Over and over again, banks have let investors down. The reason is simple -- so simple that it defies logic that banks have made the same mistake countless times since the advent of banking.
New research released by the New York branch of the Federal Reserve shines light on exactly why banks just can't help making the same mistakes over and over. The study is a sobering reminder to investors of the dangers of bank stock investing.
A business built on risk
Banks accept deposits from the community and then use those funds to make loans. The bank's profit is the difference between the interest charged on those loans and the interest paid out on its deposits.
Banks fail when they extend high-risk loans that are not likely to be paid back. When a loan isn't repaid, the bank loses not only the potential interest income, but also the underlying deposits used to fund the loan.
In the pre-FDIC era of banking, depositors would lose their savings at the same time that the bank failed, and shareholders lost their investments. But since the banking crisis of the Great Depression, new regulations and deposit insurance largely protect the deposits. Shareholders, though, remain on the hook.
Complex issues driven by a simple psychological flaw
On the one hand, many bank managers become overly focused on short-term results. Driven by either Wall Street pressures or short-term bonus incentives, these managers sacrifice loan quality for profits this quarter. That sacrifice may not cause problems for months or even years. But by the time it does, it's often too late to fix the problems and avoid big losses and a tanking stock price.
That effect is compounded by the cyclical nature of the economy. Local, national, and global economies are characterized by periods of expansion followed by periods of contractions. Two steps forward, one step backward; it's just the way the system works.
When the economy is expanding, loans to mediocre companies or individuals can look pretty attractive. For banks that succumb to those short-term profit and growth pressures, there are plenty of deals available to meet even the most ambitious of goals.
A few years later, though, that expansion ends, and the economy grinds to a halt. It's only at this point that banks uncover and pay for all of those less-than-ideal loans. Worst of all, at this point the damage is already done, and it can't be undone.
You're probably thinking, "Well, if that's the fundamental problem, why the heck would banks repeatedly make low-quality loans that won't get repaid?" After all, most bankers are normal people just trying to make a living; there must be something deeper driving this behavior.
That's an excellent question, and one the Fed seeks to address with this new research.
Evaluating risk, forgetfulness, and self-deception
The New York Fed thinks the answer lies in a psychological phenomenon in how we balance short- and long-term risks in our decision making.
People -- not just bankers, mind you -- tend to be much more concerned with imminent risks rather than distant risks. We tend to focus on what's right in front of us, rather than what's three, four, or even 10 years in the future.
Given the short-term pressure of quarterly reports, or the short-term motivation of bonus incentives, the human mind has a tendency to "forget" past risks and simultaneously downplay longer-term risks. In other words, the brain tricks itself into accepting much higher risks in the name of successfully accomplishing short-term goals.
The subprime mortgage crisis is a great example of this phenomenon. Those loans came with high yields, there were tons of potential loans to make, and they boosted short-term bank profits for years -- that is, until they didn't. When the bubble burst, those long-term risks suddenly surfaced with painful consequences. Bank managers' perception of risk was distorted, resulting in a skewed risk-reward scenario.
The New York Fed paper puts it this way: "If the present self can conceal information about risks from the future self, the latter will underestimate such risks and therefore take higher risks than it otherwise would, thus alleviating the inconsistency between the present self's preferences and the future self's actions."
The researchers found that even if an individual understands this mechanism, that person still succumbs to it. It's hard-wired into the brains of bankers, you, me, and everyone else.
This isn't a deal breaker, but it is a valuable word of caution
This is a sobering and scary reminder for bank investors. The financial crisis was seven years ago, and if history is any guide, the next recession is likely to hit sooner rather than later. When that happens, we will once again find out which banks chose short-term objectives over long-term risk management.
In my view, the best way to avoid those short-term risk-takers is to look for banks with a track record of strong performance throughout the economic cycle. Those banks have proven that they have the discipline and risk culture to resist temptation, and they are the most likely to continue to do so in the future.