The Evolution of Bank Management

This is a chapter in a book I helped boutique investment banker Cohen Bros. & Company create. The Cohen family has a notable heritage in banking and financial services, and with this work they wanted to formalize some of their thinking and observations on banking gleaned over the years.

David R. Evanson

Present Value: Essays on the Revolution & Evolutio, Winter, 2005

It should hardly come as a surprise that there is a winnowing pool of senior executives with the managerial talent required to run a regional or community bank. It’s not that bank executives are outmatched by the demands of their jobs, but rather that there is fertile ground for a mismatch. After all, look at what’s happened in the banking industry during the last 25 years. In fact, many of the changes listed below occurred during the last 10 years.

The repeal of interstate banking laws
Deregulation of interest rates on demand deposits
The introduction of ATMs
The Sarbanes-Oxley Act of 2002
September 11, 2001
The repeal of the Glass-Steagall Act
CRM systems
Sunday banking
J.P. Morgan Chase
Junk debt
Asset/liability committees
The Latin-American debt crisis
Regulation FD
The Anti-Money-Laundering Provisions of the Patriot Act
Industry consolidation
The Euro
The S&L crisis
1 percent Federal Funds rate

Some of these may seem to be outliers, but upon closer examination they turn out to be germane. Consider the Latin-American debt crisis. It seems barely a memory, but its effects were far-reaching. When combined with the S&L crisis and the real estate recession of the early 1990s, the net result was a crack in investor confidence in money center banks. As a consequence, institutional investors looked for value and prudence among regional and community banks. The resulting increase in institutional ownership has fundamentally and completely changed the role and responsibility of chief executives and the senior management teams they lead.

Likewise, who would have thought that a growing terrorist threat culminating in the September 11th attacks would change the regulation faced by banks in the heartland of America? Or that the accused or proven malfeasance of executives at Fortune 1000 telecom, energy and industrial firms would result in corporate governance regulation that would confound chief executives and terrify boards?

And we haven’t even discussed the Internet.

Thus, we can hypothesize that bank failure or underperformance can be blamed not so much on changing conditions but on the absence of executive teams with the skill sets that the new conditions dictate. Support for this notion seems to come from a study by the Comptroller of the Currency, starkly titled Bank Failure. The report’s central finding is that senior management and boards of directors, not poor economic conditions, are responsible for bank failure. The question became relevant in the 1980s, when a wave of bank failures -– with a high proportion in regions with troubled economies -– came on the heels of economic declines in agriculture and oil and gas.

The introduction sums up the findings: “The study showed that while poor economic conditions make it more difficult to steer a profitable course, the policies and procedures of a bank’s management and board of directors have the greater influence on whether a bank will succeed or fail. In other words, poor management and other internal problems are the common denominators of failed and problem banks.

“Management-driven weaknesses played a significant role in the decline of 90 percent of the failed and problem banks the OCC evaluated . . . In other cases, director’s or management’s overly aggressive behavior resulted in imprudent lending practices and excessive loan growth that forced banks to rely on volatile liabilities and to maintain inadequate liquid assets.”

The study measured eight broad categories of weakness in failed banks to see which the determinants of failure were. As FIG #X demonstrates, most of the weaknesses that undermined banks are directly or tangentially related to the chief executive officer.
Weakness Percent of Failed Banks
Exhibiting This Weakness

Policies, planning and management 90%
Audits, controls and systems 25%
Asset quality 98%
Liquidity and funds management 10%
Nonfunding expenses 9%
Insider abuse 35%
Material fraud 11%
Economic environment 35%
Source: Comptroller of the Currency

Perhaps the findings of the Comptroller of the Currency may be extrapolated. That is, if poor economic conditions cannot be blamed for bank failure or underperformance, then neither can changing economic (political, regulatory and competitive) conditions be blamed. Thus, regardless of external conditions, the success of a regional and/or community banking institution rests solely with the skills, experience and acumen of its senior management team.

Given this, what are the critical skill sets necessary in today’s environment?

First, in order to succeed and lead the institution to success, the senior executives, who include the chairman, chief executive officer, chief financial officer, chief operating officer and chief marketing officer, must be consummate communicators. In a business that from all outward signs is numerically driven, this seems perhaps an unlikely candidate for the keystone skill.

But there are several reasons this is true. First, regional and community banks are in many instances outsourcing a number of different functions, from data processing to loan servicing. What’s left is a retail operation. While a nuts and bolts orientation is vital to the success of a retail operation, so too is marketing -– and perhaps even more so. After all, if customers keep coming through the door, operations will eventually get it right. But if there are no customers, the best operation in the world cannot survive. As a result of this shift, there is now a greater need for a senior management team that thoroughly understands and believes in the power of communications.

How else to explain the case of Charles J. Hamm, retired chief executive of Independence Community Bank and now its chairman, who was recruited by the bank’s board of directors from the advertising industry? Hamm had spent 24 years in advertising and was executive vice president of McCann-Erikson Inc. when he was approached by Independence. Hamm told ABA Bank Marketing magazine in 2002, “I think what the board saw in my candidacy was an opportunity to grow the bank . . . in ways that mutual, savings or even commercial bankers might not be sensitive to.”

