Why Buying Banks Is a Horrible Idea

Let me start by saying that I like banks and bankers, generally. I worked for Barclays (NYSE: BCS  ) UK Retail for a few years and didn't meet a single member of management who was willing to overlook customers' needs. That's not to say that everything that happened was ideal for customers, but they were always in the equation. Having said that, let's look at why investors should be very worried about the future of banks, and the nature of banking customers.

Local boy named king bee
The LIBOR scandal involving interest-rate manipulation has gotten everyone all riled up. But people are riled up about the wrong things. Headline after headline is telling us how badly behaved bankers are, usually throwing out the bottle-of-bubbly quote from the Barclays investigation for good measure. But that doesn't tell me anything about the core problem, or how we're going to do anything other than what we've always done.

What we need to do is to think about the root problem: Banks were incentivized to manipulate LIBOR. As it turns out, banks were incentivized to issue bad home loans. To take on extra market risk. To look the other way when money launderers came calling. So maybe the problem isn't just that bankers are greedy, but that the institution of banking is a place where being greedy is also heavily incentivized. And that problem can be summed up in one phrase: shareholder value.

How did we end up here?
"The ultimate objective of our strategy is to create and deliver long-term sustainable shareholder value." That's a quote from Barclays' 2011 annual report. The problem with that quote is that it's just straight-up wrong. Barclays is a bank, and banks are shepherds of risk. They (should) manage risk in such a way that the company earns a return for taking on the risk of customers. By being better risk managers, the banks should make more money. But CEOs around the world, especially in the financial sector, have traded the idea of running a good company in for the idea of maximizing shareholder value -- which inevitably means they destroy shareholder value.

The underlying problem in the focus on shareholder value is compensation. Bankers are rewarded for creating value, but the biggest value is generated through the largest risks. That means that instead of producing sustainable value, bankers are making risky, short-term-focused transactions. The banks are rewarding them for being bad managers of risk.

It's only now that the world has come crashing down that banks are even beginning to see the value in managing risk again. Bank of America's (NYSE: BAC  ) 2011 annual report says, "We deliver to three groups of customers and clients the leading capabilities they need to manage their financial lives and businesses." This is a better picture than it painted in 2007, when shareholders were still firmly in the focus.

How can banks do well for shareholders?
The system of banks that focus on shareholder value is clearly broken. Over the past five years, big bank stocks are trading down more than 50%, almost across the entire sector. There are some notable exceptions to this trend. Wells Fargo (NYSE: WFC  ) -- which is where I keep my pittance these days -- is roughly flat over the past five years.

Looking at its stated goals from 2007, Wells Fargo's strategy was "to increase the number of products our customers buy from us and to give them all of the financial products that fulfill their needs." That's pretty darn focused on customer outcomes, and the company's stock has beaten our shareholder-focused companies like Barclays, HSBC, and Bank of America.

What alternatives are there?
Talking about how broken the system is doesn't help, unless we can think of a better system to replace it. A good place to start would be with most successful retail companies. Look at Buckle (NYSE: BKE  ) , one of my current favorites. The company has done well for investors over the past five years, with the share-price increase of 72%. That rise has been accompanied by a 71% increase in revenue.

But the company hasn't done this by focusing on maximizing shareholder value.

Instead, Buckle has emphasized its customer-focused, disciplined growth strategy for the past five years. You'll see that focus in every annual report. This focus on customers and growing sustainably is a good place for banks to look -- but it's not going to just happen. Banks have gotten used to growing as much as possible as quickly as possible. While there has to be a change in mentality, an even more important change has to come externally.

The bottom line
I don't like excessive regulation, but the fact is that banks have proved that the incentive model in place gives them no reason to try to play fair. If we truly want to see a change in banking, it's going to have to be an external push. Only then will banks revisit the need to treat customers well, and manage the risk that is in their portfolio. I can't say that I know how that's going to happen, but it's not going to happen without action.

Until it does, I have no desire to be a part of any bank that focuses on increasing shareholder value, instead of on providing customers with good products. Maybe the change is coming, but I have my doubts. For now, I like what Wells Fargo is doing, I like the value it's generated for investors over the past year, and I like that it's done that by focusing on customers. Until other banks figure that system out, I'd stay very, very far away.

There are a few other banks that seem to be doing things right, and the Fool has pulled together a report focusing on one of them. It's a smaller regional bank that our banking experts see as a promising investment. You can get all the details for free in "The Stocks Only the Smartest Investors Are Buying." Download a copy, get the inside scoop, and decide for yourself. Get your free report today.

Fool contributor Andrew Marder owns shares of Barclays, and he banks with Wells Fargo. The Motley Fool owns shares of Buckle and Bank of America. Motley Fool newsletter services have recommended buying shares of Wells Fargo and Buckle. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.


