Summary
- I am periodically asked about my view on European banks.
- Though dirt cheap, in my view, European banks are to be avoided.
- The risk profile of the banking industry in Europe remains High and Increasing in light of continued governance failures.
- Five concerns: 1) Absence Reliable Data Source, 2) Serious CEO Gaps, 3) Under-skilled Directors, 4) Acute Shortage Skilled Risk Executives, and 5) Muddy Regulatory Design.
- Until all five shortcomings are rectified, I will not own European banks as has been my position for the past decade.
Five Reasons I Will Not Own European Banks
Background
As a Bank of America risk executive, I spent a fair amount of time from 2009-2011 in London with European bank risk executives as well as with European bank regulators.
At the time I was our bank's representative to the Operational Risk Exchange ("ORX"), a London-based consortium of 50 banks from around the globe that gathered, analyzed, and reported operational risk loss data.
This background is germane to my investment view of European banks.
I saw first-hand that European regulators were lax in their supervision. Specifically, European regulators prematurely designated their banks as accredited experts in "Advanced Measurement Approaches," a designation indicating not only expertise in Operational Risk Management, but also indicating successful control and reporting of operational risks.
At the time, the only banks in the world with "AMA" designation were European banks. By virtue of the number of European banks with "AMA" designation, it was assumed by most bankers, I included, that European banks were simply the best in the world at overseeing non-credit risk.
History shows that the European banks were not only not ahead of other banks across the world, but actually far behind. But because of weak regulatory supervision, European banks got an unjustified seal of approval that ultimately delayed recognition of the profound shortcomings of European banks.
For reasons I still do not understand, European banks and regulators have made little progress rectifying the five gaps identified for this article.
1. Absence of Reliable, Comprehensive, Timely Data Source of Bank Performance
God bless former FDIC leader, Bill Seidman, a Reagan appointee, who realized early in his tenure (1981-82) that the FDIC lacked a reliable, comprehensive, and timely data source for bank performance. As a result, Seidman, an accountant by training, built it himself. Such data has now been available since 1984 for U.S. banks (as well as non-US banks that operate FDIC-insured subsidiaries in the U.S.). Today bank analysts have access to nearly four decades of FDIC data which is critical to trend analysis.
To my knowledge, no similar data source is readily available to investors in European banks.
The FDIC data base provides a single source for investors to analyze banks. The data is timely, comprehensive, and reliable. In addition, it is relatively easy to use and manipulate for analytical purposes. Absent such data, I lack the tools and information needed to invest in European banks.
2. Profound Shortage of CEOs and CEO Candidates
While the absence of reliable bank performance data is reason enough to avoid European banks as a whole, the most compelling reasons to avoid these banks are related to People Issues .
The most profound of the people issues facing European banks is the lack of a bench of potential bank CEOs. The dearth of CEO talent became abundantly apparent a decade ago when Europe's banks kept turning to U.S. banks (especially JPMorgan Chase) for CEOs.
Bewilderingly, European banks continue to play a constant game of "musical chairs" when it comes to bank CEOs. Pick the bank, and it is hard to find any with a CEO who has been on the job for more than three years.
How can an investor have confidence in a bank that churns CEOs every couple of years?
I prefer to own banks guided by a steady-hand, proven CEO with a track record of superior performance. While troubled banks overseen by a new CEO often appear to be wonderfully cheap (low P/E, P/B, P/TBV), my experience is that banking is not the place to bet on a fast (<3 year) turnaround.
3. Under-Skilled Bank Directors
Hand-in-glove with the CEO problem is the problem European banks face in assembling skilled boards of directors.
The textbook study of this deep-rooted and widespread challenge is the Royal Bank of Scotland which the UK government effectively took over during the Great Financial Panic.
RBS's former regulator, the Financial Services Authority ("FSA"), published in December 2011, the definitive tome of how a bank dies. This 452-page pathology report spells out in fascinating detail the demise of RBS. Pages 220-252 address "Management, Governance, and Culture." It is must-reading for bank CEOs, directors, risk managers, and yes, even bank investors.
