Reconstructing the B-School

Clio in the Business School: Historical Approaches in Strategy, International Business and Entrepreneurship

by Andrew Perchard (Stirling), Niall Mackenzie (Strathclyde), Stephanie Decker (Aston) and Giovanni Favero (Venice)

On the back of recent and significant new debates on the use of history within business and management studies, we consider the perception of historians as being anti-theory and of having methodological shortcomings; and business and management scholars displaying insufficient attention to historical context and privileging of certain social science methods over others. These are explored through an examination of three subjects: strategy, international business and entrepreneurship. We propose a framework for advancing the use of history within business and management studies more generally through greater understanding of historical perspectives and methodologies.

Keywords: History, strategy, international business, entrepreneurship, methodology

Freely available for a limited time at: Business History, 59(6): 904-27

Review by Mitchell J. Larson (University of Central Lancashire)

Recently Martin Parker (Bristol) has taken to the airwaves promoting the idea of bulldozing the business school. In sharp contrast, Andrew Perchard, Niall McKenzie, Stephanie Decker, and Giovanni Favero make a compelling case for certain disciplines in the management sciences to open themselves to alternative methodological and epistemological approaches. They argue that the fields of strategy, international business, and entrepreneurship have not embraced historically-oriented research to the same extent as other fields within business and management studies. The authors also admit that many scholars conducting historical business research have not made a sufficiently solid case about the robustness of their historical methodology(s) or data to convince other social scientists about the validity of their claims. Drawing upon an impressive range of previous works to develop their discussion, the paper attempts to reconcile these discrepancies to highlight how a more explicit articulation of the historian’s process could overcome the concerns of ‘mainstream’ management scholars regarding theorization and methodology in these three fields specifically and in management studies generally.

One major concern held by non-historians is that historical work illustrates an alleged a-theoretical or even anti-theoretical nature of scholarly writing (Duara, 1998). A second major concern is that historical methods (i.e. of data collection) are not sufficient grounds upon which to base management theory. The authors demonstrate the complexities of these issues with respect to existing historical work in business and management studies, such as the ‘cherry-picking’ of outlier events to support a more general point – especially by scholars in other fields applying historical methods rather casually – and place responsibility upon business and management historians to make their process(es) more transparent and explain themselves and their work better to other social scientists. The article claims that the “continuing distinctions drawn between the primary data created by social science research…with the collection of ‘secondary’ documentary evidence in archives…are misleading.” (p. 915). Whereas social science researchers will be aware explicitly about potential sources for bias in their data and often include discussions about this in their work, the historical process ‘internalizes’ these judgements and thus appears to hide them from the reader. The discipline of history, so accustomed to the individual historian’s assessment of the materials being examined, assumes that with satisfactory preparation the historian’s assessment will be reasonable based on her (or his) knowledge of the historical context, the actors involved, and assumptions about the rationality and practicality of the various decisions that might have been made at any particular point in the timeline. But it is this internalization of decision-making and assessment which so troubles non-historians and why the authors call for business and management historians to “more clearly articulate the methodologies adopted by historians to show the value of history to business and management studies…” That there is value to be realized is shown through the acceptance of historical approaches by other branches of the management studies arena, and their point is that these three sub-fields have been slower to warm to their use than others.

The major difficulty here lies in the way data are encountered: the social scientist generates new ‘primary’ data through his or her interaction with respondents whether actively (through interviews or questionnaires) or passively (through observation). Given the nature of historical work, of course this style of primary data generation is seldom possible: all the protagonists are gone and even the organization(s) to which they were affiliated may have disappeared or transformed beyond anything the historical actors could have imagined. Indeed even the labels of what constitutes ‘primary’ and ‘secondary’ data differ between historians and other groups of social scientists. What the historian then faces is piecing together traces of the past much like an archaeologist might do when exploring new ruins. The main difference is that the business historian deals with written records while the archaeologist deals with physical remains, but in both cases often as much (or more) remains hidden as is brought to light in the process of discovery. This process, and the gaps in data continuity that it allows, appear to bother social scientists whose epistemological approach is steeped in the rationalist arguments of the physical sciences and applies only to the data they have actively sought to collect. That other elements can be discarded as irrelevant to the analysis likewise troubles historians for whom contingency and context are vitally important pieces of the story.

