This is one of my favourite management quotes because this is all strategy is about. I heard it in a lecture during my MBA course back in 2000. This was the time when the Internet was said to change the way business is done for ever and the New Economy was booming. This context had influenced my understanding of the quote for a long time. For me this was some sort of reminder that businesses should never rely on their current strategic position, however comfortable it might be. Businesses should always look out for new strategic opportunities, should scan the horizon for upcoming changes like disruptive technologies (which was a big buzzword at that time), and should try to change the rules of the game (another popular term).

You don’t have to be a gifted strategist to understand that it is better to make things happen – i.e. to be active and to drive changes – than to see things happen – i.e. just to react to changes. If you come into a situation that you wonder that things happen you probably are in serious trouble because it might be too late to react at all.

Today we have a different situation. There is a financial crisis which is probably followed by a crisis of the real economy in many countries. I guess if there was any chance to avoid an economic crisis it was given away by talking so much about the danger of a crisis that it will finally become a self-fulfilling prophecy. In this situation, the majority of companies belong to the categories that see things happen or even wonder that things happen. I suppose no company intentionally made these things happen. Hence, it is first priority for managers and business leaders to manoeuvre their companies through this crisis and to keep them in business at all. This task is difficult enough these days.

However, if I know one thing about the actual crisis it is that it will be over some day sooner or later. It doesn’t take much strategic foresight to know that the business world will look different than. When this time comes, to which category do you want your company to belong? To those that make things happen, to those that see things happen or – again – to those that wonder that things happen? It is already today that business leaders can determine to which of these categories their companies will belong once the crisis is over. Besides the daily struggle for survival, they should devote some time to thinking about how the business world will look like after the crisis. There are some straightforward approaches, for instance:

• In many industries, there will be a higher concentration. Some players will be gone or be taken over by others.
• Customers’ priorities will probably change. They might be more careful about their spendings and might prefer products with other characteristics, e.g. locally made, more durable, less risky etc.
• As for the financial services industry, we can be sure that there will be more regulation. The only question is how exactly this regulation will look like. Nevertheless, one can already try an informed guess about that.

Hence, it should not be too difficult to develop some realistic scenarios for most industries now. It is a good idea to keep those in mind even for today’s business decisions. Today’s decisions are not only about bringing the company through the next couple of days but also about positioning it for the future: If there will be less but larger competitors – how will you compete with them. Are you in a position to put some struggling competitors on your watch list so that you might take them over once the time is up? If the new regulation for the financial services industry will reduce the industry’s ROE, what will be your new value proposition for your shareholders? Now is a good time to go through your portfolio of strategic ideas, be they in experimental stage or just an unfinished thought in your mind. Those ideas might not have been a promising business opportunity in past times, but they might become more interesting in future.

The quote about companies that make or see things happen is not only valid for boom times when businesses try to outsmart competitors by trying to invent the next big thing technology or business model. It is as important in times of a crisis. While most companies are more than busy trying to survive or to minimise their losses, the smarter ones already think about the next boom. Those will be the ones that make things happen in future.

Using two new advertising clips from the “get a mac” show, Apple makes fun of a very expensive MS advertising campaign, which Microsoft has started for Windows. The cost of the MS campaign has been estimated for 350 million US dollar that had it start in Germany recently. Last weekend Apple started two new funny commercials that address this campaign for Vista in detail. (In the US the windows campaign for Vista was started with two commercials featuring Bill Gates and star comedian Seinfeld.)

The two new commercials:
 
 

On Youtube you can also find the entire “get a mac” show:

Since there a lots of comments for this campaign; I have to inform you (you might notice that this is some sort of disclaimer) that the Judo approach is the core. The IT matter is just the example. Furthermore: We use PCs to run our websites, to do accounting, to edit graphics ….

Lesson 1: We had to learn the “to big to fail” is not always a reliable option; under specific circumstance (say hello to the Black Swan) everything is possible. Lesson 2: Liquidity is not just a question of price (in this particular case: spread), it is more a question of trust and price…and therefore illiquidity is not always available for everyone in the market place. What Lehman Brothers was for the US, was Hypo Real Estate and its subsidiary DEPFA for Germany. But this is not specific enough: There is a similarity and a difference. The similarity is: Both banks (the collapse of Lehman and the nearly collapse of HRE) represent the watershed how the Governments and their authorities managed these issues. After two risks situations for a collapse of HRE (yes, we had two situations for the same bank, since the organization was not able to quantify their liquidity needs precisely enough) Germany had to learn that the financial crisis would affect the German financial landscape “a little bit more” than predicted. The difference is: Since the Lehman collapse and its dramatic impact on the financial markets took place before HRE, the German government was prepared mentally to act…So let’s describe it this way; Germany and other countries had luck since they could observe a collapse of a large bank and its impact on the market place.

