Modern Capitalism as the Solution to the Financial Crisis: The Caux Round Table Approach

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Modern Capitalism as the Solution to the
Financial CrisisThe Caux Round Table Approach

• Stephen B. Young
• Global Executive Director
• The Caux Round Table
• Belgrade, December 2008

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(No Transcript)
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• Financial meltdowns are a systematic
• Dysfunction of capitalism
• Tulip mania 1620
• Mississippi company France1719/1720
• South Sea Company London 1711/1720
• Wall Street 1929
• Junk bonds 1980s
• Dot.coms/telecom 1990s
• Sub-prime mortgages/CDOs

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• "Men, it has been well said, think in herds it
  will be seen that they go mad in herds, while
  they only recover their senses slowly, and one by
  one!" Charles Mackay
• Irrational Exuberance Alan Greenspan

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• Charles MacKay, Extraordinary Popular Delusions
  and the Madness of Crowds, with a foreword by
  Andrew Tobias (1841 New York Harmony Books,
  1980).
• Mike Dash, Tulipomania The Story of the World's
  Most Coveted Flower and the Extraordinary
  Passions It Aroused (1999)
• Peter M. Garber, Famous First Bubbles The
  Fundamentals of Early Manias (Cambridge, MA MIT
  Press, 2000).
• Charles Kindleberger, Manias, Panics, and
  Crashes A History of Financial Crises (Wiley,
  2005, 5th edition)

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• What Causes a Financial Crisis?
• Mis-pricing of risk
• Increases in real risk are not captured in
  nominal market prices
• Asset prices become irrational
• Valuation becomes unrealistic

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• Present value reflects the risk of actually
  receiving future income
• Capital value is a function of income!
• Misjudgments about future income distort present
  capital values

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• In financial bubbles, mis-pricing is sustained by
  infusions of debt
• Higher and higher asset values are supported by
  borrowed funds
• Excess liquidity based on future promises to
  pay transforms investment into speculation a
  trading mentality takes over the markets
  prudence loses out to greed illusion trumps
  reality for a time

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• "Of all the offspring of Time, Error is the most
  ancient, and is so old and familiar an
  acquaintance, that Truth, when discovered, comes
  upon most of us like an intruder, and meets the
  intruder's welcome."

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Dynamics of the Current Crisis

• Sub-prime mortgage loans made, more and more
  against future resale value of the home, not
  against real income
• Mortgage loans packaged and sold to global
  capital markets
• Collateral Debt Obligations (CDOs) issued to
  finance purchases of packages of sub-prime
  mortgages and to invest in hedge funds
• Credit Default Swaps invented to give added value
  to CDOs
• Debt upon debt upon debt
• Low interest rate environment
• Incentive structure driven by fees not investment
  in long term returns

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Current Crisis is Global

• AIG
• Fortis
• Iceland
• EU guarantees bank deposits
• UK takes over two banks
• Equity markets in Asia tank
• Price of Oil drops by 50
• Real economies lose employment and consumer demand

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• When financial markets implode, capitalism loses
  liquidity, exchanges of goods and services fall,
  output is reduced, employment is cut
• Debt must be taken out of the financial system
• Asset values have to be reset at lower levels
• Asset owners loose wealth

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• World Economic Order has inadequate mechanisms to
  prevent financial crises
• WTO
• IMF
• World Bank
• G8
• OECD
• Bank for International Settlements

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• Central Banks must step up and inject liquidity
  into the global system of financial
  intermediation
• Government budgets must inject new capital in
  financial institutions
• Bankruptcies must eliminate amounts of liquidity
  both equity and debt
• Bear Sterns - 80 to 2
• - Lehman Brothers - liquidated

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What is the fair value of an investment in
business?

• Quality Income Stream
• High net present discounted value
• Good capitalization multiplier
• Good Corporate Value
• (Warren Buffet would buy it)

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Today where does most corporate value come from?

• Intangible Assets!

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50 Best Performers of 2005Business Week

• Burlington Northern Santa Fe Market value 29.2
  billion
• Balance sheet assets
• 103 of market value (30.3 billion)
• Goodwill None
• Caterpillar Market value 49 billion
• Balance sheet assets 95.9
• Goodwill 4.1
• United Health Group Market value 79 billion
• Balance sheet assets 52
• Goodwill 48
• Apple Market value 58 billion
• Balance sheet assets 19.8
• Goodwill 80.2

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50 Best Performers of 2005Business Week

• Microsoft Market value 279 billion
• Balance sheet assets 33.7
• Goodwill 66.3
• Best Buy Market value 26.3 billion
• Balance sheet assets 39
• Goodwill 61
• Starbucks Market value 27.8 billion
• Balance sheet assets 12
• Goodwill 88
• Goldman Sachs Market value 61.7 billion
• Balance sheet assets 1.1
• Goodwill 98.9

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What is the Most Common Form of Intangible Wealth?