There are a number of significant factors here which the article discusses at some length, but what is striking about the discussion is that there is, perhaps ironically, seemingly little consideration for how these disciplines arose and evolved over time and whether these differences in development might be at the root of the issue. History as an activity reaches back to antiquity but the modern discipline of history received fresh articulation in the early nineteenth century. In contrast, the fields one might ascribe to the ‘social science’ area relevant to business and management (anthropology, communications, economics, geography, sociology, and psychology, for example) tend as a group to be newer and as part of their growth had to justify space in the academic environment for themselves. The process of doing so led these fields to ally themselves with the methods and approaches of the physical sciences to gain scientific credibility in a way that the traditional subject of history never did. The discipline of history, and by extension business and management history, is now playing a catch-up game to find ways to articulate and justify its value as a discipline in the face of criticism from practitioners in other fields. Perchard et. al. try to move this process forward by explaining to historians how their work could or should be explained differently (not necessarily done differently) to assist non-historians in assessing and appreciating its value. Here they remind us of the work of Andrews and Burke (2007) whose ‘five Cs’ (change over time, causality, context, complexity, and contingency) provide a useful guide to help non-specialists appreciate the aspects that historians are likely to fix upon as explanatory variables. The authors also point to the work of Jones and Khanna (2006) and Maclean, Harvey, and Clegg (2016) as helpful in making historical work relevant to mainstream business and management studies.

The article is a valuable contribution to the on-going effort to bring management and business historians closer to those studying and theorizing about management and business activity. Its relevance touches on a number of critical issues both in the academic field of study and related to the career development of those engaged in this kind of research.

References

Andrews, Thomas and Burke, Flannery (2007), “What Does it Mean to Think Historically?”, Perspectives in History, available at: https://www.historians.org/publications-and-directories/perspectives-on-history/january-2007/what-does-it-mean-to-think-historically

Duara, Prasenjit (1998), “Why is History Anti-theoretical?”, Modern China, 24(2): 106.

Jones, Geoffrey and Khanna, Tarun (2006), “Bringing History (Back) into International Business,” Journal of International Business Studies, 37(4): 453-68.

Maclean, Mairi, Harvey, Charles and Clegg, Stewart (2016), “Conceptualizing Historical Organization Studies,” Academy of Management Review, 41(4): 609-32.

Palm Oil, Rubber, and Colonialism

The Emergence of an Export Cluster: Traders and Palm Oil in Early Twentieth-century Southeast Asia

by Valeria Giacomin (Harvard-Newcomen Fellow in Business History during 2017/2018)

Abstract: Malaysia and Indonesia account for 90 percent of global exports of palm oil, forming one of the largest agricultural clusters in the world. This article uses archival sources to trace how this cluster emerged from the rubber business in the era of British and Dutch colonialism. Specifically, the rise of palm oil in this region was due to three interrelated factors: (1) the institutional environment of the existing rubber cluster; (2) an established community of foreign traders; and (3) a trading hub in Singapore that offered a multitude of advanced services. This analysis stresses the historical dimension of clusters, which has been neglected in the previous management and strategy works, by connecting cluster emergence to the business history of trading firms. The article also extends the current literature on cluster emergence by showing that the rise of this cluster occurred parallel, and intimately related, to the product specialization within international trading houses.

Freely available at Enterprise and Society, Volume 19, Issue 2, June 2018, pp. 272-308

Review by Helena Varkkey (University of Malaya)

In this article, Giacomin presents an archive-based historical analysis of how palm oil became one of the most important traded commodities from Southeast Asia to the world in the early- to mid-1900s. She uses the cluster (defined as a “geographically proximate group of interconnected companies and associated institutions in a particular field, linked by commonalities and complementarities”) approach to explain how the organizational structure of the pre-existing rubber cluster in the Malay peninsula (at the time a British colony) and Sumatra (under the Dutch) formed the basis for an emerging palm oil cluster in the same geographical region.

