Title: Four Ways to Fix Banks. By: Krawcheck, Sallie, Harvard Business Review, 00178012, Jun2012, Vol. 90, Issue 6
This Article from HBR will help to write Dissertation on Financial Crisis or Corporate Goverance of Banks in Financial Crisis
A Wall Street veteran suggests how to cut through the industry's complexity
It is tempting to view the financial downturn as a closed chapter whose primary causes have been resolved--perhaps not perfectly, but fairly comprehensively--by the Dodd-Frank Act's reregulation of the financial services industry. But big banks continue to have a governance problem, which poses significant risks not just to them but potentially to the entire economy during the next downturn.
It is well-known that many banks were nearly wiped out in 2008 by a global financial crisis they helped cause. Since then most of them have been nursed back to health, with lots of help from taxpayers and central bankers. Yet despite the reregulation, they remain complex, opaque institutions in the business of taking enormous risks. Figuring out how to oversee them successfully--to keep their risks in check while allowing them to be profitable and economically productive--is a continuing unmet challenge for boards, regulators, and society as a whole.
Upgrading bank boards is one way to take on the challenge. Since the crisis, boards at major banks have revamped their membership and substantially increased their time commitments. This movement could be taken even further: Robert C. Pozen has suggested ("The Case for Professional Boards," HBR December 2010) that board membership at a big bank should be a full-time job. But even smart, experienced, full-time board members would struggle with the staggering complexity of the biggest banks. Without a way to cut through this complexity to the core issues and drivers, they'd have little hope of steering their institutions in a risk-sensitive fashion.
The main tool with which boards and regulators have managed risk at banks in recent decades is the capital ratio. The logic is that the higher the capital ratio--that is, the more money set aside against potential losses--the lower the risk. This is simple enough in theory but wildly complicated and confusing in practice. It's not at all clear what the right amount of capital is; in fact, it's not even clear how capital should be measured. At any given board meeting, bank directors will hear about GAAP capital, capital as measured under the current Basel regime (international standards set by bank regulators), capital as measured under the coming Basel regime, and the bank's own view of the right amount of capital, often called economic capital. Within these categories are various subcategories, including Tier 1 capital, tangible capital, and total capital. These capital measures often fail to keep up with market events. Also, the calculations can be shaped by banks' own assessments of risk, regulators' assessments of banks' risk models, and ratings from rating agencies--all of which are subject to underlying biases, to put it mildly.
So the capital ratio clearly isn't the answer. Boards need simple and commonsense--but powerful--tools to cut through the complexity and push management behavior in the direction of responsible risk taking. Here are four that, if adopted widely, could help a lot:
1: PAY EXECUTIVES WITH BONDS AS WELL AS STOCK
Management compensation is a powerful driver of corporate behavior. But the debate over how best to use this tool in financial services has been clouded by emotion and popular outrage--and action on compensation has been limited primarily to adjusting the mix of bonus and salary and of cash and stock.
Since the crisis, regulators and boards have gravitated toward increasing the amount of stock-based compensation and lengthening the mandatory holding period to induce senior banking executives to behave properly. Underlying this seems to be a belief that if a bank's CEO--let's call him Handsomely Paid--earns and holds $40 million worth of stock in his bank, rather than earning $20 million in cash and holding $20 million in stock, he will lead his institution in a more risk-sensitive manner. Don't be too sure about that.
Multiple academic studies done since the financial crisis have shown a strong correlation between "shareholder friendly" governance and compensation policies and financial distress during the crisis. The financial company executives with the biggest equity stakes at the end of 2006 were James Cayne, of Bear Stearns; Richard Fuld, of Lehman Brothers; Stan O'Neal, of Merrill Lynch; Angelo Mozilo, of Countrywide; and Robert J. Glickman, of Corus Bankshares, according to Rüdiger Fahlenbrach and René M. Stulz, the authors of one of these studies. Not exactly a great advertisement for increasing stock-based compensation.