Is this the end of the story? No, definitely it is not. The next months we will struggle with secondary effects in the real industry. But I would like to have a brief look at the regulatory side. What can we expect in terms of new regulatory issues?

• Existing sophisticated risk management systems/approaches were not able to enough to protect banks against financial losses from credit default risks (evaluation risks). Banks focused on external ratings instead of really analyzing the background of structured products; rating agencies could not offer reliable data.
• Liquidity risk management approaches used assumptions that not were valid in stress situations.
• Write offs in assets reduced the tier 1 capital, hence banks came under pressure to find new capital sources. In the past some banks had optimized their equity in order to establish the mathematical fundament for very high ROE ratio.

Taking these issues into consideration, I assume that

• Banks will change the management of their equity and will operate their business with a larger amount in terms of tier 1 capital. The process to manage equity in stress situations will become more important.
• The regulator will establish / define specific risk scenarios or even stress tests for liquidity management. Furthermore the regulator will focus more on the underlying assumptions that have been employed to assess risk situations.
• The regulator will force banks to check the value of their assets not only on the fundament of external ratings. A look-trough approach will gain more importance.
• The regulator will check whether the salary structure and the benefit scheme might cause risk situations and might lower the attention for long term success.
• Accounting of SPVs, SEV and derivative financial instruments will become more complex in order to address the inherent risks of those products and operations.

In sum this situation will change how banks manage their business and their risk situation. The perception of the banking industry has got a negative touch. It will take years to reconstitute trust.

Q: Thank you very much for the opportunity to make this interview. Time is money; hence I would like to start with my first question right away. Liquidity has become one of the most important business aspects. How would you describe the current situation of your organization?

A: “We have achieved our best-ever geographic diversification, with half of the Firm’s revenues generated outside the Americas. The result of all this is that we have built a balanced global organization – able to withstand the stresses of rapid shifts in world liquidity flows.

Our Firm ranks #1 “Most Admired Securities Firm” by Fortune. The organization achieves record net revenues, net income and earnings per common share for the fourth consecutive year based on record results in all three business segments.”

Q: Could you please describe your general management approach?

A: “We effectively managed our risk, balance sheet, and expenses. Ultimately, our performance in 2007 was about our “One Firm” sense of shared responsibility and careful management of our liquidity, capital commitments, and balance sheet positions. We benefited from our senior level focus on risk management and, more importantly, from a culture of risk management at every level of the Firm.”

Q: Could you describe your general risk management approach?

A: “Our goal is to realize returns from our business commensurate with the risks assumed. Our business activities have inherent risks that we monitor, evaluate and manage through a comprehensive risk management structure. These risks include market, credit, liquidity, operational and reputational exposures, among others. The bases of our risk control processes are:

• We establish policies to document our risk principles, our risk capacity and tolerance levels.
  
• We monitor and enforce adherence to our risk policies.
  
• We measure quantifiable risks using methodologies and models based on tested assumptions.
  
• We identify emerging risks through monitoring our portfolios, new business development, unusual or complex transactions and external events and market influences.
  
• We report risks to stakeholders.”
  

Q: Many people are confused that certain banks did obviously not manage their liquidity risks. What is your organizational structure to manage liquidity risks?

A: “Management’s Finance Committee is responsible for developing, implementing and enforcing our liquidity, funding and capital policies. These policies include recommendations for capital and balance sheet size as well as the allocation of capital to the business units. Management’s Finance Committee oversees compliance with policies and limits with the goal of ensuring we are not exposed to undue liquidity, funding or capital risk. Our liquidity strategy seeks to ensure that we maintain sufficient liquidity to meet all of our funding obligations in all market environments.

That strategy is centered on five principles:

• Maintaining a liquidity pool that is of sufficient size to cover expected cash outflows for one year in a stressed liquidity environment.
  
• Relying on secured funding only to the extent that we believe it would be available in all market environments.
  
• Diversifying our funding sources to minimize reliance on any given provider.
  