The first part of her paper focuses on how the regional rubber cluster structure developed. While the literature commonly credits unique local factors in the development of such clusters, Giacomin instead looks at nonlocal factors: (1) mainland Chinese traders that controlled regional trading routes from major Southeast Asian ports and brought in low-skilled tappers and harvesters from surrounding territories, and (2) Western traders that brought in capital inputs (seeds, machinery and finance) and highly-skilled human resources (estate managers and engineers) from Europe and other parts of the Empire and established headquarters in major European trading ports, allowing them to access crucial market information on demand. Both of these foreign merchant communities congregated in the emerging trading hub of Singapore, strategically located in between British Malaya and Dutch Sumatra, and developed a mutual dependency: Chinese contacts were vital for Western traders wanting to run a business in the Eastern colonies, while the Chinese needed Western traders to scale up their region-based commercial activity to a global scope.

The second part of the article explains how palm oil became the “spin-off” crop of the rubber cluster in the region. During the natural rubber boom in the early 1900s, the Malaya-Sumatra rubber cluster became over-dependent on this export and thus over-specialised in terms of existing practises, agronomic knowledge (through R&D agencies like the Rubber Research Institute), and coordinating institutions (eg. the Rubber Growers’ Association). When the advent of synthetic rubber in the 1920s caused natural rubber prices to fall, companies desperately looked to diversify their production to recoup and replace their losses. However, this over-specialisation meant that they could consider only a limited range of crops similar to rubber for diversification. As it happened, the rubber estate structure could be conveniently repurposed for into oil palm estates. Furthermore, the oil palm flourished in a much narrower latitude span compared to rubber, giving confidence to companies that the demand for palm oil would be more sustained since supply would be more limited.
Giacomin concludes that even though the literature often regards over-specialisation as fatal, in the case of the Southeast Asian rubber cluster, this serendipitously led to the emergence of one of the most enduring regional clusters serving the global economy. Today, Indonesia and Malaysia account for over 90% of global palm oil exports.

While the significance of the rubber sector in paving the way for palm oil in Malaysia and Indonesia is well known, this paper remains an important and significant addition to the current literature, not only on general business management and strategy, but also more specifically in terms of (1) palm oil expansion and development and (2) agricultural systems (estate vs. smallholdings).

Firstly, the specific role of nonlocal (especially Chinese) entrepreneurs in connecting the production areas in this region to the consumption areas in the West was previously not well understood. In the context of the “global north” and “global south”, palm oil can be considered a uniquely “southern” vegetable oil. Compared to other oils like sunflower, rapeseed, and soya bean, the production, major business players, beneficiaries and direct impacts of palm oil is situated more comparatively in the global south. Giacomin alludes to this in reference to the narrow latitude where oil palm can be grown. This northern/southern framing has coloured much of the recent debates and controversies over palm oil today. This paper’s analysis on the historical role of Chinese merchants is especially useful in further informing the idea of palm oil as a “southern” oil, while at the same time, the equally important role of the Western merchants that Giacomin highlights may be useful in moderating certain northern arguments in this ongoing debate.

Secondly, the historical nature of Giacomin’s analysis of this sector is especially timely in the current period where other regions, like West Africa and Latin America, are looking to increase their global trading share of palm oil. Giacomin mentions that even though the oil palm originated from and was first produced commercially in West Africa during colonial times, Western African territories were unable to effectively penetrate global markets because they did not display the same institutional cohesion across neighbouring territories, something that Southeast Asia managed to do through the pre-existing rubber cluster. This “cluster” model may thus provide an exemplar to be used by emerging palm oil production regions and companies as an effective way to possibly break the current oligopoly (Indonesian and Malaysian firms) which is the palm oil industry. Especially for West Africa, which is considered the current “greenfield” area for palm oil outside Southeast Asia, current strategies can be developed to avoid past mistakes.

