When size becomes a problem

The last 20 years have seen in the global banking system a strong process of mergers & acquisitions creating a number of big banks around the world. The mantra that has been driving this process is that economies of scale make the banks more efficient.
The evidence that we are facing today points to a different direction and the only reason many big banks are not failing is that they are “too big to fail” and are finding the protection of Governments.
The question is, how far gigantism in banks is part of the problem and can actually be identified as one of the sources of the current credit crisis?

Banks are a different business
No matter how technology re-shapes the businesses, the banking business of borrowing money from savers and lending to companies and individuals is different from any other business.
The traditional banking companies are intrinsically leveraged businesses that borrow and lend for a multiplier of their capital. Even the wealthiest, best managed bank in the world can default at any time if all of its depositors ask their deposits back simultaneously. This is not the case for other businesses.
Banks are different. They have an intrinsic weakness, no matter how big, well (or badly) managed and powerful they are.

The Mistake of Gigantism
We believe that the search for size has been a dramatic mistake that has made them not-controllable and has not delivered the efficiency that was promised. We illustrate below a number of reasons that support the case.

Systemic Risk. Given the intrinsic weakness of banks, it is in the interest of the communities (no matter if States or Continents or the entire World) to limit the size of a single bank. When one bank becomes too big, the embedded weakness of being a bank translates to the full economy and becomes a problem of the community, as we discovered during the crisis. Profits are private, BIG losses become public.

Economies of Scale. Economic history counts many cycles of mergers and de-mergers in the banking sector. The main reason being that banking is based on relationships: the human component is important and limits the economies of scale that can be reached with size. Mergers have been followed by de-mergers because the diseconomies of scale that came with size had not been overcome by the economies of scale. This happens because the revenue side of the P&L sheet remains strongly linked to the human workforce of the bank and precisely to its size and its skills.
We had been told that this time it was different. The important IT investments and the technological innovation of these years had created a fundamental new area of economies of scale for the banking business. While this is undoubtedly true there are a number of flaws in this thinking:

- in deciding for mergers banks have looked only at the economies of scale in the cost side of the P&L sheet and have not focused at all in the diseconomies of scale in costs and revenues. Size comes at a cost and increases in size make only sense if the economies of scale are higher than the diseconomies of scale.
- One of the reasons IT costs are so high at banks is that banks are not necessarily good in doing businesses different from banking. If we have economies of scale in the IT divisions, then let’s spin off the IT divisions, specialize them as service providers, let them compete to become more efficient and let them serve different banks. In other words, business process outsourcing could make for all the economies of scale that banks were looking for in the merger-mania. Let me make an example based on my personal experience. I have seen in banks Market Risk departments of 100 people with highly inefficient cost/benefit ratio. Speaking to the Head of the Desk he/she was telling you how proud they were to have such a big team. I was instead thinking that you could reduce the team by 70% and get much better results with outsourcing that activity to companies that are specialized into that segment, profiting from the important economies of scales in the data management and IT side. The Risk Manager was thinking in terms of power, I was thinking in terms of efficiency.

Business of Relationships. If you agree with me that banking is a business based on humans where human relationships and the human factor is central, then gigantism has failed on 3 respects:

- humans are not scalable, if for increasing revenues you need a proportional increase of headcount you have a business that is intrinsically not scalable;
- size comes with several diseconomies of scale, among which a complication of communications and inter-company relationships: this makes tougher to direct a bigger organization rather than a smaller one. Diseconomies of scale associated with size have not been taken into appropriate account and not measured consistently while deciding for mergers.
- The increase of size has come together with a very centralized business model. The availability of technology has created the false belief that it is more efficient to centralize all decisions on lending, standardizing the lending process via technology and models, trying to cancel or minimize the human component. If banking is based on relations this was a mistake and the centralization process has created a bigger and bigger gap between the bank and its clients, fundamentally destroying the relationship of trust. My opinion is that we have gone too far and have used technology in the wrong way, with the false illusion that it was efficient to remove the power of local relationship managers: these managers know clients, they know their story, they know the entrepreneurs, their reputation. The importance of these elements has been undermined by the combination of increased size and increased centralization.

