Last year was a watershed year for the financial markets in many respects, as the ‘great unwinding’ of multi-year leverage made itself felt across many asset classes. Anything or anyone that relied on debt to ‘juice’ investment came under pressure as liquidity dried up, loans were called in and asset values plunged under the weight of collapsing confidence and forced selling. The demise, or near-demise, of many hitherto blue-chip institutions - and the occasional country - created plenty of opportunities for hysterical headline writing.
What was less evident during all the sound and fury, however, was any real discussion on whether sacrosanct business models had contributed to the systemic failures. Sure, we’ve had some comment that bank business models had ‘asymmetric’ risk - of the ‘heads I win, tails you lose’ variety - built in, with staff incentivised to take on ever-greater risk to maximise short-term paper profits and their own bonuses, with little by way of penalty if the trades didn’t actually work.
What we have not seen so far is much analysis of the degree to which underlying business models - rather than risk management systems - failed for many banks and financial institutions.
Take private banking, for example. (Here I need to disclose a personal interest - I run a firm that offers independent wealth management and investment advice.)
The term ‘private banking’ used to conjure up images of slightly stuffy institutions with ancient roots and even more ancient wood-panelled offices. These outfits were conservative to the core and focused on providing discreet - even secretive - services to their blue-blooded and very wealthy clients. Everybody else used the local ‘high street’ bank - poor them.
Things began to change in the 1980s when, under the twin impetus of deregulation and new entrants, private banking started to morph into a cross between the traditional private banking of old and the new breed of more gung-ho investment banks that were all about maximising returns for any given level of risk. For a while this seemed a good idea. Clients were presented with more varied investment opportunities that helped them maximise returns, and banks were able to grow their business.
However, pumped up by the febrile atmosphere of the Greenspan era of easy credit and ever-more lax lending policies, things started to spiral out of control. Private banks started to lose sight of their historic - ‘customer focused’ - business model. The priority became, above all, growth in assets under management (AUM), rather than developing the longer-term relationship with their clients. (Bank first, client second?) It seemed that the priority was more on bringing in new business, rather than making sure existing assets were looked after in the same, dull, prudent fashion of old. Institutions that had, for generations, prided themselves on ‘putting the client first’, sacrificed this in favour of an increasingly aggressive ‘sales focused’ business model in which distribution of products - mostly self-created, since this type of product carried bigger margins than using someone else’s - took precedence. Private bankers became ever-more subject to targets for product sales, as well as the acquisition of new assets.
An easy way to meet these increasingly onerous targets was for private banks to encourage clients to take on leverage - that’s debt, to you and me. Let’s say, as a private bank, you had a client with US$2 million in AUM. By going to the client and offering some extra leverage, say, 50 per cent, this particular client’s account would jump from AUM of US$2 million to US$3 million. Even better if the proceeds of that leverage were invested in some ritzy, internally manufactured ‘structured product’ which the bank’s computers said should work. All of a sudden, that US$2 million account has been multiplied several times - and the bank’s AUM growth looks spectacularly impressive.
What is much less clear is whether the bank - and more importantly, the client - was sufficiently cognisant of the fact that leverage multiplied their risk exponentially and even more so if invested in a leveraged investment. Judging by the truly desperate stories we have heard over the past few months from outraged investors, it is clear they were not properly informed of the risks involved - the list of private banks that look to have been guilty of fiduciary shortcomings is long and global.
That’s not to say all private banks have failed their customers. There are undoubtedly many that have stayed true to their historic roots and viewed the inebriation among their peers with quizzical bemusement.
I cite, as one example, the private bank I use in London - C Hoare & Co. This is a true private bank, still owned by the same family that established it in the same premises in The Strand in 1672 - one of a small band of businesses that can trace its direct roots back more than 300 years. The key is: the family still owns it; the family still has its money invested in the bank, and the partners still have the personal liability (financial and reputational) that goes with that. The mind becomes wonderfully concentrated when it’s your capital at risk. Suddenly, short-term profits and short-term targets become much less important than minimising risk in pursuit of a very long-term objective. Profits are still important, but not to the extent that they require corners to be cut. As a result, this particular private bank focuses on taking deposits, lending money to its customers and helping out a bit with investment. That’s it. I would like to think - and hope - that as the current financial shake-out continues and the process of re-regulation begins, many private banks will decide to go back to the same sort of model. It’s what they once did best - look after their clients’ assets in a way that focuses on longer-term returns for those clients, rather than maximising their own revenue in the short-term. The objective of bank and customer comes into alignment once more.
Private banking as an industry used to make a virtue out of being dull. Maybe, with hindsight, that wasn’t such a bad thing.
