Guest Post: Banks Must Change - But Not Like You Think

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Submitted by Mark Garbin

Banks Must Change - But Not Like You Think

Is there anyone out there who, rationally, likes banks?  Yeah, I suppose Dick Bove still likes them but he liked them in 2008 when, in true Kevin Bacon style, he shouted “ALL IS WELL”.

Why do Banks remain such lousy investments?

  1. Is the revenue model fundamentally broken? 
  2. Is the capital model fundamentally broken? 
  3. Is the risk model fundamentally broken?
  4. Is the compensation model fundamentally broken?
  5. None of the above?
  6. All of the above?

Do I REALLY have to give you the answers to these questions?

But the solutions to most of the above problems are occurring right before our eyes.  Revenues are being squeezed by a combination of the market and the practical elimination of high profit making activities such as private equity and prop trading.  The capital model is violently being adjusted by a market that views bank balance sheets as bogus and by national governments who may save banks but force either great pain or a vicious consolidation.  The risk model is changing because as banks sell assets at or below their balance sheet carrying value, by definition, bank risk & Basel III models will automatically adjust to maintain a required return on equity.  Bottom line, as Tom Mitchell, senior financial analyst at Miller Tabak points out, US banks are simply not well designed for long periods of low real interest rates, low economic growth and decreasing leverage ratios,

This is a very painful process and is reflected in the continuing collapse of $XLF and the rise of $FAZ. 

There is, however, one aspect that the banks can and must change themselves before it too is superimposed on them drastically and dramatically by politicians, regulators, the market or investors:

COMPENSATION

Wait!! I’m not one of those OWS folk who think that we should just redistribute all the bank deposits and give it to them.  I’m not one of those nimrods in the federal government who think bank compensation should be regulated.

Change is needed to the METHOD of compensation.  Once that is changed the value proposition is changed.  And if you think the banks have changed materially, I’m here to say “BULLSHIT”!!

In a disingenuous way, because of the spotlight on bonuses, banks have really jacked up base compensation.  This is becoming a cause cèlébre in London not, surprisingly, spearheaded by the government, but by institutional investors who are fed up.

http://on.ft.com/s71qAh 

Short version? How the hell can banks pay so much when investors have been hosed? 

My views are twofold:

1)    It about time investors started to become activist
2)    It’s not just about reducing compensation, it’s about reorienting it

Banks must readjust base compensation back to levels that existed pre-crisis.  This will enable them to hire enough client oriented people to make good commercial loans and provide great service in secondary market trading and sales of securities to institutional investors.  How can banks even pretend to have a client facing business when they can only reduce headcount to the point where they are scratching and clawing at the largest 200 institutional investors & corporations in the world or their own “captured” client base?  By correcting base compensation, either the level of client service increases, the revenue producing client base grows or returns to investors increase.

Next, as described in Nissim Nicholas Taleb’s book “The Black Swan”, the asymmetry of bank compensation has historically encouraged individuals to maximize their bonus by taking enormous risk with the bank’s capital.  When they win, they personally make tons of money but when they lose they get fired but don’t have to pay back any money; hence the asymmetry.  There has been some attempt at deferring compensation but certainly not enough. 

The concept of asymmetry should be altered.  Current deferred bonuses in stock makes people slaves to the decisions made by senior execs not on the direct firing line or worse, not in their specific area of competence.  Compensation should not just be deferred.  Instead, profit center reserves should be allocated each year to balance shortfalls created by boneheaded management decisions or bad judgment by other profit centers.  Why should a great client service equities department making lots of money be dependent on the mortgage origination desk for their livelihood?  Why should a great high yield trader rely on the ability of the CEO to allocate capital and risk? If a product line consistently loses money, the bank should lose the product line.

The consequence of this is that if you want to be a bank executive, you can’t just live anymore by the adage “Shit flows downhill” i.e. underlings pay the price of your crappy decisions.  It’s more like the famous Jacques Chirac quote: “Les merdes volent en escadrilles” – “Shit flies in squadrons” and you, the executive, as the squadron leader, get dumped on first.  If you don’t like this, don’t take the job and it’s high pay.

In summary, banks are changing before your eyes.  These changes are being superimposed by numerous forces that are driving their stocks down.  However, change must come to the fundamental driver of the industry, compensation.  Right now, there is a chance to dramatically and structurally change the process voluntarily.  If it doesn’t happen, even these changes will be superimposed on the banks and EVERYONE will get on the $FAZmobile.

DISCLAIMER:  Although the information contained herein has been obtained from sources Coherent Capital Management LLC & Miller Tabak + Co., LLC believe to be reliable, its accuracy and completeness cannot be guaranteed.  This report is for informational purposes only and under no circumstances is it to be construed as an offer to sell, or a solicitation to buy, any security.  At various times we may have positions in and effect transactions in securities referred to herein.  Any recommendation contained in this report may not be appropriate for all investors.  Trading options is not suitable for all investors and may involve risk of loss.  Coherent Capital Management LLC & Miller Tabak + Co., LLC shall not be responsible for any loss due to inaccuracies in the information provided.  An options disclosure document may be obtained from Mr. Jay Stenberg, CCO, Miller Tabak + Co., LLC,  331 Madison Avenue, New York, NY 10017.  Member SIPC.  Member NYSE, NASD, CBOE, PHLX, ISE, NFA. Additional information is available upon request.