Why Banks Should Clean up their House and How they Can Take Advantage of the Opportunity of Modern Times

A financial and economic catastrophe of unprecedented proportions has so far narrowly been avoided. Yet, big dangers are still looming over the horizon.

Unemployment and underemployment are very high and levels of capital flows and lending to the real economy continue to fall. The huge public stimulus is about to fade away leaving behind an enormous debt for present and future generations. A wall of liquidity is directed towards the “wrong places”. New distortions, unbalances and “asset bubbles” appear to be recreated. In all, an anaemic western world filled with uncertainty is struggling to readjust, and also find a proper leading role in front of the growing and inevitable importance of the emerging economies. The risks of the biggest depression are still real.

Yet, a historical opportunity lies ahead. And the banks could bring it forward achieving successfully the transition to the information era.

“Never has so much money been owed by so few to so many”!

As Bank of England Governor Mervyn King stated, “Never, in the field of financial endeavour, has so much money been owed by so few to so many”. Without a huge amount of public money, key support and a promise of an unlimited guarantee, no bank on this planet would have survived the crisis. Therefore, we would hope that all can see reality – at least retroactively!

This has been a systemic and structural crisis and, unless radical changes are brought forward in our businesses, operating models and in our economic infrastructure, the problems will not go away. Many of these problems belong to and were generated by the financial industry, particularly in its transformation of risk and in its modus operandi of the recent years. Yet, on the verge of year end results announcements and bonus payments, the banks seem not to grasp the tsunami that is likely going to reverse on them given their business as usual behaviour. To worsen things, the disproportionate and oligopolistic concentration of the financial industry and the worrisome tendency of similar drawbacks in other main sectors of economic activity, this too is favoured by the investment banks.

A Need for Change

Even after what has happened, the rules which brought us to the breakdown are still in place. We still live with the moral hazard and the “excuse” of “too big to exist”. We still tolerate the conflicts of interest brought by entities that perform a range of functions, which is too wide. We still allow traders to “corner” markets.

Ownership and management in the financial services industry became more and more detached. To make matters worse, the appearance of a perennial and unlimited government guarantee allows these entities to defy the gravity of open market rules at the expense of everyone else.

These concerns are shared by the public, the media, and by industry insiders.

The Incentive for Change

Bankers are currently seen by the general public and by the media like the “tourists of capitalism”, who cause the world to collapse one day leaving the land of open markets to go to the commune and socialize their losses; just to travel back again a few days later to free markets territory and privatize profits among a restricted few. All of this is bailed out on the back of the genuine hard work, economic and social activity of others.

The financial services industry appears to be in psychological denial. It is to be admitted that the banks have never found themselves in a similar situation before. But are the banks confident to be able to rely just on their strong lobbying power to avoid changes?

Yet, while the public and the media focus their anger on the banks, now such an easy and foreseeable target, the latter should instead take the leadership and solve their own house problems.

The best opportunity of modern times. Taking responsibility: Self regulation is the key

In reality, for the first time the banks have in front of them a historic opportunity to reform themselves and re-launch the economy. Let’s see why and how they should capture it and bring about changes. These will first of all reinforce the industry and pave the way for a brighter future in the western world.

The reasons why the banks should bring these changes forward are simple. Firstly, only the experts know where to put their hands on and how to fix the engine. It is the car and engine that they very much built. So the changes should be best brought forward and devised by the banks themselves. The incentives given as a reward should not be current bonus levels but future ownership.

Secondly, it is also a matter of pride to regain the people’s trust (has anyone still got these words in their dictionary?) Something along the lines of, “I may have created these problems but I am responsible and magnanimous enough to fix them now and go beyond.”

Thirdly, there is also the matter of control and leadership. Taking care of our own problems means to retain control and respect. If we do not, and the government or anyone else will feel obliged to do it, control will be lost by the banks in all or in part. The latter should be better avoided. We all know the importance and social function of banks in the economy and forcing things will likely impede the proper displacement and exercise of this function. Not to be forgotten is that it is much easier and effective to bring about your own changes. Congress would get lost arguing over a myriad of exceptions and regulations.

The banks should promote and facilitate the following: a) “Direct Investing”, i.e. the opening of non banking lending channels; b) the proliferation and direct ownership of a variety of financial market players; c) the revamping and empowering of the boards and their functionality; and d) explain all this upfront in a massive public and media information campaign.

“Direct Investing”, proliferation of players, empowering boards

In order to solve matters and to emerge as winners, banks should promote “direct investing”, i.e. the creation and development of non bank lending channels to restart the economy, reduce the risk of losses, and insure against future financial shocks.