Hamm succeeded admirably in his job, growing Independence from a real estate lender into a commercial bank with several lines of business and the kind of opportunity that could attract and retain top-flight management.

The need for superb communications skills goes well beyond their importance in marketing. Several of a bank’s primary constituents are on edge, and they need to be communicated with very persuasively and unequivocally. Specifically, institutional investors, bank regulators and board of director committees, particularly the audit and compensation committees, are exerting their influence more forcefully than in any other period in the history of modern banking. The factors that brought these forces into play are independent, but they have nonetheless conspired to potentially weaken the power and the influence of the senior management team.

After all, what stands between oversight of the bank and its operations by the executive management team and oversight by any of the above-mentioned constituencies other than the management’s ability to communicate its vision, effectiveness and control?

Next, the executive management team of a community or regional bank must be financially skilled in several areas, rather than in just the one area of strength or focus for the bank. This skill set transcends mere facility; to succeed, an executive management team must be able to focus its financial analyses within a strategic framework for decision making. Simply put, the team must make more decisions because it has more lines of business, more opportunities and more risks. And it must now justify its decision making to outside constituents.

For instance, when the rates on demand deposits were regulated, chief executives didn’t have to think about them very much. The decision was already made for them. Now, chief executives must not only decide upon a strategy for positioning their demand-deposit products, but they must also be able to defend their strategy to shareholders and a strategic-planning committee. Likewise, when savings banks were precluded from business lending, no further thinking was required. But when business lending was allowed, even doing nothing required justification. “You are not pursuing the small business lending market because …?”

Insurance services, wealth management, brokerage services, branch expansion, branch acquisition, commercial mortgages, SBA loans, Internet banking services, consumer mortgages, outsourced data processing, CRM systems and demand-deposit features, among other elements of banking, all represent important considerations that were not previously present in the industry. As a result, the senior management team’s decision on each of these matters must be analyzed, presented and defended. Because of this reality, a senior executive’s financial skills must not only be quite broad but also quite deep.

A wider breadth of skills is important not just for decision making. The fact is many banks already offer a wider array of services. The broader skill set is required, because members of the senior management are responsible for communicating regularly with investors, regulators and the board and, as a result, they must be in command of the facts beyond mere rote assimilation. They need to know how these facts impact their operations, not only in the areas of loan pricing, liability management and rates paid on CDs, but also regarding the composition of mortgage-backed securities and treasury portfolios, swap pricing, customer profitability, product-line profitability, and corporate-finance alternatives and their effects on the weighted average cost of capital.

Finally, today’s senior bank managers must master crisis and risk management. In many businesses these are separate disciplines, with risk management a function of the board and “C” level executives and crisis management remaining the province of corporate communications or public affairs or even public relations. It’s not that chief executives don’t become intimately and personally involved in crises when they occur, but in their hearts many managers don’t really believe that a crisis will occur. Therefore, they leave the attendant preparation to communications professionals, not senior executives.

This model cannot succeed in banking today. To understand why, consider the following scenario:

Riggs Bank, headquartered in Washington, D.C., often called itself “the most important bank in the most important city in the world.” For most of Riggs’ 167-year history, both claims were tenable. However, the increased scrutiny of international money flows that followed the September 11, 2001, terrorist attacks brought to light another side of the bank. This other side brought down the house of Riggs in scandal.

The first documented foray into questionable business practices came after a business-development trip that Riggs employees took to Chile in 1994 to meet with then Chilean dictator Gen. Augusto Pinochet, later accused by the Chilean government of involvement with death squads, drug trafficking and arms sales. The Riggs team succeeded in earning Pinochet’s business.

Despite a fabrication by Riggs in 2000 that kept U.S. regulators from finding out about the dictator’s accounts, the heightened scrutiny following September 11 brought them to the attention of the Comptroller of the Currency in the spring of 2002. The regulators, understaffed and overworked as a result of the recent attacks, advised Riggs officials that they would return.
Even thought an investigation was pending, Riggs sent $500,000 to Pinochet just days later. Then, before the regulators arrived, Riggs closed the accounts and returned the money in them to Pinochet rather than freeze the funds, which would have been considered customary.

By November 2002, another scandal was about to engulf Riggs. The FBI had investigated Riggs’ Saudi business and passed along its findings to bank regulators, who after their five-month investigation turned up improprieties with 150 Saudi accounts. Even though bank regulators issued a public cease-and-desist order, unexplained transactions between Riggs and its Saudi accounts continued, resulting in a $25 million fine -– the largest ever levied against an American bank.

In the midst of the Saudi account investigation, Riggs’ dealings with Equatorial Guinea came to light. According to a report issued by the Senatezzs Permanent Subcommittee on Investigations, a Riggs employee took up to $3 million in shrink-wrapped bills — collected from Equatorial Guinean politicians and packed into suitcases — right through the front door of the bank. Teodoro Obiang Nguema Mbasago, the country’s dictator, who had a string of well-documented human rights abuses, began dealing with Riggs in 1995 and ultimately became its largest customer, with some $700 million deposited in accounts with the bank.

