Wishful thinking about banks and shareholders

If only we paid greater attention to shareholders then all would be well. That's the gist of a column in Monday's Financial Times by London Business School adjunct professor Robert Jenkins, a former money manager who also serves on the Bank of England's interim Financial Policy Committee (I'm not sure what that "interim" is, except it sounds like the Brits are about to change the name of that committee). Jenkins avails himself of two of the more hackneyed conceits in print punditry: first, the I-had-a-dream motif, followed by a speech or a letter to someone, often a leader or a candidate. In this case, Jenkins dreams he's attending a major global bank shareholder meeting -- his dreams do not resemble mine -- when the CEO offers the bracing declaration that he has decided (no mention of the board) that his bank will now take bold steps designed for long-term stability, safety and, he insists, shareholder joy. Capital will be increased, valuations confirmed by outside experts, and costs reduced by 20% by slashing cash salaries and handing out deferred shares instead. Bonuses will be paid in shares "with an exercise price well above the current share price" as will dividends for two years. The bank will then boost tangible equity by 50%, commit to a 75% dividend payout ratio and "remove return on equity as a target of anything other than long-term performance and substitute short-term measures that more clearly adjust for the risks we take."

All this sounds wonderful. Of course it's a dream. The logic behind it is that if such steps were taken, shareholders would, once the short-term dilution generated by those share grants and bonuses passed, be rewarded. The market would recognize a stable bank full of motivated long-term bankers with plenty of capital. Jenkins, alas, does not answer every question shareholders might raise. What if I'm a short-term shareholder? Obviously, you should sell your shares to someone with a longer-time horizon. If such a scheme works, and the market rewards this big bank, why won't other banks follow, thus eliminating any particular advantage? And, most importantly, how is this virtuous bank going to make the kind of high, steady profits that will win a rising share price? And just out of curiosity, how will those profits be measured, once you toss the currently controversial ROE out the window? Is there any evidence that in the long-run shareholders favor this kind of safe and stable bank against go-go banks that aim for ROE targets and thus try to keep capital low and leverage high?

Obviously, much of this is wishful thinking on Jenkins' part, which he's frantically signaling with the utopian conceit. But Virginia, can't dreams come true? Well, certainly they can -- just not forever. And that's essentially the theme of today's sermonette. It's very possible that in this period of uncertainty, volatility, fear and sensitivity to systemic and financial risk, that such a bank that Jenkins describes, particularly if it's able to differentiate itself over time for smarts and integrity (a big if), will be rewarded by shareholders who in turn reward themselves. After all, the market is seeking out safety and stability. And it may well be that consumers, corporate customers, clients and counterparties will also favor such a relatively safe and prudent institution. Perhaps it's also possible -- though more of a gamble -- that the talent will remain at a bank that defers compensation for so long (Goldman, Sachs & Co. once pulled this off, but anchored in a partnership, not a public company, and the long-term reward was steeper than any traditional bank would likely achieve).

But the real problem here is that nothing in the market stays the same. Jenkins' dream is based on the underlying idea that the current Zeitgeist is the "real" one -- and we will never return to periods of euphoria and loosed animal spirits. But of course we will. And when we do, the real problem -- the real stress -- on these institutions will come from the very constituency he claims must be placated and rewarded: shareholders. The market is a moody bastard, currently somewhat bipolar. It consists of many interests, some short term, a few long; some in love with risk, others risk-averse. Eventually, those interests will shift away from safety to something with some earnings (however defined) pop. Memories will fade -- hell, they've already faded, at least in the U.S. Shareholders will demand that CEOs and boards generate the kind of high-revving earnings that makes a case for investing their dollars or pounds in Barclays, say, rather than Intel. Their portfolios are diversified enough to withstand losses; and by the time the bull returns there will be an ample pent-up demand for equity performance. There will not be a sudden demand to loosen up the shackles. It will, as always, occur incrementally, nearly invisibly, bureaucratically and legalistically, particularly at the start when regulators, who have (yes they do) longer memories than investors, will resist change. But eventually regulators too will be captured by the encroaching Zeitgeist. History tells us this, again and again and again.

That doesn't mean we shouldn't do our best to shore up the ruins; some of Jenkins' ideas are smart. But there are a few points here that should be reiterated. First, nothing stays the same; and changing market moods exert a powerful influence on everyone involved. Second, shareholders, even before regulators and executives (except when they're heavily incentivized by shares), live and die with market performance. Third, the "owners" will make their desires known, and always have (despite the notion beloved of governance advocates that shareholders are somehow blocked at every turn; the issues that they're "blocked" on tend to be those favored by the governance establishment not by most shareholders). By heavily incentivizing executives with shares, you do align their interests with shareholders, but you create an even greater sensitivity to the changing market Zeitgeist.

We, of course, have been here before. It was not a dream, but it turned out to be a nightmare. You can't just write off the influence of shareholders on the banks. But it's arguable that we should just design everything to cater to them. Banks are utilities of sorts, which explains regulation. We need more, not fewer, buffers against the market, which means at the end of the day, investors. Regulators are clearly a key layer of protection. But what we know about the banks is what we have learned about natural disasters: No measure is infallible, memories always fade, and new self-interests always emerge. We need to impose new elements of resistance -- capital rules, leverage ratios and perhaps size limitations. But to believe that any of these will serve as effective levees against misjudgment and imprudence forever is simply a fantasy. - Robert Teitelman