Finally, Giacomin’s analysis of early smallholders is useful to inform current discussions on the ideal agricultural systems for oil palm. Her paper argues that in the mid-20th century, the fact that the palm oil was an estate crop (involving high costs and favouring large-scale production) provided a solution to the problem previously faced by rubber companies that were facing competition from and losing market share to rubber smallholdings. While this might have been the case historically, oil palm today has been successfully adapted to the smallholder model in both Indonesia and Malaysia, with a significant share of both countries’ production (about 40% each) coming from either organised or independent smallholders. Giacomin’s analysis stops at the early decolonialisation period, before the newly independent nations began to formulate oil palm smallholder schemes as a strategic tool for rural development and poverty eradication for both countries. Her analysis however can serve as a useful starting point in the ongoing debates on if and how both the estate and smallholder systems can co-exist efficiently and in harmony.

Overall, this paper is a valuable piece of business history that helps to further shed light on a controversial agro-economic sector often shrouded in secrecy. The fact that palm oil continues to be a hot topic worldwide today underlines the relevance and importance of such forays into history to inform the present.

Computers and Business History: Mira Wilkins Prize Winner

IBM Rebuilds Europe: The Curious Case of the Transnational Typewriter
By Petri Paju (Turku) and Thomas Haigh (Wisconsin, Milwaukee).

Abstract: In the decade after the Second World War IBM rebuilt its European operations as integrated, wholly owned subsidiaries of its World Trade Corporation, chartered in 1949. Long before the European common market eliminated trade barriers, IBM created its own internal networks of trade, allocating the production of different components and products between its new subsidiaries. Their exchange relationships were managed centrally to ensure that no European subsidiary was a consistent net importer. At the heart of this system were eight national electric typewriter plants, each assembling parts produced by other European countries. IBM promoted these transnational typewriters as symbols of a new and peaceful Europe and its leader, Thomas J. Watson, Sr., was an enthusiastic supporter of early European moves toward economic integration. We argue that IBM’s humble typewriter and its innovative system of distributed manufacturing laid the groundwork for its later domination of the European computer business and provided a model for the development of transnational European institutions.

Enterprise & Society 17(2, June 2016): 265-300

DOI: https://doi.org/10.1017/eso.2015.64

URL: https://www.cambridge.org/core/journals/enterprise-and-society/article/ibm-rebuilds-europe-the-curious-case-of-the-transnational-typewriter/35D5A3FD95F5948F12754DBE07E9D89F

Free download (for limited time): https://www.cambridge.org/core/services/aop-file-manager/file/59e769bb60a7c0f73791cd84

Review by James W. Cortada (Charles Babbage Institute, Minnesota)

Prizes are awarded all the time for “best article” in a particular field, calling our attention to a well-executed, thoughtful one. But, occasionally, a prize winning article signals bigger shifts in a discipline than might otherwise be noticed. With this year’s award of the Business History Conference’s “Mira Wilkins Prize,” for the best article published in Enterprise & Society, we have such a signal.

Petri Paju and Thomas Haigh wrote “IBM Rebuilds Europe: The Curious Case of the Transnational Typewriter,” published in June 2016. They were recognized for “the best article on international business history,” the objective of this prize, but it is far more than good international business history.

The article chronicles how IBM created an internal network across eight national electric typewriter plants in post-World War II Europe to manufacture parts and to assembly these products. While electric typewriters were in great demand and IBM made what many considered to be the best one, the company created an internal network for their manufacture and distribution that transcended international borders in the decade after the war, presaging what would happen for some European products after the establishment of the European Union. But that was never solely the point—to create a European-wide market by governments—rather, it was to drive down production costs, increase demand for and the ability to deliver enough machines, while promoting IBM management’s belief that “World Peace through World Trade” could be a global objective for nations and companies. The authors trace how parts were made in one country, shipped to another, put together then sold, called the “Interchange Plan.” This experience taught IBM management how to create a more formal pan-European wide, later worldwide organization in 1949 that could manufacture, sell, and support its products called IBM World Trade. Within a half generation, World Trade did as much business as the American side of IBM.

