Risk is cool and sexy. It's also what destroys financial institutions and gets executives fired.
At the end of last week, I wrote an article about "the most important thing" in banking. The thing -- or rule if you will -- had nothing to do with sophisticated hedging strategies, revenue growth, or capital allocation. It also didn't involve wining and dining wealthy clients or wooing the executives of multinational corporations.
It was instead much more pedestrian in nature.
The key to running a world-class and investor-friendly bank is to avoid underwriting bad loans. That's it. There's nothing more to it. Okay, well, perhaps there is. But the other things are easy. It's the prudence that's so difficult to come across on Wall Street -- or, for that matter, Main Street.
To this day, the writer that best articulated the qualities of a good banker was Fred Schwed Jr., the author of the post-Depression era classic "Where Are the Customers' Yachts?"
The conservative banker is an impressive specimen, diffusing the healthy glow which comes of moderation in eating, living, and thinking. He sits in state and spends his days saying, with varying inflections and varying contexts, "no." He is at the top, or close to the top, of one of those financial empires whose destinies have been guided with such prudence, shrewdness, and soundness that today the Great House has darn near as much money and prestige as it had in 1900.
He says "yes" only a few times a year. His rule is that he reserves his yesses for organizations so wealthy that if he said "no," some other banker would quickly say "yes." His business might be defined as the lending of money exclusively to people who have no pressing need of it. In times of stress, when everybody needs money, he strives to avoid lending to anybody, but usually makes an exception of the United States government.
The point is that a good banker, a conservative banker, manages risk by saying "no." That is, by not underwriting bad loans. Had the nation's largest banks actually practiced this timeless lesson in the lead-up to the financial crisis, there would have been no crisis.
But that's obviously asking too much.
What enticed me to write this was a chart that I came across in a presentation that U.S. Bancorp's (NYSE:USB) executives gave at their annual investor day last week. The chart uses five circles to depict how much money each of the nation's five largest commercial banks lost between 2010 and 2012 as a result of malfeasance in and around the crisis, at the center of which was imprudent underwriting.
Here it is:
From left to right, the banks represented here are Bank of America (NYSE:BAC), JPMorgan Chase (NYSE:JPM), Citigroup (NYSE:C), and Wells Fargo (NYSE:WFC) -- as well as, of course, U.S. Bancorp. The settlements that each of these lenders signed onto include, among others, ones with Fannie Mae and Freddie Mac, private-label investors in mortgage-backed securities, and various government regulators.
The thing to note is the vast difference between the losses suffered by the big four and those at U.S. Bancorp. What, besides size, explains this? It's simple. U.S. Bancorp never lost sight of Schwed's words -- which, mind you, are anything but revolutionary in the world of risk management.
And things haven't changed. Here's U.S. Bancorp's chief credit officer explaining the bank's philosophy on risk at its investor day.
[W]e've used the word conservative a lot. I think that's appropriate when we talk about the culture of the bank. And we've also used the word prudent. I like the word prudent because it means that you're actually thinking about what you're doing, you're evaluating it. That's what we do, we evaluate the risk. We're risk managers, and then you take action on that. So that's -- prudent is a good word to describe our credit culture.
In sum, it's easy to get swept up in the sophisticated games Wall Street plays. But it does so merely to enrich itself, and most certainly not for the benefit of investors. The good banks today are the same as the good banks 100 years ago. They manage risk, plain and simple. And, by doing so, they maximize return.
John Maxfield owns shares of Bank of America. The Motley Fool recommends Bank of America and Wells Fargo. The Motley Fool owns shares of Bank of America, Citigroup, JPMorgan Chase, and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.