The obvious lessons of Washington Mutual and other high-profile failures in the industry have not gone unheeded, keeping banks busy these past three years fixing their approach to risk.
But reworked pay formulas, tighter credit standards, software upgrades and governance reforms address only half the equation that added up to a sector in crisis — and unfortunately it's not the half that chief executives are hardwired to focus on, day in and day out.
Maximizing share price, satiating a savage market hell-bent on seeing earnings growth every three months — those are matters that weighed heavily on bank CEOs precrisis. In the intervening years, banks got something of a pass to push their stocks sideways for a while and to miss a few quarters of financial estimates while both the industry and the markets regrouped. But there is nothing to suggest that the industry has broken free of the pressures of either the daily trading session or quarterly earnings.
If anything, concern about stock performance and bottom-line growth seems on the rise again, with CEOs from banks large and small preoccupied of late with the idea of returning capital to shareholders and replacing fee income lost to regulation.
"I think all [bank CEOs] will tell you that they're working for the long term," said Steven Gerbel, founder and president of Chicago Capital Management, a small merger-arbitration fund that invests in banks and other stocks. "But I find it hard to believe that if they were working for the long term and trying to prepare themselves for Basel III that they would be so concerned about dividends."
Of course there's nothing wrong with pursuing dividend increases per se. Distributing resources and increasing shareholder value are two of the most sacred duties of a corporate CEO.
But when those tasks are carried out more with short-term benefits in mind than long-term consequences, trouble can arise.
The short-term-versus-long-term conundrum that banks sometimes face was illustrated vividly in the complaint that the Federal Deposit Insurance Corp. filed in March against three former Wamu executives. The lawsuit cites a June 2006 company memo in which Wamu CEO Kerry Killinger noted that the housing bubble was due to burst and that the company's credit costs would climb when it did.
Faced with his own predictions, Killinger nevertheless ordered, in the very same memo, that the company heap on more credit risk, explaining that "Wall Street appears to assign higher [price-to-earnings ratios] to companies embracing credit risk."
If that kind of thinking seems more emblematic of the dot-com boom that ended six years before Killinger would have penned that memo, Shivaram Rajgopal, a professor at Emory University's Goizueta Business School, said it reflects a psychology that has never really gone away.
He sees the widely shared fixation on stock price as the product of a confluence of developments, including the proliferation of stock-based compensation, the decline in trading costs that made it economically feasible for day traders and "stock jockeys" to exert influence on the market and the waves of consolidation in different industries that relied on stock as the primary currency for acquisitions.
"The fever has probably subsided some since the dot-com days," said Rajgopal, whose research focuses on financial reporting and on the relationship between executive pay and executive behavior in areas such as risk-taking. "But I think the tendency to want to please the market hasn't changed that much."
What has changed, according to consultant Chris Thompson, is the starting point that companies are using to determine what kinds of returns they expect to provide to the market.
Instead of deciding on the necessary deliverables and tallying up the risks afterward, some banks are first setting their risk appetite, and then determining how best to satisfy it, said Thompson, the North American lead for risk management at Accenture.
When his firm was brought in to work with the board of a company that had cut back substantially on risk-taking because of the crisis, "the question was not just 'How do we do more business — oh, and by the way, will that be risky?' " Thompson said. "It was, 'How do we take the right amount of risk over the next three years, and how do we manage that from a business standpoint?' "
Rob Carpenter, senior vice president of CoreLogic Dorado, sees at least one respect in which the demands of the market have had a positive impact on his firm's clients: the reputation risk surrounding mortgage industry practices has ensured that the mortgage operations of larger banks are no longer run in virtual isolation. Instead they have captured the focus of retail banking executives who want their brand names protected.
"The market is correcting the risk profile in that way. And given that, [banks] are beginning to make decisions around technology and operations that would imply better behavior," Carpenter said. "It's not necessarily that they grew a soul all of a sudden. They're making good business decisions, and their understanding of risk is now more aligned with the events of the past three years."
Had Wamu been outfitted with the latest generation of technology — had the company not been, as the FDIC asserts in its complaint, unable to "adequately track and analyze its loans" or "measure or price for its risks" — would Killinger have ignored the siren call of a higher P/E ratio and chosen a different strategy?
Linda Allen suspects not. But Allen, an economics and finance professor at Baruch College in New York, said Killinger's chosen strategy speaks less to the state of the stock market and more to the state of the financial system, which allowed systemic risks to grow unchecked at no apparent cost to the firms generating those risks.
"This risk that was being posed on the economy was free, and it would be irrational for [Killinger], on behalf of his shareholders, not to take advantage of something that was free," Allen said. "That's why banks are different, and that's why systemic risk, which is outside the decision-making process of any individual executive, has to be internalized in some sense."
That's one option for controlling banks' behavior. Technology that promotes accountability by producing auditable trails as loans work their way through the system might be another. But even Carpenter, as energetic as he gets when discussing the workflow technology that CoreLogic Dorado makes for mortgage lenders, sees the limits to what his firm can offer clients.
"While our technology is really quite fantastic," he said, "it's not capable of providing virtuous behavior to an executive."
