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In a little-noticed – but bracing – article, “American Banker” recently reported that US bank regulators have determined that the Boards of Directors of only two of the 19 largest national banks exercise proper oversight. (!!!)
As those Boards now work overtime to improve governance, here is one thing to change in 2013: senior executive compensation. Coming out of the crisis, the national discussion focused on “pay them less” and very little on “pay them better.” Instead, the long-term conventional wisdom that senior executives should be aligned with equity holders remained unexamined: the amount they are paid is often based on stockholder metrics (like ROE), and the form of payment is in increasing proportions of stock.
But we have learned (and I have certainly learned) that banking is not like any other business – not even close – and the Boards should thus approach management compensation differently. Here are 10 reasons why the move to more equity ownership for senior bank executives is a move in exactly the wrong direction:
1. Equities encourage risk. An equity’s downside is capped (it can’t go below $0), but its upside is not. Therefore, the right “play” over time is to take on more risk, to try to capture that asynchronous upside.
2. Equities encourage risk, part 2. We understand this asynchronous play intuitively. Did you ever buy a stock because you hoped to get back just your principal? No. You bought it because you wanted it to go up (ok, plus dividends). And the way it goes up is by the management team taking some form of business risk in order to increase earnings and returns.
3. Equity holders have short-term time horizons. And equity holders want that upside quickly. The conventional wisdom that shareholders have a long-term perspective is outdated. There is only one Warren Buffett because there is only one Warren Buffett (or close to it; you get the point). In contrast, bank shareholders’ holding period averages 3 months.
I can’t tell you how many times I’ve been in meetings with equity investors in which they encouraged / pushed the bank management team to grow earnings more quickly (and the only quick way to do that is to take on more risk). No, not always hedge fund managers; also conventional mutual fund managers looking to reap the benefits of short-term performance for their own hugely important quarterly performance reporting periods.
4. Banks already have plenty of risk: consumer credit risk, corporate credit risk, interest rate risk, market risk, currency risk, operational risk, balance sheet risk, liquidity risk, counterparty risk, reputational risk, regulatory risk, complexity risk, interconnectedness risk, legal risk, compliance risk, people risk, to name just a few. And yet we encourage more risk through a risk-encouraging instrument.
5. The impact of mis-judging and mismanaging that risk extends beyond equity holders. Equity is just a small part of a bank’s capitalisation, with big US banks currently funding themselves with an average of $13.5 of debt and deposits for every $1 of equity. With equity compensation, bank executives’ incentives are directly aligned with only one of their funding sources…and by far the smallest one at that.
6. The impact of mis-judging and mis-managing risk extends even further. Uniquely, banks sit at the centre of economic activity; as we have seen, their mistakes have a significant multiplier effect on markets, economic growth, the psyche of “Main Street” and, at extremes, on governments and taxpayers. Why should bank executives only be aligned with equity holders?
7. The margin of error for mistakes is low. As noted, big US banks now average $13.5 of assets for every $1 of equity (much better than the $40:$1 that some had before the financial crisis). But what exactly does this mean? It means that a loss equating to just 7.4% of a bank’s net assets completely wipes out equity. That’s right: just 7.4%. (Of course, in reality, the bank would go under well before this decline, as its funding would dry up.)
8. And the chances of these types of declines has been increasing, as the volatility of bank assets has gone up. According to Andy Haldane, Executive Director for Financial Stability at the Bank of England, the volatility of bank asset returns has increased 2.5 times over the past 100 years.
9. Big banks are bigger than ever. With the biggest banks bigger than they have ever been, the impact of a single management team making a mistake is amplified. The top five banks account for 52% of bank assets, up from 30% in 2001 and 17% in 1970, according to Fed numbers. It used to be that many management teams had to make mistakes simultaneously for it to matter; now that risk is no longer as diversified.
10. And, finally, look at the evidence. The biggest CEO equity holders in 2007 were at Lehman Brothers, Bear Stearns, Merrill Lynch, Morgan Stanley and Countrywide. ‘Nuff said.
Bonus Reason: a study out of the London School of Economics and Manchester Business School showed that banks whose Boards were more insulated from shareholders engaged in less risky behaviour in the run-up to the crisis, thus performing better during the crisis.
A thoughtful reevaluation of senior bank compensation is called for, and a more balanced
approach is merited. For example, Boards could also pay executives in bonds, which are fundamentally risk-discouraging. Regardless, it is the responsibility of the Boards of Directors of the large banks to look past stale, unexamined conventional wisdom on executive compensation, to protect their banks (and the economy) from incenting excessive risks…and to demonstrate that they are now exercising thoughtful, engaged oversight. More to come on these topics…..
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