Boomer Banker

On 19 April 2021 the European Central Bank released its review of the reliability and comparability of  internal risk models used by the larger banks for their risk weighted assets. Although the summary headline on their website seems to be a relatively positive message, digging into the details suggests that there are real issues in the use of these models. The review of the individual bank models “resulted in a 12% increase, or about €275 billion, of risk-weighted assets for the investigated models” which reduced the capital adequacy for these banks by 70 basis points. That is not an insignificant change in the capital levels.

There are of course two questions that remain open. The first was well captured in a speech by Andrew Haldane in 2012 at Jackson Hole, Wyoming, USA titled “The dog and the frisbee.” This speech is well worth reading on a regular basis. In looking at risk models, the research behind the speech comes to the following conclusion: “Complexity of models or portfolios generates robustness problems when understanding a complex financial system over plausible sample sizes. More than that, simplicity rather than complexity may be better capable of solving these robustness problems.”

The second question relates to the fundamental nature of human beings. Or rather foxes. Do we want the foxes in the banking system guarding the henhouses (e.g. risk and capital adequacy)?

Yesterday a coalition of investors with more than $11 trillion in assets under management called on banks “to set enhanced net zero targets for 2050 or sooner with interim targets to be included, scale up green finance and withdraw from projects that fail to meet Paris Agreement goals.” The Institutional Investors Group on Climate Change issued this demand via a press release that is available on their website. This call to action is just another example of the rapidly increasing pressure on banks to align their financing with the need to meet the Paris Agreement goals.

Of interest is that among the investors, there are also many asset management arms of banks or other financing sources. These include Fidelity, Handelsbanken, KBI, Nordea, Northern Trust, PIMCO, Robeco and SEB. It would be of interest to note if the asset management arms are putting the same pressure on their internal financing activities as they are putting on other financial institutions.

In any case it is clear that banks and asset managers must take seriously the goals of the Paris Agreements and ensure that their financing activities are aligned with meeting those goals.

About one week ago I wrote about Credit Suisse and the issues they were facing that has led to reduced bonuses for the very top of the bank as well as the loss of employment for many responsible for the activities that have led to losses. Today the Financial Times reported that these losses have led to a reduction in the bonus pool for all of its staff – an estimated reduction of $600 million in the bonus pool. As noted in the FT article: “(I)ts top executives face a dilemma over paying out bonuses to support staff morale, while shareholders nurse losses tied to the fallout from Archegos and Greensill.”

This dilemma highlights an important change in the investment banking culture that has arisen from the shift from an ownership form that was primarily partnerships to one that is primarily publicly owned banks. That shift in ownership structure occurred more or less simultaneously with the end of Glass-Steagall in the United States and the Big Bank in London. Whilst much of the criticism over the current structure of the financial industry focuses on those two changes, it could be argued that the end of partnerships are just as responsible for the excesses and problems that arise in the financial system.

Under a partnership gains and losses from business were shared among the partners. That approach built into the business a natural risk management function as partners and those seeking to be partners acted responsibly to curb risk activities that could lead to losses. The current structure with public ownership eliminates that natural (and one could argue more effective) form of risk management. Under public ownership the upside goes to the staff (or at least the highly paid and powerful members of staff) and the downside goes to the shareholders. If the problem is serious enough the downside is covered by public funds to ensure that a too big to fail bank survives.

So as we look for solutions to the underlying issues facing the banking industry, perhaps a return to true partnerships for investment banking activities should be considered.

A large network of central banks that takes seriously the issue of climate change has developed over the last few years . The Network for Greening the Financial System has nearly 90 members and 13 observers. This network covers all major financial regulators and many multi-national financial institutions. As noted on their website: “The Network’s purpose is to help strengthening the global response required to meet the goals of the Paris agreement and to enhance the role of the financial system to manage risks and to mobilize capital for green and low-carbon investments in the broader context of environmentally sustainable development. To this end, the Network defines and promotes best practices to be implemented within and outside of the Membership of the NGFS and conducts or commissions analytical work on green finance.”