In the end, Riggs and its management team were no longer tenable. The company was sold to PNC Corp in a $780 million transaction. At the time the deal was disclosed, PNC indicated it intended to divest non-core businesses, resulting in the shedding of loans, deposits, other assets, and assets under management totaling some $5.7 billion. Once-venerable Riggs was reduced to a shadow of its former self and today survives as a tool for the geographical-expansion strategy of PNC Corp.

What does a postmortem of the Riggs scandal reveal? What was the true cause of demise?

First, the bank’s approach toward risk management was inadequate. Second, the resulting breaches of internal audit, policy and controls — combined with the breaches of regulatory compliance — developed into a crisis that neither the bank’s chief executive, Joe Allbritton, nor his senior management team were able to manage. And because banks like Riggs are more heavily regulated and often maintain outside ownership, their foibles are more likely to be played out in the glare of the media, intensifying the heat and the deepening crisis.

As a parting thought, it’s productive to think of the evolution among bank management as a differential equation. That is, the job requirements are not the only variable. How senior executives of regional and community banks view their jobs and the challenges that face them is changing, too, and not in subtle ways.

To understand the importance of perspective, consider the following data points taken from the 1994 and 2004 surveys of Community Bank Executives by Grant Thornton. Though the time frame between surveys is only 10 years, the challenges that kept bank executives up late at night seem to be worlds apart. The lists show the concerns that were on these bankers’ minds, and the percentage of bankers who ranked the particular issue most important for the bank’s success.

Top Concerns, 1994
Financial cost of regulatory compliance: 95%
Documenting internal controls as required by the FDICIA: 78%
The cost of employee healthcare insurance: 76%
Truth in Savings compliance: 73%
Increasing noninterest income: 71%
Time spent dealing with all regulators: 70%
Mark-to-market accounting: 64%
Proposed interest rate risk rules: 53%
Lender liability for environmental pollution: 49%
Minimizing corporate tax liability: 42%
Asset liability management: 42%
Complying with risk-based capital rules: 25%
Source: Grant Thornton

Top Concerns, 2004
Retaining key employees: 95%
Developing new sources of revenue: 84%
Offering Internet banking services: 79%
Updating/expanding technology to better track customer needs: 76%
Expanding services for business customers: 74%
Measuring customer profitability: 69%
Planning for management succession: 67%
Expanding traditional banking services: 53%
Offering broker/dealer services: 33%
Offering insurance services: 24%
Offering nontraditional services, (e.g. leasing, travel services, business advisory, check cashing: 12%
Source: Grant Thornton

What do these surveys suggest? Two points seem germane. First, the survey results reflect a massive shift in the attitude toward regulation. It appears that chief executives and senior leaders of banks in the early 1990s possessed a palpable fear of regulation. How much time would they have to spend with regulators? What exactly were the new rules? How could they create systems to document compliance with these new regulations? What would be the ultimate cost of all this regulatory compliance?

Of the 12 factors thought to be of concern to bankers in 1994, eight of them, or fully 75 percent, were related to regulation. By contrast, in the most recent Grant Thornton survey, regulation never showed up among the top concerns of chief executives and senior level bankers.
Does this mean that bankers don’t care about regulation anymore? Hardly. The Sarbanes-Oxley Act of 2002 is still reverberating, yet it did not rank among the top concerns considered most important for a bank’s success.

This would appear to suggest a certain coming of age or perhaps resignation –- you decide — in the chief executive’s suite. Not that banking leaders of any era were ever naïve about the implications of engaging in a business so closely associated with the public trust. But the current generation appears to accept regulation as an inevitable part of doing business and to understand that beyond ensuring compliance, one of their principal duties is to make sure that regulation’s impact on the growth and profitability of the business is minimal. How else to explain such a dramatic shift in thinking?

This brings forward the second germane point indicated by the data points in the Grant Thornton survey. Bankers today appear to be more tactical in their thinking than ever before. They are wrapped up in the nuts and bolts of CRM, because pushing information toward the boundary of commerce -– in this case, tellers, branch managers and loan officers — is critical to competitiveness. They want to measure customer profitability, because chief executives are more accountable than ever to outside constituencies. They want to add Internet banking, not because it will make a marked improvement in their valuation, but because the Internet is a stalwart if tertiary distribution channel that consumers now expect. They are engaged in succession planning, because they are stewards of a strategic vision for the bank, or they have designed a strategic vision that must have continuity to reach fruition.

Lastly, and notably, chief executives are concerned about retaining key employees. This concern might be as perplexing as it is prescient. Surely, there are other weighty and complex matters facing bankers and the banking industry, so how is it that personnel became a top-of-mind issue?

Perhaps chief executives have recognized that no matter how complex banking may be perceived to be, it maintains at its core a simple business model: the acceptance of demand deposits and the generation of loans. Employees who carry out these functions represent perhaps the most compelling and important point of differentiation between institutions, and these employees include, of course, the executive management team that is ultimately responsible for the success or failure of the bank.

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