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Saving Banks from the Bankers
Sallie Krawcheck, former president of Bank of America Global Wealth & Investment Management and author of the HBR article “Four Ways to Fix Banks.”
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An interview with Sallie Krawcheck, former president of Bank of America Global Wealth & Investment Management and author of the article Four Ways to Fix Banks.
JUSTIN FOX: Welcome to the HBR IdeaCast from Harvard Business Review. I’m Justin Fox, and I’m talking today with Sallie Krawcheck, a former top executive with Bank of America and Citigroup, and author of an article in the June issue of Harvard Business Review, titled “Four Ways to Fix Banks.” Sallie, welcome to IdeaCast.
SALLIE KRAWCHECK: Justin, thank you for having me.
JUSTIN FOX: Now, you’ve helped run banks. You were chief financial officer of Citigroup, then head of the Wealth Management divisions at Citi and B of A. But before that, you examined banks from the outside, right?
SALLIE KRAWCHECK: That’s right. I was a research analyst, covering the industry for a number of years.
JUSTIN FOX: So when you moved from the outside to the inside, were things better or worse than you expected?
SALLIE KRAWCHECK: I certainly have had the ability to gain an interesting perspective from both the analyst side and the internal management side. And they’re both very tough jobs. Understanding a financial services company from the outside is challenged.
And the analysts say, well, just do this, or just do that. And you say, it’s just not that easy, for goodness’ sake. So I always used to say all CFOs should be analysts for a period of time, and all analysts should be CFOs to recognize neither job is particularly easy.
JUSTIN FOX: Well, in your article, you argue that governing the really big banks has become almost impossible. Why is that?
SALLIE KRAWCHECK: Well, let’s say it’s challenging. And as I thought about the article and began to put it together, I almost thought of it in the form of a memo to bank boards. Because spare them a thought, spare them a moment. The jobs that they are being asked to do are enormously complex.
And the fact that bank boards clearly don’t meet all the time and all day for weeks and weeks at a time. They tell you they spend a lot of time on it. But the challenge in governing and trying to help manage these banks is very significant, in good part because of their complexity.
And while complexity has been reduced in certain areas, some might argue that some of the trading businesses have become less complex, though the recent JP Morgan loss might argue against that. But while certain areas may become less complex, certainly on the governance front, complexity has been heaped on top of complexity, making these bank director jobs very, very challenging.
JUSTIN FOX: And is upgrading the boards or making them work longer hours, is that a solution?
SALLIE KRAWCHECK: Well, there are those who say that some of the board members should be full-time even. In terms of upgrading the board, oh, we should just have smarter people. Good luck. Good luck.
They’re very intelligent people who are on these boards currently. The challenge is not getting a couple more or a couple tens of more IQ points. The challenge is really finding the levers that can really hit the heart of the issue as to how to manage these banks.
JUSTIN FOX: So what’s your idea for making it better? What are your–
SALLIE KRAWCHECK: Well, we really are trying to get back to sort of a first-principles idea. And when folks begin to talk about how to manage banks, the idea of compensation is generally front and center. In fact, I think the national discussion we’ve had about what went wrong with the banks has really centered around the issue of corporate greed. That’s a one-note debate.
And the debate, I think, needs to move forward from that and really get to some of the other root causes. And so we start with compensation. And the discussion really has been around should bank CEOs and senior managers be paid less? Should they be more tied to the company?
But I really try to get to the fundamental issue of we’ve moved toward paying bank CEOs and senior management team more in stock. I believe that has been shown to drive fundamentally riskier behavior.
Equity investors are short-term in nature. They tend to become shorter-term in nature over time. In my personal experience, they have driven the banks to take on more risk. You see it in a recent debate about more dividends, equity investors looking for more dividends, which, by its nature, drives a riskier capital structure.
And so I start, number one, with the idea of compensating bank management not just in equity, but in order to tilt their risk profile of the individuals in some combination of equity and fixed income, fixed income investors being much more risk averse, with the idea being to do it based on the underlying capital structure of the company. So here’s the idea, which is, if a bank is 100% equity financed, pay the senior management team 100% equity. Interests are very much aligned.