• Government Issued Fiat Money
• Its value is to be used as legal tender
• What is a Dollar worth today?
• A dollar bill has no tangible worth what is the
  value of ink on paper?
• Its value lies in the mind of whoever will take
  it.

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What is Another Very Desirable Common Form of
Intangible Wealth?

• Stocks and Bonds
• Who Determines their Values?

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Financial Meltdown of 2008

• Bear Stearns
• on Friday, 80 per share book value
• on Sunday sold for 2 per share
• Lehman Brothers
• Billions in balance sheet assets
• liquidated as no one wanted to buy them on a
  going concern basis

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What is a company worth?How to we measure its
value?

• Most simple calculation
• Discounted net present value of future income X
  capitalization multiplier

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First Fundamental Conclusion

• You cannot establish value without
• putting risk into the calculation
• What is the risk of not achieving predicted
  future revenue? How certain are estimates of
  future income?
• What are the risk factors that determine the
  capitalization multiplier? A higher risk demands
  a lower multiplier
• Higher risk gt more uncertainty gt lower present
  value

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Note

• Each source of risk drives business value up or
  down

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Second Fundamental Conclusion

• Management of Risk Enhances Enterprise Value
• Risk management leads to more certain income
• Risk reduction leads to higher valuation

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How do you manage risk?

• -Each risk hides in a relationship
• - customers
• - investors
• - government regulation
• - employees
• -Each relationship is an intangible asset of the
  business (Assets can Appreciate or Depreciate).
• -Lowering risk for each relationship enhances the
  quality of intangible assets and increases
  business valuation

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CSR Valuation

• Intangible Assets CSR Stakeholder Relationships
• Customers
• Employees
• Owners/Investors
• Suppliers
• Competition Strategies
• Community Support

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Tangible Values
(Generally Audited Financial Information)
Intangible Values
(Generally Non-audited, Non-financial Information)
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Growing Importance of Intangible Wealth

• Change in US Employment Dec 2007 - Nov
  2008tangible sector (manufacturing,
  construction, natural resources, real estate,
  wholesale and retail, transportation and
  warehousing)
• - 1,791,000 jobs
• intangible sector (education, health care,
  computer system design, finance and insurance,
  scientific research, etc.) 515,000  jobs
• all other services
• - 635,000 jobs

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To improve company valuation,Improve CSR
relationships!Good CSR Relationships Lead to
The Sustainable Corporation
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How to measure CSR Relationships

• Use CRT Arcturus
• Risk Assessment Instrument
• New metrics for enhanced profitability

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How to Manage for Sustainable Value?

• CRT Theory of the Firm
• Arcturus

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Theory of the Moral Firm (self interest
considered upon the whole)
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Capital Accounts

• Capital Accounts are your defense against risk
  and your resource base for competitive
  initiatives
• Finance Capital
• Physical Capital
• Human Capital
• Reputation Capital
• Social Capital

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• FINANCE CAPITAL
• Traditional capital account stock of ready
  money and amount of sunk cash investments

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• PHYSICAL CAPITAL
• Traditional capital account
• Plant and equipment
• Tools of the trade
• Sub account really of financial capital as
  purchased with monies raised in the past

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• HUMAN CAPITAL
• Non-traditional capital account
• - intangible asset
• - vital for success in services and high tech
  businesses
• - takes care of customer needs and demands

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• REPUTATION CAPITAL
• (brand equity goodwill)
• - needed for quality income
• - needed to get low cost of capital and the best
  employees
• - gets you through rough times
• - avoids commodity pricing/builds value added

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• SOCIAL CAPITAL
• Internal
• - culture
• - leadership
• - strategy
• External
• - rule of law/no corruption
• - education
• -public health
• - public goods market regulation,
  transportation, etc.

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Inter-relationships among capital
accounts

• Social Capital Reputation Capital
• Human Capital
• gt gt
• Finance Capital Physical Capital

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• Stakeholders
• Customers moral compass for capitalism
• Employees moral agents, not parts for a machine
• Owners and Investors fiduciary duties of
  loyalty and due care
• Suppliers friends, not foes
• Competitors compete with quality and
  innovation, not price
• Communities enhance social capital to enhance
  future profitability

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Stakeholders and Capital Accounts

• Internal Social Capital owners/employees/supplie
  rs/competitive strategy
• External Social Capital Community
• Reputation Capital customers/employees/ owners/s
  uppliers/community
• Human Capital employees

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• Taking Due Care of Stakeholders
• Enhances Capital Accounts
• Undermining Stakeholders Puts Capital Accounts at
  Risk

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• How Can you Measure
• and, therefore, Manage
• Stakeholder Relationships
• And all a companys
• Capital Accounts?