The Proposed Way Forward
I think that smaller banks will consistently reduce systemic risk and become even more efficient, with further benefits to the Community.
The concept of “small” should be applied where the systemic risk operates. Today, this systemic risk operates at Country, Nation level. Single Nations are rescuing banks; they pay the price of gigantism.
This implies that we can and probably must have Global banks, but that we need to create disincentives to size at Nation’s level, not at global level. Global banks should have local entities, subject to local capital requirements.

My proposal is to increase capital requirements – at Nation’s level - as size increases above a certain threshold. Such a mechanism would leave banks totally free to grow: if they are able to be efficient and use size to find the economies of scale that can pay for the higher capital requirements, then we should let them grow, but let them be better capitalized than smaller banks.

On the other side, the important IT economies of scale created during the merging-mania can be easily maintained by spinning off the IT divisions of these banks. These companies could be further merged to maximize the economies of scale and should compete with each other, in a search for improved efficiency.
Outsourcing is growing because it is efficient and makes a lot of sense. In the 70s you had mega IT desks of banks trying to build their own computer processors. Then Intel and the others came, making it clear how silly it was for a bank to invest massive sums of money in the highly-scalable business of producing computer processors.
Similarly, you have a plethora of areas where outsourcing and IT centralization among banks would dramatically increase efficiency.

A future of smaller banks with bigger business process outsourcers (BPOs) would deliver to the banks all the economies of scale they were researching in a merger, without penalizing them with the diseconomies of scale linked to banking size. Banking would definitely become a much better and efficient sector.

Dario Cintioli is Head of Risk at StatPro

Why we need to create the role of the Super Employee

How the current employment law protects CEOs from losses


Credit crunch fatigue is probably setting in for many people, but I am sure that even they have some venom left for those individuals who presided over the whole debacle and yet walked away with millions of dollars and pounds. How was it possible that we “allowed” this to happen? Why is it that there is not a regulation that stops all this?

Well the short answer is that there are lots of regulations, but most of these are focused on stopping an organisation from doing things it should not. The officers of these organisations can be held personally responsible if it can be proved that they deliberately endangered the business entrusted to them or behaved fraudulently. The problem is that 99% of these bosses were just incompetent and when they are hauled up in court by angry shareholders, the judge is going to say that whilst the fellow was clearly a fool that is not grounds for suing him and as an employee, he has rights under statute that mean the company have to pay him off. Why is this?

Well employment legislation is (quite rightly) heavily weighted toward the employee. The employee is seen as subject to the power of the employer and so in a vulnerable position. If an employer imposes a clause in a contract with the employee which the judge finds unreasonable, it can be struck out on the grounds that the employer must have bullied or fooled the employee into accepting it. The judge effectively acts as a retrospective lawyer for the employee. The reverse is not true of course.

These days we have a situation where individuals who have not created a giant public enterprise are entrusted to run it for a short period of 3 to 5 years. They may well have fought hard to achieve this position of tremendous responsibility and they will certainly have a detailed employment contract put in place setting out terms they get and they probably feel they have a relatively short time to maximise their gains and establish their reputation before they move on. They will not think like the entrepreneur who started the original business. They will not see the institution which they work for as all important but rather think that they are important because they run the institution.

People have long recognised this problem and thought that loading an executive with options would motivate him or her properly by aligning interests with other shareholders. However this method of incentive has been proven to not have succeeded if the objective was to increase shareholder value. Indeed, I suggest that shareholders, remuneration committees and others can make up new schemes as much as they like but they will not solve this problem. The hired hand does not think like the person that built the business. He or she is either good at their job or not. The individual either behaves responsibly and takes long terms matters into consideration or not. In fact, some schemes provide perverse incentives to do the wrong thing. For example an acquisition might not make complete sense, but if a £10 million bonus is on offer for doing it and £0 for not doing it, it would take a person of extreme integrity to call it off.