This network has a variety of work streams and provides resources and reports to support banks seeking to be proactive in addressing climate change. In a recent report issued in March 2021, current market dynamics relative to sustainable finance were analysed leading to five key takeaways:

This list is a very useful summary of the work that needs to be done. Hopefully the network and its members will immediately begin addressing these issues in their daily work. Hats off to regulators who are leading to develop a financial system that addresses the key issue of our time: climate change. Now it is time for the banks they regulate to also step up their actions in this area.

A recent article in The Economist regarding China’s approach to Hong Kong had within it a hidden pearl of wisdom. Whilst overall critical of the Chinese policy in Hong Kong, there was also a focus on the impact on the financial sector in Hong Kong. The financial sector has a business model that is traditionally “Western” in its orientation with the goal of being part of the international “free market” and “Neo-liberal” system. But does that business model deliver results for society?

As noted by The Economist, Chinese leadership has “an ideological distaste for high finance among party bosses who see the proper role of banks as supporting the real economy by lending to businesses that make and sell tangible products.” That comment captures very well an appropriate criticism of the “Western” approach to the financial system that has unfortunately not focused on the real economy but rather on making money from money and trading financial products without considering if those activities deliver any real value to society other than supporting high levels of bonuses for bankers.

Too often when mistakes are made at banks there are no consequences for senior management. This week Credit Suisse made it clear that consequences, even for senior managers, will occur when there are serious errors made that lead to losses. This is a hopeful change in the culture of banks that should only be encouraged.

For Credit Suisse it may be cold comfort for the shareholders but senior managers from both the commercial and risk management areas of the bank have paid the price for the cost of three recent incidents that call into question the ability of Credit Suisse to manage its risk positions. This story began to appear in public with issues related to Greensill Capital. On 11 March the Financial Times reported extensively on various issues related to this exposure including that headquarter based senior risk managers overruled risk managers in London regarding a loan to Greensill. The exposure for Credit Suisse turned out to not only be related to loans to Greensill but also to funds managed by Credit Suisse that had significant exposures to Greensill related debt instruments. The overall losses related to Greensill at Credit Suisse will probably never be fully known but they are likely to be in excess of $1 billion.

The second risk management issue arose relative to Luckin Coffee in China. As reported by Bloomberg, “’I’ve had I don’t know how many dinners with him in Beijing and he’s absolutely the poster child for what we want to do,’ Tidjane Thiam said at a conference last year when he was still head of the bank.” These dinners were part of an integrated strategy of Credit Suisse to provide both private banking and commercial banking services to wealthy individuals. As Thiam went on to say “He’s a dream client.” More likely a nightmare at this point as Luckin Coffee has collapsed due to an accounting scandal that has led to loan defaults.

But for Credit Suisse three times is not a charm but rather just more bad luck (or bad risk management). As reported by the Financial Times on 6 April, Credit Suisse is facing losses of $4.7 billion on its exposures to Archegos through its prime security lending and synthetic equity financing activities. For regulators and shareholders there is limited transparency on these activities so that large losses can surface unexpectedly.

But among this tale of woe there is a bright side. Again from the Financial Times of 6 April is a report that at least seven senior managers have lost their positions. Furthermore as reported: “The bank’s senior executives have had their bonuses for the year withdrawn, while outgoing chair Urs Rohner waived his SFr1.5m chair fee after facing criticism over his unchanged total pay of SFr4.7m for the year.” Clearly consequential actions but limited in comparison to the losses realised by Credit Suisse and the end of a share buy back program and a significant reduction in the dividend payment. But at least a step in the right direction of creating management accountability.

On March 11 the Financial Times reported that HSBC was successful in securing investor support for HSBC’s plan to address climate change. By doing so HSBC was able to avoid a vote at its shareholders annual general meeting on a proposal to revamp its financing of coal and address other financing for companies and projects with a carbon intensive footprint. But HSBC is far from the worst among large banks relatieve to carbon footprint financing as detailed in a report issued by a coalition of NGOs focused on climate change. HSBC ended up ranked 11th in that report and was only with total lending on fossil fuels about a third of the amount lent by JP Morgan Chase – the largest lender with more than $300 billion lent over the time period covered.

