Praise for FINANCIAL DARWINISM

"The best business management tool is common sense. While such a timeless truth remains indispensable, it takes new thinking to navigate the astonishingly complex and rapidly changing world of finance. Over the years, I have personally witnessed leading organizations' reliance on Leo Tilman's advice and insights to deliver consistent profits and manage risk. I hope the readers of this smart, original, and practical book will benefit in kind."
Alan C. "Ace" Greenberg, Vice Chairman Emeritus, J.P. Morgan

"Responding to earnings pressures with outdated concepts and tools or, worse yet, blind risk-taking has an unhappy ending in every case. Get your organization's costs under control and staff it with highly competent professionals. Then use Financial Darwinism to prosper in the world of globalization and deregulation."
Jamie B. Stewart Jr., President and CEO, The Federal Farm Credit Banks Funding Corporation Past Acting President and COO, The Federal Reserve Bank of New York

"A masterful treatise on piloting complex financial institutions through the newer and tougher challenges imposed on them by the evolving marketplace. Tilman presents a unified conceptual framework that not only resonates with one's intuition, but also offers specific structural approaches to the decisions made by financial executives. This book is a must for anyone interested in improved strategies for risk management and economic performance."
Dr. Darrell Duffie, Dean Witter Distinguished Professor of Finance, The Graduate School of Business, Stanford University

"Tilman has distilled the larger pattern from the seemingly endless reorganizations of financial institutions, some strategic and others quite foolish. Financial Darwinism articulates a framework for understanding and, for financial executives and practitioners, initiating strategic choices."
Dr. Bennett W. Golub, Vice Chairman, BlackRock, Inc.

"Financial Darwinism explains the tectonic shifts now underway in the investment world far better than any book I have seen to date. Those who are interested in really understanding how financial markets have dramatically changed in the past few years and how they are likely to change again in the next few years would do well to read and absorb this important work by Leo Tilman."
David M. Rubenstein, Cofounder and Managing Director, The Carlyle Group

Leo M. Tilman (NY, NY) has been named Young Global Leader of the World Economic Forum for his professional accomplishments, commitment to society and potential to contribute to shaping the world.  As the Chief Institutional Strategist and Senior Managing Director at a leading investment firm, Tilman is known for providing institutional clients with advice and solutions regarding strategic decision making, corporate finance, investment strategy, product design, asset/liability management, and risk management.  Tilman is also a lecturer in the financial engineering program on foundations of finance at Columbia University.  He is co-author of Risk Management and editor of Asset/Liability Management of Financial Institutions, as well as contributing editor of The Journal of Risk Finance.  He makes regular TV appearances and is often quoted in the financial media such as The Wall Street Journal, New York Times, Forbes, Bloomberg, and Barron’s among others.  He earned his B.A. and M.A. degrees from Columbia University.

Financial Darwinism

Create Value or Self-Destruct in a World of RiskBy Leo M. Tilman

John Wiley & Sons

Copyright © 2008 Leo M. Tilman
All right reserved.
ISBN: 978-0-470-38546-3

Chapter One

Understanding and Navigating the Financial Revolution

Introduction: The Need for Transformational Thinking

The world of modern finance is beset with complexity, dynamism, and risk. On a path of ever-intensifying evolution, it presents a landscape of significant uncertainty but also of rapid innovation and opportunity. More so than ever before, success rests on the ability to make sense of the evolutionary changes, link up seemingly unrelated phenomena, and understand the global forces at play. There is a lot to absorb indeed. Once-comfortable financial businesses are confronted with the increased competition and lower margins. Time-tested strategies are being threatened by disruptive technologies and globalization. Financial crises that are deemed "once-in-a-lifetime" by financial models seem to be occurring with an alarming regularity. Sensationalist news headlines and prognostications of financial pundits are obscuring, rather than illuminating, the reality. Worse yet, there is no coherent paradigm to help financial executives, investors, practitioners, and regulators around the world wrestle with these universal challenges and navigate the ongoing tectonic financial shift.

During a recent Harvard Business School seminar, a well-known investor observed that "traditional asset-allocation strategies are having trouble in today's world." A Wall Street executive echoed the sentiment during a TV interview: "being a great M & A advisor alone doesn't cut it anymore. Unless you can also provide a client with a [multibillion dollar] financing package, you're irrelevant." "If you want to stay alive in the asset management business," an equity analyst wrote in a research note, "you have to go into unique products and go out on the risk spectrum." "We've had a tremendous golden age of [commercial] banking, and we are not going to continue to see that kind of performance," concluded the head of a government agency in the United States. Similar urgency is often conveyed behind closed doors of executive offices and boardrooms-in relation to lending activities, the fight for bank deposits, secular fee compression, declining margins of traditional financial businesses, tougher global competition, and increasingly discerning and informed consumers. The resistance to acknowledge the dramatic and permanent structural transformation of the world of finance-along with the seemingly accelerating pace of change and innovation-is entirely understandable: Change is hard work. Deep down, however, executives and investors know-some more viscerally than others-that the new financial order demands decisive actions on the part of those who want to avoid becoming casualties of financial natural selection.

