Banks Need To Get Smaller

Watching Bank of America's management take continuing headers on banana peels, I thought it a good time to pull back and think again about governance issues and the banks.  I still can't get away from the fact that the banking sector needs to de-concentrate and get more competitive.

Ironically, as we are rightly bemoaning the anti-competitive aspects of ATT's merger with T-Mobile, we seem to have accepted a more anti-competitive and systemically dangerous concentration of assets among the remaining mega-banks.

I'm going to walk through an interesting survey paper by Mehran, Morrison, and Shapiro of the New York Federal Reserve Bank, Staff Research Report 502, "Corporate Governance and Banks:What Have We Learned From the Financial Crisis?"  I think it more instructive than wallowing in the reality show that seems to be the financial news.

The governance of public banks is more complicated than for non-financial companies because of (1) the multiplicity of stakeholders, and (2) the complexity of their business portfolios, which include traditional banking, investment banking, and proprietary trading.

Bank stakeholders include depositors, debt holders, shareholders, and the government, both as the provider of deposit insurance and as the holder of systemic risk in the event of bank failure. Even though bank capital structures are about 90% debt, as opposed to 40% on average for non-financial corporations, shareholders with their thin layer of equity are given primacy in strategic, business and governance issues.

The authors look as debt as a financing decision for non-financial corporations, whereas they say it is a "factor of production" for modern banks.  Deposit insurance, despite attempts at improving the system, is still essentially a fixed price insurance, and not risk-based in pricing.  I don't believe that any part of the current bogus financial reform has changed this feature, which would put any traditional insurer, but not the Federal government, out of business.

Shareholder primacy has led to executive compensation schemes that are heavily weighted to short-term rewards, which encourage imprudent risk-taking.  They note that from 1996-2007, 29% of the options issued to the top five executives of banks surveyed vested in one year.  According to the authors, "Since 2006, CEO's in the banking sector have had the highest pay of all the executives in the economy."  This is turning anything like traditional economics on its ear.  It makes no rational sense.  The final ignominy: none of this higher incentive has led to better share price performance.

The authors diligently search for better compensation metrics.  They suggest that a metric for CEO's should be related the CDS for their corporation, but this seems subject to too many random elements, and it has not been shown to be a market price with high informational content.  A better idea would be to have a higher percentage of the CEO deferred compensation at risk for bank failures or rescues.  The operational problem would be when the CEO's lawyers and the corporate lawyers draft up what constitutes a failure or a rescue, accounting for every contingency.  Maybe more research would be useful.

Risk management, they find, is typically separated by product line or by organizational lines.  Boards are not able to give an acceptable band of risk taking for the corporation as a whole.  Compensation for key management is all about attracting and retaining, the marketplace never talks about risk management in compensation or in management objectives.

The authors think that regulatory capital can be a substitute governance tool, but I wouldn't be optimistic about it being a sufficient one.  They point out that much of the new capital raised by banks has been through hybrid instruments like preferred stock. This is before Warren Buffett's "trick or treat" with Bank of America.  Rather than raising common equity, because of  low stock prices resulting from their own mismanagement, managements continue to pay dividends and give away free equity kickers to preferred holders.  The authors note that this has overturned the primacy of debt holders despite their being 90% of the capitalization.

The much ballyhooed Volcker Rule has been substantially watered down in both Dodd-Frank and in the Consumer Protection Act of July 2010, which means that the banks will continue to remain systemically important and susceptible to requiring bailouts in the future.  It's not a pretty picture for governance making the sector better, or for learning from our mistakes.