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• ASK QUESTIONS!
• Assess the Quality of your
• relationships

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Arcturus Risk Assessment
Instrument Criteria Matrix
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Assessment Framework Criterion/Benchmark
Example CUSTOMERS (Section B) 1B - Beyond
Shareholders towards Stakeholders -
Customers Does the company provide its customers
with quality products and services at reasonable
prices, and on fair terms, while protecting their
health and safety and their physical environment,
and respecting their culture and individual
dignity? POINTS TO CONSIDER The company
seeks customer feedback on its practices,
monitors impacts, and is prepared to modify
production or service as a result, plus provides
relevant training of staff. Point(s) Please
circle 1 2 3 4 5 6 7 Please write down any
concerns, explanations or additional comments on
how or how not, the company is performing.
_________________________________________________
__________________________________________________
__________________________________________________
__________________________________________________
_____________ 2B - Economic Social Impact of
Business - Customers Do the companys products
and services contribute to the economic and
social advancement of its customers and to the
well-being of their communities? POINTS TO
CONSIDER Quality of product/service
development product quality and safety
adherence to relevant customer, safety and
environmental codes products / services
positively impact living standards? Point(s)
Please circle 1 2 3 4 5 6 7 Please write down
any concerns, explanations or additional comments
on how or how not, the company is performing.
_________________________________________________
__________________________________________________
__________________________________________________
__________________________________________________
_____________
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The Corporate Improvement Cycle
Performance Improvement
Management Action
Performance Feedback to Management
CRT Assessment
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Who Participates?

• Board of directors
• CEO
• Senior management
• Division heads and group managers
• Unit managers
• Employees

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Sample Gap Analysis between Managements and
Employees(Provided by CRT-Japan)

A. Fundamental Duties B. Customers C. Employees D. Owners/ Investors E. Suppliers/ Partners F. Competitors G. Community Performance by Principle
1.Responsibilities of Businesses 6.5/5.2 6.3/5.1 6.0/4.8 6.8/5.2 5.9/4.9 6.1/4.8 6.4/5.4 44.0/35.4
2.Economic/ Social Impact of Business 6.0/5.3 5.6/4.7 6.7/4.5 4.9/4.4 4.9/4.4 6.6/4.6 5.1/5.2 39.8/33.1
3.Business Behavior 6.4/5.0 5.8/5.0 5.8/4.2 6.2/5.0 5.0/4.5 5.5/4.6 5.2/4.5 39.9/32.8
4.Respect for Rules 5.9/5.3 6.8/5.9 6.5/5.6 6.5/5.7 6.1/5.6 6.2/5.6 6.9/5.2 44.9/38.9
5.Support for Multilateral Trade 6.9/5.2 6.3/5.0 6.5/5.2 6.2/5.2 6.0/4.8 6.4/4.4 7.2/5.0 45.5/34.8
6.Respect for Environment 7.0/6.6 6.0/5.3 5.7/4.4 6.3/5.6 5.2/4.2 4.4/4.4 4.7/4.0 39.3/34.5
7.Avoidance of Illicit Operations 6.7/5.8 6.5/5.8 6.8/6.5 6.3/5.4 6.5/5.2 6.0/5.2 5.9/5.7 44.7/39.6
Performance by Stakeholder 45.4/38.4 43.3/36.8 44.0/35.2 43.2/36.5 39.6/33.6 41.2/33.6 41.4/35.0 298.1/249.1
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Sample Radar Chart (Provide by CRT-Japan)

Vision not yet fully embedded across the company.
No integrated local community development program
across different countries.
Company internal communication is poor on the
issue of environment.
Customers' trust is weak. Communication with
suppliers/partners is poor.
High level of compliance, risk management and
internal audit have been achieved.
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How Do Companies Create Value?

• The Good
• The Bad
• The Ugly

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The Good (Moral Capitalism)

• Risk Assessment/continuous Risk Reduction
• Optimize Stakeholder Benefits

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The Bad (Brute Capitalism, Crony Capitalism)

• Feed Shareholders, Abuse Stakeholders
• Commodity pricing/ compete on pricing/low costs
• Rent seeking (market power)
• Take the money and run short termism
• Unsustainable Valuations -
• Eventual Failure

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The Ugly (Punting on the trading floor)

• No net wealth creation speculation in trading
• (Rob Peter to pay Paul)
• Irrational Exuberance
• (Market traders/short termism)
• False Valuations
• (Enron Ponzi Scheme sub prime mortgages,
  CDOs, CDSs)
• Encourage unsustainable pricing of securities
• (CDOs, CDSs)
• INEVITABLE FINANCIAL MELTDOWN

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Thank You