Actually, this is not exactly the question I want to answer with this post. It is borrowed from an article in today’s Financial Times Deutschland, which is titled “For they know not what they do”. Author Tobias Bayer looks at the latest bank-failures (or better almost-failures) in Germany and presents some surprisingly simple explanations:

At first, he refers to the ‘too big to fail’-phenomenon. Banks enter too risky and too speculative businesses since they can expect the state to rescue them. The implication for the financial system and the economy would be far too severe. This is what economists call ‘moral hazard’ – wrong incentives lead to wrong behaviours.

However, Bayer argues that the deeper reasons of latest problems are even simpler: Banks have started to do things they don’t understand – for they know not what they do. Almost failed IKB is a mid-sized bank focused on mid-sized companies in Germany. Similarly, troubled WestLB is a German public sector bank that originally was intended to be the central bank for a German federal state and a partner for the local savings banks. Bayer lists several terms from the world of modern finance that are all related to the actual market turmoils (derivatives, conduits, special purpose vehicles, liquidity facilities, securisation structures, investment grade ratings etc), and assumes that such businesses are way outside the banks core business models. Hence, banks were not fully able to evaluate what they entered into.

At this point, Bayer refers to a study from the Bank of England about ‘Causes and Management of Banking Crises’. (I will come back to this later) This study analysed 22 cases of banks which failed or encountered severe difficulties, of which 18 were partly of fully due to mismanagement (poor strategy – 11, poor systems and control – 17). Bayer concludes that both banks, IKB and WestLB lack a sound strategy and business model. They had no answer to the question why they are actually in business and hence, tried to increase their profits with risky businesses.

Well, I don’t disagree with Tobias Bayer. It seems quite plausible to me that many smaller and mid-sized banks did not fully understand the risks and implications associated with all their activities. But I would like to add one more explanation here, since it is all too easy to think that banks simply said ‘Hey, let’s do some business in these cool derivatives and ABS structures our consultants told us about!’. Why did they do that? I can’t imagine that they were simply bored to death from giving loans to some German mid-sized companies. I think this is also about the increasing impact of the idea of shareholder value and the associated focus on returns as a measure of success. RoE (or return on whatever you like) and some other figures become the key indicators everybody looks at. Investors and analysts alike have a look at the year to year or even month to month development of these figures and also compare them with the indicators of other banks. This puts an increasing pressure on management to continuously improve their results:

• We all can remember cases when a company has increased its profits as projected and its share price fell anyway, just because some analysts had expected an even higher increase in profits.
• Banks like the ones we talk about here cannot achieve by their very nature the same RoEs as their global and diversified counterparts like Deutsche Bank. Nevertheless, investors seem to be inclined to hope for returns at least close to this benchmark.

So what do you do when your shareholders and analysts expect higher returns every year? Well, it is common sense that higher profits are in most cases associated with higher risks. To take it the other way around – it is a compelling solution improve your profits with some high-risk side activities. It is even more compelling if these business options come with a AAA or AA rating and have some years of track record for enormous rates of return with almost no losses. Some of these structures are also called high-yield products, which makes them look even more attractive and less dangerous. Who would resist this opportunity? Only here Bayer’s theses fit in. In this situation banks were all too willing to follow their consultants who promised to help them with their conduits, derivatives, ABS-structures and the like. And I agree with Bayer’s doubts if everybody, including top management, board members, risk managers and internal control officers, had fully understood these complex business structures.

Having said that, it is time to come back to the study from the Bank of England mentioned above. This study is still available on the web and I read through it in some detail. The surprising insight for me is that this study is already ten years old. It is from 1997! It reads as if it was written yesterday and thus is highly recommended. A statement from the study I especially like is the following (page 24):

‘In many instances the problems of a bank have been brought about by the shortcomings of its own strategy or by operational failure. It is debatable to what degree supervisors should also be held responsible for having allowed poor strategies to be pursued; strategies are usually only known to be brilliant or disastrous after the event, and in a market economy it is questionable how far supervisors should interfere.’

Strategies are usually only known to be brilliant or disastrous after the event – today it is so easy for investors, for analysts, for all of us to blame the management of all the troubled banks for their risky strategies. Of course, it was wrong to accumulate such high risks. However, it were the same investors, analysts and general public who praised the same managers for the same (than profitable) strategies, before the sub-prime-crisis started this chain reaction.