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

1. Modern Capitalism as the Solution to the Financial Crisis:The Caux Round Table Approach Stephen B. Young Global Executive Director The Caux Round Table Belgrade, December 2008

3. 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

4. "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

5. 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)

6. 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

7. 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

8. 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

9. "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."

10. 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

11. 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

12. 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

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

14. 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

15. 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)

16. Today where does most corporate value come from? Intangible Assets!

17. 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%

18. 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%

19. 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.

20. What is Another Very Desirable Common Form of Intangible Wealth? Stocks and Bonds Who Determines their Values?

21. 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

22. What is a company worth?How to we measure its value? • Most simple calculation: Discounted net present value of future income X capitalization multiplier

23. 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 > more uncertainty > lower present value

24. Note: Each source of risk drives business value up or down

25. Second Fundamental Conclusion Management of Risk Enhances Enterprise Value • Risk management leads to more certain income • Risk reduction leads to higher valuation

26. 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

27. CSR & Valuation Intangible Assets = CSR Stakeholder Relationships • Customers • Employees • Owners/Investors • Suppliers • Competition Strategies • Community Support

28. Financial Capital Tangible Assets Intellectual property Sustainability Brand loyalty Quality of employees Community support Labor environment Unallocated goodwill Tangible Values (Generally Audited Financial Information) Intangible Values (Generally Non-audited, Non-financial Information)

29. 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

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

31. How to measure CSR Relationships Use CRT Arcturus Risk Assessment Instrument New metrics for enhanced profitability

32. How to Manage for Sustainable Value? • CRT Theory of the Firm • Arcturus

33. Theory of the Moral Firm (self interest considered upon the whole)

34. 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

35. FINANCE CAPITAL Traditional capital account – stock of ready money and amount of sunk cash investments

36. 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

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

38. 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

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

40. Inter-relationships among capital accounts Social Capital + Reputation Capital + Human Capital > > Finance Capital + Physical Capital

41. 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

42. Stakeholders and Capital Accounts Internal Social Capital = owners/employees/suppliers/competitive strategy External Social Capital = Community Reputation Capital = customers/employees/ owners/suppliers/community Human Capital = employees

43. Taking Due Care of Stakeholders Enhances Capital Accounts; Undermining Stakeholders Puts Capital Accounts at Risk

44. How Can you Measure and, therefore, Manage Stakeholder Relationships And all a company’s Capital Accounts?

45. ASK QUESTIONS! Assess the Quality of your relationships

46. Category 1. Fundamental Duties 2. Customers 3. Employees 4. Owners/ Investors 5. Suppliers/ Partners 6. Competitors 7. Communities 1. Responsi-bilities of Business Criterion 1.1 Criterion 1.2 Criterion 1.3 Criterion 1.4 Criterion 1.5 Criterion 1.6 Criterion 1.7 2. Economic and Social Impact of Business Criterion 2.1 Criterion 2.2 Criterion 2.3 Criterion 2.4 Criterion 2.5 Criterion 2.6 Criterion 2.7 3. Business Behavior Criterion 3.1 Criterion 3.2 Criterion 3.3 Criterion 3.4 Criterion 3.5 Criterion 3.6 Criterion 3.7 4. Respect for Rules Criterion 4.1 Criterion 4.2 Criterion 4.3 Criterion 4.4 Criterion 4.5 Criterion 4.6 Criterion 4.7 5. Support for Multi- lateral Trade Criterion 5.1 Criterion 5.2 Criterion 5.3 Criterion 5.4 Criterion 5.5 Criterion 5.6 Criterion 5.7 6. Respect for the Environment Criterion 6.1 Criterion 6.2 Criterion 6.3 Criterion 6.4 Criterion 6.5 Criterion 6.6 Criterion 6.7 7. Avoidance of Illicit Operations Criterion 7.1 Criterion 7.2 Criterion 7.3 Criterion 7.4 Criterion 7.5 Criterion 7.6 Criterion 7.7 Arcturus Risk Assessment Instrument – Criteria Matrix

47. 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 company’s 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. ____________________________________________________________________________________________________________________________________________________________________________________________________________________

48. The Corporate Improvement Cycle Performance Improvement Management Action Performance Feedback to Management CRT Assessment

49. Who Participates? • Board of directors • CEO • Senior management • Division heads and group managers • Unit managers • Employees

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