My purpose in writing this book was to make sense of this new realm in which financial institutions and investors find themselves and to describe-in both theoretical and practical terms-how they can adapt and prosper. The more conceptual portion of this work is Dynamic Finance-an evolutionary thesis about the origins, the drivers, and the implications of the ongoing financial revolution. The practical part of this work is Financial Darwinism-an actionable decision-making framework that draws on this evolutionary perspective to help financial executives and investors navigate the dynamic new world. This chapter is a nontechnical overview of the entire book that is designed to introduce the underlying ideas in broad conceptual strokes. Figure 1.1 presents this book at a glance.

The Transformation (Chapters 1 and 2)

Today, huge pools of capital freely roam about the global financial system in search for investment returns. Capital markets and financial institutions play an increasingly important role in the lives of consumers and real economies. Financial markets are more efficient and interconnected than ever before. Financial instruments and financial institutions are opaque and complex. The static, fragmented, heavily regulated, simpler, comfortable, and accounting-based financial regime has given way to a dynamic, chaotic, globalized, heavily interconnected, deregulated, complex, uncertain, and risk-based realm.

The Evolutionary Thesis (Chapters 2 and 3)

It has been argued that financial services represent an evolutionary system in which no formula works forever: "today's successes will be tomorrow's failures unless they adapt and innovate." In this spirit, Dynamic Finance endeavors to comprehensively explain the process of economic value creation by financial institutions. With the ultimate objective of guiding strategic decisions, it examines how financial institutions used to created economic value in the past and then uses financial theory to offer a concise new approach to thinking about economic performance in today's world. In the process, as the multitude of drivers that put pressures on traditional financial businesses is discussed, I argue that many of these forces are secular in nature i.e., expected to last over very long time frames. This makes the return to the comfortable old world of finance highly unlikely.

The Decision-Making Framework (Chapters 4 and 5)

By drawing upon this evolutionary perspective, Financial Darwinism blends business strategy, corporate finance, investment analysis, and risk management to give financial executives a menu of broad choices on how to create or enhance economic value. Complexity is filtered out, while the richness of unique circumstances and institutional landscapes is preserved. Throughout, I argue that the strategic vision of today's executives must encompass business strategy, dynamic risk taking, and business model transformations-the new concept introduced in the book. This, in turn, requires an expanded skill set on the part of senior decision makers as well as their command of the entire arsenal of advanced financial tools. Importantly, many leading companies are already adapting to the changed financial landscape in the general spirit of this book's ideas, even in the absence of a comprehensive framework. These desirable evolutionary responses pose a stark contrast to the notable failures to recognize the new realities and adapt accordingly, as demonstrated by modern financial crises and other institutional experiences with sad endings.

The Conceptual Anchor

In the center of it all-linking the seemingly disparate macroeconomic and financial market phenomena as well as institutional behaviors-is the concept of economic performance and its own evolutionary transformation. The old-fashioned, accounting-earnings-inspired formula for economic performance was reflective of the buy-and-hold nature of traditional financial businesses. I propose that the basic key to understanding the behavior of modern financial institutions and capital markets lies in the recognition of the fact that the process of economic value creation in finance has undergone a fundamental transformation. More specifically, due to significant margin pressures on basic financial businesses, active risk taking has begun to play an increasingly dominant role in how financial institutions create and destroy shareholder value. Therefore, the analytical expression for economic performance should change accordingly. The introduction of the risk-based economic performance equation enables the development of both the evolutionary thesis and the resulting practical decision-making framework underlying this book.

The Role of Risk Management

One of the important motifs of this book is the convergence of business strategy, corporate finance, investment activities, and risk management under the umbrella of executive decision making. Risk has always been a major factor in financial transactions and the lives of financial institutions. However, as any practitioner would attest, a palpable disconnect between risk management and executive decision making has largely persisted with risk management often viewed as a policing function or a passive safety-and-soundness verification. More often than not, the risk manager continues to be brought in after major strategic decisions had already been made. It is, therefore, not surprising that despite the advances in financial theory, analytics, and technology that afforded an increasingly rigorous understanding of complex portfolios and balance sheets, elevating risk management to be an important decision tool has proven challenging. On the pages that follow, I explain why pressures on traditional financial businesses are likely to become a catalyst for changing the mental paradigm underlying executive decisions, with active risk taking and risk management becoming explicitly linked to the process of economic value creation. It is imperative that risk management becomes the very language of enterprise-wide strategic decisions going forward and that the chief risk officer becomes an executive who gets an equal seat at the table where corporate strategy is decided.

In order to set the stage for the discussion of the old financial regime and the way it worked, let us look next at a classic American film that takes us back to the origins of the world of finance as we know it.