If, however, there’s $40 of debt for every $1 of equity, pay the senior management team $1 of equity for every $40 of debt. I can promise you that the risk tolerance of that senior executive team will shift. And they will pay much more attention to that $40 of debt they’ve been paid in and getting that repaid, rather than spending their time focused on upside in the $1 of equity.
JUSTIN FOX: And in terms of the way banks actually work, they are mostly debt financed, right?
SALLIE KRAWCHECK: That’s exactly right. These are levered institutions, which, by their nature, means they’re financially riskier. By doing this, you’ll shift the risk profile of the management team and what they think about to being much more risk averse. And so there’s sort of a natural hedge here, that as the bank gets riskier, that the management team becomes more risk averse.
JUSTIN FOX: And because you think of financial companies, where, in a lot of cases, the ratio between debt and equity is much more even, it’s not so big a problem to be paying people with stock. Whereas with banks, if you’re paying them exclusively and stock, you’re actually cutting out most of the people who have an economic interest in the bank.
SALLIE KRAWCHECK: Well, that’s exactly right. But the other point, Justin, is that who [INAUDIBLE] other institutions. So if the corner grocery store that has debt on it goes broke or a supermarket chain goes broke, it has very different implications for the state of the financial markets, clearly, and many would argue, for the economy, as well. And so, therefore, there’s a greater national vested interest in this topic than there is– what a simple professor would sort of drive towards.
JUSTIN FOX: So that’s your idea number one for fixing banks, is changing the pay structure. What’s the second one?
SALLIE KRAWCHECK: Well, the second one still gets to this issue of capital safety and capital preservation. And it’s so interesting that today we really are seeing a drive from investors and a drive by the institutions themselves for reinstating an increase in dividends. And I tell you, I wouldn’t have guessed that this soon after the downturn and the significant capital scares that we all lived through, that you would see a drive for return of these dividends as quickly as we’ve seen.
The issue with putting dividends in place, this structure or the convention that we have, is the dividends are stated at x cents per share. And the calculation that underlies it, I can tell you from my time in finance internal to the banks, the calculation is a percentage payout of earnings, percentage payout of earnings. The problem is that when earnings go down– and they, for these institutions, that we’ve seen can go down dramatically– the CEOs and the boards are reluctant to cut them and reluctant to preserve capital.
Had they done this in 2008, this would have made a meaningful difference in the capital that was retained for these institutions. They would have had to go out to markets and raised quite a bit less capital.
And so what I propose is this implicit way of calculating dividends becomes explicit. And the dividends, instead of being at a stated dollar level are instead a percent of earnings. And therefore, they would rise when earnings rise, and shareholders would benefit. But very importantly, they would decline when earnings decline.
And even though history has sort of been rewritten in everyone’s mind and that we have this, what you call a creeping determinism, whereby, in theory, everybody knew how bad 2007 and 2008 we’re going to be– I can tell you, I was on the inside– people didn’t know it. And that realization dawned on individuals very slowly. And that’s what typically happens when you have turn of events as significant as this, downturns as significant as this.
And so people didn’t not cut dividends because they weren’t smart but evil. They didn’t not cut them because they didn’t fully recognize how bad the emerging downturn was. By going to a percentage of earnings, this would take away that human– I don’t want to say blindness– but that would take away the human factor here, which is that we change our minds very slowly, and would automatically provide a braking mechanism on capital release at a time when capital needs to be retained.
JUSTIN FOX: And it’s also sort of a loss of face to reduce your dividend, whereas it would happen automatically this way.
SALLIE KRAWCHECK: Well, you make a very, very good point, which is, in discussions that I’ve been involved in in cutting dividends, there really is a lot of discussion about how shareholders will react, what the stock price will do, the signal it sends. It’s underlying all of that, and usually unstated, but underlying all of that. Nobody likes to deliver bad news. And nobody likes particularly to deliver bad news when it happens on their watch and when it affects all the people they go to work with every day and interact with in a negative financial fashion. So it takes away, again, in my experience, not bad people, but it takes away that very human reaction to delivering bad news.
JUSTIN FOX: OK, so that’s two ways to fix banks. Right. What’s next?