• Assessing our liquidity at the legal entity level. For example, because our legal entity structure can constrain liquidity available to Holdings, our liquidity pool excludes liquidity that is restricted from availability to Holdings.
  
• Maintaining a comprehensive funding action plan to manage a stress liquidity event, including a communication plan for regulators, creditors, investors and clients.”
  

Q: Are there specific reserves or pools that your firm can use to protect their liquidity status? For which period of time can you ensure your liquidity in a stress situation?

A: “We maintain a liquidity pool available to Holdings that covers expected cash outflows for twelve months in a stressed liquidity environment. In assessing the required size of our liquidity pool, we assume that assets outside the liquidity pool cannot be sold to generate cash, unsecured debt cannot be issued, and any cash and unencumbered liquid collateral outside of the liquidity pool cannot be used to support the liquidity of Holdings.”

Q: Do you have some kind of emergency plan for stress situations?

A: “We have developed and regularly update a Funding Action Plan, which represents a detailed action plan to manage a stress liquidity event, including a communication plan for regulators, creditors, investors and clients. The Funding Action Plan considers two types of liquidity stress events—a Company-specific event, where there are no issues with overall market liquidity and a broader market-wide event, which affects not just our Company but the entire market. In a Company-specific event, we assume we would lose access to the unsecured funding market for a full year and have to rely on the liquidity pool available to Holdings to cover expected cash outflows over the next twelve months.

In a market liquidity event, in addition to the pressure of a Company specific event, we also assume that, because the event is market wide, additional counterparties to whom we have extended liquidity facilities draw on these facilities. To mitigate the effect of a market liquidity event, we have developed access to additional liquidity sources beyond the liquidity pool at Holdings, including unutilized funding capacity in our bank entities and unutilized capacity in our bank facilities. We perform regular assessments of our funding requirements in stress liquidity scenarios to best ensure we can meet all our funding obligations in all market environments.”

Q: Thank you very much for the interview. This a lot of excellent information about the risk management structure of your firm.

A: Not a told, it was a pleasure.

Resume

Everything does sound fine, doesn’t it? It might be that you are banker and interested to join this bank? This bank manages its liquidity situation and can cover expected cash outflows for 12 months. Those aspects have gained a major meaning for bank management.

Well, I have very bad news for you. This was a fictitious interview with a US bank. What is the name of the bank? Lehman Brothers; hence an application for a job interview is not an option. The idea for this post was to find relevant statements how a bank manages its liquidity needs and how appropriate approaches and tools have worked in real life stress situations. The organization describes this system in details. Considering all the statements above, everything is fine. The core question for the risk management of your organization: How does your firm manages black swan effects? Do you have a plan B?

Note: All statements have been extracted from Lehman Brothers Annual reports 2007 or the firm’s website. Specific words and terms (e.g. Investment bank) have been replaced with the term “organization” or “firm” in order not to disclose the source of answers to early.

We all witness the worst financial crisis most of us would have thought of in these days. We also witness the breakdown of more and more financial institutions. With every such breakdown, the remaining banks and financial institutions get into more problems and the risk of even more breakdowns increases. We can safely assume that all those banks in trouble have (or had) some sort of strategy. Banking regulators and capital markets explicitly require that. Hence, we can also safely assume that those banks have (had) some intelligent, well educated and highly paid strategists. Many may also have hired strategy consultants who are even more expensive. According to the above definition, wasn’t it the job of those strategists to prepare their employers or customers for hard times, even for a financial crisis? Have they all failed?

To my opinion – yes and no. 

Why ‘no’?
As it seems, many banks are not really prepared for a severe worldwide financial crisis. However, is it really possible to prepare for a crisis like this? The latest events at the financial markets are the worst, many experienced bankers could think of. What we see these days is a worst-case scenario that comes true. With this in mind we come to the point. I bet there is more than one bank which has a description of a crisis very similar to the current one somewhere in their strategy folders. This will be labelled “worst-case scenario” and it will probably sit right beside a similar paper labelled “best-case scenario” which describes a bright future with booming financial markets and increasing real estate prices. No manager in his right mind would develop a strategy for his business based on only one of these two extremes. Scenario planning is about developing a set of different scenarios. By nature, some of them are more probable than others. Than, you decide for one scenario which potentially has a high impact on your business and a fairly high probability of occurrence. Of course, you may also go for a combination of two or three scenarios, that all have a high impact and considerable probability. This scenario or combination of scenarios becomes the basis for your strategy. Following this procedure, it is not advisable to develop a strategy for a worst-case scenario. Though it might have an extremely high impact on the business, its probability of occurrence is very low.

