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Sunday, August 17, 2014

This pope means business


This pope means business

by Shawn Tully in Fortune Magazine

The wildly popular Francis is more than a pontiff of the people. He’s an elite manager who’s reforming the Vatican’s troubled finances.

The new pope wanted to talk about money. That was the message that went out to a group of seven prominent financiers—major Catholics all—from around the world in the summer of 2013. Barely five months after the shocking resignation of Pope Benedict XVI, Pope Francis had summoned them to assemble at the seat of holy power, the Vatican. They knew their general assignment: to create a plan to restructure the Vatican’s scandal-plagued finances. And like Catholics everywhere, they knew that Francis had already signaled that he was a new kind of pontiff, a “people’s pope” who championed charity and tolerance over dogma. Still, they didn’t know what to expect when they arrived at the Vatican for a meeting with the pope on the first Saturday in August. How interested was he in finance, really? And how serious was he about changing business as usual inside the Vatican?

A major hint came from a change in tradition upon their arrival: The visitors didn’t report to the Apostolic Palace, the Renaissance showplace where for centuries past popes had received visitors in high style. Instead they entered Vatican City on the other side of the colonnade of St. Peter’s Square and took a 150-yard stroll through the hilly enclave to the new pope’s place of business—Casa Santa Marta, a five-story limestone guesthouse that could be mistaken for a newish hotel. There they were ushered into a nondescript meeting room on the first floor with no paintings or religious ornaments and took their seats around a conference table. The members—including Jean-Baptiste de Franssu, ex-chief of asset-management giant Invesco in Europe; Jochen Messemer, a top executive at ERGO, a large German insurer; and George Yeo, former foreign minister of Singapore—chatted nervously as they waited.

After 15 minutes, Pope Francis entered the room—and got right down to business. Attired in a simple white cassock and plain metal cross, he took his place standing at the head of the table. With little preamble, he began outlining his strategic vision, in an approach described by one participant as “highly managerial.” Speaking in fluent Italian and taking frequent pauses while a translator repeated his words in English, the pope explained to the group that for his spiritual message to be credible, the Vatican’s finances must be credible as well. After centuries of secrecy and intrigue, it was time to open the books to the faithful. Strict rules and protocols must be adopted to end the cycle of scandals that had plagued the Vatican in recent years.

Francis declared that sound financial management was a pillar of his greatest mission: aiding the poor and underprivileged. That mission was endangered by volatile, unpredictable budgets that careened from modest surpluses to steep deficits. The Vatican’s inept practices had inhibited giving, he explained, and had to stop. “When the administration is fat, it’s unhealthy,” he said. Francis wanted a leaner, more efficient Vatican administration that would be solidly “self-sustaining.” That, he said, would free up more money for his charities. “You are the experts,” the pope said, “and I trust you. Now I want solutions to these problems, and I want them as soon as possible.” With that, Francis left the group to figure out the details.

There was no ambiguity about the job ahead. “The Holy Father’s message was crystal clear: ‘Let us make money to go to the poor,’” recalls Joseph Zahra, chief of the panel, a pontifical commission known by its acronym, COSEA. Zahra, a former chairman of the Bank of Valletta, Malta’s largest bank, says of Francis: “In finances, he’s not a micromanager but an inspirational leader.”

As the spiritual shepherd of the world’s 1.2 billion Roman Catholics, Pope Francis, 77, has already done more in 18 months to energize the church and burnish its image than anyone has since the heyday of John Paul II in the mid-1980s. What’s far less appreciated is his intense engagement—and astounding success—in overhauling the Vatican’s finances and pushing the adoption of modern practices it had resisted for decades. “The changes are massive,” says René Brülhart, chief of the AIF, the Vatican equivalent of the Securities and Exchange Commission. “Now a clear game plan has been put in place, and we’re really part of the international community.”

The past 15 years have been a time of turmoil and decline for the church. It has suffered blow after blow to its image, from the pedophilia scandals that have plagued it for over a decade to the recent “Vatileaks” affair, in which Pope Benedict’s butler smuggled letters to the press that warned the pontiff of corruption and cronyism in the Vatican. The church has often promoted issues that tended to divide Catholics more than unite them. And the backlash made Rome look defensive, as many bishops and cardinals viewed their role as defending Catholic doctrines against a hostile culture of secularism.

