CEO Incompetence and Operational Risk

Eric Falkenstein  10/1/03

I recently read an enjoyable book, "Searching for a Corporate Savior" by Rakesh Khurana (2002 Princeton University Press), which included many juicy anecdotes about banking, specifically Bank One’s process in choosing Jamie Dimon as CEO. 

But the author also makes two important general points.  First, that CEO’s don’t matter as much as people think, and secondly, that a CEO’s charisma (aka ‘leadership’) is less important than people think.  These criticisms of CEOs imply a conundrum for operational risk.

To recap the main points, first, charisma is clearly overrated as a management skill.  As historian Paul Johnson has noted, many of the greatest mass murders of the 20th century were also the most charismatic: Hitler, Mussolini, Mao, Idi Amin.  This is not to imply that a CEO with charisma is a potential mass murderer, but it’s important to note that overzealous leadership without a truly consistent and realistic plan is a recipe for self-destruction.  Most charismatic but otherwise incompetent CEOs sense this—that their ignorance is dangerous if applied to major decisions—and therefore spend most of their time exhorting the troops while delegating all major strategic decisions via recommendations from their minions.  There’s nothing more common than a CEO with good hair (cut weekly), who mouths Successories clichés, but is only superficially conversant with the strategic issues facing their firm.  Unfortunately, choices involve tradeoffs, and prioritizing charisma deprioritizes other skills, namely, mastery of the details.

Secondly, though many CEOs are assumed prominent in a firm’s success, if not its existence, there is little reason to think so.  It is easy to fall habit to attributing a group’s success to its titular leader (e.g., think Rudi Guiliani recently defending Dick Grasso’s pay package by giving him almost single-handed credit for the reopening of the NYSE after 9/11), but the bigger the organization, the less important they become.  This is because in large organizations the main competitive advantage comes from the sum of so many different strategic decisions made in various business lines.  The CEO is clearly incapable of mastering and minding these crucial decisions, so all he is really doing is allocating capital and hiring other managers.  These are important, but sufficiently dependent upon others that it implies a much diminished importance.  As shown by recent Super Bowl-winning quarterbacks, as well as academic research highlighted in Khurana’s book, the chief's proportional importance declines the larger and more complex the institution.

The relevancy to these issues goes beyond the CEO.  Operational risk is exacerbated by charismatic yet strategically irrelevant CEOs.  Kenneth Lay is a perfect example (though he was Chairman). He was well regarded in political, business, and charitable circles.  He was also totally ignorant of the drivers of Enron's profits. While probably innocent of conspiring in Enron’s financial legerdemain, he was certainly negligent.  A charismatic manager who does not ask tough questions but only rewards recent profits encourages mistakes that in retrospect look downright insane. 

But if operational risk is in large part a function of senior management, how does one in charge of risk management adequately capture this?  It’s bad enough having to tell your CEO that your company’s P/E lags your peer group because the market undervalues senior management, but at least there you can blame it on specific analysts not imbued with their far-sighted vision (as Jeffrey Skilling was wont to do in conference calls).  If one of the main risk factors is you subjective assessment of your boss’s competence, however, clearly this is not a situation designed for candor.  No one, especially charismatic bosses, truly want constructive criticism.  This creates a positive feedback loop with disastrous implications: greater operational risk embodied in senior management, through their bullying and incompetence, biases the internal perception of operational risk ever downward. 

I have always considered operational risk to be the most important risk as far as impacting a business, but also the least important as far as any practical relevancy to those working there because it is hard to measure, and even harder to implement meaningfully into incentive compensation or business line evaluation.

From a shareholder perspective the takeaway for hiring CEOs, or any important manager, is that if you want a motivational speaker, rent Anthony Robbins.  Prioritizing skills that are not specific to one’s industry is a recipe for failure, based on the quaint notion that nabbing one of the Business Elite will buy success the way a state license grants one monopoly profits in many countries.  Fannie Mae, a franchise in an airport terminal, or the NYSE, can afford charismatic yet functionally irrelevant leaders because as long as outsiders like what these guys seem to be, they won’t crimp the status quo, and therefore continue generating monopoly returns.  Fortunately, most business is not done this way, which means there is no monopoly given to club members.   Real motivation of the troops comes not from slogans, but from knowing that those in charge are making good decisions every day, and making good decisions requires competency as much as demeanor.  While we must admit that the preoccupation with detail necessary for works of genius is correlated with an inability to manage or delegate (e.g., Newton or Einstein would probably not be good CEOs), this does not imply an ignorance of detail is innocuous.  It’s always a balance, but I would bet those CEOs minimizing operational risk, and winning market share, have more technical competence than their peers, because it is competence rather than charisma that is usually shortchanged when choosing important managers.