This is annual report season for many companies, especially banks. Since I own 25+ banks in my portfolio I've been inundated with bank annual reports. I rarely read the entire report because in most cases I've already seen the bank's financials on CompleteBankData.com by the time I receive the report in the mail. Even though I've seen the financials I like to receive the reports for a few reasons. The first is I like to read the President's letter if there is one. Secondly I like to evaluate the quality of the report, by this I mean the material it was printed on. Some annual reports appear like they were Xeroxed off in the back room, stapled by the tellers and mailed third-class. Others are heavy card stock and fully of colorful glossy pictures and inspirational quotes. But what I really enjoy looking at are the profiles for the directors of the banks.
After thumbing through some of the proxies send with the reports this week I have to ask:
Who are the empty suits filling bank board rooms?
The board of directors at a company are supposed to represent shareholders' interest in the company. Shareholders elect them to hire and fire the management team and run the company for the benefit of the shareholders. That's the theory at least.
The reality is often very different. A bank's board of directors are usually friends and acquaintances of the CEO or Chairman. They are often somehow involved in the community which in the community banking world somehow qualifies them for directorship. A friend of mine jokes that being a funeral director is a qualification to being a community bank director.
If the board is tasked with managing the managers it would make sense for them to know about banking. Good managers should have an idea of what their subordinates are doing. Bad managers are clueless and often have their head in the sand. The problem is most bank directors have zero banking experience meaning they are ineffective at managing a bank's executives. At these banks the board is reduced to agreeing with management because they don't know better. If the CEO says the lending environment is difficult they agree nodding their heads in unison.
When I page through proxies for some of the banks I own I see directors that run HVAC companies, a golf course, an organic vegetable farm, a seafood company, and a lot of real estate and construction related businesses. In most cases the bank states that the individual's experience in running some small company in their community qualifies them because of their experience with the local market.
A former bank regulator told me a story about a bank he worked with in the 1990s. He said that as he was evaluating the board he discovered that all of the directors had ties to the local auto industry with most being car dealers. When the regulator began to examine the bank's loan book he found that most of the bank's loans were auto loans. Guess what dealerships were doing significant business with that bank? The regulators forced the bank to reduce their auto lending and change the composition of their board. Unfortunately management abuse isn't always that obvious.
I sometimes wish for radical and honest transparency. It would be refreshing to see the truth in a proxy. What if a director nominee's blurb stated something like this: "The CEO and the nominee's sons play on the same soccer team. The nominee and other directors have been in the same fantasy football league for 13 years." or "This nominee's business does significant business with the bank. The bank CEO informally agreed to put the nominee on the board in exchange for continued business."
Another axe I have to grind are with directors who make a career out of being directors. You know the type, their bio talks about a job they held in "business development" in the early 1980s. Since then their only experience seems to be serving on boards. Some directors serve on a number of different boards, enough that they can string together quite a salary.
There are always exceptions to the rule, but not many. One bank I own seems to have the type of board I'd like to see everywhere. FS Bancorp's board consists of individuals who have prior banking experience, or worked in finance and investing. Another exception is in the bio of one director at Sound Financial. This director works in the food industry but states that he has taken extensive training courses and seminars on banking during his term as a director. Even though his professional experience isn't in banking he's made a significant effort to learn the industry something that should be applauded.
There are two solutions to this problem, a regulatory solution and a market solution. The regulatory solution would be a set of rules that force director independence. These rules already exist and they don't seem to be working. The market solution is for investors in these sleepy and mismanaged institutions to fire the directors and to nominate new ones with satisfactory backgrounds. Some of this is accomplished through activist investors, but the majority of the work needs to come from non-activist bank shareholders. I vote against almost all director nominees at banks I own. If someone owns a Vitamin Shoppe that doesn't qualify them to be a director, I let the bank know that with a no vote.
Disclosure: Long Sound Financial, Long FS Bancorp
Looking for value in the overlooked margins of the market.
Nate,
ReplyDeleteI am sure you're aware of the obvious comeback here which is that a bank doesn't just need people overseeing it who understand the nature of banking operations, but they also need people who understand the business community and can increase the marketability of the bank's lending services with those connections because the essential function of a bank is intermediation of loanable funds.
But I wonder here if you've considered another objection: that the "market" solution hasn't been fully tried in banking and that we continue to witness the failures of regulation instead in that no bank is allowed to fail.
What incentive do the customers of a bank have to police management if the FDIC covers any mistakes? Similarly, because of the rules and regulations related to "shareholder activism", what realistic opportunity do shareholders have for agitating for change and improved oversight when there are things like poison pills, staggered board elections, etc., to insulate the board and management from anyone who might come to overturn their apple cart?
It is funny, people think risk is something that can be legislated away, just like poverty.
Taylor,
DeleteYes, that is the comeback, and that's what every banker claims as well. But I'd argue you don't need to pat someone's back to know what the business environment is like either.
You bring up an interesting point about market regulation. I'm just thinking out loud here. We have a regulator who "guarantees" the banking system, which in turn artificially lowers interest rates. If things are guaranteed some of the risk is removed and rates are lower. Lower rates stimulate the economy and encourage growth. So maybe a line of thinking is that the risk of insuring and taking care of failed banks is a smaller cost than higher rates across the board. That a certain amount of banks will fail and that's built into the model.
That's probably how the FDIC would respond.
What would be awesome is some sort of a new system. One where customers are helping to make the lending decisions. Think about all the information that customers have about their community. They know about the location that every restaurant that goes into fails, or that a business has a bad reputation. If that knowledge could somehow be acquired or merged with the bank's knowledge better lending decisions would occur. In turn the bank would be safer and depositors would entrust the bank with more money.
