Monday, July 18, 2016

The Seven Deadly Sins of Banking

From Capital Returns (the excerpt below was from a Marathon letter written in November 2009):
One large European financial institution, however, which didn’t blow up during the Global Financial Crisis is Svenska Handelsbanken, Sweden’s largest bank and a long-term Marathon holding. Over the years we have gotten to know the bank quite well. Our meetings with management have often provided timely insights into the folly of their European banking competitors. A recently published book about the bank, entitled A Blueprint for Better Banking, by Niels Kroner, describes the history and culture of the bank and, as the title suggests, argues that many of the recent problems of the financial system could have been avoided if other banks were run in the “Handelsbanken way.” 
Handelsbanken is a very conservatively run, branch-based retail bank which was the only major Swedish bank not to break in the Nordic banking crisis of the early 1990s. This time around, Handelsbanken has pulled through yet again, avoiding the need to raise fresh capital or receive government support. That puts it on a short list of only three major European banks. Handelsbanken’s decentralised business model encourages branch managers to make loans based on local, face-to-face knowledge of customers rather than relying on centralised credit scoring techniques, as their competitors do. The bank consistently has the best customer service ratings in the industry and the lowest costs (as demonstrated by a low cost to income ratio compared with other banks). A few years ago, we asked management why (as we had been told) there were holes in the carpets at many of its branches. “Carpets don’t make money,” was the reply. 
Having avoided the disasters of its peers, since the beginning of 2007 Handelsbanken shares have outperformed those of all other major European banks. According to Niels Kroner, Handelsbanken has succeeded by not committing what he calls the Seven Deadly Sins of Banking. These are as follows: 
First deadly sin: Imprudent asset-liability mismatches on the balance sheet 
Obviously there are many cases around the world of how borrowing short and lending long can go wrong for banks. Recent examples in Europe include Northern Rock in the UK and the Irish banks. During the boom years, the Irish banks financed household mortgages that had a contractual maturity of two decades or more, with commercial paper of less than one year’s duration. Handelsbanken is acutely conscious of the risks posed by asset-liability mismatches. The bank uses a central treasury function to match and price deposits and loans according to their respective maturities. In this way, branches cannot report a profit by simply engaging in maturity transformation. 
Second deadly sin: Supporting asset-liability mismatches by clients 
The classic example here is foreign currency lending to households in Central European countries. Not long ago, European banks were providing low interest euro and Swiss franc mortgages to Hungarian and Latvian consumers. It was unlikely these customers understood the foreign exchange risk they were running. Handelsbanken does not engage in such lending, mainly because the primary incentive of the branch managers is to eliminate default risk. The worst thing a branch manager can do is to run up bad loans. Internally, branches are ranked on this measure to shame the underperformers. 
Third deadly sin: Lending to “Can’t Pay, Won’t Pay” types 
Here one immediately thinks of banks lending to subprime borrowers and private equity firms. Handelsbanken’s approach is rather to “lend to people with money.” Theirs is a niche lending approach rather than a mass market one. In company research meetings over the years, Handelsbanken told us that the banking industry had become obsessed with earning a few extra basis points of spread each quarter, while losing sight of credit risk, namely the chance that borrowers might never be in a position to repay the principal. 
Fourth deadly sin: Reaching for growth in unfamiliar areas 
A number of European banks have lost billions investing in US subprime CDOs (UBS has blown some $40bn in this manner), having foolishly relied on “experts” who told them that these were riskless AAA rated credits, i.e., they outsourced the underwriting decision. In Scandinavia, many banks pursued growth in the Baltic states and have suffered as GDP in the region has contracted by 15–20 per cent this year (house prices in Latvia are now down 70 per cent from the peak). Handelsbanken’s approach to foreign expansion, by contrast, has always been one of cautious “organic incrementalism,” as they describe it. The bank largely eschewed the Baltic states as too risky. Instead, Handelsbanken expanded its branch network in a number of mature Western European markets – including UK, Germany, and Norway – where it has been easy to recruit good branch managers among those who have grown disillusioned with the centralising tendencies at their old banks. In the UK, Handelsbanken hired local branch managers who brought with them their best clients and most highly regarded colleagues. 
Fifth deadly sin: Engaging in off-balance sheet lending 
Recent examples of the cardinal banking sin of off-balance sheet lending include the use of conduits and SIVs by European banks. By contrast, Handelsbanken’s approach is to accept only risks which it is prepared to hold on its balance sheet until maturity and not to lend money to those that are in the business of lending money themselves. Incidentally this principle also restrained the bank from engaging in pass-the-parcel securitization schemes which have had such a damaging effect on underwriting standards across the European banking system. 
Sixth deadly sin: Getting sucked into virtuous/vicious cycle dynamics 
The sixth deadly sin is to be seduced by what might be termed Ponzi economics. Lending by Scandinavian banks in the Baltic states seemed like a good idea for a long time partly because GDP was growing rapidly. The strong economic growth, however, was a function of rapidly growing credit supplied by the banks themselves. The fact that every bank was lending in the same market made it feel safe, and for a while the virtuous cycle continued. Real estate markets around the world were similarly characterised by the notion that asset quality was independent of credit conditions. Handelsbanken prides itself on its contrarian streak. It is less prone to high level “strategic” moves (which normally entail engaging in happy groupthink) because of its reliance on the branch network. The branches have a fairly consistent risk appetite through the cycle and so tend to lose market share in frothy times (e.g., during the 2006–08 period) and gain share when others are unwilling or unable to lend. 
Seventh deadly sin: Relying on the rearview mirror 
A recent expression of this common financial vice includes the widespread use of value-at-risk models. Such models tend to be based on a limited amount of historic data, which in the years before the crisis were relatively benign. True risk was understated. In its 2007 annual report, Merrill Lynch reported a total risk exposure – based on “a 95 per cent confidence interval and a one day holding period” – of $157m. A year later, the Thundering Herd stumbled into a $30bn loss! After house prices have risen by 85 per cent in ten years, as they had in the United States, was it realistic to expect a maximum decline of 13.4 per cent (Freddie Mac’s worst case scenario)? Handelsbanken determined its capital requirements based on more pessimistic crisis scenarios, such as a repeat of the Swedish banking crisis. 
There are many other ways in which Handelsbanken is different from its peers. In its dialogue with investors, bank representatives refuse to engage in the game of trying to estimate this year’s profit number. They have no other choice, since divisional budgets were abolished in 1972. If managers have budget targets, so the thinking goes, it becomes more difficult to stay out of the market when pricing is unfavourable. 
Management incentives are also unusual. The bank funds an employee profit-sharing scheme called the Oktogonen Foundation, which receives allocations when the group’s return on equity exceeds the weighted average of a group of other Nordic and British banks. If this criterion is satisfied, and it usually is, except at the peak of the cycle, one-third of the extra profits can be allocated to Oktogonen subject to a limit of 15 per cent of the dividend to shareholders. If the Handelsbanken lowers the dividend paid out to its shareholders, no allocation is made to the profit-sharing foundation. 
The foundation channels a large part of its resources into Handelsbanken stock and currently holds 11 per cent of the bank’s equity. All employees receive an equal part of the allocated amount (without the traditional skew towards the upper echelons), and the scheme includes all staff in the Nordic countries and, since 2004, in Great Britain. Disbursements are only made once a member of staff has reached the age of 60. Employees who have been working for Handelsbanken since 1973 have around $600,000 – which turns out to be roughly half the value of a Nobel prize – due to them at retirement, regardless of whether they have worked as the CEO or as a security guard. The system undoubtedly contributes to the bank’s tribal culture and aligns employee interests with shareholders.