How Banks Can Fail

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Banks are a very important piece of Singapore’s economic fabric. In the share market, banks too have a huge presence.

The three local banks – DBS Group Holdings Ltd (SGX: D05), Oversea-Chinese Banking Corp. Limited (SGX: O39), and United Overseas Bank Ltd  (SGX: U11) – collectively make up close to one-third of the market’s benchmark index, the Straits Times Index (SGX: ^STI).

Given their relevance, it thus makes sense to think of how banks might fail, in order for us to be able to spot problems early. For that purpose, my American colleague John Maxfield had recently written a great article titled “7 Lessons about Banking from 200 Years of History.

The article is culled from John’s research and study of American banking history over the years. While there are huge differences between banks in the USA and banks here, there are still overarching threads of similarity which we can apply locally. Within his seven lessons, three in particular stand out in helping us get a head-start in spotting potential trouble in the future of Singapore’s banking scene.

I’d let John take the lead now. Everything within the confines of the two horizontal lines are his work.

4. The most important thing is a long history of prudent risk management

Financial professionals like to say that past performance doesn’t guarantee future results. But when it comes to bank stocks, I’d urge you to turn this cliché on its head. Indeed, past performance, and particularly as it relates to risk management, is the most important thing to consider before investing in a bank.

My favorite example of this is Citigroup. Its unparalleled knack for landing in the middle of banking crises dates back to the Panic of 1907, when trading by its securities affiliate fueled the panic itself, the founding of the Federal Reserve, and the subsequent passage of the Glass-Steagall act which forbade the commingling of commercial and investment banks until 1999.

Over the next 100 years, Citigroup rarely missed an opportunity to disparage its own reputation. In the early 1920s, sugar loans to Cuba “threatened to wipe out the total capital of the bank.” Later that decade, its securities affiliate was caught unloading toxic securities onto the bank’s unwitting depositors. In the early 1930s, it underwrote more than $100 million in loans and bonds for the Swedish “match king,” Ivar Kreuger, who turned out to be running a Ponzi scheme. And the examples go on and on.

Consider this passage from former Treasury Secretary Timothy Geithner’s memoir, Stress Test: Reflections on Financial Crises:

We never thought of Citigroup as a model of caution. It had been at the center of the Latin American debt crisis of the 1980s. The New York Fed had cracked down on it for shenanigans related to the Enron scandal shortly before I arrived, and we hit it with the subprime lending fine that pleased Paul Volcker shortly after I arrived. In 2005, after Citi was forced to shut down its private banking operations in Japan because of illegal activity, we banned the company from major acquisitions until it fixed its internal controls and other overseas governance issues. The British banker Deryck Maughan, whom I knew from his days running Salomon Brothers in Japan, came to see me after he was forced out of his job as chairman of Citigroup’s international operations. His message was that Citi was out of control.

Meanwhile, here’s how Citigroup’s investors have fared since the end of 2006:

5. Be wary of banks that obsess over growth

Banking seems complicated, but it’s not. “Banking is a bit like running a small retail store,” says Jamie Dimon. “You gotta work out what kind of stuff your customers want. Then you gotta get the stock in, and sell it as quickly as you can, making a profit.”

But unlike a universal bank like JPMorgan Chase, a typical lender sells only one thing: money. Borrowers need it to buy houses and open or expand businesses, and banks sell it to them at a price (i.e., interest rate) reflecting the likelihood it’ll be repaid.

One way a bank can grow quickly, in other words, is to simply loosen its credit standards and sell more money, as you’d be hard-pressed to find someone who won’t accept a loan if the price is right. And it’s for this reason, that a banker’s best quality is the ability to say “no.”

As Fred Schwed observed in his 1940 satire of Wall Street, Where Are the Customers Yachts?:

The conservative banker is an impressive specimen, diffusing the healthy glow which comes of moderation in eating, living, and thinking. He sits in state and spends his days saying, with varying inflections and varying contexts, “no.”

He says “yes” only a few times a year. His rule is that he reserves his yesses for organizations so wealthy that if he said “no,” some other banker would quickly say “yes.” His business might be defined as the lending of money exclusively to people who have no pressing need of it.

Or, in a slightly more serious tone, Phillip Zweig explains in his biography of former-Citigroup chairman Walter Wriston: “A banker’s character should be contradictory; he must be a salesman who can say no.”

6. The other most important thing is efficiency

I trust it’s obvious that a more efficient bank is preferable to a less efficient one — I’m referring here to the efficiency ratio, which is computed by dividing operating costs by net revenue. But what isn’t as apparent is just how important this is.

A bank’s objective is to maximize its return on equity. If this objective is hindered by low efficiency, then the slack must be made up elsewhere. And the easiest way to do so is to increase leverage and reduce credit standards — which, as I’ve already intimated, is a recipe for disaster.

Discussing how inefficiency fueled the latest crisis, Columbia business school professor Charles Calomiris explained in Fragile By Design: The Political Origins of Banking Crises & Scarce Credit (emphasis added): “Given an environment in which risk-taking with borrowed money was considered normal, it is easy to understand why some bankers, particularly those who were having trouble competing against more efficient rivals, decided that the right strategy was to throw caution to the wind.”

It accordingly makes sense that the banks which fared best in the latest crisis — some even thrived because of it — were also some of the most efficient. Three that come to mind immediately are Wells Fargo, US Bancorp, and M&T Bank.

Consider this anecdote from a recent profile of Wells Fargo CEO John Stumpf:

John Stumpf, a banker who earned almost $23 million last year, is cheerfully picking the stuffing out of a cracked leather armchair in his office. The chair, inherited from an even more frugal predecessor, is the most decayed of a worn set around Stumpf’s conference table, a perfect set piece for his brand of subtle showmanship. He revels in his humble surroundings, proudly pointing out the “shabby” decor and rust-red carpet (“very ’70s”) of his yellow-lit executive suite.

Asked if Wells Fargo would ever upgrade its San Francisco headquarters or consolidate its scattered offices around the city into a gleaming flagship, something to rival Manhattan’s spaceship-like Bank of America tower or its elegant new Goldman Sachs building, Stumpf scoffs: “That’s not us.”

This is me (Ser Jing) again. So, from John’s framework, there are three things that can help point out a bank’s chances of failing in the future. The first is a bank having a history of imprudent financial management; the second is a bank’s obsession over growth, regardless of how healthy that growth is; and the third is a bank having a chronic inability to control its costs.

With respect to the three signs, investors in Singapore might perhaps breathe somewhat easy – there’s nothing our three local banks have displayed in their history which might possibly point to them being banks which have a high chance of failure.

The best evidence for my statement immediately above would perhaps be the prudence with which our local banks handled their finances in the years prior and during the Great Financial Crisis of 2007-09, a crisis which destroyed Western banks aplenty. In addition, the trio have also had remarkable efficiency ratios (remember: The lower the ratio, the better) as seen below:

So right now, investors can rest easy. But, do start worrying if you ever see any of them start chasing growth indiscriminately, piling on the leverage, or have their cost efficiencies decline!

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn’t own shares in any companies mentioned.