Most equity investors focus on the upside: How high can the stock go? Over what (preferably brief) period of time? Why can't it go up even faster? When I was the chief financial officer at Citigroup, I sat in meetings with equity investors who literally rolled their eyes when the CEO projected a growth rate they thought was too low--even when it was multiples of GDP growth. This impatience has only risen as stock ownership periods have declined, shrinking investors' time horizons. In contrast, fixed-income investors focus most on limiting the downside: Can interest payments be made? Can principal be returned? In other words, equity investors tend to be more risk-seeking and debt investors more risk-averse.
A simple but powerful way for boards to alter the risk appetite of senior bank executives would be to add fixed-income instruments to the compensation equation. Any shift in this direction would have an impact, but the most logical end point would be a compensation mix that mirrors the bank's capital structure. Thus, as bank financial leverage (and therefore financial risk) increased, senior executives would be motivated to become more risk-averse.
An example: If Handsomely Paid's financial institution had $1 of debt for every $1 of equity, his $20 million in compensation (down from $40 million because of pressure from shareholders) would be paid as $10 million in debt and $10 million in equity, and his risk tolerance would probably remain relatively robust. If the capital structure shifted to $39 of debt for every $1 of equity--a hugely risky position--his compensation would be paid as $19.5 million in fixed-income instruments and $500,000 in equity, and the CEO's attention to risk would be heightened. He would most likely focus on enabling repayment of the debt in a timely fashion, rather than on increasing the upside for the $500,000 in equity. This structure would thus provide an automatic brake on the bank's risk taking.
Note that debt market values move up and down according to a variety of factors, including interest rates. Boards would want to put in place a mechanism, such as CEOs' holding the debt to maturity or receiving principal at a specified date, to negate this impact and keep executives focused on repayment of the debt.
Management compensation is a powerful driver of corporate behavior. But the debate over how best to use this tool in financial services has been clouded by emotion and popular outrage
2: PAY DIVIDENDS AS A PERCENTAGE OF EARNINGS
Boards can also adjust dividend policy to moderate capital risk. When earnings begin to deteriorate, management teams (and boards) are usually too slow to cut dividends, which sap capital when it is most needed. It is human nature to recognize meaningful inflection points only gradually (as obvious as such changes always appear in hindsight, according to the pundits). It is also human nature to see backing down on a commitment as an admission of failure.
Changing human nature is too tall an order; changing conventions around dividends shouldn't be. Today dividends are declared as a set dollar amount. Many boards evaluate them internally as a percentage of earnings, but when they commit to a payout, it's always expressed as, say, $0.15 a share.
A more risk-sensitive approach would be to pay dividends as a percentage of reported earnings. At a stated 15% payout rate, shareholders would get $0.15 a share if earnings came in at $1 but only $0.015 if they fell to $0.10. This approach would provide a capital buffer by naturally reducing dividends in a downturn (even as boards and management failed to foresee the downturn's length and severity) and would pass strong earnings along to shareholders during an upturn. The additional layer of protection would have been meaningful in the most recent downturn.
Shareholders might well be skeptical of having dividends paid out as a percentage of earnings rather than a fixed dollar amount--but the financial crisis would have been a perfect opportunity to make such a change, given that during it many banks stopped paying dividends entirely. A percentage is better than nothing, after all. Regulators and the industry have so far missed this opportunity, with more and more banks resuming or increasing their dividends. Over time that could be bad news for taxpayers and investors of all stripes.
When earnings begin to deteriorate, management teams (and boards) are usually too slow to cut dividends, which sap capital when it is most needed.
3: DON'T JUDGE MANAGERS (JUST) BY EARNINGS
Bank executives' performance is typically evaluated in large part on the basis of earnings. But as the financial crisis brought home, not all bank earnings are created equal. Those driven by additional business from satisfied customers are worth much more over the medium to long term than those achieved by trading, expense cuts, or increases in banks' net interest income. The first leads to a sustainable earnings stream. The others, by their nature, do not grow the underlying business over time. In the wake of the financial downturn, much ink has been spilled on the subject of trading income and its risks. But net interest income, with its disproportionate impact on the bottom line, is perhaps the least understood of banks' earnings streams.
