“Strategic vision of financial executives on how to generate economic performance while controlling risk is likely to become a differentiating factor, a determinant of not only success but of the very economic viability of financial institutions in the changed world. Have leading financial firms and institutional investors come to the same conclusion?”
This is from the book “Financial Darwinism” by Leo Tilman.( http://seekingalpha.com/article/221607-making-money-in-the-21st-century-financial-darwinism-create-value-or-self-destruct-in-a-world-of-risk-by-leo-tilman)
The banking industry has provided an answer and the answer is “No!”
The banks have beaten down the accounting industry: “Banks Force Retreat on Fair-Value Plan” is the title in the print edition of the January 26, 2011 Wall Street Journal; “Retreat on ‘Marking to Market’” is the title in the electronic edition. (http://professional.wsj.com/article/SB10001424052748704013604576104012708309774.html?mod=ITP_moneyandinvesting_1&mg=reno-wsj)
“Accounting rule makers, bowing to an intense lobbying campaign, took a key step Tuesday to reverse a controversial proposal that would have required banks to use market prices rather than cost in order to value the loans they hold on their balance sheets.
The debate over the proposal is the latest chapter in a battle pitting investors who wanted better disclosure of the value of bank’s assets against the banks themselves. Banks have argued against so-called fair-value accounting, saying market prices would have left them at the mercy of volatile markets and could have caused additional strain during the financial crisis.”
The banking industry is still back in the middle ages. And, this is just what Tilman is arguing about.
To Tilman, the “golden age” of banking was when commercial banks worked with a “Static Model” of banking. Banks lived off the “carry trade”: because of highly restricted and regulated banking markets, banks operated in quasi-monopoly positions where they could earn relatively high returns on the loans they made and pay zero or close to zero on the deposits they attracted, providing them with a “lusty” net interest margin (NIM). Their model was static because they could originate loans or buy securities and hold them until they matured. Marking to market was not an issue. Credit risk was the only real risk bank lenders had to be worried about.
Today a “Dynamic Model” of banking exists and the transition to this dynamic model was horrendous. The “buy and hold” strategy could no longer work. In the late 1960s, interest rates began to rise. In the 1970s, declining NIMs became a major problem and the banks countered the declining margins by moving into fee income. In the 1980s all hell broke loose as NIMs practically vanished and banks began diversifying into other assets in order to generate returns that justified their existence.
Banks did not adjust their thinking in terms of risk management during this time period. As Tilman describes in his book, as commercial banks moved into Principal Investments (α-type investments) and investments exhibiting Systematic Risks (β-type investments) their risk management knowledge and skills lagged far behind the dynamic changes that were taking place in financial markets.
On top of this commercial banks continued to add leverage to their balance sheets as a means of generating another 5 or 10 basis points or more to their return on equity.
When the cookie began to crumble, it became obvious that financial institutions had mis-managed their risk exposure and had leveraged-up to such a degree that there was little or no way to keep the cookie together. The industry had to be bailed out.
In the modern world where the “Dynamic Model” of financial management rules, the “buy-and-hold” philosophy that applied to the “Static Model” of banking is legacy.
By getting rid of “Mark-to-Market” the banking industry is kidding itself and just setting itself
up for future trauma. It is hiding its head in the sand and pretending that the world has not changed.
The world has changed. Net interest margins are not what they once were. Buy-and-hold policies are not realistic. And financial leverage is going to be more severely regulated. So who is going to manage risk if it is hidden on the balance sheet?
My advice to bank managements: mark your portfolios to market. You don’t have to, but, for once, “get real.” If you are going to buy risky long term investments…accept the fact that they are subject to interest rate risk…and credit risk. You don’t get the return unless you assume something to justify the extra return. Who are you fooling by not marking-them-to-market? You are only kidding yourselves.
Tilman argues that generating “economic performance while controlling risk” is going to be “a differentiating factor”, a determinant of success but also of the economic viability” of a financial institution.
In the 1950s and 1960s banking was a very quiet and stable environment. The industry did not attract the “best and the brightest.” There was the joke around Philadelphia that in wealthy families that had three sons, the smartest became a doctor, the next smartest became a lawyer: the dumbest became a banker.
The thrift industry was even worse. Tilman titles his book “Financial Darwinism.” In the case of survival, most thrift managements were awful, much worse than bank managements, and, the thrift industry is dead,! Are the smaller commercial banks the next in line for extinction?
When I joined the Finance Department at the Wharton School, UPENN, (in 1972) "Finance" did not have a course on the financial management of commercial banks. (I did create that course while I was there.) The reason why no bank management course existed was that the big banks, City, Morgan, Chase, and so on, did not recruit students at Wharton. They recruited from the history department, the literature department, and so forth…well, they really recruited from the social clubs, the tennis team, and the golf team. They wanted people who could socialize with customers and get along with them at the highest social levels. They didn’t want some sharp intellect that was quantitatively orientated to work in “their shop.”
Bankers have never liked uncomfortable situations. They have been notorious for keeping bad loans on their books until they absolutely have to charge them off. They are also notorious for refusing to acknowledge that some of their assets might be “under-water”. Bankers are notorious as risk managers.
Risk management is going to be a major differentiator of bank performance in the future. We have seen how inadequate risk management can help the industry self-destruct. Anyone investing in banks…or regulating banks…should pay special attention to how a management recognizes risk; the policies and procedures it puts in place to manage risk; and the efforts it makes to disclose to people the value of the assets the bank has on its balance sheet.
The banking industry is changing. I have just written up my view of some of the changes that are coming (See http://seekingalpha.com/article/247809-banking-is-changing-look-out-for-opportunities) Good risk management is going to be a “decider” of who survives