Lessons learned in forming a pan-European typewriter business made it possible for IBM to develop a pan-European computer business that quickly dominated the mainframe business in Western Europe and in other parts of the world. Just as important, when IBM moved into the computer business, it already had factories, sales offices, and experienced employees in those countries that would become its best customers. These include Great Britain, France, West Germany, the Nordics, Italy, Spain, and a sprinkling presence in every country that eventually became part of the EU. The authors explain how the company created and learned from its “Interchange Plan,” operationally and strategically. They explored the accounting level to explain how money and budgets were exchanged across borders when governments had yet to sort out those issues, let alone even allow such exchanges.

The benefits to IBM were both obvious and extraordinary. Obvious ones included reduced operating costs for the manufacture and increased sale of typewriters. Less obvious, but ultimately more important, “this system would also foster interdependence among the various national [IBM] firms,” while spreading capabilities across multiple countries so that if one nation were to nationalize or block local IBM production, as occurred during World War II, another plant could pick up the slack. The company used its system in its public relations campaign to promote international trade through American managerial leadership and “to meet the challenges of communism” in the Cold War. Other American corporations—all of them with close ties to IBM’s management—took note of what IBM was learning and applied those lessons as well. IBM’s country organizations could also claim to be local, since each employed nationals, Fins in Finland, French in France, and so forth.

The lesson urged by these two young historians is an appropriate one at the moment: “think more carefully about the assumption that postwar globalization of European trade can be reduced to ‘Americanization’,” because IBM’s experience reflected a “hybridization of U.S. technology and management in postwar Europe.” Apply their suggestion worldwide. IBM was also prepared to experiment and operate in ways that valued expansion into new markets even at the costs of profits. That is one reason why it came to dominate the mainframe market so fast and for so many decades. The wisdom of today’s corporate fixation on shareholder value is challenged by this study of how IBM ran its typewriter business.

Perhaps the greater lesson, the more significant observation for why this prize this year is so important, lies elsewhere. For the past two decades, a month has barely gone by without an historian or economist publishing on the interactions of computing technology and business management. E&S is not alone in doing so; Technology & Culture has published some two-dozen similar articles in the new century, and Information & Culture is rapidly becoming another journal with a mix of business/information technology conversations. Petri Paju and Thomas Haigh are more than two gifted prolific article writers, they are teaching a new generation of scholars how to understand the role of information technologies and of management, business operations, and corporate strategy in a world filled with computers. Simply put, this article is seminal, worthy of being studied across multiple disciplines. The Mira Wilkes Prize Committee is to be congratulated for not letting this paper slip through the cracks.

Governance structures and market performance

Contractual Freedom and Corporate Governance in Britain in the Late Nineteenth and Early Twentieth Centuries

by Timothy W. Guinnane (Yale University), Ron Harris (Tel-Aviv University), and Naomi R. Lamoreaux (Yale University)

Abstract: British general incorporation law granted companies an extraordinary degree of contractual freedom. It provided companies with a default set of articles of association, but incorporators were free to reject any or all of the provisions and write their own rules instead. We study the uses to which incorporators put this flexibility by examining the articles of association filed by three random samples of companies from the late nineteenth and early twentieth centuries, as well as by a sample of companies whose securities traded publicly. Contrary to the literature, we find that most companies, regardless of size or whether their securities traded on the market, wrote articles that shifted power from shareholders to directors. We find, moreover, that there was little pressure from the government, shareholders, or the market to adopt more shareholder-friendly governance rules.

Business History Review, Volume 91 (2 – Summer 2017): 227-277.

DOI: https://doi.org/10.1017/S0007680517000733

Review by John Turner (Centre for Economic History, Queen’s University Belfast)

Tim Guinnane, Ron Harris and Naomi Lamoreaux are three scholars that every young (and old) economic historian should seek to emulate. This paper showcases once again their prodigious talent – there is careful analysis of the institutional and legal setting, a lot of archival evidence, rigorous economic analysis, and an attempt to understand how contemporaries viewed the issue at hand.

