The more you learn about banking, the more you realize that just a few qualities separate top-performing bankers from the rest.
One of the most important of these qualities, I believe, is the ability of bankers to combat what famed investor Warren Buffett calls the “institutional imperative.”
Buffett, the chairman and CEO of Berkshire Hathaway, wrote about this in his 1990 shareholder letter:
“The banking business is no favorite of ours. When assets are twenty times equity — a common ratio in this industry — mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failing that we described last year when discussing the ‘institutional imperative:’ the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so.”
At the time, Buffett was referring to a credit-fueled bubble in the commercial real estate market. The bubble was in the process of popping; commercial real estate prices would decline 27% between 1989 and 1994.
The subprime mortgage and leveraged lending markets in the lead-up to the financial crisis offer more recent examples. No bank wanted to lose market share in either business line, even if doing so was prudent. This was the impetus for Citigroup CEO Chuck Prince III’s oft-repeated quote about having to dance until the music stops.
“When the music stops, in terms of liquidity, things will be complicated,” Prince told the Financial Times in 2007. “But as long as the music is playing, you've got to get up and dance. We're still dancing.”
Here’s the problem: A bank that loses market share is vulnerable to criticism by analysts and commentators.
In 2006, for instance, JPMorgan Chase & Co. began offloading sub-prime mortgages and pulling back from the market for collateralized debt obligations. “Analysts responded by giving JPMorgan Chase what one insider calls ‘a world of [expletive] for our fixed-income revenues,’” writes Duff McDonald in “Last Man Standing: The Ascent of Jamie Dimon and JPMorgan Chase.”
“One of the toughest jobs of the CEO is to look at all the stupid stuff other people are doing and to not do them,” a long-time former colleague of JPMorgan’s Chairman and CEO Jamie Dimon told McDonald.
You would think that analysts and commentators would, at some point, realize that it’s ill-advised to pressure bankers into prioritizing short-term results over long-term solvency, but there’s no evidence of that.
Darren King, the chief financial officer of M&T Bank Corp., noted at a conference in late 2018 that, “The narrative around the industry is that M&T has forgotten how to lend.”
M&T Bank has been one of the top-performing banks in the country since the early 1980s. King was referring to analysts and commentators’ reaction to the fact that M&T’s loan growth over the past two years has lagged the broader industry.
But as King went on to explain: “Generally what you find is when economic times are strong, we’re growing but generally not as fast as the industry. And in times of more economic stress, we tend to grow faster.”
So, how does a bank combat the institutional imperative?
The simple answer is that banks need to cultivate a culture that insulates decision-makers from external pressures to chase short-term performance. This culture is a product of temperament and training, as well as institutional knowledge about the frequency and consequences of past credit cycles.
This culture should be buttressed by structural support, too. Skin in the game among executives is a good example; a supportive board focused on the long term is another. A low efficiency ratio also enables a bank to focus on making better long-term decisions while still generating satisfactory returns.
In short, while the institutional imperative may be one of the most dangerous forces in banking, there are ways to defeat it.