Clearly bigger is not always better.

You have seen a consolidation of the banking industry partially because of economies of scale. The cost to play the game from a technology, regulatory and infrastructure standpoint has become huge and continues to grow. Complying with things like Patriot Act, Sarbanes-Oxely, etc. is very costly and quite frankly probably adds little value. The cost for developing and supporting all the products and delivery channels people want today, is very expensive and generally provided for free to consumers (like online banking). Smaller banks have trouble bringing the level of resources to the table that is required to play today’s banking game. Addtionally, organic growth for most banks has been very difficult, so buying marketshare was a cheaper way to grow. Thus the case for bigger.

Bigger banks do represent more complex organizations and many larger banks end up being very siloed in their lines of business. It would be a pretty safe bet to say most CEO’s do not fully understand all the risks within their organizations as they have depended on others below them to understand and manage this risk (this lack of understanding and direct accountability for these risks is also what makes the level of pay some CEO’s receive ridiculous). Ultimately the only place the complete picture of all this risk comes together is in the executive suite and in most cases they don’t have the skills to properly manage it.

Many of today’s large banks have had their size grow faster than their capabilies to manage this growth (this is the biggest issue with the size question). Most of your CEO’s and upper management are in their 50-60’s and few if any have devoted much effort to continue to grow their skills since they left college in understanding the new risks that are out their today and how they are measured and monitored. The skills to manage a large bank in 2009 is much different than the skills required to manage a much smaller bank in 1995 (which is where many skill levels remain). Most management just has not made that transition. You could also say this for many of the bank regulators, but they have probably been more active in trying to advance their skills than most bank management. Bank management has hired PhD’s and other quants as a substitute for them growing their own skills. The quants may be wondeful at cranking the numbers and building the models, but they often lack business experience.

When you have complex organizations, you usually rely on risk models to help you understand the risks and their correlations. Unfortunately most risk management modeling is a “rear-view mirror” process. That is all your risk models are based on historic data and they only work if history repeats itself, which contrary to some popular belief, it doesn’t. The fact that this downturn looks different than previous downturns should not be a surprise. They are all different. Consequently, the fact that models develped by risk quants were wrong in many cases in defining the risk profiles should not have surprised anyone either.

There seems to be some belief that the people behind these models were just over-paid (perhaps) Wall Street buffoons and it was all their fault. Boys and girls, the models were right on, it was simply a case that the models and the realities did not align. Had the economy acted just like it did when the data was created behind the models, everything would have been fine. The problem with the models was that people did not understand that models are mathematical interpretations of reality and not reality itself. This requires that somewhere along the way humans with common sense and some level of experience have to assess the model outcome and compare it with the reality around them and say does this make sense. This is a CEO’s job. They for the most part didn’t do that because it was beyond their skill level.

On the flip side, community banks have really been no better and from a numbers standpoint as most of the failures are small banks that have experienced the same types of loan losses recognized by bigger banks but do not have the capital or other sources of revenue to absorb the unusual loses. Consequently going back to 30,000 community banks is not the answer either.

So what is the answer? Bigger makes economic sense and will probably continue. Models are tools that can be beneficial in taking complexity and making it measurable (within reason). Things will continue to get more complex. Ultimately we will have to move to having more professional CEO’s run these organizations that come to the table with the skills and knowledge to properly manage this size and complexity. From over 40 years in the business, I can tell you the best and brightest rarely rises to the top in banking today. In some cases it is the most politically astute. In some cases it is just dumb luck of being in the right place at the right time. In other cases it is simply having done nothing stupid (at least nothing that can be assigned to you). In many cases their is lots of ego and little leadership. In many cases group think abound within the executive suite as many of the teams have worked together forever and have well embedded paradigms relative to their view of “reality.” This will have to change. These guys at the top are going to have to up their game beyond just pounding their shoe on the EPS table. This will require a much different approach to how these C level jobs are filled in the future.

- zebhead

Related Posts:

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• I own a business. I see first hand what the recession has done to people’s spending habits.
• “Employers really want to hold onto the work forces that they have if at all possible,”
• We will remain in the bottom of the V or U or even W.
• THE DIRECT CAUSE OF THE INFLATION

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