By David B. Moore
Gresham’s Law, according to Wikipedia, is an economic principle which states that: “When a government compulsorily overvalues one money and undervalues another, the undervalued money will leave the country or disappear from circulation into hoards, while the overvalued money will flood into circulation.” It is more commonly stated as: “Bad money drives out good”.
A classic example of Gresham’s Law at work is the case of silver coins that were widely circulated in Canada (until 1968) and in the United States (until 1965 for dimes and quarters, and 1971 for half-dollars). As Wikipedia further explains: “These countries debased their coins by switching to cheaper metals as the market value of silver rose above that of the face value. The silver coins largely disappeared from circulation as citizens retained them to capture the higher current or perceived future intrinsic value of the metal content over their face value, using only the newer coins, comprised of cheaper metals, in daily transactions.”
Any informed post-mortem of the recent global banking crisis must conclude that a Gresham’s Law of management permeated the banking industry’s executive suites between the mid-1990s and mid-2000s; that is, bad management drove out good. More specifically, most bank executives who were deemed excessively cautious (“appropriately” cautious, in hindsight) during the late-1990s and early-2000s were either demoted or their influence reduced as the credit/housing bubble made excessive risk-taking, among other bad management practices, look prudent. By 2007 most overly (again, “appropriately”) cautious bankers no longer had a voice at the table.
To wit, among the myriad damning passages buried inside the Federal Deposit Insurance Corp.’s complaint against former executives of Washington Mutual, Inc. (“Wamu,” a $330-billion asset savings bank holding company that failed in 2008) is the following:
“Wamu’s compensation structure for loan officers was based on the volume of loans originated, and thus loan originators were incentivized to push as many loans through the system as possible, creating additional risk to Wamu. For instance, Wamu’s 2006 compensation plan for loan originators stated: ‘Rewards will be based on the dollar volume of loans funded each month.’ Wamu’s compensation policy for underwriters similarly created strong incentives to increase the volume of loans.”
Now, imagine the reaction of Wamu’s senior management to the executive who suggested in, say 2004, that maybe, just maybe, basing compensation solely on the volume of loans originated might lead to lax underwriting standards (and in some cases – gasp! – fraud), thus potentially “creating additional risk to Wamu”. The reaction was likely to resemble closely that of someone being either demoted or fired. Thus, because caution in the banking industry for so many years failed to remunerate, extreme risk takers all too often were the last executives standing among the ranks of senior management as the financial crisis unfolded. In too many cases, bad management and poor practices had driven out good management and sound practices because the former had been more profitable than the latter for too many years.
The case of Dirk Röthig, a former executive with Germany’s IKB, is instructive as a specific case in point. Röthig had in the early-2000s set up an offshore vehicle for IKB called Rhineland Funding that borrowed in the (short-term) commercial paper market and invested that money in longer-term structured credit products such as US subprime bonds. By 2004 Rhineland seemed like such a good idea that other German banks were setting up their own versions of Rhineland in order to acquire subprime-mortgage bonds for themselves. Röthig had created Rhineland at a time when the company was being paid well for the risk it was taking. By the end of 2005, however, Mr. Market was extremely optimistic and the price of risk had collapsed.
As author Michael Lewis explains (in a recent issue of Vanity Fair): “Röthig says he went to his superiors and argued that IKB should look elsewhere for profits. ‘But they had a profit target and they wanted to meet it. To make the same profit with a lower risk spread they simply had to buy more,’ he says. The management, Röthig adds, did not want to hear his message. ‘I showed them the market was turning,’ he says. ‘I was taking the candy away from the baby. So, I became the enemy.’ When he left [in 2005], others left with him, and the investment staff was reduced, but the investment activity boomed. ‘One half the number of people with one-third the experience made twice the number of investments,’ he says. ‘They were ordered to buy.’”
And buy they did. After Röthig left, the IKB portfolio went from $10 billion in 2005 to well over $20 billion by the time the market crashed in 2007. Having lost over $15 billion against $4 billion in capital, IKB had to be rescued by a state-owned bank in July 2007. Gresham’s Law had proved out again: bad management had driven out good.
In hindsight, it is clear that the Greenspan-era Fed’s interest rate policies – specifically, to reduce interest rates anytime even a hint of economic weakness was in the air (the so-called “Greenspan Put”) – artificially extended the U.S. economy’s expansion, thus playing an unintentionally important role in keeping reckless financial executives in place. Had the Fed allowed a more normal business cycle to transpire, perhaps we would have witnessed a garden-variety recession during the early-2000s – accompanied by modest financial stress and related management cleansing – and avoided the disastrous credit bubble-cum-financial collapse that transpired instead.
Unfortunately, there is no simple solution for this Gresham-related predicament. After all, as Upton Sinclair noted sagely, “It is difficult to get a man to understand something when his salary depends on his not understanding it.” Nevertheless, it remains the principal role of bank boards and regulators to ensure that a Gresham’s Law of management doesn’t permeate the institutions under their purview. That board members and regulators have done such a pitiable job over the past decade doesn’t change this fact. All we are left with after the dust has (seemingly) settled is the hope that the past will not be prologue.
David B. Moore is a managing director with Resource Financial Institutions Group.
A quarter of banking customers noted an improvement in customer service over lockdown, research shows
SAS research reveals that banks offered an improved customer experience during lockdown
This represents some good news for banks in an extremely challenging time, with 59% of customers also saying they’d pay more to buy or use products and services from any company that provided them with a good customer experience over lockdown.
The improvement in customer experience also coincides with a rise in the number of digital customers. Since the pandemic started, the number of banking customers using a digital service or app has grown by 11%, adding to an existing 58% who were already digital customers. Over half (53%) of new users plan to continue using these digital services permanently moving forward.
