Sheikh Hasina Wajed, Bangladesh’s prime minister, accusing it of “sucking blood from the poor”. Yunus himself became embroiled in a battle for control with the government and stepped down as head of the bank aged 70 in 2011.
Undeterred, he continues in books and speeches to champion “social business”, which, like Grameen, reinvests profits rather than paying out dividends.