So far, the strategists are not to blame. They have prepared strategies for a more likely course of events than a worldwide financial crisis which includes the breakdown of banks that were considered “too big to fail”. Imagine a bank had prepared and executed a strategy that expected this type of financial crisis two years ago. They would be very lucky today. Before the beginning of the crisis, however, they would have been criticized for being overly risk averse. To guard against any thinkable risk would simultaneously limit any options to generate returns. To loosely quote from the movie “War Games” – The only way definitely not to lose anything in this game is not to play it. Therefore, half of my above answer is no, strategists haven’t failed.

Why ‘yes’?
Nevertheless, if that was the right thing to do, what would than be the point of preparing a worst-case scenario at all? As I see it, a worst-case scenario is there to sensitize planners and managers for very dangerous developments which ware although unlikely not impossible to come. They should at least have thought about their options under that scenario. So they would have some ideas how to react and what to do. If they all had done their homework, how could this crisis have taken anybody so much by surprise? Is there any bank that can refer back to their strategy folder because they discussed a scenario of a worldwide financial crisis and brainstormed some things to do in this unlikely case? If you look at the apparently completely unprepared financial market players, the other half of my answer is yes, strategists have failed.

To be honest, this last statement might be a bit unfair. Only failing banks hit the news these days. So I really don’t know if there aren’t any banks that do exactly that – look at their worst-case scenarios and their prepared plans for those so that they have a nice set of ideas to start with. If there are some, maybe we will read about them in some strategy textbook case studies after some years.

Unfortunately this is likely not to be the case. A key role is given to real estate market in the United States. As long as we see a decline in real estate prices, we cannot expect a total stabilization in US financial markets, US economy or US financial system. Declining prices for real estate does not only reduce the wealth of US consumers. It also reduces the value of mortgages and therefore the values of structured financial products and bonds that are linked with the value of these mortgages. How long may it take before we see the bottom line in terms of house prices? The ratio between real estate prices and rents can be used as an indicator (some sort of price-earnings ratio for real estate). Until the year 2000 this ratio was quite stable. The strong price increase for real estate did change this ratio after 2000. Taking into account the development of the Case/Shiller Index –which shows a 16 % decline per year for 10 selected cities – as well as rent increase, it would take several months (until 2010!) before the ratio has reached it long term median. Of course, everything (different to this) is possible. But considering this ratio it can be assumed that real estate prices will be under pressure in 2009, too.

Since the beginning of the financial crisis US banks had to write down 260 billion USD. But they were just able to raise 184 billion USD in terms of new equity to stabilize their capital base. Due to an ongoing decline in real estate prices it can be expected that this disproportion will continue. Even if the US government’s plan to buy bad securities from banks can be described as a right step, the pressure for the US banking system will keep high. Do we face the risk to end in a situation like Japan in the early 90’s? Probably this won’t be the case. The US economy can be characterized by extremely flexible labor- and commodity markets. First and foremost US banks have started to write downs their mortgages and securities more quickly compared to Japanese banks at the early 90’s. Furthermore the US government seems to accept a more active role to stabilize the markets. In sum it cannot be recommended to put US situation on a level with the situation in Japan.

• All CDS positions (CDS = credit default swaps) have to be cleared and processed. Their sum has been estimated about 1400 to 1600 billion USD. (The total market size is 62000 billion USD).
• The total of mortgage based securities (e.g. mortgage backed securities) that have been issued from Freddie Mac and Fannie Mae counts for 5500 billion USD. This is nearly 50 % of the US market, which counts for 12000 billion USD.
• The US government is ready to invest 200 billion USD in preferred shares. The sum of all public spending was 2700 billion USD in 2007.
• The month the US government will spend 5 billion USD for bond issues of Freddie and Fannie.
• Two month ago the Congressional Budget Office estimated the financial burden resulting to rescue Freddie Mac and Fannie Mae. The forecast was 25 billion USD.
• Indeed the cost of this rescue measure will account for 300 billion USD (outcome of a new forecast). This amount would nearly twice the number in terms of US net raising of credit in 2007.

