View Full Version : Peter Principle - why (European) banks failed

28-08-2009, 07:46 PM
Great article from John Kay who writes for the Financial Times

Variation of the Peter Principle in that diversification to the level of incompetence will continue to be a powerful element in business behaviour.

Seems to sum up the behaviour of some NZ companies - diversified into things they did really understand etc .... and highlights how lucky Aust banks have been ... they came close to being like their European and US cousins

Banks brought down by new Peter Principle

Financial Times 26 August 2009

It is particularly easy for those who work in financial institutions to make the mistake of believing that their success is the result of exceptional skill rather than good fortune. Until vanity is vanquished, I anticipate that diversification to the level of incompetence will continue to be a powerful element in business behaviour.

Forty years ago, Dr Lawrence Peter enunciated what he immodestly called the Peter Principle. Individuals would find their level of incompetence. If you were good at doing a job, you would be promoted until you were appointed to a job you werenít good at.

The recent failures of financial institutions suggests an organisational analogue. Financial institutions diversify into their level of incompetence. They extend their scope into activities they understand less until they are tripped up by one they cannot do. It was almost refreshing when the Chelsea Building Society announced large losses because it had been a victim of mortgage fraud. The bankís problems related to its core business. Most financial institutions that have come close to failure have done so as a result of losses in essentially peripheral activities.

The principle of diversification into incompetence applies from the largest financial institution to the smallest. AIG was Americaís leading insurance company. The company did not just undertake credit insurance, but was the largest trader in the credit default swap market. That is how its financial products group, employing 120 people in London, brought about the collapse of a business that employed 120,000.

The very name of the Dunfermline Building Society evokes prudence, its base the home town of that canniest of Scotsmen, Andrew Carnegie. For more than a century, the society collected savings to lend to careful homebuyers. What were they thinking of when they decided that 2007 was the perfect moment for aggressive development of their commercial lending portfolio?

Hypo Real Estate was Germanyís largest property lender: it is hard to think of a duller but more profitable dominant position. So the bank bought a business that specialised in raising funds on wholesale money markets to lend to public authorities. No doubt its advisers offered an explanation of how you can make lots of money doing that. But whatever the explanation was, it was wrong, and led to Europeís most costly bank bail-out.

The boredom factor is important. Much of traditional banking is quite boring. The desire to find new challenges is an admirable human trait. It is, however, very expensive for shareholders to allow their chief executives to indulge it.

Public sector bodies are usually constrained in their activities, so deregulation is often a trigger for expensive experimentation. In Britain, many of the efficiency gains from privatisation were squandered in diversification: I watched senior managers spending 80 per cent of their time on activities that generated 1 per cent of turnover and minus 10 per cent of profit. But it is more fun to go on jollies to Buenos Aires than to fix leaking pipes.

To win an auction when you donít know what you are bidding for is often to lose. This winnerís curse is often behind bad acquisitions because the successful purchaser is the bidder most willing to pay too much. Hence the contest between Royal Bank of Scotland and Barclays as to which bank would court bankruptcy by buying ABN Amro. Ignorance of products may also be a problem. When you are the newcomer and know little, the business that gravitates to you will be the business no one else wants.

But the driving factor is hubris. Jim Collinsís well-timed study of How the Mighty Fall applies to every business I have mentioned. The financial services industry is particularly vulnerable to hubris because sections of it are not very competitive, and randomness plays a large role in the outcome of speculative transactions. It is therefore particularly easy for those who work in financial institutions to make the mistake of believing that their success is the result of exceptional skill rather than good fortune. What more natural to believe than that extraordinary talent will find pots of gold under other rainbows? Until vanity is vanquished, I anticipate that diversification to the level of incompetence will continue to be a powerful element in business behaviour.


28-08-2009, 07:57 PM
Excellent article. Thanks, winner.
His remarks about how people can delude themselves into thinking that success is due to their exceptional skill rather than good fortune doesn't apply only to bankers. How about investors pre-1987 and again pre-2008 who decided they were financial geniuses because their share portfolios had grown so strongly.

29-08-2009, 06:46 AM
If the Peter Principle has any gredence you have to wonder about the track PGC has gone and is going down .... like in an article in The herald ..... PGC which hopes to transform the finance company into a registered bank..........recently announced a diversification into funds management.........fact that Marac had "got caught up in the demand for property development finance and the high returns that were offered".

Esp in the context of as the head honch said Marac's core business had performed well. .... and that the current year was a disappointing after a long and proud past

29-08-2009, 07:58 AM
Yet we are all vulnerable to this principle of thinking we are way better than we really are,you only need to look at that old school accountant Alan Hubbard to realise this,what more conservative a gentleman could you get,and a stingy number cruncher to boot.
There are others of course.
Then I look at my own track record and try to work out which was supposed skill,and bloody good luck,or just common sense.

Is good article,it comes down to ego and trying to impress I think,but we are starting to get into trading psychology, so not go down that road,haha.

30-08-2009, 10:47 AM
great article Winner

Peter principle has become a very common problem in modern day....but no one really admits it....it is largely under the radar.

Life was a lot simpler back in the 2 knob radio days (one knob off/on/volume and one knob for tuning) when most jobs could be done by anyone... and the "office boy culture" within a company....of rising up the ranks and if he stayed there long enough he would've been CEO eventually.
Free market reform 1984 -1987 in NZ showed up our underlying PP problem big time ..when NZ companies were released from their protectionism shackles and thought they could conquer the world......(fail!!!)

Complexities in modern life now requires qualified/skilled people for every job position...have to maximise efficiency just to be able to stay in the ball game.

The biggest Peter Principle problem is in HealthCare.. Job swapping such as doctors going into managerial positions.

Investing in a company these days it certainly pays to look at the people who are running the show.

30-08-2009, 02:41 PM
...only European Banks?? after reading the following article, think that Bernanke himself gto the disease

Bernanke Sees A Recovery - How Would He Know?
John P. Hussman, Ph.D.

“Our forecast is for moderate but positive growth going into next year. We think that by the spring, early next year, that as these credit problems resolve and, as we hope, the housing market begins to find a bottom, that the broader resiliency of the economy, which we are seeing in other areas outside of housing, will take control and will help the economy recover to a more reasonable growth pace.”

Ben Bernanke, Federal Reserve Chairman in 2007 just as the credit system started to implode...

Kind Regards