Before Francis’s arrival, attendance at mass was declining and the recruitment of priests and nuns had plateaued. The difficulties extended to fundraising. “The church was underperforming for years in raising money, and it started with the pedophilia scandals,” says Kerry Robinson, executive director of the National Leadership Roundtable on Church Management, an organization that advises parishes and dioceses on financial management.

By contrast, Francis’s upbeat, quotable approach and emphasis on charity over doctrine have quickly made him perhaps the most talked-about and admired person on the planet. (Fortune named him No. 1 on its World’s Greatest Leaders list earlier this year.) His famous “Who am I to judge?” declaration on homosexuality distanced him from Benedict’s severe criticism of gays. Francis could be called the first modern pope. His Twitter account, @Pontifex, boasts 4.3 million followers in nine languages. And his message is universally appealing: The paramount duty of the church and its faithful is to aid those in need.

Although it’s too early to make a definitive judgment, the “Francis effect” appears to be reversing the church’s fortunes. Mass attendance is surging in Italy, for instance. The Jesuits, Francis’s religious order, are seeing more inquiries about priestly vocations. And donations are on the rise at dioceses around the world.

What has been less appreciated by outsiders until now is the pope’s elite managerial skill set. Like a great CEO, he has the ability to set a strategic vision, then choose and motivate the right people to make it work. His rapid overhaul of the Vatican’s finances is both one of the most unusual case studies in the annals of business and one of
the more instructive.

Francis was elected with a mandate for reform. After Pope Benedict, on Feb. 28, 2013, became the first pontiff in six centuries to resign, the 115 cardinals who assembled to pick his successor held eight days of meetings, or “general congregations,” to discuss the priorities for the next pontiff. Benedict had been considered a brilliant theologian, but he was no manager. Cardinal after cardinal expressed outrage over reports of the overpriced, no-bid contracts handed to officials’ friends in Italy and the criticism of the Vatican bank’s disclosure policies by the Italian government. The feeling was that the next pope should be someone with the leadership skills to bring professional management to a clubby bureaucracy that was expert in blocking change.

As an outsider who had expressed contempt for the Vatican’s status as an insular “royal court,” Jorge Mario Cardinal Bergoglio, then archbishop of Buenos Aires and a native of Argentina, was the overwhelming choice. Pope Francis—the first pontiff to take the name of Saint Francis of Assisi, patron saint of the poor—came in with a plan. His central idea was revolutionary: Money matters are not a core competency of the clergy, as the record shows. So he began replacing the old guard of cardinals and bishops with lay experts who are now largely setting strategy, heading regulatory oversight, and running day-to-day operations.

Indeed, Francis has brought in some of the biggest brand names in the world of business. KPMG is implementing uniform, internationally accepted accounting standards to replace the Vatican’s previous crazy quilt of bookkeeping. EY (the former Ernst & Young) is scrutinizing management of the Vatican’s stores, utilities, and other municipal services. Deloitte & Touche now audits the accounts at the Vatican bank. And Spencer Stuart has recruited top management talent from around the globe. Heading the effort to restructure media operations, assisted by McKinsey & Co., is Lord Christopher Patten, a former head of the BBC and the last British governor of Hong Kong.

When Pope Francis puts a cardinal in charge of something, the choice is typically an outsider. His most important appointment so far, either lay or religious, is Cardinal George Pell, an Australian whom he recruited from the archdiocese of Sydney. Pell now heads the newly formed Secretariat for the Economy, and Pope Francis has granted Pell power over finances that no official has remotely held before. He’s responsible for setting and enforcing all budgets and managing all investments. The son of a heavyweight boxer, Pell, 73, is an imposing figure who is short on niceties and brutally frank about the necessity to radically pare costs.

Pope Francis has a complex but pragmatic view of money. “Money is useful to carry out many things, for works to support humanity,” he has said. “But when your heart is attached to it, it destroys you.” His humble lifestyle follows those precepts. He resides in a one-bedroom, second-floor suite in Casa Santa Marta overlooking the entrance. (Benedict, the former pope, lives nearby in a converted monastery called Mater Ecclesiae and occasionally sends Francis notes with feedback on his interviews.) Visitors say the pope’s lights go on at 4:30 a.m. He’s frequently spotted in the buffet line, tray in hand, at the Santa Marta dining room, where the cuisine isn’t fancy—it offers a choice of two main courses for lunch and dinner, and features Italian specialties such as pasta con pomodoro and pollo arrosto. He takes no holidays, explaining that if the poor can’t take vacations, why should he?