Net interest income is a fundamental part of banking. Banks collect deposits in return for paying a certain rate of interest, and they use the deposits to make loans at a higher rate. The spread between those two rates--the net interest margin--fluctuates for a number of reasons, most of which are out of banks' control. A key factor is the external interest-rate environment. A steep yield curve, on which long-term rates are much higher than short-term ones--as can happen when the Federal Reserve drives down short-term rates with an easy money policy--tends to increase net interest income, whereas a flat one does the opposite.
Suppose a steepening yield curve drives a bank's net interest margin from 250 basis points (2.5 cents on the dollar) to 350. That added penny on the dollar falls directly to the bottom line. The bank doesn't have to do any more work, open any more branches, or answer customer calls any more quickly. And when the yield curve flattens, revenue goes down without any associated decrease in costs. So changes in net interest income can have a powerful effect on a bank's earnings while giving no indication of how well the bank is serving its customers or how likely those customers are to stick around.
Changes in net interest income can significantly mask the underlying strength (or weakness) of a bank's business, in some cases for years. Indeed, in the recent past a full range of banking "experts" have greatly underestimated the negative impact of falling net interest income (and thus greatly overestimated banks' earning power) as the interest-rate environment became unfavorable, leading to earnings shortfalls and highlighting poor capital allocation.
In my experience, bank boards and even management teams do not fully differentiate between net interest income and customer-driven net income changes. Boards should take steps to isolate changes in each and evaluate their senior management teams not according to aggregate earnings but according to the elements of earnings they can affect.
Boards would also be well advised to pay close attention to indicators other than earnings. Perhaps the most crucial metric is customer satisfaction. More business from happy customers represents quality earnings. Continuing business from unhappy customers who feel stuck--because of the increasing prevalence of fees to close accounts, the time needed to retype automatic bill-payment addresses at another bank, and confusion about whether another bank's products are equivalent--represents a real risk for today's banks and a real business opportunity for competitors and new entrants. The current disconnect between customer dissatisfaction with the banking industry (relatively high) and customer churn levels (relatively low) is simply not sustainable over the long term.
The current disconnect between customer dissatisfaction with the banking industry (relatively high) and customer churn levels (relatively low) is simply not sustainable.
4: GIVE BOARD SCRUTINY TO BOOMING BUSINESSES, TOO
A board's scarcest resource is its meeting time. Boards should change how they use it.
Most board members will tell you that their meetings are spent on governance issues, business updates, and "problem children," with well-performing business segments given an affectionate nod. This should be reversed. Boards should actually spend much more of their time reviewing the business segments with the highest returns. In banking--an industry with few copyrights or patents to act as barriers to entry--product and business complexity has historically served as a barrier to entry. If competitors can't figure out a product, they can't copy it. This may lead to higher returns for a while, but it means that high-return businesses are often among the most complex--and therefore the riskiest. Certainly not all high-return businesses crash, but variations on the comment "In hindsight, the returns were probably too good and too steady" are all too common in the financial sector. Industry-wide, this was true of collateralized debt obligations, which generated spectacular returns before causing spectacular losses. And at Citigroup, before regulators forced the company's private bank to shutter its operation in Japan owing to improprieties, its returns were at the very top of Citi's businesses--driven, as it turned out, by those same improprieties.
Boards should also prioritize their business-line review according to capital consumption. Spending time on the businesses that use the most capital, and working to reduce the need for that capital by controlling risk, will deliver a higher payoff.
Board members usually spend most of their meeting time on governance issues, business updates, and "problem children." They should focus instead on the businesses that use the most capital.
In a post-crisis world, boards must accept that their role has changed. A key to operating successfully is finding and using simple tools to cut through the business's underlying complexity in order to manage risk. This change in approach is needed to increase customer and shareholder value in the banking system and to protect the broader economy.
Idea in Brief
Even after the financial crisis and a giant wave of reregulation, big banks continue to have a governance problem.
The problem is that they have become too complex for boards to effectively oversee. Boards need simple ways to cut through that complexity:
- Pay top executives with bank debt as well as stock and stock options, to make them more sensitive to risk.
- Pay dividends as a percentage of earnings rather than as a set amount, to preserve capital in downturns.
- Ignore net interest income in judging bank performance, and pay much more attention to customer satisfaction metrics.
- Focus not on the most troubled business segments but on those that are using the most capital.
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