In this paper, Guinnane, Harris and Lamoreaux (GHL) examine the corporate governance of UK companies in the late nineteenth and early twentieth centuries. The UK liberalised its incorporation laws in the 1850s and introduced its first Companies Act in 1862. From a modern-day perspective, this Act enshrined very little in the way of protection for shareholders. However, the Appendix to the 1862 Companies Act contained a default set of articles of association, which was the company’s constitution. This Appendix, known as Table A, provided a high level of protection for shareholders by modern-day standards (Acheson et al., 2016). However, the majority of companies did not adopt Table A; instead they devised their own articles of association.

The aim of GHL’s paper is to analyse articles of associations in 1892, 1912 and 1927 to see the extent to which they shifted power from shareholders to directors. To do this, GHL collected three random samples of circa 50 articles of association for 1892, 1912 and 1927. Because most (if not all) of these companies did not have their securities traded on stock markets, they also collected sample of 49 commercial and industrial companies from Burdett’s Official Intelligence for 1892 that had been formed after 1888. However, only 23 of these companies had their shares listed on one of the UK’s stock exchanges.

GHL then take their samples of articles to see the extent to which they deviated from the clauses in Table A. Their main finding is that companies tended to adopt governance structures in their articles which empowered directors and practically disenfranchised shareholders. This was the case no matter if the company was small or large or public or private. They also find that this entrenchment and disenfranchisement becomes more prominent over time. However, GHL unearth a puzzle – they find shareholders and the market appeared to have been perfectly okay with poor corporate governance practices.

How do we resolve this puzzle? One possibility is that shareholders (and the market) at this time only really cared about dividends. High dividend pay-out ratios in this era kept managers on a short leash and reduced the agency costs associated with free cash flow (Campbell and Turner, 2011). Interestingly, GHL suggest that this may have made it more difficult for firms to finance productivity-enhancing investments. In addition, they suggest that the high-dividend-entrenchment trade-off may have locked in managerial practices which inhibited the ability of British firms to respond to future competitive pressures and may ultimately have ushered in Britain’s industrial decline.

Another solution to the puzzle, and one that GHL do not fully explore, is that the ownership structure of the company shaped its articles of association. The presence of a dominant owner or founding family ownership would potentially lessen the agency problem faced by small shareholders. In addition, founders may not wish to give too much power away to shareholders in return for their capital. On the other hand, firms which need to raise capital from lots of small investors on public markets may adopt more shareholder-friendly articles. The vast majority of companies in GHL’s sample do not fall into this category, which might go some way to explaining their findings.

A final potential solution is that the vast majority of firms which GHL examine may have raised capital in a totally different way than public companies, and this shaped their articles of association. These firms probably relied on family, religious and social networks for capital, and the shareholders trusted the directors because they personally knew them or were connected to them through a network. Indeed, we know precious little about how and where the multitude of private companies in the UK obtained their capital. Like all great papers, GHL have opened up a new avenue for future scholars. The interesting thing for me is what happens when private firms went public and raised capital. Did they keep their articles which entrenched directors and disenfranchised shareholders?

Unlike the focus of GHL on mainly private companies, a current Queen’s University Centre for Economic History working paper examines the protection offered to shareholders by circa 500 public companies in the four decades after the 1862 Companies Act (Acheson et al., 2016). Unlike GHL, it takes a leximetric approach to analysing articles of association. Acheson et al. (2016) have two main findings. First, the shareholder protection offered by firms in the nineteenth century was high compared to modern-day standards. Second, firms which had more diffuse ownership offered shareholders higher protection.

How do we reconcile GHL and Acheson et al. (2016)? The first thing to note is that most of Acheson et al’s sample is before 1892. The second thing to note is that in a companion paper, Acheson et al. (2015) identify a major shift in corporate governance and ownership which started in the 1890s – companies formed in that decade had greater capital and voting concentration than those formed in earlier decades. In addition, unlike companies formed prior to the 1890s, the insiders in these companies were able to maintain their voting rights and entrench themselves. This corporate governance turn in the 1890s is where future scholars should focus their attention.