In sum it will be a very expensive rescue measure for the public budget. But alternatives – doing nothing – could be second best solutions, furthermore they bear the risks to become far more expansive due to avalanche impact chains.

Competitive advantages exist when an organization has a specific resource structure in comparison to other firms. Such a differentiation in terms of resource structure can be achieved and protected by investment activities (e.g. by R&D activities; establishing a new plant with a very efficient production line that creates a cost advantage). Due to incomplete information and a future perspective investment activities are always linked with uncertainty. No matter how good your analysis and forecasting have been, you always deal with the future and hence there is no guarantee that you receive your expected returns. But this uncertainty is not the only critical issue. Another attribute for an investment activity is its irreversibility. This irreversibility occurs due to the impossibility to reverse an investment without consequences. Typical consequences are sunk costs (see this old post concerning sunk cost dilemma). Could one reverse investment activities without cost, every investment activity could be made without any kind of risks.

Another critical issue is commitment that can be defined as to stick to a chosen strategic direction. In corporate practice this stick is called “commitment” very often. Reasons to stick are called “sticky factors”; four different types of these sticky factors can be distinguished.

• The first factor is an exit barrier which creates a lock-in situation. It is established by composition of everlasting and specialized factors which make it difficult to turn back to the starting point. Sunk cost and the loss of intangible assets represent the most critical issues.
• Barriers for a re-entry. An exit from a specific strategic direction can be inappropriate since a re-entry to this direction might be difficult or impossible afterwards.
• The time lag between strategy implementation and observation of results is another issue. During this time an organization will stick to selected strategic direction.
• Organizational idleness arises from different psychological or sociological reasons, e.g. that a project promoter does not want to accept a failure. This factor has its share that an organization sticks to a selected strategy, too.

Choosing the right strategic direction is a hard business. When identifying the need to change this direction you have to keep in mind that there are sticky factors which create barriers to shift to a new direction.

As an example and as a small contribution to the knowledge of our international readers about Germany I will present some very interesting figures concerning German understanding about the value of knowledge and education. German understanding is (unfortunately) different to understanding / perception in the Anglo American world. Students protest against study fees of the universities, but not for an extension of the scholarship system. Education / Knowledge is not allowed to become an asset. (Note: Transfer this perception to the bookstore next to you, and you should get all literature for free). Politicians of all segments agree on education equity – but accept that the very first education (neonatal training in kindergarten) has to be paid. Okay, that won’t be a strategic issue in terms of organizational management…anyway I found those numbers quite interesting.

• Daily entertainment consumption (TV, Internet, Computer games) of 10 year kid in North Germany within an immigration family on weekend: 340 minutes
• Daily entertainment consumption (TV, Internet, Computer games) of 10 year kid in South Germany within an German family (at least one parent has a high school degree) on weekend: 54 minutes
• Annual fee for a private kindergarten (5 star quality) near Berlin: 11.760 EUR
• Annual fee for a public kindergarten in a rich town in South Germany for a 4 year kid (parent’s income is under 45.000 EUR): 0 EUR
• Annual fee for a public kindergarten in a “not so rich town” in North Germany for a 4 year kid (parent’s income is under 45.000 EUR): 1.752 EUR
• Study fees for the public university in the same town in North Germany within the first 14 terms: 0 EUR

(Data Source: The world in Numbers (Brand eins Journal, vol. 5, 2008).

General Motors (GM) operates the brand Chevrolet that can be described as a maker of automotive icons like Corvette sports car or Blazer jeep. Daewoo, a South Korean car maker, also belongs to the GM Empire. Due to an idea of GM, Chevrolet also transfers its large brand to small Daewoo cars like the Aveo. Once upon a time the Chevrolet Aveo was the Daewoo Kalos, than it became a Chevy car.

© GM Media; Source: Press information by Chevrolet Deutschland GmbH

Well, in the case that you buy a Chevrolet you will not be happy about those kind of statements from a current German newspaper: …Indeed it is hard to find superior attributes within the Aveo…”. That is not a good feedback, but at the end of the article an interesting mixture of feedback and humor creates a very sticky summary: what is left after 14 days of testing? “…we got a parking ticket…and a memory of the most lamely engine since an Opel Diesel car in 1990…”

I cannot believe that GM brand managers will be happy about this type of feedback. In the South Korean market the Chevrolet Aveo is still a Daewoo car, hence it would be helpful to transfer this approach to other markets and to protect the Chevrolet brand.