I am proposing that the banks should favour what is effectively a new asset category which does not exploit the owner in terms of fees, governance, control and transparency. “Operation Direct Growth”, is a strategic plan which focuses on opening a “direct reallocation of the capital use” between capital rich institutions with a medium to long term horizon and firms in sound conditions that yet need further resources, a strategic support and a better future prospect. Please see my previous paper: Roubini.com Operation Direct Growth by C. Resta, Nov 2009

It will be in the banks’ best interest to favour this interim process even if there will be no intermediaries in the exchange. The main actors of this plan are a consortium of institutional investors, pension funds, endowments, sovereign funds, and other long term investors. Funny enough, these are the owners of the majority of banks stock!

Such a new investment way is directed towards infrastructure projects and sound firms in the real economy that due to the current circumstances, are not able by themselves to capture business opportunities. Therefore, the investment subjects will be in “sound” sectors with good growth potential, which is now held back by the general lack of trust and the absence or withdrawal of banking facilities.

The aim is not to substitute public recovery efforts, or to replace the fundamental banking functions, but to favor enterprises to restart the economy and prevent future shocks from happening. Such interventions will also enable the application of ethical values, best corporate governance practices and aim for sustainable growth. The recipient firms will then begin to hire new employees and develop new projects. The economy will restart again and with a renewed dynamic for the west.

Secondly, the banks should promote the proliferation of players in financial services, re-establishing partnerships, de facto breaking up the banking activities in federated entities of operation. This is going to again separate banking functions, mainly deposit taking and lending from riskier trading and a variety of other more sophisticated activities. It will be wiser that the banks themselves bring this transformation forward rather than leaving it to antitrust laws to force a break up. This is logical, feasible and not unheard of. It happened in the past with in the oil, railroads, and more recently in the telephone industry.

The only real slogan to be heard in the industry now should be: de-merger and break up of the financial activities; this will unleash huge value. In fact, it can easily be demonstrated that the value of the individual components of any of the top largest banks is now much higher than that of the whole bank.

Recreation of medium size entities deeply specialized in their area of expertise and where management and employees are owners. Governments would grant incentives and award tax breaks if current management, or several executives who walked away with substantial fortunes, were to reinvest them back into the industry. Tax advantages should be open to capital to promote long term ownership, specialization, and medium size operations in recreating direct ownership and focus on financial services specialty areas.

This would represent a huge incentive for change and the real reward for the financial industry, reopening healthy competition and establishing a higher level of industry specialization now needed in the western economies in their transition from industrial to information societies. Since capital and lending facilities would start flowing again to the real economy, due to the “Direct Investing Factor”, with the growth of a multitude of financial players, several hundred thousands of skilled financial services employees would be happily returning to work with much benefit for the community. This will also generate a virtual circle in terms of consumer spending.

Finally the problem of systemic hazard will be resolved and the risk diversification will then keep things under control. Allowing long term incentives for management buyouts will bring back that famous “skin in the game” element, that responsibility that is so healthy in any human activity and endeavour. It will make taking calculated risks and receiving proper rewards possible.

Thirdly, the banks should favour a total revamping of the board of directors and operating committees. Chairmen and board members should focus on their duties and should be qualified with material, relevant and specific skills to the business. Their mandates should allow them to have only a very limited number of other tasks elsewhere. Smaller entities will favour real control and more reactive management from both boards and top management.

Therefore, it will be the board of directors who deal with how to distribute profits and determine how to remunerate top management and employees – and not anyone else. The problem today is that too many boards have de facto no control. In addition, these institutions are so huge that is easy to see how impossible to manage and steer them effectively – hence, the consequence of being uncontrollable giants.Fourth and final measure, the banks should conduct a clear and wide media and public information campaign.

The most comprehensive media campaign should be developed to explain to the general public the ways in which the financial services industry is taking care of its problems and how it is helping the economy to regain ground and helping the community.

This four pronged approach will be a win-win move for the banks and it will bring about a much needed economic recovery. It will give back to the financial services industry that sense of mission that belongs to the sector. This will re-launch the performance of that banking social function that is so important for the prosperity of any society; the rewards will be considerable.

If we are determined to resolve this unprecedented crisis and have the opportunity to make a better world, we need the maximum contribution and effort from all parts of our society. Unless we are united, we will not win. The banks need to regain the leadership.

“And a merchant said, ‘Speak to us of Buying and Selling.’

And he answered and said:

‘To you the earth yields her fruit,

and you shall not want if you but know how to fill your hands.It is in exchanging the gifts of the earth that you shall find abundance and be satisfied.

Yet unless the exchange be in love and kindly justice

It will but lead some to greed and others to hunger’”

by Khalil Gibran, The Prophet.