From George Bailey to the Golden Age

My students and colleagues are often puzzled with the frequency of my references to one of the most beloved American cinema classics, It's a Wonderful Life (1946). To me, however, in addition to bringing reflection and a sense of purpose to so many viewers every holiday season, this film is indispensable in any discussion on the evolution of the financial system and the nature of financial intermediation. Next time you immerse yourself in the film's nostalgic snow-covered world of Bedford Falls, you just might see certain aspects of this life-affirming story through a different lens.

The life of George Bailey (Jimmy Stewart) is neither prosperous nor carefree. In fact, we first learn about him on a Christmas Eve through the prayers of Bedford Falls' residents. Overwhelmed by his misfortunes and "worth more dead than alive," George is contemplating a suicide. As the movie progresses, we realize that George's life-as that of his father who started and ran the Bailey Brothers Building and Loan Association-is a far cry from "lassoing the moon and bringing it down." More than anything, George wants to leave the "crummy little town," see the world, go to college to "see what they know," and then do something big and important. Instead, he devotes his life to running the "measly, one-horse institution" where people can come to borrow money. George sends his brother to college in his place, marries his childhood sweetheart, spends his honeymoon money on averting a bank run, and fights the "the richest and meanest" man in town, Mr. Potter (Lionel Barrymore), to keep the building and loan association going. What drives him is a deep-seated belief that hard-working people deserve to "work and pay and live and die in a couple of decent rooms and a bath."

An angel (Second Class) is dispatched to save George by showing him how much he has contributed to the lives of so many. As they walk through the town seeing what life would be like if George had never been born, they discover that Bedford Falls (named Pottersville, instead) is a dystopian nightmare. The Bailey Brothers Building and Loan Association is long closed, Bailey Park with pretty homes for the working families has never been built, and Ma Bailey, his mother, is running a boarding house. As George realizes that his life has had a profound effect on the town and returns to his family, the Bedford Falls residents rush to his rescue with their savings-more than making up for the funds his uncle mistakenly lost. In an inspirational and deeply spiritual ending, as the camera glances over the pile of money on the table, we see George-happy and at peace-with his little daughter in his arms (and her flower petals in his pocket). In the way that matters, he truly is "the richest man in town."

The world of finance-along with its evolution toward the Golden Age witnessed toward the end of the twentieth century-has come a long way from the time depicted in "It's a Wonderful Life." George could not have known that home ownership would become a major public policy objective in the United States and an amazing source of wealth creation for the population as a whole. Nor could he have imagined that 60 years later a complex network of securities firms, commercial banks, and government-sponsored enterprises would pool together, securitize, guarantee, make markets, slice and dice, and sell mortgages, credit card receivables, and student loans of Bedford Falls' residents to investors in Rio de Janeiro, Abu Dhabi, Beijing, and Moscow.

Gradually, throughout the latter half of the twentieth century, macroeconomic and financial landscapes evolved toward more sophisticated regulation as well as more deliberate public and economic policies. Toward the end of the century, financial businesses became more institutionalized. Risk-management practices and tools improved. Economic volatilities-swings in unemployment, output, inflation, and interest rates-declined. Regulation greatly enhanced the safety and soundness of financial intermediaries, protecting their clients and stakeholders. The power of the informed and discerning consumers steadily increased, and client service became one of the key ingredients of success (pace, Mr. Potter).

Among other benefits and apart from rare exceptions, this allowed executives running financial institutions to spend honeymoon money on honeymoons as opposed to averting bank runs. While the good times were occasionally interrupted by rocky periods-such as the inflationary experience of the 1970s, the Savings and Loan crisis of the 1980s, and the Asian and the Long-Term Capital Management crises of the late 1990s-everything culminated in what can be described as a Golden Age of financial intermediation. Why is that? While the external environment dramatically improved, fees and other forms of compensation for basic financial services generally remained handsome, inspiring such old saws about the banking businesses as: "Borrow at 2 percent, lend at 6 percent, and be on the golf course by 3:00 pm." George Bailey would have liked that!

Interestingly, as financial intermediaries were becoming convinced that the Golden Age would never end, a tectonic shift was already underway. The financial landscape changed significantly-slowly at first, and then gaining speed-and a vast array of new financial products and services began competing in an increasingly complex and global marketplace. Margins on traditional businesses began to decline, forcing financial institutions everywhere to start exploring ways to adapt to the unfamiliar new world.

Accounting for Profits the Old-Fashioned Way

Before I turn to the discussion of the tectonic financial shift itself and the evolutionary changes that it brought about, I want to look more closely at the process of shareholder value creation by financial institutions during the old regime. On the surface, of course, success was measured by their ability to generate stable and growing accounting earnings. Deep down, not surprisingly, powerful economic considerations were at play. They represent a critical building block of this book's evolutionary perspective.

(Continues...)

Excerpted from Financial Darwinismby Leo M. Tilman Copyright © 2008 by Leo M. Tilman. Excerpted by permission.
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