19 Jun. 2012 | Comments (0)
Despite the new regulatory regime, big banks continue to suffer from significant governance challenges. Boards have limited time to wade through the substantial complexity of the banks' businesses. This poses significant risks not just to banks but potentially to the entire economy during the next downturn.
Bank boards need simple and commonsense — but powerful — tools to cut through the complexity and push management behavior in the direction of responsible risk taking.
Here is one that could help a lot: Boards should not judge managers (just) by earnings.
Bank executives' performance is typically evaluated in large part on the basis of earnings. But as the financial crisis brought home, not all bank earnings are created equal. Those driven by additional business from satisfied customers are worth much more over the medium to long term than those achieved by trading, expense cuts, or increases in banks' net interest income. The first leads to a sustainable earnings stream. The others, by their nature, do not grow the underlying business over time. In the wake of the financial downturn, much ink has been spilled on the subject of trading income and its risks. But net interest income, with its disproportionate impact on the bottom line, is perhaps the least understood of banks' earnings streams.
Net interest income is a fundamental part of banking. Banks collect deposits in return for paying a certain rate of interest, and they use the deposits to make loans at a higher rate. The spread between those two rates — the net interest margin — fluctuates for a number of reasons, most of which are out of banks' control. A key factor is the external interest-rate environment. A steep yield curve, on which long-term rates are much higher than short-term ones — as can happen when the Federal Reserve drives down short-term rates with an easy money policy — tends to increase net interest income, whereas a flat one does the opposite.
Suppose a steepening yield curve drives a bank's net interest margin from 250 basis points (2.5 cents on the dollar) to 350. That added penny on the dollar falls directly to the bottom line. The bank doesn't have to do any more work, open any more branches, or answer customer calls any more quickly. And when the yield curve flattens, revenue goes down without any associated decrease in costs. So changes in net interest income can have a powerful effect on a bank's earnings while giving no indication of how well the bank is serving its customers or how likely those customers are to stick around.
Changes in net interest income can significantly mask the underlying strength (or weakness) of a bank's business, in some cases for years. Indeed, in the recent past a full range of banking "experts" have greatly underestimated the negative impact of falling net interest income (and thus greatly overestimated banks' earning power) as the interest-rate environment became unfavorable, leading to earnings shortfalls and highlighting poor capital allocation.
In my experience, bank boards and even management teams do not fully differentiate between net interest income and customer-driven net income changes. Boards should take steps to isolate changes in each and evaluate their senior management teams not according to aggregate earnings but according to the elements of earnings they can affect.
Boards would also be well advised to pay close attention to indicators other than earnings. Perhaps the most crucial metric is customer satisfaction. More business from happy customers represents quality earnings. Continuing business from unhappy customers who feel stuck — because of the increasing prevalence of fees to close accounts, the time needed to retype automatic bill-payment addresses at another bank, and confusion about whether another bank's products are equivalent — represents a real risk for today's banks and a real business opportunity for competitors and new entrants. The current disconnect between customer dissatisfaction with the banking industry (relatively high) and customer churn levels (relatively low) is simply not sustainable over the long term.
This blog first appeared on Harvard Business Review on 06/12/2012.
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