Sunday, February 24, 2008

Dangerous animals in the banking zoo

(FT) Can banks run investment banks? This has not been a good week for a number of proud European institutions that have expanded into more exotic areas of finance. Credit Suisse was embarrassed, only a week after publishing its results, to announce that it had “identified mismarkings and pricing errors by a small number of traders” to the tune of $2.85bn. Société Générale, meanwhile, was criticised by a report into Jérôme Kerviel’s €4.9bn trading loss. It raises the fundamental question of whether commercial banks have the right culture to manage risk-taking traders.

Commercial and retail bankers are like battery hens. You put them in a small cubicle, pressurise them with tough sales targets but provide a decent salary, and they will produce a steady steam of returns. Most are conservative, somewhat harassed souls, who seldom think to bite the hand that feeds them.

An investment bank is more like a zoo, full of bizarre, prideful and sometimes dangerous animals. A zookeeper who pushes them around, or issues orders, is asking to have an arm bitten off. Instead, the job is to keep the animals in their cages, so they do not savage the paying customers, while understanding their individual behaviour patterns. What does it mean, for example, when a derivative trader refuses to take a holiday?

There are reasons why commercial bankers want to run investment banks. The biggest is that large companies have turned more and more to markets, issuing bonds rather than taking loans from banks. A top-tier investment banking franchise can earn superb returns on capital. And commercial banks have argued that, because of their large balance sheets and existing customer relationships, they have a competitive advantage in trading and advice on merger deals.

The practical evidence is mixed. NatWest, Commerzbank and Bank of America are commercial banks that struggled with investment banking. HSBC and Citigroup have had mixed results. Barclays Capital, Société Générale and UBS have generally done well in specific niches. Plenty of investment banks, meanwhile, Merrill Lynch and Bear Stearns, for example, have had trouble in the credit squeeze.

Rather than background, strategy and management seem to be the pro­blem. Heavy write-offs at UBS and Merrill Lynch are the result of throwing capital at the credit markets late in the boom. At Société Générale, meanwhile, some have spoken of a “culture of deference”, in which back-office staff found it difficult to question successful traders. A stressed-out trader, asked to reconcile his positions, is likely to respond with a string of expletives. But that is the challenge of running an investment bank: risk-taking traders have their own incentives and motivation. Commercial banks need to hire risk-takers of their own in order to manage them.

Fix financial incentives (by William Cohan)

One hates to prejudge, but it seems highly unlikely that Stan O’Neal and Chuck Prince will share the real reason for the financial crisis when the former Wall Street chief executives testify on Thursday before US Congressman Henry Waxman and his committee on oversight. Both men were deposed last autumn, from Merrill Lynch and Citigroup respectively, in the wake of billions of dollars in losses while they were in control. Nevertheless, they still left with tens of millions of dollars in compensation.

“I request that you be prepared to provide your perspective on this reported pay package,” Mr Waxman wrote to Mr O’Neal, “how it aligns with the interests of Merrill Lynch shareholders and whether this level of compensation is justified in light of your company’s recent performance and its role in the national mortgage crisis.” A similar letter went to Mr Prince.

The truth is that Mr O’Neal’s $161m and Mr Prince’s $42m exit packages are in no way justified by their performance either as executives or as fiduciaries for their shareholders. These vast overpayments – contractual though they may be in part – for mediocre performance are the latest examples of how irretrievably broken Wall Street’s compensation system is.

It is no exaggeration to lay the blame for the financial crisis and a host of others – among them, the internet bubble (1999) and the telecommunications bust (2001) – on Wall Street’s compensation system. Ignoring that somewhere between 50 and 60 cents in every dollar of revenue that Wall Street receives is paid out in compensating its employees, is it any wonder that when you reward bankers with absurd sums to generate innovative securities – collateralised debt obligations or mortgage-backed securities – they react the same as one of Pavlov’s dogs? Or, since mergers and acquisitions bankers get paid and promoted only if deals close, is there any surprise that their agenda is to push deals to close, not to offer unbiased advice?

These perverse incentives are exacerbated by Wall Street’s lack of accountability. Huge bonuses are deposited and consumed long before the bad deals that generated them can slam investors. If Bruce Wasserstein’s “dare to be great” advice to Robert Campeau in the late 1980s on his acquisitions of Allied Stores and Federated Department Stores ended up being more than a little off the mark, should Mr Wasserstein be held responsible? Or are bondholders, shareholders and employees left to bear the brunt of bad advice?

Of course Mr Wasserstein should have been held accountable. But he was not. By the time the deal cost investors billions, he had left First Boston for his eponymous firm. As chief executive of Lazard – where the stock price declined 14 per cent in 2007 – he is now lionised and overcompensated. Mr Wasserstein is not alone. He is joined by countless other masters of the universe who provided the rationale for such flops as AOL-TimeWarner, DaimlerChrysler and Alcatel-Lucent.

While M&A bankers like to make the specious argument that their reputations are at risk when they give bad advice, for the anonymous bankers that manufacture and trade CDOs, leveraged loans and derivatives, there is not even that minor brake on bad behaviour. Unless, of course, things reach epic proportions and then we know them by their names: Jérôme Kerviel, Nick Leeson and Joseph Jett.

What is a remedy for this vicious cycle? At the risk of seeming disingenuous, since I benefited from this system for 17 years, I propose an extreme makeover for compensation. M&A advisers should be paid by the hour for their advice, just as their well-paid deal colleagues in the legal and accounting professions. This would rein in unnecessarily massive M&A fees and return to the days of unbiased advice. Changing compensation for bankers who innovate and sell financing is harder but must include a way to hold back a large percentage of the pay until – and when – the success of the product can be determined over time. It is evident that the excess that led to the sub-prime crisis was not worthy of reward.

So, sure, Mr Waxman, go ahead and publicly flog Mr O’Neal, Mr Prince and the heads of their boards’ compensation committees, who are also due to testify. But other board members should also testify and explain why they have voted to perpetuate this broken system.

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