May 8, 2020
The Peculiar Business of Banking

The business of banking is tailor-made to compound value, thanks to the immense amount of leverage employed by banks.

At the same time, this leverage leaves little margin for error. To run a top-performing bank, lending and capital allocation decisions have to be correct upwards of 99% of the time, through all stages of multiple credit cycles.

That’s hard. 

It’s so hard that the typical publicly traded bank, over time, hasn’t earned its cost of capital.

This begs the question: How have some banks — like M&T Bank Corp. and Glacier Bancorp — been able to turn this paradigm on its head?

The simple answer is that they have traditionally run their businesses to maximize long-term value and, as a corollary, to avoid the siren song of excessive short-term revenue growth.

This is easier said than done due to two peculiar supply and demand dynamics of banking. On the supply side, a bank doesn’t know its cost of goods sold until sometimes long after the goods (loans) are sold — i.e., when there’s a downturn. Meanwhile, the demand for credit is effectively infinite so long as loan rates and terms are sufficiently low and lenient.

Combatting these peculiar dynamics requires disciplined decision-making. And an especially effective way to instill this is through skin in the game — equity ownership purchased by bank executives and directors with their own money. (We talked about this earlier in the week in relation to Jamie Dimon.) 

This establishes symmetry between the risks and rewards of one’s decisions. It encourages efficiency and prudence as well, two fundamental and self-reinforcing pillars of long-term value creation.

Meaningful equity ownership also promotes good capital allocation decisions. It fortifies management against pressure from analysts and institutional investors to chase short-term growth at the expense of long-term solvency. And it discourages dilutive or otherwise imprudent acquisitions and share repurchases.

To be clear, there is no single panacea when it comes to long-term value creation in banking. After all, Bear Stearns Cos. CEO Jimmy Cayne held $1 billion worth of its stock in 2007, a year before it collapsed into the arms of JPMorgan Chase & Co.

There are instead multiple, interrelated qualities that top-performing institutions tend to exhibit. But all those qualities rest on a bed of disciplined decision making. And there is no better way to encourage discipline than exposing oneself to the risks one takes.

• John J. Maxfield, executive editor of Bank Director