A lot of people are still furious at the big banks, and every positive earnings report and bonus announcement in the coming months will only stoke their fury. Here is an industry which virtually vaporized itself less than a year ago, which are among the living today only by virtue of taxpayer financing and risk-bearing, and much of which has bounced back to its old sharp-elbowed self while the public is still gasping for air and trying to figure out how massive bailout will ultimately be paid for – higher taxes, reduced spending or higher inflation. No wonder the public perception of bankers has eclipsed such perennial favorites as trial lawyers and insurance salesmen in the social pecking order.
Whatever the merits and the hyperbole, people think bankers paid themselves too much and turbocharged their incentivized risk taking. Regulators think bankers were too reckless in creating massive amounts of systemic risk exposure which ultimately would have to be borne by society at large. Investors think bankers and their consultants have been flogging a broken business model – the financial conglomerate – far too long. The anger is converging in the scattershot regulatory proposals in the US and Europe — proposals to limit risk taking, increase capital requirements, shrinking and breaking-up financial supermarkets, charging surviving banks for the failure of their cohorts, restricting compensation of senior managers and risk-taking bankers, providing greater consumer protection from incomprehensible and abusive products, regulating derivatives and hedge funds, and many more. Much as they would like to have it otherwise, banks and bankers today are on the defensive in the court of public opinion, and will soon be in the regulatory target-zone as soon as the politicians get themselves organized.
Maybe it’s time for a brand new approach – one that has been successful in other industries but has never been tried in today’s fast-moving world of banking and finance.
Here’s the idea. One or more of the major banks that have survived the crisis intact might step forward and offer a new best-practices “compact” with the regulators — acknowledging that banks and other large financial firms do in fact create risks that cumulatively can be dangerous to the world financial system and the economy at large. Since it is difficult for individual banks, vigorously competing for business, to avoid creating systemic risk without killing their market share and profitability, a few of the strongest “high road” banks acting together, would recognize this reality and offer-up what they are willing to live with in terms of their business conduct and then walk the talk – this is the way a real financial statesman like Morgan or a Warburg might have thought about it back in their day.
The banks willing to step-up might say something like this: We agree to abide by the principles proposed time and again by people like former US Federal Reserve Chairman Paul Volcker, a man unique in both stature and perspective:
· We will discontinue all proprietary trading and investing activities undertaken only for the bank’s own book, and restrict our trading to normal market-making and client oriented transactions. In other words, we will become classic financial intermediaries, efficiently and innovatively serving investors and issuers.
· Activities that do not fit this core function as a financial intermediary we will no longer fund with our shareholder capital. Instead, we will sell or spin-off such business units to our shareholders as separate risk-taking businesses. The new owners are free to hold or sell the newly independent businesses. Let the investor do the investing, instead of passing-off a prepackaged financial conglomerate that combines everything from public utilities to casinos.
· We agree not to park assets and other risky exposures off the balance- sheet, or create unguaranteed investment funds with our name of them. From Enron and AIG to SIVs and Fannie Mae, these “dotted lines” are recipes for disaster.
· We will elevate the status of our chief risk officer to the small circle of our most senior executives, who report directly to the CEO. We will move risk management out of the basement and into the center of things in order to stand toe-to-toe with revenue generation in committing the firm to business opportunities.
· We agree to narrow the information gap between ourselves, the regulators and the investors by providing timely and accurate information on our financial condition and the transparency of our products. This includes data on every position every day so that the regulators can monitor their exposure to risk in real time, both nationally and internationally — it is opaqueness that led to the structured finance and interbank market seizures of the recent crisis. When there are significant information asymmetries, markets tend to freeze since those with an informational disadvantage refuse to participate. These asymmetries will persist as long as banks we unwilling to fill key information gaps.
· We agree to adopt incentive-compatible compensation practices proposed by the Federal Reserve and many others, which take into account the creation of systemic risk – assuring that bonuses will be calculated after full consideration of the risk exposures taken in earning them. Some of us have already done this. Others need to follow, and refrain from taking advantage of the first opportunity to poach staff by violating their own commitments.
In return, we ask that regulators refrain from imposing increased costs, greater compliance complexity, size restrictions or capital requirements that would take away from large banks the ability to be innovative, responsive to clients – as well as fully competitive with rivals around the world. Before new rules are imposed that tighten financial regulation in the US – some of which may indeed be necessary – the Federal Reserve should first attempt to strike an agreement with European and other regulators as to the basic principles that will be applied globally, so that all large banks are subject to approximately the same rules.
While they are working on a sensible compact with the regulators, the banks ought to consider a similar compact with their investors, many of whom have fled the sector in the volatile, high- volume of trading of the last year. Most large banks now trade at prices close to book value, rather abysmal by historical standards and compared with other industries. Maybe they should-offer up something like this:
We agree to take the repeated surprises (most of them negative) out of our quarterly earnings reports – surprises from unexpected write-downs, black-box trading losses, and legal settlements from previous overly aggressive financial practices. We agree to focus on growing our financial intermediation activities gradually and organically without promising 15+% annual increases in earnings per share which often rely on large, disruptive, overpriced and hard-to-control acquisitions to achieve growth objectives. This will enable us to avoid businesses that are difficult to manage, preserving cash and capital to be returned to shareholders through dividends or stock buybacks. We aim to again become an attractive long-term holding for major institutional as well as individual investors, with our stock priced at a level that appropriately values our solid, steady and profitable business franchise.
During much of the this decade, many large banks and financial conglomerates have been intently focused on increasing size, complexity and market share in pursuit of higher shareholder value. The opposite result has occurred. Much shareholder value has been destroyed. Or transferred to the lucky shareholders of acquisition targets. Markets are hard to bamboozle for very long. Banks need to recognize that investors will pay more for above average, regular and predictable earnings growth and formidable market shares than for bold, erratic and flashy efforts to capture investor attention through poorly considered strategic actions and business tactics that backfire much of the time.
To recover the ground they have lost in the recent crisis, the big banks and financial conglomerates are going to have to come to terms with the general public, their regulators and their own investors. They ought to take the initiative soon, or be prepared for the public to do it for them.