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Value extraction is widespread but backlash is growing
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Ten years ago banking secrecy was the bed-rock of Swiss banking’s wealth management business. Today banking secrecy is gone. Switzerland has agreed to the OECD’s automatic exchange of client banking information.
For decades Swiss private banks used the country’s legal protection of individual financial privacy to offer tax evasion advisory services, at the expense of the countries where their clients’ wealth was created. With hindsight, it is clear that they should have been much more careful.
Looking back at the way the world was, it is difficult to argue that they should not have taken advantage of Swiss banking secrecy. Or, that they should not have participated in the growth of the US mortgage derivatives market prior to the financial crisis. The problem with these activities was that they were based, not on value creation, but on value extraction.
Value extraction involves capturing value from other stakeholders by distorting the competitive market process. Tax evasion advice distorted the fiscal receipts supporting the markets for government services. Opaque mortgage derivative products distorted the markets for fixed income products.
Although value extraction is widespread, the societal backlash is growing, accompanied by tighter regulation and a technology-driven trend towards more accountability.
Sucked into fraud
Value extraction can become addictive, to the point where it drives out real value creation based on innovation and efficiency. The classic case is that of Enron which found it easier to book paper profits than develop competitive value propositions. It finally got sucked into fraud to capture value.
To avoid the potentially fatal attraction of value extraction, the board and top management first have to identify the dependency on value extraction by looking at the ways in which it is done.
This involves using political influence, market power, or deception to restrict competition and distort market pricing. The banking industry created and took advantage of the deceptive pricing of mortgage derivative products while accumulating profits prior to the financial crisis. In many cases, exploiters use existing market distortions to shift costs onto society, like the unpriced effects of pollution.
Two forces can make value extraction unsustainable.
First, the legal and regulatory environment, influenced by affected stakeholders, social opinion and the media, can impose unbearable costs on value extraction. Swiss banks misjudged the speed with which cash-strapped governments, especially the US, would become intolerant of tax evasion. The oldest Swiss private bank, Wegelin, which refused to hand over client and employee names, was indicted and could no longer operate in the financial markets. It sold off the competitive part of its business, paid the fine and liquidated.
Second, easy money from value extraction can erode the competitive advantage of a business model. Many of the investment banks that participated in the mortgage derivative boom did so well that they did less and less to increase the competitiveness of the rest of their business model. When the mortgage pricing bubble burst, some of the business models were so weak they had to be restructured, or closed.
In brief, value extraction is increasingly under threat in today’s rapidly changing regulatory and societal environment.
Paul Strebel is a professor emeritus of governance and strategy at IMD Global Board Center. Salvatore Cantale is a professor of finance at IMD. Reprinted with permission from IMD.
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