Banks must change – But not like you think

Guest Post By - Mark Garbin, CFA

Twitter: @coherentcapital

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?

(a) Is the revenue model fundamentally broken?

(b) Is the capital model fundamentally broken?

(c) Is the risk model fundamentally broken?

(d) Is the compensation model fundamentally broken?

(e) None of the above?

(f)  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,

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