An unappreciated cause of the financial crisis that remains beyond the scope of legislation and the regulatory community is the quarterly earnings pressures on financial services firms. For most corporations, and particularly for financial companies, this pressure to meet analysts' immediate expectations is pernicious.
A strong, vibrant economy depends on the intermediation of short-term liabilities and long-term assets, but it is difficult and risky work — particularly for banks operating in markets where unemployment is at a 75-year high, property values have dropped precipitously and customers are fearful and cautious. We too easily forget the mettle it takes to maintain standards in markets that seem to have forgotten them, and to sacrifice quarterly profit in order to take a long-term view of risk.
Instead of bestowing premiums upon financial firms that take prudent, long-term views, analysts too often expect quarterly growth miracles. Banks' quarterly efforts to satisfy Wall Street are exhausting and counterproductive. In most firms, preparing for the analysts' conference call alone takes weeks of intense focus on how best to announce results that demonstrate profit growth in the past quarter and beyond, or explain why it wasn't achieved in this quarter but will in subsequent quarters. The week in which results are released is preceded by several weeks' focus on meeting earnings expectations, setting those expectations and trying to guide realistic expectations for the next quarter. Even good quarters can turn into a nightmare if analysts' expectations are not met. And shortly after the process culminates, it begins all over again.
The toxicity of the excessive quarterly focus on earnings extends beyond the earnings call and immediate market reaction. Otherwise sensible investors — even large institutional investors with longer-term horizons — subtly or not so subtly put pressure on CEOs on the basis of these quarterly results. Too many CEOs and other senior bank officials get calls from big investors inquiring about "what's up" when quarterly earnings are not up.
This kind of direct and indirect pressure reinforces short-term behaviors that are just not desirable. Pressures can result in lowered underwriting standards, riskier trades than would otherwise be booked, and either eating into the loan-loss reserves more vigorously than desirable or failing to increase it with appropriate vigor, depending upon where the bank is in the cycle and the realities it faces.
Furthermore, the regulatory counterweight is ill constructed to deal with these short-term pressures. Regulation and supervision are by nature backward-looking. When pressures arise to take precipitous actions, particularly where an institution has a decent regulatory rating, there is not much the regulator can do until it is too late. As one regulatory bard often puts it, "When the bullet is already in the body, there is not much the regulator can do."
There are some steps to take to ease the pressure. First, banks can meaningfully shape investor expectations by downplaying the quarterly theater. CEOs can be extremely effective in speaking out on their own and the industry's behalf to encourage the market to shift its focus away from quarterly numbers. Robert Wilmers, chairman and CEO of M&T Bank Corp., has long made it clear to investors that he places a commitment to prudent banking and long-term results above short-term thinking — an approach that long ago attracted Warren Buffett as an investor. Buffett himself does the same in his own way, and indeed a great portion of his phenomenal success can be attributed to a perspective that looks beyond the current quarter, or even the current year.
It would also be helpful if well-regarded regulatory and other governmental officials used public appearances to emphasize the virtues of taking the long-term view of financial performance, and indeed, the dangers of overemphasizing a quarter-by-quarter earnings focus. Regulators should stress looking through bottom-line results to the quality of earnings when evaluating a bank.
From time to time, even healthy franchises are punished in terms of their ability to acquire and/or have orders lifted where they may be showing conservative, solid quality but modest earnings in a quarter, where on the other hand their competitor is given a boost for greater short-term earnings, that may be less sound.
Moving away from an excessive focus on quarterly earnings can produce real safety and soundness gains for financial institutions and strengthen the regulatory mechanism. Just as important, it can rectify the eroding dynamic between banking executives and those who purport to represent the interests of investors.