The pontiff does not talk about balance sheets and cash flow. He leaves the numbers to the experts. His forte is leadership. Like any good chief executive, he knows that the culture of an organization is established at the top. And he is always well prepared. “He has five or six sources of information on every subject,” says Austen Ivereigh, author of a forthcoming biography of Francis, The Great Reformer. “It’s impossible to hoodwink him.” By getting the views of many participants—both Vatican officials and lay advisers—in all of his reform initiatives, the pope quickly determines if his instructions are being implemented or blocked by the old guard. If he sees resistance from old-school directors, he’ll quickly make changes, as when he replaced the entire board of the AIF, the financial regulator.

One of his rules is that big donors and companies that do business with the church should get no special treatment. Before he took charge in Buenos Aires, the archdiocese was a large shareholder in Argentine banks, and the banks regularly granted their ecclesiastical investor loans on easy terms. As cardinal, Francis denounced the arrangement as a blatant conflict of interest and sold all the archdiocese’s bank holdings. He also refused to attend fundraising dinners, usually regarded as one of a cardinal’s top jobs. His aversion to catering to the wealthy didn’t stop with his ascension to the papacy. It’s a Vatican tradition that the Secretariat of State, which receives donations from the rich on the pontiff’s behalf, would reward big donors by arranging special audiences and masses with the pope. Pope Francis ended the practice.

Pope Francis is a strong believer in workers’ rights. But that view is highly nuanced. He has famously denounced the excesses of capitalism and firmly believes that the rich get too much from the market economy while regular workers often don’t receive enough. In contrast to his readiness to ax high-ranking officials who block his agenda, he doesn’t believe in firing rank-and-file employees. But he despises waste and inefficiency, and he thinks the Vatican can run better with fewer employees.

The catholic church is highly decentralized financially. In terms of money, the Vatican basically stands on its own. That’s a major reason its finances are far shakier and its wealth is much more modest than its image of sumptuous wealth. The church is divided into three branches: the Vatican, the religious orders, and the dioceses. Each maintains separate finances. In fact, the Vatican has no official claim on or access to the wealth of the two branches that it oversees. The members of the 296 religious orders and congregations are priests, nuns, and brothers who specialize in education (the Jesuits), missionary work (the Missionary Sisters of the Sacred Heart of Jesus), and helping the poor (Franciscans). Frequently, regional units within the orders control their own finances.

The dioceses are where the Catholic Church meets Main Street. The more than 2,800 dioceses, each headed by a bishop or an archbishop, supervise the networks of parishes from Lagos to Manila to Detroit where Catholics attend mass, get married, and send their children to the 95,000 elementary schools. Each diocese is a separate corporation with its own investments and budgets, including the metropolitan archdioceses. The dioceses do send substantial amounts of money to the Vatican each year, but most of it is earmarked for either missionary work or the pope’s charitable giving. The funds sent to support the Vatican’s operations are important but account for around 4.5% of total revenues.

Since the church contributes only modestly to funding its operations, the Vatican must generate substantial income on its own and supplement that income with a steady flow of donations from the faithful. The Vatican serves two functions. First, it is a fully sovereign, independent nation with its own laws, courts, stores, security force of gendarmes, and an “army” of 110 ceremonial Swiss guards. Cloistered behind 40-foot stone walls in the heart of Rome, the Vatican is the smallest nation on the planet. It occupies just 110 acres—or one-eighth the size of Manhattan’s Central Park—and is home to just 837 citizens. The Vatican has no legislature; the pope, the world’s last absolute monarch, can unilaterally announce new laws, create or eliminate departments, and hire and fire as he pleases. Any money the Vatican generates in excess of its expenses can be used at the discretion of its ruler, the pope.

The Vatican’s second and principal function is its role as the hierarchy of the church. The pope heads a large bureaucracy called the curia, which exercises a wide range of power and provides advice and assistance to the church at large. The curia’s most powerful bodies are nine congregations, each headed by a cardinal, that resemble the U.S. government’s cabinet departments. One congregation, for instance, appoints the world’s almost 3,000 bishops. Another does the detective work needed to name new saints.