References

Acheson, Graeme G., Gareth Campbell, John D. Turner and Nadia Vanteeva. 2015. “Corporate Ownership and Control in Victorian Britain.” Economic History Review 68: 911-36.

Acheson, Graeme G., Gareth Campbell, John D. Turner. 2016. “Common Law and the Origin of Shareholder Protection.” QUCEH Working Paper no. 2016-04.

Campbell, Gareth and John D. Turner. 2011. “Substitutes for Legal Protection: Corporate Governance and Dividends in Victorian Britain.” Economic History Review 64: 571-97.

No man can serve two masters

Rogue Trading at Lloyds Bank International, 1974: Operational Risk in Volatile Markets

By Catherine Schenk (Glasgow)

Abstract Rogue trading has been a persistent feature of international financial markets over the past thirty years, but there is remarkably little historical treatment of this phenomenon. To begin to fill this gap, evidence from company and official archives is used to expose the anatomy of a rogue trading scandal at Lloyds Bank International in 1974. The rush to internationalize, the conflict between rules and norms, and the failure of internal and external checks all contributed to the largest single loss of any British bank to that time. The analysis highlights the dangers of inconsistent norms and rules even when personal financial gain is not the main motive for fraud, and shows the important links between operational and market risk. This scandal had an important role in alerting the Bank of England and U.K. Treasury to gaps in prudential supervision at the end of the Bretton Woods pegged exchange-rate system.

Business History Review, Volume 91 (1 – April 2017): 105-128.

DOI: https://doi.org/10.1017/S0007680517000381

Review by Adrian E. Tschoegl (The Wharton School of the University of Pennsylvania)

Since the 1974 rogue trading scandal at Lloyds’s Lugano branch we have seen more spectacular sums lost in rogue trading scandals. What Dr Catherine Schenk brings to our understanding of these recurrent events is the insight that only drawing on archives, both at Lloyds and at the Bank of England, can bring. In particular, the archives illuminate the decision processes at both institutions as the crisis unfolded. I have little to add to her thorough exposition of the detail so below I will limit myself to imprecise generalities.

Marc Colombo, the rogue trader at Lloyds Lugano, was a peripheral individual in a peripheral product line, in a peripheral location. As Schenk finds, this peripherality has two consequences, the rogue trader’s quest for respect, and the problem of supervision. Lloyds Lugano is not an anomaly. An examination of several other cases (e.g. Allied Irish, Barings, Daiwa, and Sumitomo Trading), finds the same thing (Tschoegl 2004).

In firms, respect and power come from being a revenue center. Being a cost center is the worst position, but being a profit center with a mandate to do very little is not much better. The rogue traders that have garnered the most attention, in large part because of the scale of their losses were not malevolent. They wanted to be valued. They were able to get away with their trading for long enough to do serious damage because of a lack of supervision, a lack that existed because of the traders’ peripherality.

In several cases, Colombo’s amongst them, the trader was head of essentially a one-person operation that was independent of the rest of the local organization. That meant that the trader’s immediate local supervisor had little or no experience with trading. Heads of branches in a commercial bank come from commercial banking, especially commercial lending. Commercial lending is a slow feedback environment (it may take a long time for a bad decision to manifest itself), and so uses a system of multiple approvals. Trading is a fast feedback environment. The two environments draw different personality types and have quite different procedures, with the trading environment giving traders a great deal of autonomy within set parameters, an issue Schenk addresses and that we will discuss shortly.

Commonly, traders will report to a remote head of trading and to the local branch manager, with the primary line being to the head of trading, and the secondary line being to the local branch manager. This matrix management developed to address the problem of the need to manage and coordinate centrally but also respond locally, but matrix management has its limitations too. As Mathew points out in the New Testament, “No man can serve two masters, for either he will hate the one, and love the other; or else he will hold to the one, and despise the other” (Matthew (6:24). Even short of this, the issue that can arise, as it did at Lloyds Luggano, is that the trader is remote from both managers, one because of distance (and often time zone), and the other because of unfamiliarity with the product line. A number of software developments have improved the situation since 1974, but as some recent scandals have shown, they are fallible. Furthermore, the issue still remains that at some point the heads of many product lines will report to someone who rose in a different product line, which brings up the spectre of “too complex to manage”.