6 Responses to "Why Banks Should Clean up their House and How they Can Take Advantage of the Opportunity of Modern Times"

  1. Riccardo Fiorito   January 25, 2010 at 11:43 am

    Current debates on the difference between commercial and investment banks reflect the perception of moral hazard costs and the risk that financial troubles might occur again if nothing is dome before recovery consolidates. Unlike asserted by many, data show that current recession was not lasting more than other postwar episodes, though little is known about the likely consequences of stopping huge fiscal stimuli too early or too late. However, since increasing debt already hits the cost of lending, other ways to help recovery must be found anyway. Your suggest that a variety of financial institutions (e.g. sovereign funds, pension funds and other specialists) should promote the investment required by fragile economies. The implied self-discipline and concern should also avoid that financial regulation is entered from outside, bringing inefficiency and bureaucracy costs. Per se, the idea seems meaningful though the incentives are not evident to me. A possible way of adding realism could be trying to evaluate first which is the financial status of the suggested consortium which – as you say – is de facto a major owner of many bank stocks. In the meantime, lending intentions cannot be independent of the consortium performance, unless this is the nickname for some government instrument without a budget constraint. Finally, could you exclude that the consortium itself was suffering big losses? Since it is virtually impossible measuring the stocks behind the reported balances, I guess that some information could be achieved reducing the statistical ambition to a minimum: at least, the available balances by sector and/or by country might produce some overall stability index, reflecting wide-sense financial market confidence. After all, such an index should not be more subjective than many other indexes/indicators currently used to evaluate or anticipate vague consumer and producer intentions.

    • Carlo Resta   January 27, 2010 at 7:34 am

      Dear Professor Fiorito,Thank you very much for your useful remarks.Many have sent me their comments to my address. It is instead much more useful to post them here and to open the debate to the widest audience.A few points:- The separation of banking activities and functions is now necessary.This should also take place in other sectors of economic endeavour. Oligopoly should be banned and medium and highly specialized enterprise should be promoted. (E.g. Tesco entering in more and more sectors of activity, gobbling up huge amount of UK land, etc. should be looked upon with serious concerns and it should be all but encouraged. Technology allows for specialized medium entities and sound open market competition.)- This recession has been the most serious along with the Great Depression of 1929.- This crisis was structural: therefore changes to the business models and architecture are to be made.- The Banks which will self regulate” themselves will thrive and succeed.Your idea of the creation of: An overall stability index, reflecting wide-sense financial market confidence, is very good.This could measure the opportunity of to create channels of lending unencumbered by legacy balance sheets.It would then appear clear that these channels would reduce the negative impact of a financial crisis in that they would mostly come into place to reduce the impact of financial shocks.This index should measure the gap that is created in the balance sheet of long term institutional investors when credit dries out and the legacy channels do not, or cannot, perform their functional duty.In fact, currently, there is a strong need to finance long term plans in the economy, and there is also a need to cover for long term liabilities by many institutional investors including pension funds and insurance companies. Both needs are currently unmatched with further risks in the system.This index could measure the unmatched “Duration Gap” in the economy or better the difference between the need to cover for long term liabilities vis-a’-vis with long term business endeavours. The other side of it is a sort of Investment Confidence Index.These economic long term needs are particularly high now in the transition period of the western societies in their transformation from industrial to information economies.In fact, because of this transition, we have massive uncertainty which brought to a huge shift towards immediate short term results and liquidity in our western societies. Therefore only a systemic approach with the contribution of long term institutions can correct this spiralling and vicious unbalance and recreate economic growth and human development.If your index was produced now it would measure the highest score in term of the highest need for long term and stable financing.It seems really worth to try to compose such an index now.Please keep me posted and let me know if I can be of assistance.Regards,Carlo Resta

  2. Guest   January 27, 2010 at 12:13 pm

    Good to see something on the future of banks. This is a crucial topic that has not had adequate exploration.The media seems to polarise between mainly anti-bank sentiment and occasional defense, but with very little depth of analysis.I agree the banks should be taking a lead – but this does not mean defending the status quo which after all allowed these huge losses.I agree too that this is an opportunity for the banks – and the risk is that the reforming will otherwise be done for them, mostly by politicians who are not conversant with the commercial realities and mostly in a punitive way. This is unlikely to help the public.

    • Guest   February 2, 2010 at 7:59 pm

      Well, Thank you for your proper comments Guest. Come again!I would just add that the only the Banks that will come forward and reform themselves will become true market leaders and gain considerable competitive edge.Many Banks took such a disproportionate amount of risk!Will any of them find now the courage to embrace the necessary change?I hope so, after all is in their best interest.Best regards,Carlo

  3. Ioannis T.   January 28, 2010 at 3:16 am

    There is no reference to the need of elimination or reduction of the high government depts of many small and large countries, all around the world. As the relibility to the economic stability, in country level, is lower, the country banking system credibility is weak and operational activities, thus and lending needs, are reduced. Additionaly banks are more dependant to the high risk world money market, in order to survive.

  4. Carlo Resta   February 2, 2010 at 6:48 pm

    Thanks Ioannis,Yet, I am not sure I fully understand your comment.The point that I make here is that lending needs are quite high but the banking system is unable to support them.In the meanwhile, governments have hugely increased their debt. The only way out is real economic recovery.I identify the key to economic recovery in “Direct Investing” or the creation of non banking lending channels.This will also be the only way in which the governments are going to reduce their debt.I hope this helps to better interpret the article.Best,C. Resta