THE CHURCH’S THREE PILLARS
Through the pope the Vatican establishes and enforces doctrine for all parts of the Catholic Church. But the other branches—the dioceses and religious orders—are financially independent. Each contributes money to the Vatican’s budget.

For financial purposes, the Vatican operates two quasi-independent entities, one for each of its two functions: operating as a nation and serving as the sprawling staff that supports the pope. The city state, or governorate, operates the Vatican’s commercial services. It resembles a medium-size municipal government. The city state has excellent sources of revenue. It garners about $130 million a year, and rising, from the thriving Vatican museums, home of Michelangelo’s Sistine Chapel. And each year tourists purchase around 2.2 million euro-denominated collector coins at its gift shops.

Last year the city state spent around $332 million and collected $377 million, for a “profit” of $45 million. It posts substantial surpluses most years. But that money usually isn’t available to fund the struggling part of the Vatican. The governorate frequently uses its excess cash to bolster the underfunded pension plan and needs to accumulate reserves to expand the museum and refurbish buildings.

The problem resides in the curia, officially known as the Holy See. The Holy See consists of many sections that spend heavily but offer little or no income. Vatican Radio, which broadcasts the pope’s readings and masses, as well as the Vatican’s news, has 330 employees and spends $37 million a year yet collects less than $1 million in advertising. Its deficit is so deep that the city state now covers half the shortfall. Operating the embassies, called apostolic nunciatures, in 113 nations runs over $30 million.

Almost two-thirds of the Holy See’s budget goes to paying salaries, benefits, and pensions for its 2,886 employees. (Including the city state, the Vatican has a workforce of 4,822.) The Vatican pays relatively low wages but offers generous health and retirement benefits. Cardinals and bishops at the congregations and councils often toil for as little as $46,000 a year, though their housing is heavily subsidized. The rank and file, including nuns and priests, are also paid below market, but make it up in benefits. The average salary for lower- to mid-level workers is around $28,000 a year. That’s about 25% less than the $37,800 average for Italian workers with similar private sector jobs. But keep in mind that Vatican employees pay no income taxes. Today around three-quarters of the Vatican’s employees are lay workers, vs. less than half 25 years ago. Vatican lay employees have jobs for life, and virtually no one leaves before retirement age.

For 2013 the Holy See posted revenues of $315 million and expenses of $348 million, for a $33 million deficit. Since 2007 the total shortfalls have totaled $56 million. Those figures actually understate the size of the Holy See’s financial problems. The current spending number is due to rise sharply for a pressing need: taming big pension liabilities. It’s a problem the Vatican shares with virtually every Western economy. The Vatican inaugurated a generous defined-benefit pension plan in the early 1960s but didn’t have an actual pension fund until three decades later.

 

THE VATICAN’S ASSETS

The Vatican is often assumed to possess great wealth, but if it were a company, its revenue wouldn’t come close to making Fortune 500. Its total operating budget is about $700 million. in 2013 it posted a small overall surplus of $11.5 million. The Vatican’s most valuable assets—some of the world’s great art treasures—are virtually priceless and not for sale. A breakdown of major holdings:

Investments: Portfolio of stocks, bonds, and gold worth $920 million.
Real estate: Holdings have an estimated value of
$1.35 billion, including some 2,000 apartments, mostly in Rome.
Vatican Bank: Book value of
$972 million.
Art collection: Worth untold billions. The Vatican’s museum brings in
$130 million a year in revenue. Treasures include the Sistine Chapel frescoes by Michelangelo (above); “Saint Jerome in the Wilderness,” a painting by Leonardo da Vinci; “Deposition From the Cross,” a painting by Caravaggio; a letter from Marie Antoinette en route to the guillotine; and the papal bull excommunicating Martin Luther.

The pope’s strategy for addressing both spending and pension issues is to gradually shrink the Vatican workforce through attrition and raise more money to maintain the benefits. In February of 2014 he imposed a hiring freeze and also stopped formerly generous overtime payments. The plan is to move existing employees from overstaffed congregations to growth areas, such as financial management, without replacing those who depart.

