Contributor: David Hamilton
In my previous two blogs, I have referenced SunGard’s Well Managed Money research. In this research SunGard identified four main stakeholder groups which will influence the future of well managed money. Today I want to talk about the third stakeholder group; Investors.
As investors and bankers, we have long known about the natural friction between shareholders and bondholders, the former seeking higher levels of return typically associated with increased risk and the latter seeking to avoid tail-risk and in so doing, protecting their fixed returns. A central pillar to most, if not all, bank strategy is the goal of maximizing shareholder value. However, maximizing value for one investor group often conflicts with the interests of one or more other groups. These externalities tend to be at their greatest during times of financial distress, particularly if the financial system is facing the collapse of major financial institutions which could basically drag various investor groups into abject misery.
In the past few years we have seen regulators and central-bankers all over the world wrestle with the imminent insolvency of numerous institutions. During this time, choices between ring-fencing toxic assets, recapitalizing the bank with preferred stock, buying common stock or having bondholders participate in a bail-out, have required banking decision makers to balance the welfare of different investor groups, often with less than ideal outcomes for many. In some instances, the initial decision to recapitalize via preferred stock was revisited and agreement on conversion to common stock was reached. This move further weakened stock-prices and resulted in rating agencies issuing revised ratings. In all instances however, governments and therefore taxpayers found themselves as large scale investors in many institutions in both Europe and the United States, fueling further complexity in the stakeholder landscape. And whilst regulatory bodies around the world seek to implement reforms to reduce such tax-payer exposure in the future, as evidenced in a recent speech by Paul Fisher, Executive Director at the Bank of England, “…some banks think they should not be required to hold capital and liquidity to deal with such extreme tail events – leaving the public sector to be the capital provider of last resort”.
An outcome of the recent financial crisis is an increased awareness of the implications of bank strategy on different investor groups during times of economic uncertainty and the consequences of strategy imbalances. Particularly relevant in the post-financial crisis climate is the need for a clear articulation of a banks’ risk-appetite. More so however is the need for risk-appetite to weigh and balance the interests of all relevant stakeholders, and today, this list feels longer by the day. In setting risk appetite, boards must not only consider both sides of the investor camp (equity and debt holders) but external stakeholders including regulators, rating agencies and as I identified earlier, increasingly the public. A well articulated risk-appetite statement not only provides an important compass bearing for bank management and strategy setting, it should also form the basis of day-to-day decision making. Thus it will help principals (i.e., investors) and agents (i.e., the bank’s management) to overcome frictions due to asymmetrical information. A strong risk-appetite framework will help banks and investors to better balance the risk/return challenge, strengthen corporate culture and most importantly enhance the reputation of the bank as a steward of well managed money.