Right now when a bank raises rates on a CD consumers flock to it, even though they know it's risky and banks on the cusp of going under do those types of tricks. Consumers aren't at risk and because of that they encourage bad behavior.
Nate,
DeleteIndeed, this is how some people defend the FDIC and similar deposit insurance institutions. I think it begs the question, "Why aren't entrepreneurs competing to provide this service themselves if it's socially beneficial?"
I suppose if you believe in "market failure" that question will go over your head, but if you understand what profitability (or lack thereof) signal then the insight should be obvious.
I guess there is a lot of trading favors going on and a lot what would be net income is going to these jokers instead. Maybe this is why a lot of banks seem to have such low bv/share growth.
ReplyDeleteI think it's more symptomatic of the fact that most banks just have average employees who aren't maximizing the business.
DeleteNothing against FS, but Directors and Officers as a class have only 3.14% of common outstanding according to latest proxy. Most of that is the CEO. I'd be concerned about risk alignment - Board has some nice paper experience in finance and consulting, but it's funny how even HVAC company owners can develop a keen sense of risk and value when it is there own capital at stake. Frankly, I'd rather see Directors that have significant portion of their personal net worth invested in the Bank - you'll get faster alignment of interest with the shareholders - keener assessment of risk (fewer stupid credit decisions) and keener focus on value (i.e. 5-6% ROE not acceptable). No regulator will ever suggest the above, but one could hope. More effective than most sophisticated risk management systems.
ReplyDeleteI agree and disagree with this. I agree that it's good to have interests aligned with shareholders. I would prefer more equity ownership rather than less.
DeleteThe problem I have with this is the Wall Street mentality that everyone is rich. If you are working at the SVP level of a small community bank maybe you're making $130k. Say you're then elected to a board. You have great experience, but where will the money come from to buy up 10% of the shares? For someone who's making an average wage, or doesn't come from old money maybe owning 1% of the company is a significant stake.
The 3% ownership stake at FS Bancorp is $1.6m. This bank used to be a credit union, and management isn't paid egregiously. To me $1.6m is a significant stake for what appears to be ordinary individuals.
This is interesting.
ReplyDeleteI think the main issue is a difference of perspective.
You think like an investor. In your mind, the purpose of a bank is to maximize returns for the shareholders.
In practice, businesses that are important to a community serve many different stakeholders. Their main goal may be to maintain their position of wealth and influence in the community. As such, they all sit on each others boards, and their directors/board members probably revolve through local government positions as well. In this way, they can all defend the dominance of their respective institutions. Profits are just one aspect of this dominance.
The purpose of a bank in this system is to support other institutions by providing credit. It may sometimes take actions that are less than entirely profit-driven to serve the business community. Not because its stupid, but because that is how the system works. If the system is working, the bank will also be allowed to get a reasonable profit.
Is this corrupt or wrong?
Not necessarily, it is just a capitalist oligarchy rather than pure capitalism.
There are disadvantages to oligarchies, but that kind of system isn’t automatically broken.
It is just run with a different set of goals than a purer form of capitalism would be (and note that both are primarily run for the benefit of a small number of people).
The number one goal of an oligarchy is to seek stability. This is arguably more beneficial to the community than the more risk-seeking profit maximizing goals of a purely rational capitalist organization. But it is less beneficial to an outside shareholder. If you’re going to invest in this kind of company, it simply comes with the territory.
Perhaps Nates' point is that if you're going to take capital from outside parties, you are obligated to be responsive to their interests, not narrowly focused on buying "stability" by getting your buddies to go golfing with you in return for investor capital paid out as salary.
DeleteA highly self-contradictory comment, but what would one expect from someone who thinks oligarchy is "beneficial to the community"?
When investors contribute capital to a bank to form it they expect that the bank will generate returns, not destroy their capital. The way to great shareholder value is to engage in relationship building in the local community. By building a network and local brand and making prudent lending decisions shareholder value is created and enhanced.
DeleteThe purpose of any business is to generate a return for the capital provider. The business does this by engaging in *something* whether it be credit formation or machining parts, or selling services. By providing the best product possible and solving customer problems a return is generated. Anything else is a charity. If your goal is to create something that provides a great experience but don't care about generating a profit then you'll be looking for donors fairly soon.
Someone above commented they want the BOD to have an equity stake. I agree, that's important. It's important because if they don't have a financial interest they're just hired management working to keep a job for themselves.
What if you contributed capital to a bank, you owned the entire thing. How would you feel if the manager came to you and said that he's paying himself all of the profits but at least the bank is stable. What's your incentive to contribute capital to form businesses like that?
Secondly a banker is contributing capital to others, if they're mistreating you how will they be at lending to others? They don't care about your money so why should we expect they care about the money they're lending?
I agree with you Nate - concept of bank as a quasi-public utility serving stakeholders other than the shareholders is a longstanding one - it is especially prevalent in areas that have historically had a high concentration of mutual rather than stock form banks and it is a difficult mindset to overcome post-conversion (possibly one of the reasons why conversions tend to sell once they are out of the blackout). Same commentor from above. I think we are fundamentally in agreement RE: importance of equity - it isn't the size of the stake relative to the Bank that matters most(I should have been clear about that) but rather the size of the Director's stake relative to his or her net worth. I prefer a high number here. You don't want a Board that has little equity and high Board fees/restricted stock grants and options. That is the worst. You last observation is a critical one - poor capital allocators make for awful lenders because they are making what are essentially highly leveraged debt investments against collateral and businesses they don't really understand. Beware the lender who thinks ROE of 6% acceptable at Bank - likely to excuse all sorts of underperformance I from borrowers.
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