The key point of the FSA's criticism of RBS's board is that its directors--many of whom were high profile CEOs of the largest companies in the UK--lacked a basic understanding of how banks operate. Lacking such knowledge, they failed to control and challenge an aggressive CEO.
While US banks faced a similar challenge 15 years ago, the Great Financial Panic was a wake-up call for the biggest banks which have since engineered a transformation in board composition. Today directors are much more often experts in banking/payments/credit, finance/accounting, technology/cyber, and operations.
European banks have not made similar wholesale progress as evidenced most recently by governance failures at Credit Suisse .
4. Acute Dearth of Seasoned Risk Executives
There is no question that the Great Financial Panic revealed serious flaws in the cultures and operating models of U.S., European, and Australian banks.
To the credit of bank regulators, as well as some bank CEOs, the industry recognized in 2008-2011 that the industry's " second line ,"--that is, risk management organizations--needed to not only have sharper teeth, but also needed seasoned, top talent capable of identifying, monitoring, mitigating, and reporting emerging risks.
Pre-Great Financial Panic, risk organizations in banks often were led and dominated by credit experts who in almost all cases were lenders by training. During the past decade, the industry has recognized that the true root cause of bank failures and massive losses are not credit per se, but failures in people selection, process supervision, and culture.
As a result, bank risk organizations have been re-engineered, not only in the U.S., but across the globe. While credit risk management remains a paramount area of attention, other risks (operational, strategic, liquidity/funding, interest rates, markets, pricing, compliance) today get equal attention. Consequently, banks of all sizes have strived to build out a deep bench of risk executives capable of overseeing a wide range of bank risks, not just credit.
Though European banks have committed to doing just this, demonstrable progress has been slow. The record shows that European banks continue to be plagued by frequent material financial losses related to process and culture failures.
In my view, some if not many of these losses could have been avoided had the banks put in place the talent and processes needed in the second line to identify and control for the inherent risks before the losses were realized. Until European banks see a meaningful decline in "surprises," I will continue to be of the view that their risk organizations lack skilled talent.
5. Muddy Regulatory Design
My fifth and final concern is related to European regulatory design and politics.
Let me preface my observation by saying that I am no fan of the U.S. bank regulatory system. For a complete discussion of this theme, see my 2013 banking book that examines why the U.S. banking system has suffered 3,500 bank failures between 1985 and 2011.
Singapore and Canada stand out as nations having the most effective bank regulatory design. In both cases, bank regulators have a wide mandate of prudential supervision that covers not only banks, but other financial risks that reside outside the banking industry (such as insurance). In addition, in those two countries, the bank regulatory design is such that regulatory supervision is clear-cut: There is a single point of failure and single point of supervisory accountability, not a shared responsibility as is the case in the U.S.
I will confess that I have not carefully studied the European bank regulatory design in recent years. But I see inherent confusion of supervisory accountability in a system that attempts to marry nation (such as AMF and ACPR in France ) regulatory supervision with the supervisory powers of the European Banking Authority.
Closing Thoughts
The trap investors often fall into is the belief that cheap equals opportunity. Sometimes that is true. Sometimes it is not.
My experience suggests cheap banks are cheap for good reason. Too often, cheap banks are cheap because risks are high and increasing.
Banking is not the place to roll the dice.
In the case of Europe's banks, they are cheap, in my view, for five good reasons. Until these reasons are remedied, I will avoid them.
Let me add one other observation.
My concern about owning European banks makes it difficult for me to own European ETFs such as Vanguard FTSE European ETF ( VGK ) and iShares Core MSCI Europe ETF ( IEUR ) because of their substantial exposure to financials. VGK currently allocates 17.7% of its assets to financial services while IEUR allocates 17.1%. This is more exposure than I prefer.
Consequently, for exposure to European equities, I currently own select large cap non-financials as individual holdings.
Caveat
The foregoing is my opinion which I share for the purpose of getting feedback and questions that challenge my ideas and assumptions.
Every investor needs to do his/her own due diligence before investing as well as determine their risk profile. I am risk-averse, preferring to invest in high-quality banks led by proven managers and directors and which earn steady returns exceeding cost of capital.
For further details see:
European Banks: 5 Reasons I Won't Own One