Banks & The Lure of High Returns

I was speaking with a friend the other day, who is a senior employee at one of the big Canadian banks.  Our conversation helped to give me additional insight into the problems of the financial sector, as well as confirming my suspicions of how difficult it is for corporate management to resist the institutional imperative.  He mentioned that over the last few years, corporate management had continuously raised the yearly ROE performance target/goal for their bank.  Last year they raised their target from 16% to 19%.

Management who continually strives to increase ROE for their shareholders should be good news to any investor.  The higher the better!

The problem is in management’s execution (how they do it).  Increasing ROE through increased debt or risk is not very good.  Generally, we want the company to increase ROE through growth, innovation, & efficiency.  We want them to do each of those in a smart way.

The banking industry in North America and many parts of Western Europe is a very mature market, so its increasingly difficult to grow & innovate at an increased pace.  Everyone already has a bank account, every bank has a brokerage, insurance products are already offered, people already carry bank branded credit cards, there is already a branch in every neighborhood, promotions are already in place to lure people away from their current banks, etc.  Efficiency has also already been addressed in recent years, with the integration of technological advances, and trimming of unnecessary expenses & overhead.  However, the effects of the housing boom over the last 5 years contributed largely to growth, but as with all things it was slowing down.

Emerging markets are a different story, with many opportunities to provide even the most basic of products & services.  Although the banks have invested in emerging markets, it is a much smaller percentage of their overall profit.  With a smaller percentage of profit being contributed by emerging markets, they can’t expect huge increases in ROE to come from it right away.  Establishing banking operations in emerging markets is a slow process, that is not without risks.  There are many factors and reasons for this, which includes gaining the trust of the local consumer, familiarization of local laws and accounting policies, government approval, political events, understanding the business landscape, language barrier, long distance correspondence, skilled/knowledgeable labour, lack of experience, etc.  Over time, operations will increase in size, at a faster rate, and with decreased risk & uncertainty.  However, bank management is not satisfied with small increases to ROE while they wait for more of their ROE growth to come from their operations in emerging markets.  They wanted more now.  They felt increasing pressure to deliver the increases, and compete with the numbers posted by other banks.  They were lured to risky investments and debt/loans, with the expectation of high returns.

Since banks are highly involved with debt, we must focus our attention on their loan, derivative, and investment portfolios.  We don’t want them to be taking on increased risk in those portfolios in order to increase ROE.  Because we can never know exactly what is in those portfolios, we have to trust the bank’s management to be very conservative and maintain good judgment.  The corporate strategy should have maintained their focus on delivering ROE performance through growth, innovation, & efficiency.  Management should have resisted the institutional imperative to post large increases in ROE, knowing that North American & Western European operations were mature, and results from emerging markets would take time.  Although the housing boom fueled a lot of growth, over the last few years that opportunity has already been exploited.  Yet, they continued to set high & unrealistic ROE increases.  Under the pressure to do what their peers at other banks were both doing and posting (increases in ROE & other numbers), they allowed for more risky loans and investments to be made.  At the end of the day, decisions were made which were not in the best interests of the shareholders.

Trusting management also applies to an investment in any company in any industry.  If you are investing to be a shareholder of a business, and do not plan on being an active part of it (such as the case for the average individual in publicly traded stocks), then you are letting the management run the show totally.  The management is your main business partner, and you need to be able to trust that they know what they are doing.  Would you buy into a retail store and partner up with the manager who you don’t trust in knowledge, skill, patience, or honesty?

Two of the best examples of banks with great management are Wells Fargo & Co (WFC) and US Bancorp (USB).  They were able to achieve high ROE without sacrificing quality.  Needless to say, they are also Warren Buffet’s favorite banks as well, and major holdings in his company Berkshire Hathaway.

When investing, its wise to always look for companies with excellent management.  Not doing so can lead to poor returns, or worse.

Let me know if you enjoyed this article, or if there is a question or topic you would like to see in a future article.

Thanks & Happy Investing!
The Investment Blogger

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