The writer is founder and CEO of Javelin Wealth Management Pte Ltd. He is a certified financial planner (CFPCM)
2 comments:
Private banks have failed their customers
Stephen Davies
10 June 2009
Last year was a watershed year for the financial markets in many respects, as the ‘great unwinding’ of multi-year leverage made itself felt across many asset classes. Anything or anyone that relied on debt to ‘juice’ investment came under pressure as liquidity dried up, loans were called in and asset values plunged under the weight of collapsing confidence and forced selling. The demise, or near-demise, of many hitherto blue-chip institutions - and the occasional country - created plenty of opportunities for hysterical headline writing.
What was less evident during all the sound and fury, however, was any real discussion on whether sacrosanct business models had contributed to the systemic failures. Sure, we’ve had some comment that bank business models had ‘asymmetric’ risk - of the ‘heads I win, tails you lose’ variety - built in, with staff incentivised to take on ever-greater risk to maximise short-term paper profits and their own bonuses, with little by way of penalty if the trades didn’t actually work.
What we have not seen so far is much analysis of the degree to which underlying business models - rather than risk management systems - failed for many banks and financial institutions.
Take private banking, for example. (Here I need to disclose a personal interest - I run a firm that offers independent wealth management and investment advice.)
The term ‘private banking’ used to conjure up images of slightly stuffy institutions with ancient roots and even more ancient wood-panelled offices. These outfits were conservative to the core and focused on providing discreet - even secretive - services to their blue-blooded and very wealthy clients. Everybody else used the local ‘high street’ bank - poor them.
Things began to change in the 1980s when, under the twin impetus of deregulation and new entrants, private banking started to morph into a cross between the traditional private banking of old and the new breed of more gung-ho investment banks that were all about maximising returns for any given level of risk. For a while this seemed a good idea. Clients were presented with more varied investment opportunities that helped them maximise returns, and banks were able to grow their business.
However, pumped up by the febrile atmosphere of the Greenspan era of easy credit and ever-more lax lending policies, things started to spiral out of control. Private banks started to lose sight of their historic - ‘customer focused’ - business model. The priority became, above all, growth in assets under management (AUM), rather than developing the longer-term relationship with their clients. (Bank first, client second?) It seemed that the priority was more on bringing in new business, rather than making sure existing assets were looked after in the same, dull, prudent fashion of old. Institutions that had, for generations, prided themselves on ‘putting the client first’, sacrificed this in favour of an increasingly aggressive ‘sales focused’ business model in which distribution of products - mostly self-created, since this type of product carried bigger margins than using someone else’s - took precedence. Private bankers became ever-more subject to targets for product sales, as well as the acquisition of new assets.
An easy way to meet these increasingly onerous targets was for private banks to encourage clients to take on leverage - that’s debt, to you and me. Let’s say, as a private bank, you had a client with US$2 million in AUM. By going to the client and offering some extra leverage, say, 50 per cent, this particular client’s account would jump from AUM of US$2 million to US$3 million. Even better if the proceeds of that leverage were invested in some ritzy, internally manufactured ‘structured product’ which the bank’s computers said should work. All of a sudden, that US$2 million account has been multiplied several times - and the bank’s AUM growth looks spectacularly impressive.
What is much less clear is whether the bank - and more importantly, the client - was sufficiently cognisant of the fact that leverage multiplied their risk exponentially and even more so if invested in a leveraged investment. Judging by the truly desperate stories we have heard over the past few months from outraged investors, it is clear they were not properly informed of the risks involved - the list of private banks that look to have been guilty of fiduciary shortcomings is long and global.
That’s not to say all private banks have failed their customers. There are undoubtedly many that have stayed true to their historic roots and viewed the inebriation among their peers with quizzical bemusement.
I cite, as one example, the private bank I use in London - C Hoare & Co. This is a true private bank, still owned by the same family that established it in the same premises in The Strand in 1672 - one of a small band of businesses that can trace its direct roots back more than 300 years. The key is: the family still owns it; the family still has its money invested in the bank, and the partners still have the personal liability (financial and reputational) that goes with that. The mind becomes wonderfully concentrated when it’s your capital at risk. Suddenly, short-term profits and short-term targets become much less important than minimising risk in pursuit of a very long-term objective. Profits are still important, but not to the extent that they require corners to be cut. As a result, this particular private bank focuses on taking deposits, lending money to its customers and helping out a bit with investment. That’s it. I would like to think - and hope - that as the current financial shake-out continues and the process of re-regulation begins, many private banks will decide to go back to the same sort of model. It’s what they once did best - look after their clients’ assets in a way that focuses on longer-term returns for those clients, rather than maximising their own revenue in the short-term. The objective of bank and customer comes into alignment once more.
Private banking as an industry used to make a virtue out of being dull. Maybe, with hindsight, that wasn’t such a bad thing.
The writer is founder and CEO of Javelin Wealth Management Pte Ltd. He is a certified financial planner (CFPCM)
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