Some people might argue that levels of pay should be capped or taxed out of existence. I say that this makes no sense. If someone succeeds, they should be rewarded, the issue is people being rewarded for failing and that is where employment law steps in.

Companies can try to impose a claw back of bonuses and pay in the event of failure, but, apart from the problem that they will probably not get many applicants for the job, their lawyers would probably advise them that it may not be enforceable to claw back pay that has already been paid, rendering the contract less effective. This is because under current employment law it would be seen as unreasonable to take back money paid in return for services already rendered even if it was by mistake.

If however, the law created a new definition of employee, let’s call it a Super Employee, this issue could be dealt with much more easily. The Super Employee would be seen as an equal to the employer not subordinate. The Super Employee would indemnify the Employer to a level that the two parties would freely negotiate with each other in the same way that a supplier may indemnify a client. I would suggest that this amount would be limited to say 80% or 90% of the money received under the contract (over several years potentially). Importantly the Super Employee would be considered to be in breach of the contract if he or she was proven to be incompetent. So in the same way that a supplier provided you with faulty equipment you can demand your money back, so too will the shareholders be able to reclaim their money if the Super Employee does not provide the services they said they would.

Whilst it is clear that the CEO of a large enterprise falls into this category, the concept could be used with highly paid employees as well. All these multi-million dollar bonuses for bankers were thoroughly deserved no doubt, but what if some people actually lost their bank lots of money having earned millions in bonuses in previous years? I think that a company might put in place a policy which said that if an employee wants to earn more than say £250,000 they have to agree Super Employee status. That way the shocking news that John Thain signed off $4 billion of bonuses for Merrill Lynch employees in a year where Merrill Lynch lost $28 billion would just not happen. Right now it is entirely rational behaviour for the individuals concerned as even if the institution loses the money the individual gains a reward irrespective of success. The worst sanction they can get is to be given a large sum of money to leave. Indeed, only in the nuclear situation where the business is bankrupt will the employees potentially lose out, but let us bear in mind those long suffering shareholders who are wiped out by bankruptcy.

The concept of Super Employee should also spread to fund managers, because of course the wiped out shareholders are not the individuals managing the money on behalf of millions of small investors in pensions, insurance funds and unit trusts. The fund managers make the decisions to invest or not. They get the big bonus if things go well, it is your pension that gets it in the neck if they fail and they just move on. Because they want to be paid large bonuses they put pressure on the CEOs to make bigger returns, which generally requires the CEOs taking on more risk. Because the CEO is not around for long, he or she happily complies with this. This suits the investment banks that make their real money from juicy transaction fees. The result is a focus on personal gain through visible action (such as an acquisition) rather than steady improvement.

All these institutions feed off each other and when something goes wrong with one it affects the others. However, the individuals who run them are not affected financially and the incentives put in place to “motivate” them do not encourage the right behaviour in all cases. There will always be failures, but the law inadvertently over-protects the people with the power to make a difference. The solution is to change the balance of legal power to a more balanced position where enforcing a rebate is relatively easy provided loss can be proven.

Once that is done, hopefully the danger of perverse incentives encouraging CEOs (and others such as traders) to take foolish risks will diminish. I don’t think that it will stop risk taking but rather align interests strongly. After all there can still be great rewards for success. Nor will it stop CEOs trying to wriggle out of their commitments as it will still be hard to prove that it was the CEO’s fault, but the key element is that if they are to blame it would be possible to get the money back. This is currently impossible unless a crime has been committed. Most of all, it would leave the problem where it deserves to be left – with the shareholders. It would be their decision to sue or not and their decision to give a CEO an easy contract or not, their decision to hold the CEO accountable if they wish.

Summary
The crisis involves the destruction of institutions by the individuals who run them
The individuals who run them have employment law on their side
The individuals can earn large sums by taking risks with the institution whilst experiencing no risk themselves
All the institutions are interlinked so destruction of one can lead to the destruction of the others
The public interest is therefore at stake and yet there is no accountability
Super Employees will lose the protection of normal employment status making it much easier to claw back remuneration using existing laws
Super Employees will only take well calculated risks if they too can lose all they have made

Justin Wheatley