Brian Holden, Director, Financial Services at SAS UK & Ireland, said:
“It’s notable that in times of need customers value being able to communicate with their bank and place an even higher value on good customer service. A rise in the number of digital customers means banks can now reach a wider audience online, leveraging AI and analytics to offer a more personalised experience.
“There is work to be done, though. Even greater personalisation is needed if banks are to win over the 12% of customers who felt banking services deteriorated over lockdown. And this personalisation will need to get right down to a segment of one to properly reflect the unique circumstances some individuals now find themselves in due to the pandemic.”
While the number of digital users grew over lockdown, there is still a quarter (24%) of the banking customer base that have chosen not to make the switch to digital services.
Meanwhile, failure to offer a consistently satisfactory customer experience could prove costly for banks, with a third (33%) of customers claiming that they would ditch a company after just one poor experience. This number jumps to 90% for between one and five poor examples of customer service, so this just underlines how much retail banks can win or lose in these difficult times.
For more insight into how other industries across EMEA performed during lockdown, download the full report: Experience 2030: Has COVID-19 created a new kind of customer?
Swedish Bank Stress Tests in Line with Recent Rating Actions
The Swedish Financial Supervisory Authority’s (FSA) latest stress test results show major Swedish banks’ robust ability to absorb credit losses. The results support Fitch Ratings’ view that short-term risks have abated in recent months, and are in line with Fitch’s assessment of major Swedish banks’ capitalisation at ‘aa-‘, which was a factor when Fitch removed the ratings of Handelsbanken, Nordea (not covered by the FSA’s stress test) and SEB from Rating Watch Negative in September.
The FSA estimated about SEK130 billion of credit losses over 2020-2022 for the three largest banks (Swedbank, Handelsbanken and SEB) under its stress test. This represents about 220bp of their loans, or about 70bp annually. However, the banks’ pre-impairment profitability in the stress test could absorb credit losses of up to about 110bp of loans annually. Fitch’s baseline expectation is for credit losses below 20bp of loans in 2020 and 8bp-12bp in 2021.
Capital remained strong under the stress test. The average common equity Tier 1 (CET1) ratio fell by only 2.8pp (1.9pp if banks did not pay dividends) from 17.6% at end-June 2020. The capital decline was not driven by credit losses, which could be absorbed by pre-impairment profitability, but by risk-weighted asset inflation.
The three banks’ 3Q20 results showed that capital has been resilient despite the coronavirus crisis. The banks had a CET1 capital surplus over regulatory minimums, including buffers, of almost SEK100 billion (excluding about SEK33 billion earmarked for dividends). SEB had a CET1 ratio of 19.4% at end-September, Handelsbanken’s was 17.8% and Swedbank’s 16.8%.
The SEK130 billion credit losses under the latest stress test are lower than under the FSA’s spring 2020 stress test (SEK145 billion), which also covered a shorter period of two years. However, they are still larger than the actual losses incurred by the three banks during the 2008-2010 crisis. This is despite tightened underwriting standards by the three banks in recent years, including, in the case of SEB and Swedbank, in the Baltics, the source of most of their loan impairment charges in the previous crisis.
In its baseline economic forecasts, the FSA assumes a harsher shock to Sweden’s GDP in 2020 and 2021 (-6.9% and 1%, respectively) than Fitch’s baseline (-4% and 3.4%), although it assumes a similar recovery by end-2022. It also assumes real estate price corrections, which appears particularly conservative in light of a 11% housing property price increase over January to November 2020.
The ratings of Handelsbanken (AA), Nordea (AA-) and SEB (AA-) are on Negative Outlook due to medium-term risks to our baseline scenario. The rating of Swedbank (A+) is on Stable Outlook, reflecting significant headroom at the current rating level following a one-notch downgrade in April due to shortcomings in anti-money laundering risk controls.
Future success for banks will be driven by balancing physical and digital services
Digital acceleration due to COVID-19 has not eliminated the need for bank branches
Faster service (23%), smaller queues (26%) and longer opening hours (31%) are among customers’ biggest asks of their bank branch, new research from Diebold Nixdorf today reveals. But with 41% consumers saying they would be comfortable to engage with all banking services via an app, it is vital that banks respond to the full spectrum of customer needs – balancing and evolving their offerings on multiple fronts.
A third (35%) of customers say they will always want access to physical, in-branch banking services in some capacity and one in ten (10%) consumers will never bank predominantly online in the future. This demonstrates that there remains an important role for the services a branch provides. This role, however, continues to shift away from purely transactional banking:
A quarter (26%) value face-to-face advice when it comes to their banking needs
One in five (18%) seek advice on different products
17% want to speak to the staff or other customers.
Matt Phillips, Diebold Nixdorf vice president, head of financial services UK & Ireland, said: “The majority of banks have spent the last decade focusing on their digital strategies and investing in improving – or establishing – their online customer experience. However, the data shows that there is still an essential role for physical branches. Banks now increasingly face the challenge of continuing to provide customers with access to a range of physical and as well as digital services, giving them the flexibility to choose the best service for them at any given moment in time.”
When looking beyond the impact of COVID-19, planned branch visits by customers are expected to rebound to 28%, following a dip to 11% during lockdown. And when asked about the new services they’d like to see inside their bank, sixteen percent of respondents said more self-service machines would improve their in-branch experience.
Matt Phillips continues: “In a world that is fast evolving and where the future is digital, there’s no doubt that high street banks must, and are, responding to the needs of highly digital customers. But not every customer requirement is digital. There is still a strong need for physical bank branches and the interaction and services they offer, and striking this balance between physical and digital is where the industry must come together to provide solutions. For example, building a strong, leave-behind strategy is something we’re seeing across the board when banks have to close branches, ensuring customers have access to self-service machines to complete all their transactional needs.”
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