Read/Post Comments (8) | Recommend This Article (17)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 31, 2012, at 12:24 PM, Stonewashed wrote:

    If you think BOA wasn't (isn't) laundering money, I got a house for sale for you in a swamp somewhere.

    Other than that, your new found wisdom is a day late and a dollar short. People that were warning of this were swarmed and called everything from Nazis to extreme Leftists, especially on this sight.

  • Report this Comment On July 31, 2012, at 1:10 PM, fool3090 wrote:

    A suggestion for those who dislike "banks"... What the too-big-to-fail "banks" are doing is not banking, it's gambling. Real banks are the small community banks that take in deposits and make loans. Do business with your community bank and you will be a lot happier. The service is better, your money stays in your community and the fees are lower. Just a suggestion. You might even invest in one. Regardless, it's vastly better to bank with your hometown bank. My 2 cents.

  • Report this Comment On July 31, 2012, at 1:16 PM, TMFRedRam wrote:

    Fool3090,

    Thanks for reading. I love that idea (though I don't do it myself since I move a lot). Even if you can't invest in the business through its stock, using good local banks is often a great investment in the local community.

    Cheers, Andrew

    PS - Stonewashed, you're right, this would have been a great article to have written in 2005. Sorry for the late notice.

  • Report this Comment On July 31, 2012, at 1:50 PM, JacksonInVA wrote:

    I will never invest in banks in my life and am pulling my money (to the extent that I can) out of banks as a result of their poor judgement and insufficient regulatory environment. They represent too much risk.

  • Report this Comment On July 31, 2012, at 2:36 PM, TrojanFan wrote:

    The only banks who prudentially managed their risks are ones that are small enough that every day their presidents and CEOs come into the office they actually fear their own demise because they know that they fall below the FDIC's capability to take into receivership and "resolve".

    Until ALL banks are made to fear the prospect of their own insolvency their behavior will not change and until they are deprived of the financial resources and power to influence politics and regulation in such a way as to make themselves unregulatable they will not fear any consequences for their actions. As long as corporate personhood is allowed to persist and these corporate "persons" funnel virutally infinite sums to the campaigns of the very politicians who appoint their regulator it should come as a surprise to NO ONE that none of them have any meaningful and operationally crippling enforcement action brought against them. Until they are made to fear the law, they will not obey it.

    Fear is the key. That is the prime motivator and it's is much more powerful then greed.

    Fear and intimidation is the antidote to hubris and we need to bring fear back into the system in a serious way.

    The most efficient (speediest) way to do this is to allow another systemically important institution to fail like we did with Lehman and just let the chips fall where they may. That way we can get all of this behind us and get on with the rest of our lives.

    Sure, there will be another one or two years of terror and it will bring pain upon the entire nation, but in five years time we'll be growing like gangbusters and the corruption will be washed out of the system the way it was in the 1930s.

    The alternative is to coddle the industry while it "grows" its way out of its problems. This entails keeping the economy at stall speed in a suspended state of animation for the better part of another decade or more. This is the method that Japan decided to employ in dealing with its very politically integrated and influential financial institutions and it lead to the Lost Generation that's been so widely discussed in economic circles.

    If we decide to coddle the industry in the same way we shouldn't expect a different result.

  • Report this Comment On July 31, 2012, at 6:30 PM, sirjenowic wrote:

    How does Wells Fargo add value to customers when they charge fees for absolutely everything and treat all their banking employees like crap? I've heard horror stories about former employees. It is one of the worst banks to have your money with and the worst to work for.

  • Report this Comment On August 01, 2012, at 12:13 AM, chopchop0 wrote:

    Ive stuck to the rule of only investing in V and MA as my "financial" stocks. Staying away from banks has been healthy for my portfolio

  • Report this Comment On August 02, 2012, at 1:50 PM, TrojanFan wrote:

    Wow, that was fast!!!

    Two days after my post and the market is dispensing swift justice against Knight Capital Group (KCG).

    Now if only the market would allowed to assisinate some truly large and systemically significant institution with a market cap of say.... I don't know maybe $100 billion+ THEN we'd really be accomplishing something truly great!!

    I'm not holding my breathe, but I do continue to hope and pray for such a systemic purging.

    Vomitting is how the human biological system purges poison. The market needs to be allowed to do the same thing and finish the dirty, efficient and necessary work that it began in 2008 but was not allowed to carry out to it's sensible conclusion because of government meddling to stem the rout.

    I support aggressive regulation, but I'm even more supportive of allowing the market to carry out it's work of creative destruction even when it hurts everyone in the short term for the sake of preserving long-term prosperity and access to opportunity to all.

    What we have today is a handful of politically entrenched monopolies who have seized control of everything. The only way to stop them is to allow them to be destroyed.

    If we stop giving them monetary assistance that is precisely what will happen and we have to just take it on faith that things will sort themselves out properly in the long run.

    It sucks if you're in your 70s or 80s, but if you're overexposed to equities at that age don't you have only yourself to blame for that?

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