Knowledge@Wharton Leadership and Change Research Article

Hardly a day goes by without yet another twist or turn in the credit crisis that has engulfed the U.S. financial system for more than a year. Bear Stearns, one of the country's largest underwriters of mortgage bonds, has been swallowed up. Venerable institutions such as AIG, Wachovia, Lehman Brothers, Merrill Lynch and Citigroup have brought new CEOs on board. Media reports suggest that the world's biggest financial institutions have absorbed more than $300 billion in asset write-downs and credit losses even as home foreclosures are at record high levels and Wall Street has laid off thousands of employees. While much of the discussion about the crisis has focused on its causes and the need for regulatory reform, former Wharton dean Russell Palmer, author of a new book, Ultimate Leadership, writes in this opinion piece that the situation offers an opportunity to learn crucial lessons about leadership.

While much of the discussion about the crisis has focused on its causes and the need for regulatory reform, I have a different perspective: I believe the situation offers an opportunity to learn crucial lessons about leadership, and if these are heeded, the U.S. will end up with a financial system that is stronger than ever.

I find it puzzling when I hear experts describe the current situation as "the biggest crisis since the Great Depression," which took years to get over. The situation is serious, but I do not believe it has yet grown to that proportion, and won't, because we have more and better means of dealing with the beginning of a crisis than we had during the 1930s. Matters could still spiral out of control, but it does not appear, now, that this will happen.

What caused the crisis? In my view, greed was the underlying factor. Wall Street hedge funds and others are looking for any financial machination that they can find to hype their financial returns. The whole mortgage fiasco is just the latest example. The dot-com bubble of the late 1990s was another instance. Anyone with any sense knew that during the dot-com mania, you couldn't sustain high prices for stocks on companies that had no current earnings, only losses. It was a bubble, just like the Tulip Mania that investors lived through during the 17^th century. With the present subprime crisis, the people originating the mortgages had to know that the higher the risk on the mortgage terms, the greater exposure there was to the mortgage going to foreclosure. So did the people who bought the mortgages, securitized the mortgages, and so on.

Not everyone kept playing the game until the roof fell in. T. Rowe Price, early on, got out of the market because of the high risk level, as did others on Wall Street who bet against this Ponzi scheme. Greed reflects a failure of leadership; turning your head to ignore the high risk because you are making big earnings today certainly shows a lack of leadership. How many people on Wall Street have been subject to less than robust oversight by their organization because they were producing such big contributions to the firm's earnings? Allowing your organization to be a party to contributing to this scheme -- even if you know that you will not be directly affected -- is not a mark of leadership. It is a sign of greed.

Much debate has taken place in recent weeks about whether the Federal Reserve, led by Ben Bernanke, and the Treasury Department, headed by Hank Paulson, did the right thing in brokering Bear Stearns to be acquired by J.P. Morgan. While the Monday morning quarterbacks are welcome to their views, I definitely think that Bernanke and Paulson acted correctly. If this isn't an appropriate role for them as leaders of the Fed and the Treasury, what is? It's their job to stem the crisis without providing the perpetrators with a bailout so they can do the same thing all over again. In the Bear Stearns case, I realize there were some aspects of a bailout.

Since then, Paulson has proposed several sweeping changes to reform the financial system. Over time, these will probably be watered down to some degree, but it's evident that we need more transparency in the system than we have now. For example, hedge funds are among the least transparent investments that anyone can make. Still, investors keep pumping money into hedge funds because they get such high returns most of the time. Now that investors are seeing what can happen in hedge funds, they are more wary, but the investors need more transparency. That is the only way investors can make knowledgeable decisions on how much risk they are willing to take relative to the anticipated returns. With the complexity of investment banking/trading/hedge fund activities it is evident that we must put transparency into the system and have some overall controls that will provide either existing regulatory bodies or new regulatory bodies with the power to oversee some of the activities that are prevalent today. In the end, the investors must make their own decisions based on adequate information and take responsibility for those decisions.

With all this as background, let me now turn to some of the main leadership lessons to be learned from the crisis on Wall Street.

First and foremost, integrity is the key to leadership -- and that is not always evident on Wall Street, as the following example will show. Not long ago, I was on the board of a company that was one of the two parties to a major merger. Throughout the month-long negotiations, some of the advisors were constantly lying to each other. They said they had other parties that they would do the deal with, but they didn't. They said that if the price they wanted wasn't agreeable, they would walk away, but they didn't. They said that they weren't leaking details of the negotiation to the media, but they were.

I am not suggesting that all firms on Wall Street lack integrity, but many of them do. Something as important as our system for financial transactions and our economy has to be built on integrity and trust as opposed to questionable and disreputable activities. Integrity begins at the top.

Another important leadership lesson involves the role of board members. Too often, in the past, boards of directors have let the CEO escape responsibility by firing a couple of people down the line and going back to work. That did not happen in the Bear Stearns case, and that's good. Boards of directors must provide appropriate oversight, but boards will never know enough about the complex world of finance and the derivatives transactions that are being effected today. Boards need to provide detailed oversight, and so they have the responsibility to see that outside experts are brought in, if necessary, to assess the risk profile of the organization. They have to rely on experts such as their auditors, regulators, and others to see that effective oversight occurs.

Finally, the leaders of these firms must be at the forefront of addressing the crisis and take personal responsibility.

At a time of crisis, leaders need to keep in mind several strategies that can make for effective execution:

• As the leader, remember that you are the person in charge. You must be the one ultimately to call the shots and be personally involved in the situation.

• Communication is essential, and key communication needs to be directly with you and not filtered through some third party.

• Denial is a major problem that plagues companies that are on their way toward a crisis but fail to recognize the symptoms. Recognize the warning signs well ahead of time and take corrective steps before the situation escalates into a full-blown crisis.

• You can also use the crisis, either during the heat of the battle or after things calm down, as a time to make transformational change. You have a burning platform and it enables you not only to accomplish change rapidly, but also to get systemic change through the organization that otherwise might be much more difficult to implement.

Even though Bear Stearns has gone under, I see no reason why that should happen to the financial system. Strong leadership leads to resilience. Once the system regenerates, in some cases with new leadership, I am convinced that it will be as strong as before, if not stronger.

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