This report used Bloomberg data to analyse 60 large banks and their financing of fossil fuels over the years since 2015 when the Paris Climate Accord was agreed. In that time more than $3.8 trillion was lent by these banks to support fossil fuels. Although there was a decline in 2020 relative to both 2019 and 2018, the amount lent was still greater than in 2015 and 2016. And consistently more than $700 billion was lend in every year since the Paris Climate Accord. What makes the report extremely valuable is the ability to sort the underlying data by a variety of criteria including each bank’s policies regarding fossil fuels. Furthermore there is a detailed description of the methodology used for the report that provides useful transparency.

In cooperation with RedMoney Seminars, I will be repeating a course on values-based banking in June. The course is two three hour sessions on 29 and 30 June starting at 10 am Singapore/7 am UK time. More information including how to register is available at this link.

The inability of parts of the US political system (e.g. the vast majority of the Republican Party) to rationally consider the impact of climate change is stunning, A recent article in The Washington Post cited a letter from members of the US Senate Finance Committee to Jerome Powell, Federal Reserve Chair, expressing their concern that the Federal Reserve should not focus on environmental concerns as it was beyond the remit of the Federal Reserve to do so. The letter states: “We urge you to refrain from taking any additional actions with respect to climate-related risks that would impose certain costs for uncertain benefits.”

But one of the key roles of the Federal Reserve is to look at systemic risk. Therefore it was of interest to see on the very same day of the letter in the US, a blog post from Luigi de Guindos of the European Central Bank that goes into detail on the risks facing the economy and hence the banking system from climate change. This post goes into detail on the approach used that leads to the conclusion that there is real systemic risk from climate change. Whilst the focus of the stress test was Europe, it is hard to believe that a similar stress test would have an alternative conclusion in the US.

Perhaps it is fine for the Republican members of the US Senate Finance Committee to want the Federal Reserve to bury its head in the sand regarding the risk of climate change. One can only hope that when those risks are realised, these same members will be happy to pay for the losses incurred by ignoring those risks. But of course those payments will not be from the individual senators but rather from US society as a whole.

Compensation for bankers, especially bonuses, are a never-ending story of unhappiness. Many of the bankers receiving large bonuses are always convinced that they did not receive enough. But investors, regulators and society are quite right to ask what are the returns they receive in return for handsome payments to individuals. The challenges were well captured in an article and Lex comment in the Financial Times on 12 March.

The article noted that for Deutsche Bank the total bonus pool of nearly €2 billion was more than 16 times the profit earned by the bank. Investors, and specifically Union Investment one of the largest German investors, are not receiving any dividend. The article goes on to note that whilst the senior executives agreed to forego one month salary as solidarity for those suffering from Covid-19, this “sacrifice” was more than offset by the high level of bonuses. Does the Deutsche Bank senior management really believe that this comparison will not be seen?

Of further note in the article was that Deutsche Bank wanted to pay even more in bonuses but was stopped by the European Central Bank. Of further interest was that of the top earners at Deutsche Bank (e.g. more than €1 million), more than 10% had left the bank and the amounts included severance payments. This sounds like a great way to reward failure rather than success.

Lex focused not only on Deutsche Bank but also on Credit Suisse where the comment also covered the impact of the ongoing Greensill scandal. Lex pointedly notes that senior Credit Suisse staff has been known to speak at the World Economic Forum in Davos on responsible leadership whilst implying that the actions of the same management relative to their own compensation calls into question their own responsible leadership. Lex goes on to note that there are very different views from within the banker bubble and outside that bubble in general society. Lex concludes: “Banking’s social contract is constantly rewritten. Paymasters should proceed warily.” Words of wisdom that I doubt will be followed.