All entries for Monday 11 August 2008

August 11, 2008

The five lessons bankers must relearn

By Philip Purcell

Published: August 10 2008 19:29 | Last updated: August 10 2008 19:29

Our financial system will get through the present crisis, although there will be some further bumps ahead and Bear Stearns may not be the only company to go under or find a merger partner. But it is not too early to ask: what went wrong and how can we avoid such crises in the future?

Attention now focuses on changes in the legal and regulatory structure. We can no longer afford fragmented oversight. The Federal Reserve and the Securities and Exchange Commission must work together more closely. If investment banks are to have access to the discount window, the Fed should be able to dictate more stringent capital requirements and monitor risk management.

Investment banks made the same mistakes and incurred enormous losses under very different regulatory re­gimes. Banks in England, France and Switzerland have suffered as much as those in the US. The lessons of the crisis, therefore, have less to do with regulation than with the need for better leadership, strategy and management. It is up to the managers of financial services companies to learn, or perhaps relearn, some time-honoured lessons.

First, profits matter more than revenues. This was well understood on Wall Street back when investment banks were partnerships. Profits were critical for a return on the partners’ capital. But when banks became owned by shareholders, this discipline faded. Instead, the emphasis shifted to the pursuit of short-term revenues, eventually in the form of proprietary bets on the market. As Henry Kaufman has written: “Not surprisingly the rain­makers within those firms garnered greater and greater prestige, influence and monetary rewards.”

Second, compensation should be based on profits, margins and return on equity over time, not current year revenues. As the “rainmakers”, or bankers and traders, have gained power, current year revenues have driven compensation. As a result, the rainmakers have pushed for control of more assets and more leverage, and have been willing to undertake greater risk to generate greater current year revenues (and larger pay cheques). It is not surprising that, as investment banks increased leverage and took on outsized risks, compensation for bankers and traders increased dramatically.

But when reckless risk-taking led to big losses, it was the shareholders, not bankers and traders, who suffered the consequences. There is a straightforward way to remedy this. Pay traders based only on returns and establish a vesting period of several years to make sure that the profits are not illusory.

Third, leverage works not just on the upside but on the downside as well. Excessive debt can turbo-charge profits during a boom, but can result in crippling losses when the bubbles burst. Because of excessive leverage in the recent cycle, investment banks found they did not have enough capital to sustain themselves in the downdraft. They have had to raise new capital, diluting the investments of existing shareholders, or sell valuable assets. Leverage must be reduced.

Fourth, diversified and recurring revenue streams not based on trading or principal investing have immense value in a down cycle. The banks most jeopardised in the recent crisis, Bear Stearns and Lehman, had revenue streams less diversified and recurring than their competitors. Even firms that are better on this score are now being forced to sell their most stable and highest-return businesses in order to make up for the massive capital losses from their highly leveraged fixed income businesses. Morgan Stanley has sold MSCI, Merrill Lynch has announced the sale of Bloomberg, and other valuable businesses will be sold.

Finally, risk management should become a board-level responsibility, with appropriate committees meeting regularly with management. In the old partnerships, the partners paid close attention to their firm’s risk for a simple reason: it was their money. Today, the capital provider (shareholders) is separated from the risk-takers, who are rewarded by compensation and not strictly by shareholder returns. Since boards are elected to represent shareholders, directors must become more informed, sophisticated and involved in the risk-taking, capital allocation and risk-management function.

Wall Street will be casting a wary eye on Washington as proposals come forth on how to deal with the financial crisis. But we must also look closer to home. The most effective remedies are in our own hands.

The writer, former chief executive of Morgan Stanley, now heads Continental Investors

August 2008

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