The issue of precautionary or governance rules, and their non-enforcement, is a clear theme in Schenk’s paper. Like the problem of supervision, this too is an issue where one can only do better or worse, but not solve. All rules have their cost. The largest may be an opportunity cost. Governance rules exist to reduce variance, but that means the price of reducing bad outcomes is the lower occurrence of good outcomes. While it is true, as one of Schenk’s interviewees points out, that one does not hear of successful rogue traders being fired, that does not mean that firms do not respond negatively to success. I happened to be working for SBCI, an investment banking arm of Swiss Bank Corporation (SBC), at the time of SBC’s acquisition in 1992 of O’Connor Partners, a Chicago-based derivatives trading house. I had the opportunity to speak with O’Conner’s head of training when O’Connor stationed a team of traders at SBCI in Tokyo. He said that the firm examined too large wins as intently as they examined too large losses: in either case an unexpectedly large outcome meant that either the firm had mis-modelled the trade, or the trader had gone outside their limits. Furthermore, what they looked for in traders was the ability to walk away from a losing bet.

But even small costs can be a problem for a small operation. When I started to work for Security Pacific National Bank in 1976, my supervisor explained my employment benefits to me. I was authorized two weeks of paid leave per annum. When I asked if I could split up the time he replied that Federal Reserve regulations required that the two weeks be continuous so that someone would have to fill in for the absent employee. Even though most of the major rogue trading scandals arose and collapsed within a calendar year, the shadow of the future might well have discouraged the traders, or led them to reveal the problem earlier. Still, for a one-person operation, management might (and in some rogue trading scandals did), take the position that finding someone to fill in and bring them in on temporary duty was unnecessarily cumbersome and expensive. After all, the trader to be replaced was a dedicated, conscientious employee, witness his willingness to forego any vacation.

Lastly, there is the issue of Chesterton’s Paradox (Chesterton 1929). When a rule has been in place for some time, there may be no one who remembers why it is there. Reformers will point out that the rule or practice is inconvenient or costly, and that it has never in living memory had any visible effect. But as Chesterton puts it, “This paradox rests on the most elementary common sense. The gate or fence did not grow there. It was not set up by somnambulists who built it in their sleep. It is highly improbable that it was put there by escaped lunatics who were for some reason loose in the street. Some person had some reason for thinking it would be a good thing for somebody. And until we know what the reason was, we really cannot judge whether the reason was reasonable.”

Finally, an issue one needs to keep in mind in deciding how much to expend on prevention is that speculative trading is a zero-sum activity. A well-diversified shareholder who owns both the employer of the rogue trader and the employers of their counterparties suffers little loss. The losses to Lloyds Lugano were gains to, inter alia, Crédit Lyonnais.

There is leakage. Some of the gainers are privately held hedge funds and the like. Traders at the counterparties receive bonuses not for skill but merely for taking the opposite side of the incompetent rogue trader’s orders. Lastly, shareholders of the rogue traders firm suffer deadweight losses of bankruptcy when the firm, such as Barings, goes bankrupt. Still, as Krawiec (2000) points out, for regulators the social benefit of preventing losses to rogue traders may not exceed the cost. To the degree that costs matter to managers, but not shareholders, managers should bear the costs via reduced salaries.

References

Chesterton, G. K. (1929) ‘’The Thing: Why I Am A Catholic’’, Ch. IV: “The Drift From Domesticity”.

Krawiec, K.D. (2000): “Accounting for Greed: Unraveling the Rogue Trader Mystery”, Oregon Law Review 79 (2):301-339.

Tschoegl, A.E. (2004) “The Key to Risk Management: Management”. In Michael Frenkel, Ulrich Hommel and Markus Rudolf, eds. Risk Management: Challenge and Opportunity (Springer-Verlag), 2nd Edition;