The Vatican’s pension plan guarantees retirees 80% of their final salaries after 40 years of service, and as noted, few employees leave before retirement. That’s a big premium over the “replacement rate” in Italy of around 72%. But Pope Francis is explicit about providing better pensions than those in Italy. The challenge is filling the huge shortfall in the pension fund. The Vatican is guaranteeing some 1,750 retirees—plus current workers who have paid into the fixed-benefit plan for years—big pensions for decades to come. Right now those future payments far exceed the amount the current fund can possibly generate in income.

According to a Vatican insider, the pension fund is short by “a few hundred million dollars.” The Vatican has been making minimal contributions to the fund for years, and employees kick in just 6% of their salaries. Cardinal Pell says that retirement benefits are safe for now but that the Vatican needs to heavily restock its pension reserves in the years to come. The Vatican could be obligated to contribute another $30 million or $40 million a year for a decade or more to build a fund large enough to pay future pensions from its investment returns.

The other major problem facing the Holy See is that its revenues from investments—almost half of its total—are unpredictable, and returns are far lower than they should be. The Holy See does own one reliable source of profits, the Vatican bank, or IOR. The IOR (for, in Italian, Institute for Religious Works) regularly provides around $70 million toward operating revenues. Perhaps the most surprising feature of the Vatican’s finances is the extremely modest size of its portfolio of stocks, bonds, and real estate. The seed money for the Vatican’s investments came from a $92 million settlement the Italian government provided in 1929, in compensation for its confiscation of the Papal States, covering much of central Italy, 60 years earlier.

Today the Vatican holds some $920 million in stocks, bonds, and gold. Its gold reserves, on deposit at the U.S. Federal Reserve, now amount to just $50 million. The Vatican usually earns between $15 million and $25 million on its holdings, much of it stashed in money-market accounts and short-term government bonds. It also generates low returns on its extensive holdings of real estate, valued on the books at around $1.35 billion. Its principal holding consists of some 2,000 apartments, which are mostly in excellent locations in Rome, including the historic districts surrounding the Vatican and the bohemian-chic neighborhood of Trastevere.

Most of the units, however, are rented to bishops, priests, and lay employees who pay minimal rent. For example, a prominent cardinal and other clergy pay token rent on a building with some 20 apartments on the tony Via Carducci. It would generate over $1 million a year on the open market. Over the past several years the real estate portfolio has returned an average of about $33 million a year.

Catholic foundations around the world actually pay a larger share of the Vatican’s operating budget than do its investments in real estate and securities. This giving is a crucial, unreported bulwark of the Vatican’s finances. Last year, by Fortune’s estimate, foundations donated more than $85 million toward the Holy See. The bounty comes from dozens upon dozens of charities, most of which pledge relatively small amounts. For example, the Legatus organization, a group of prominent Catholic business executives, pledges 10% of its annual dues to the pope, amounting to $500,000 a year.

To turn the vatican into a consistent profitmaker, the new regime is counting on two institutions with the potential for big growth in earnings: the museums and the Vatican bank. “Those are the two main income sources for the future,” says Zahra, the Maltese adviser to the Vatican.

The museums are the only branch of the Vatican run like a true business. This year the museum is on track to host 5.5 million visitors, or three times the figure 30 years ago. It now ranks as the world’s fifth-most-visited museum, behind only the likes of the Louvre and the British Museum. Traffic this year has risen by 1 million visitors from 2013, largely because of the Francis effect. The Vatican museum famously boasts one of the world’s greatest collections, from its frescoes by Raphael to da Vinci’s painting “Saint Jerome in the Wilderness” to the ultimate trophy attraction, the Sistine Chapel. Cardinal Pell and the reformers want the Vatican to exploit its hidden treasures for additional profit. The goal is to use promotional campaigns and new exhibitions to push museum revenues far above the current $130 million a year.

The Vatican bank is also a potential growth franchise. The IOR resembles a holy savings and loan. The basic purpose of the IOR is simple, and essential. The wealthy dioceses, religious orders, and Catholic charities collect huge sums each year destined for the developing world and deposit the funds in the Vatican bank. That money frequently comes in cash. The Vatican bank wires the funds to all corners of the developing world to build churches and schools, run hospitals, and pay priests and nuns. It’s also the everyday bank for Vatican employees. It has a single branch with eight teller desks, situated in a medieval Gothic prison built by Pope Nicholas V. Its ATMs, all in Vatican City, provide instructions in Latin. The bank’s basic business is highly profitable. Last year the IOR paid around 1% interest on its $3.1 billion in deposits and invested that money in government bonds at over 3.3%. That model generated “spread income” of over $70 million.