SALLIE KRAWCHECK: Well, the other thing that I advise with bank boards is that a lot of time, of course, is spent on the earnings. And management teams are compensated in good part on the earnings of the company. And the point I make is be careful, because not all earnings are created equally, and to really spend time digging into quality of earnings.
The issue with banks is that things can appear to be very good for very many years, based on factors that are essentially outside of management’s control. What do I mean by that? The best environment for a financial services company for a bank is a steep yield curve with declining interest rates. Because of the mismatch that these institutions, by their nature, take in terms of the durations of their assets and liabilities, there are earnings that fall to the bottom line in terms of net interest income during steep yield curve periods that have nothing to do with–
JUSTIN FOX: And a steep yield curve period is where longer-term rates are much higher than shorter-term?
SALLIE KRAWCHECK: That’s exactly right. And so, therefore, money can be made at these banks and is made at all banks through what you call a duration mismatch. As interest rates move down during the course of a cycle, banks can benefit from this through an increasing net interest income. And net interest income makes up a very significant double-digit percentage of banks’ revenue. Some good part of that is simply because of the interest rate environment.
So I think about it as, if the yield curve environment or the interest rate environment is favorable to banks, banks’ net interest income increases. But they’ve done nothing good for their customers. They haven’t necessarily added another customer. They don’t have to add any expenses to it. It simply is a market related outcome of banking.
And so these things can last for years and years. Net interest income has very much an outsized impact on the bottom line. In fact, I say, much of net interest income falls from the top line to the bottom line and never touches an expense on the way down.
The same thing, by the way, can happen to the negative in a bad time. But it tends to be because board meetings are rushed, there’s lots of stuff on the agenda. Really digging into quality of earnings is important, and really understanding what our earnings that are driven by doing good jobs for customers, which are sustainable, and earnings that are driven by the external interest rate environment, which are not, by their nature, fully sustainable. It is very important for a bank to judge how the institution is doing over the long term.
JUSTIN FOX: Now, your final recommendation is also something you want boards to be focusing on, right?
SALLIE KRAWCHECK: Indeed. And boards tend to, again, because of time constraints, focus on the governance, which they have to, in banking, of course; regulatory issues these days, which they have to; and then, by nature, tend to then turn their focus to the problem children. These days, I can assure you, there’s an enormous amount of time being spent at these institutions on the mortgage businesses. They’re the problem children.
Well, it’s the good kids of today who, in banking, can turn into bad kids of tomorrow. And so, therefore, really, for these bank boards to dig into the businesses that are earning the high ROEs– in fact, I would recommend spending time in each board meeting on the highest ROEs– in almost every downturn, or in almost any trip-up, be it idiosyncratic to companies themselves, this business didn’t do well.
I’m thinking my time at Citi, when the private bank in Japan didn’t do well. Or for the industry CDOs, the businesses that typically trip are the ones that were great businesses to start with. They were outside, sort of “middle of the road” in terms of returns.
And by focusing on those and asking the questions, which is, OK, why are the returns so good? What are we doing that’s different? Why are the returns on this better than our competitors? Why do we think it’s sustainable? Spending that time, which feels like a luxury, after all the have-to-dos that the bank boards have to go through, spending time on that, I think, if you step back in history, having done that would have averted some number of the big trip-ups that we’ve seen.
JUSTIN FOX: So basically, in banking, high margins are very often a sign of trouble.
SALLIE KRAWCHECK: High margins and high returns in banking can be a sign of trouble. And the banking business, which, if you step back, doesn’t have enormously high barriers to entry, certainly the trading parts of it. Why’s that? Really, no copyrights, no patents. People are mobile.
You need capital to get in. The capital, we’ve seen for years and years and years, has been willing to flow into the system. If this US bank or financial institution or trading business fails, there’s a European bank that gets in, there’s a Japanese bank that gets in, there’s a, there’s a, there’s a, there’s a.
So if you look at the business, there’s no particular reason that returns on a specific business should stay high for a period of time. If they’re out a line, check it. Check it.
JUSTIN FOX: Sallie, thanks so much for talking with us.
SALLIE KRAWCHECK: Justin, so happy to do it. Thank you for having me.
JUSTIN FOX: That was Sallie Krawcheck. Her article in the June Harvard Business Review is called “Four Ways to Fix Banks.” For more, go to hbr.org.