Back to the Future: Are Banks Getting Religion?

Credit pricing and appetite based upon the market's gauge of a bank's cost of capital? Numerous examples of firms' moving away from the "universal bank" model towards one that is better focused and more streamlined? Suffice it to say, these are basic building blocks of sounds financial management and business strategy, yet have not been the hallmarks of most financial institutions' decision-making over the past 20 years. Get big. Build market share. "Diversify" by adding seemingly uncorrelated business lines, yet somehow extract synergies by having all these capabilities under one roof? What a joke. The detritus left in the wake of these poor decisions is not very funny, however.

Pricing Loans Based on a Firm's Cost of Capital? Duh.

This is simply not revolutionary, my friends. In theory, and now in practice, you need to be able to mark your books to market. Banks using the credit derivatives market as a vehicle for pricing and risk managing loan portfolios is not new. I can't tell you how many times, when either looking at large credit-bearing derivatives trades or friends in leveraged finance evaluating large underwriting positions, have tapped the credit derivatives market either for outright credit protection or for a benchmark of how much spread to build into a transaction. This from Sunday's Financial Times:

Morgan Stanley and Goldman Sachs are responding to the credit crisis with systems that use the market's view of their own creditworthiness as a basis for lending decisions, according to people familiar with the matter.

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Morgan Stanley is essentially tying its promise to provide financing to hedge fund clients to the prices of credit insurance on its own debt. If the cost of the protection rises to a certain level, that would trigger a reduction in Morgan Stanley commitments to hedge funds. Goldman Sachs is understood to have a similar arrangement that uses its bond prices as a reference point for credit commitments to hedge fund clients.

This is simply common sense. If this really didn't happen before, well, it's about time. Its not as if you can easily buy credit protection on a hedge fund that has not publicly listed securities. Further, the value of internal capital is so high in this uncertain environment that banks need to spend it wisely, and only at times when exporting it (via client default risk) is more valuable than retaining it (to avert firm default risk). Bottom line, this is a straight-forward and common-sensical concept. If this is news to senior bank management and/or risk managers, the out to be shown the door. Immediately.

All Things to All People? It Didn't Work for Sears, So Why Should it Work for Banks?

The "universal bank" craze was crazy from the get-go. There was a time when conglomerates were all the rage - ITT, Gulf & Western, and so many others. This was the 1960s. Expert centralized management and financing creating synergies for myriad operating companies, regardless of synergies among them. "Give us your money, and we'll diversify it for you" was the mantra. This is NOT Berkshire Hathaway, either. Warren buys companies that meet his criteria for shareholder value creation. Period. No synergies expected. With very few exceptions, the conglomerate model has been proven to be a failure. Do what you're best at, do it exceptionally well, and win in the marketplace. Let investors diversify themselves; they can do it much better than you can, anyway. Yet this is not the approach taken by many of the financial institutions across the globe. Give them personal and mortgage loans. Give them credit cards. Give them investment products. Advise their companies. Finance their companies. Insure their companies. And on and on. Firms that started to look more like governments than private enterprises. And if we know anything about government, enterprises that spread themselves too thinly ultimately do badly at pretty much everything. And this is what we've seen over the past several years.

Good times mask a lot of problems. Bad times, well, we're seeing that right now. Correlations go up. The benefits of diversification are illusory. All you see is a mismanaged pile of assets, the problems of which are of stratospheric proportions due to the sheer size of the enterprises in question. American Express Shearson Lehman Hutton. Anyone remember them? Citicorp Travelers Salomon Smith Barney? Another winner. Sears Dean Witter? A beauty. UBS Swiss Bank O'Connor Brinson Warburg Dillon Read? Oh, baby. The list goes on and on. Value creation? When a rising tide is lifting all boats, sure. In times of distress. Forget about it.

Anyway, hopefully some of these "forward-thinking" firms will get back to basics. Because I don't think the global financial system can take any more expressions of growth-at-all-costs machismo. It's really about growing and protecting shareholder value. Really.

Comments

[tolu]

Hey Roger,

Many of these companies would argue that they are attempting vertical integration, not diversification. In addition, more focused banks have suffered just as much as the universal ones in the latest crisis. Some universal banks (okay, i can only think of one-JPM) are gaining on the competition dring this crisis.

I had the opportunity to listen to several bank executives this summer, and the ones from the unis stated (universally ;-) that they viewed the model as an advantage in a time of crisis. I actually don't agree with them, but I'm just as hesistant to believe opponents of the universal banjking model.

In short, I think its the management and the business specifics, not the model. Please disabuse me of any incorrect thinking here.

[Greg]

While your comments are specific to financial institutions they are equally true for many of the mergers that have produced many other cross industry conglomerates. Berkshire Hathaway is the exception for precisely the reasons you mention. True excellence stems from doing what you do well and no one and no corporation can be expected to do everything well. The other millstone dragging down our economy is the idea that bigger is always better and companies must grow at double digit rates every year if they are to be considered successful and not sold off to investors in other countries.

[Walt French]

Lord knows, there are lots of shots to be taken at the mutual fund industry. But at least some firms (i.e., the one where I work) compensate PM's only on long-term out-performance versus a benchmark or fund category median performance, and explicitly NOT on assets managed.

Not directly, anyhow. Certainly, firm earnings and growth factors in. Typically, the CEO gets paid on organic growth, while individual PMs' best shot comes from beating his/her benchmark/category.

Meanwhile, EVERYBODY knows the studies that show how monies quickly! drain out of bottom-quartile funds and move into top quartile funds.

[Greg Battle]

As they always say, if you want to know what's really going on in a company, follow the cash - monetary incentives dictate decision making. The conglomerate model only rewards CEO's whose compensation level relates to market cap rather than increased shareholder value. It's like the difference between mutual funds and hedge funds where the former is compensated on asset gathering vs. the latter compensated on investment performance (granted, I know these lines have become massively blurred in the second wave of superfunds). If incentives were aligned with shareholders and investors, you'd see a whole lot more public companies issuing larger dividends and a more hedge funds willingly returning cash respectively. Alas, that's not the case.

Bigger is only better for those who profit from being bigger.

[Buck Woodford]

Agree 100%, Roger. Especially on the cost of capital part.

That news story read as if this were a novel concept. I'd say the same for this one about FNM/FRE implementing new fees for bad credits yet waiving them for good credits (http://www.bloomberg.com/apps/news?pid=20601087&sid=awmXieu6LR84&refer=home).

As you duly noted, it's just not that difficult a concept.