the widening financial gyre

TURNING and turning in the widening gyre
The falcon cannot hear the falconer;
Things fall apart; the centre cannot hold;
Mere anarchy is loosed upon the world,
The blood-dimmed tide is loosed,

(from William Butler Yeats’ The Second Coming (1919))

Sometime in the late 1980s bank executives discovered that their institutions should be “high performance companies.” It was no longer possible, after two decades of rampant disintermediation and the buffeting forces of deregulation, to generate quiet but respectable profitability by running highly efficient operations. Net interest margins had been stable enough to assure good profits to a protected business if one did not make bad loans. But banks had come face to face with fierce new, largely unregulated competitors and they discovered it was no longer business as usual.

Enter the management consultants. By the time I entered the financial industry in 1995 the exhortations from McKinsey & Company, perhaps the most influential of all for the industry, to stretch bankers’ goals and vision toward high performance had become a daily mantra among bank executives. We all read Jim CollinsBuilt to Last and Good to Great, inspiring works (though their lessons were not always heeded).

One of the axioms to be learned was that high performance banks should deliver an return on equity (ROE) of nothing less that 12 percent; indeed, the expectation (and for a while the norm) became 15-20%. And in a world in which net interest margin could not get us there, the only alternatives were more and more fee-income businesses and leverage. The former involved new ventures and business combinations–the beginning of the rise of the new American universal bank–and the latter entailed greater and greater risk with other people’s money. The math is unavoidable.

So while expenses had to be hacked out of the traditional bank in order to retain some success in an increasingly volatile and often yield-narrowing interest environment–read outsourcing, offshoring, layoffs and our mortgage foreclosure debacle. And new sources of revenue had to be discovered. The drive to increase fee income and increase leverage beyond official limits–read securitization and other off-balance sheet activities–led almost everyone in the financial industry down an inexorable path to systemic financial instability. The rest, as they say, is history. (There is of course a small problem with this history: it is coming around rather faster these days.)

Yet without profound industry, regulatory and market restructuring we have not readjusted our expectations. Indeed, all other things remaining the same, we probably cannot readjust them. It is likely that the executives of our gigantic financial institutions are still aiming at the same goals, that performance bonuses, though apparently sometimes inapplicable to CEOs, are still tied to the same results. Indeed, McKinsey & Company has just produced a report entitled In search of a sustainable model for global banking (for public access to the shorter version, see here). In its report the Company correctly notes the following:

In 2010, the US and European banking industries delivered Returns On Equity (ROE) of 7.0% and 7.9% respectively. Even when these returns are “normalized” by assuming loan losses equivalent to the 2000-07 average plus a “buffer”, the 2010 figures would only increase to 9.3% in the US and 9.2% in Europe. At this level, banks’ ROE is still some 1.5 percentage points below their cost of equity, which averaged globally 12% last year. Even before the industry has digested the additional capital requirements from Basel III, Systemically Important Financial Institutions (SIFI) surcharges and other national “finishes”, developed country banking is facing a significant “return gap”. . . .
Achieving ROE of 12% by 2015 will require US and European banks to increase their profits dramatically. This is asking a lot given that, over the past decade, fewer than one in ten US and European banks succeeded in improving both their cost to income ratio and their revenue margin.

McKinsey then gamely suggests a number of ways in which these institutions might try to achieve the goal of 12% ROE by 2015. The array of possibilities indicates that managements will be trying to do more of what they were doing in the runup to the crisis, not less. True, McKinsey does not encourage recklessness but it is hard to see how such might be avoided. A philosophical reflection suggests as much:

Banking is not the first industry to grapple with a profoundly changed operating environment. Telecommunications players, for example, experienced an upheaval in the late 1990s when regulators helped usher in new competitors and technologies by removing monopolies. In response, incumbent companies undertook far-reaching transformations, reducing cost and staff numbers by 30-50%, and improving productivity by a similar quantum.

And we see efforts to implement this advice playing out all around us as the large banks announce huge planned layoffs and new ventures.

Yet herein lies the dilemma: even if some financial companies do succeed in attaining heroic levels of performance, what about the ones that don’t? Martin Wolf, member of the Independent Banking Commission in the UK, which last week delivered the much publicized Vickers Report, put the problem succinctly to reporters:

If you live in a world in which the real rate of interest on safe government bonds, bonds that the world regards as safe, is about half a percent or less, you might wonder whether you can reasonably expect a reasonably safe return of 15 percent on equity in a bank . . . [Shareholder expectations] are just a little bit unrealistic.

In a turbulent and gloomy environment, here and even more so in Europe, the high performance play is a zero sum game that does not augur well. Who will keep us safe from those that lose?


Last week it was reported that Lloyds Bank has a target ROE of 14.5%. This is consistent with the expectations described in this post. Today, Martin Wolf drives his point home in another succinct analysis of this expectation:

The conclusion is quite simple. If a bank says it needs a real return on equity of 15 per cent, to obtain funds from investors, it is telling you that it is running an enormously risky business. The question you need to ask yourself is this: can we afford to have financial institutions that are both so large and so essential and yet run such huge risks? I suggest the answer is: no. Make them safer. It really is not going to hurt.

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