Bankers and Entrepreneurs

My working career has been spent working as a commercial banker and later as an entrepreneur (someone who starts up new businesses and makes them grow). Bankers and entrepreneurs represent two fundamental dimensions of the business world.

Many years ago, I was struck by the remark of a major bank president, who said that all businesses, big and small, have 50% of their elements in common: they all have owners; bankers; customers; employees; suppliers; competitors; lawyers; assets; an office, shop, or store; inventory; receivables; accounting; a supply of capital; etc.

Businesses get started by entrepreneurs (even if they don’t know this word). And most businesses usually need other people’s money to grow, which they mostly get from their banker.

Let me start first with bankers and how they think and operate. Bankers use other people’s money which they get as deposits. They lend this money to businesses at a higher interest rate then they pay for deposits. This interest spread is their income, which pays for operating their bank.

Imagine that a banker takes $50,000 of capital and then matches it with $950,000 of deposits; so 95% of the money loaned out belongs to depositors, who must be repaid, no matter what. So bankers are concerned above all about keeping the risk very low for all loans.

The entrepreneur starting out in business usually has very little money, unless they inherit a lot. So they must “beg, borrow or steal” enough money to get their new business going. The entrepreneur typically goes to the bank, hoping to get a bit more money to get the business up and running. But the banker says: “NO. Come back once your business is successful and I will be happy to lend you some money”. So entrepreneurs and bankers mistrust each other from the start, and their relationship rarely gets any better.

The only way they can get along is to understand each other very well. The banker must keep risk very low, because it is other people’s money being loaned out. A depositor expects zero risk. So the banker cannot afford to make many mistakes. That attitude causes entrepreneurs to think of bankers as being uncaring and unintelligent.

Entrepreneurs by contrast take enormous risks. They put every thing they own on the line to support their new business concept. If it succeeds, they hope to get back 10 times or 100 times their investment. They often go broke, or nearly broke. They live on the edge. They become incredibly resourceful.

I have oversimplified the banker and the entrepreneur types to make it easier to understand how they operate. But in a 25 year career as a banker to both small businesses and to some very large businesses, I have seen these fundamental patterns occur again and again.

I also have had a career as an entrepreneur, first working on several small businesses while I was still a banker, and then later working as a CFO to several major entrepreneurs, where I was a risk partner in the business.

Our economy needs bankers who keep risks low and don’t get swept away by the temptation to take bigger risks to earn quicker profits. Due to economic cycles and other unpredictable events, it is very hard for bankers to make loans which are going to be repaid in full. Bankers are not paid to think like entrepreneurs.

Equally, our economy needs great entrepreneurs who are the backbone of economic growth. Most entrepreneurs will never make much money; they are lucky if they don’t go broke and stay broke. But for those who eventually succeed, their huge rewards are fairly earned. They sometimes get paid well for taking the big risks.

Although bankers must keep their risks low and entrepreneurs necessarily need to take enormous risks, they have one thing in common: they both need to be exceptionally good at calculating risks in order to succeed. Surprisingly, some of the best entrepreneurs are those who have been originally trained as bankers.

(There are other sources of capital for entrepreneurs, beyond conventional bankers. I will write later about venture capital, investment banking, and the role of capital in company growth.)

A Hard Rain's A-Gonna Fall

Bob Dylan, the poet and singer, often captured economic reality in his metaphors better than thousands of economic analysts. He understood storms of all kinds when he sang:

And it's a hard, and it's a hard, it's a hard, it's a hard,
And it's a hard rain's a-gonna fall.

Here were some of the news headlines from March 2007:

• World stock drop hits second week
• U.S. Stock-Index Futures Slide; GM, Wal-Mart Drop After Asia, Europe Slump U.S. stock-index futures tumbled after shares in Europe and Asia extended a global selloff that wiped out $1.5 trillion in world market value last week
• Mortgage Crisis Spirals, and Casualties Mount

A few weeks after these headlines, the world markets recovered and everyone quickly forgot about their fears of the economy going into free fall. They returned to complacency. But they shouldn’t.

Sooner or later, we will see fierce worldwide economic storms that make the Indonesian Tsunami and Hurricane Katrina seem like small local incidents. At some point in the coming years or decades, stock markets will likely plunge around the world in dismaying amounts. Potentially we could see 20%, 40% or even 60% of equity values wiped out in a very short time. And nobody will know the date or the year of this disaster until afterwards, because that is the way it is with the biggest storms.

This has happened before and it will happen again. My father lived through the Great Depression of the 1930’s and that event was etched into his mental wiring. It is likely that this giant economic storm was also the largest cause of World War II where tens of millions of people died all around the world.

No one can adequately explain the cause of economic calamities. They are partly caused by physical realities, like energy shortage, wars, and other natural disasters. They are also caused by speculative build-up of markets to unhealthy levels, which makes a collapse a near certainty. They are caused by enormous debt loads by consumers, companies and governments that prove unsustainable. Finally, there is a psychological element where euphoria can turn overnight into nightmarish fears.

When I was a student at Harvard, and soon after as a manager on Wall Street, I was told that these economic disasters would never happen again, due to rapid progress in economic knowledge and monetary management by central banks. My teachers and bosses were unfortunately overconfident and mistaken. Several major recessions have occurred throughout my working life, and none of them has been expected by the experts.

It was helpful decades later to hear someone of the stature of Allan Greenspan, the former Chairman of the US Federal Reserve Bank publicly acknowledge that central banks and economists live in the dark like the rest of us when it comes to predicting the economy. At best, they examine trends and potential scenarios to get some sense of the direction of the wind.

So, don’t ever leave yourself vulnerable by betting everything you own on the assumption that markets will always go up. You might be right for a year or two, but dead wrong later. Remember the thousands of technology millionaires that lost everything when the NASDAQ market collapsed by over 75% at the end of the 1990’s. A few cashed out in time, but most believed that this new easy money would last indefinitely.

So I return to Bob Dylan, who describes this well:

And what did you hear, my blue-eyed son?
And what did you hear, my darling young one?
I heard the sound of a thunder, it roared out a warnin',
Heard the roar of a wave that could drown the whole world,
Heard one hundred drummers whose hands were a-blazin',
Heard ten thousand whisperin' and nobody listenin',
Heard one person starve, I heard many people laughin',
Heard the song of a poet who died in the gutter,
Heard the sound of a clown who cried in the alley,
And it's a hard, and it's a hard, it's a hard, it's a hard,
And it's a hard rain's a-gonna fall.