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Home > Blogs > Ian Fraser > Buffett advocates more stick, less carrot to ensure bank bosses shape up

Buffett advocates more stick, less carrot to ensure bank bosses shape up

Finance Blogger: Ian Fraser Ian Fraser

Legendary Omaha-based investor Warren Buffett often uses his annual letter to shareholders [PDF, 112 KB] in Berkshire Hathaway group to impart some homespun financial wisdom and disseminate a few trade secrets. The letter accompanying the conglomerate’s 2009 annual report, released on Saturday, doesn’t disappoint.

Perhaps Buffett’s most pertinent recommendation, concerns the corporate governance of large financial institutions. Buffett, 79, strongly believes that the chief executives of banks and other large financial institutions should be accountable for all internal risk-management decisions.

Should risk-management procedures fail—as happened at a great many Anglo-Saxon financial institutions during the credit boom—it is the chief executive who should take the rap, said Buffett.

Buffett wrote: “In my view a board of directors of a huge financial institution is derelict if it does not insist that its CEO bear full responsibility for risk control. If he’s incapable of handling that job, he should look for other employment. And if he fails at it—with the government thereupon required to step in with funds or guarantees—the financial consequences for him and his board should be severe.

The crisis sunk many US-based institutions including Lehman Brothers and forced others, such as AIG and Citigroup, to seek government aid. But in Buffett’s view, many guilty CEOs got away too lightly with some keeping their jobs, despite the messes they created, and the financial pain their flawed decisions caused for shareholders.

“Their fortunes may have been diminished by the disasters they oversaw, but they still live in grand style. It is the behavior of these CEOs and directors that needs to be changed: If their institutions and the country are harmed by their recklessness, they should pay a heavy price—one not reimbursable by the companies they’ve damaged nor by insurance.

“CEOs and, in many cases, directors have long benefited from oversized financial carrots; some meaningful sticks now need to be part of their employment picture as well.”

Buffett devoted another part of his letter to derivatives. He confirmed that Berkshire Hathaway has been a major user of derivatives since 1998 and that its preference is for derivative contracts that he and colleague Charlie Munger, 86, believe to be mispriced.

“The dangers that derivatives pose for both participants and society—dangers of which we’ve long warned, and that can be dynamite—arise when these contracts lead to leverage and/or counterparty risk that is extreme. At Berkshire nothing like that has occurred—nor will it.”

Buffett said he and Munger take 100% responsibility for all aspects of risk control in Berkshire’s $6.3bn derivatives portfolio. “At Berkshire, I both initiate and monitor every derivatives contract on our books … If Berkshire ever gets in trouble, it will be my fault. It will not be because of misjudgments made by a risk committee or chief risk officer.”

Buffett is clearly looking forward to the shareholder meeting on May 1, expected to be attended by some 35,000 people, and concluded by saying that despite their ages, both he and Munger still “tap-dance to work.”

Whilst the economic downturn has hurt many of Berkshire’s businesses—and the group posted its worst performance in Buffett’s 43-year time at the helm—the crisis has also presented Buffett with the chance to buy some distressed assets at fire-sale prices. “We’ve put a lot of money to work during the chaos of the last two years,” Buffett wrote. “It’s been an ideal period for investors. A climate of fear is their best friend.”

The value of Berkshire’s derivatives portfolio rebounded last year, helping bolster net income to $8.1bn from $5bn in 2008, although Berkshire closed 2009 with $30.6bn in cash, down from $44.3bn. Another $8bn is earmarked for BNSF, the US railway he agreed to buy.

Further reading on corporate governance and risk management

Further reading on Warren Buffett

Tags: accountability , banking , corporate governance , derivatives , risk management , US , Warren Buffett
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