Despite its simple mission, the Vatican bank has in the past found itself ensnared in scandal. Perhaps the most decisive transformation under Pope Francis is the remaking of the IOR from a near wreck to the useful institution it should be. Today it is central to the Vatican’s plans for financial growth.

The Vatican bank’s recent troubles started in 2009. As an “offshore bank” outside the European Union, the IOR had no rules or protocols for combating money laundering. The Vatican was already using the euro but couldn’t sell large quantities of its own euro collectors’ coins, a potential source of revenue. So that year the Vatican signed a special monetary agreement with the EU that allowed it to offer those special coins in its gift shops. In return the Vatican agreed to follow the EU’s strict policies on money laundering and financing of terrorism.

But the Vatican bank management was unprepared and unwilling to make the changes necessary to comply. Under Italian law, the IOR was not required to notify authorities of the identity of clients who transferred money to accounts in Italy. The system was ripe for abuse, and abused it was. When the authorities asked IOR officials to identify senders of money, the typical response was, “Our laws don’t require us to tell you.” The old guard in the bank adamantly opposed lifting the veil. But the Bank of Italy started pressuring correspondent banks in Italy to cease dealing with the IOR. In March 2012, J.P. Morgan Chase cut off business with the Vatican bank in Italy, and then worldwide. Nine months later the Bank of Italy declared that the IOR was failing to comply with international anti-money-laundering laws
and forced all banks in Italy to close their IOR accounts.

By early 2013 the IOR was on the verge of collapse.

Francis empowered two key officials to clean up the mess. The first was Brülhart, the head of the AIF. A Swiss lawyer who had previously headed an anti-money-laundering initiative in Liechtenstein, Brülhart is an uncommonly glamorous figure in the Vatican hierarchy. Nicknamed “the Vatican’s James Bond,” Brülhart, 42, sports a perfectly groomed black-stubble beard and beautifully tailored three-piece suits. Brülhart’s group, the AIF, was charged with both monitoring the IOR for suspicious transactions and making the Vatican comply with all EU and other multinational regulations.

Brülhart at first faced stiff resistance from the powerful Secretariat of State. The secretariat had the authority to veto any agreement for exchanging information with a foreign government. Those covenants were crucial to Brülhart’s efforts. Last December, Francis canceled that authority, giving Brülhart free rein. Then, in June, the pope fired and replaced the AIF’s entire board.

The second key reformer was Ernst von Freyberg, who was named head of the IOR in its darkest days in early 2013 by Pope Benedict—and started the day the pope officially resigned. Von Freyberg hired Promontory Financial Group, a compliance and auditing firm based in Washington, D.C., to review every one of the bank’s then 19,000 accounts. He ended up shuttering 755 accounts held by outsiders, containing over $250 million. He also published two extremely thorough annual reports, the first publicly released financial statements in the IOR’s history. Von Freyberg resigned in July to return to his family shipping business, but his achievements are respected by bankers worldwide.

Cardinal Pell has original ideas on how the IOR can generate more revenue. And get this: The Vatican is now in the institutional money-management business. With the pope’s blessing, Pell is gathering all Vatican investments into a newly created unit called Vatican Asset Management, or VAM. It’s headed by de Franssu, the former mutual fund executive whom Francis has named to head the IOR.

Pell and de Franssu figure that dioceses and religious orders, especially in poor countries, sorely need professional money management and will relish entrusting their nest eggs to VAM. The plan is for VAM to distinguish itself as a specialist in so-called ethical investing, which will align with the church’s values and those of its clients. As VAM gathers in billions in assets to manage, it should throw off millions in annual fees. “The future of the IOR is asset management,” declares Pell.

Pell meets with Pope Francis once every two weeks at Casa Santa Marta to brief him on the progress being made by their handpicked team of financial experts. He describes the pope as a good example of the “old-style Jesuit” who “knows which way is up” and asks the right questions. To serve his higher calling as a pope of the people, Francis knows, he must continue to keep one eye on the bottom line.

Additional reporting by Anna Artymiak

This story is from the September 1, 2014 issue of Fortune.

 

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