Krawcheck: Banks Have a Governance Problem

Anyone who has ever wondered how Sallie Krawcheck might run a bank can get a pretty good idea from reading the June issue of the Harvard Business Review.

In a lengthy op-ed, the former chief financial officer at Citigroup and global head of wealth management at Bank of America wrote that, even after a crippling financial crisis, large banks are still too complex and still too prone to take undue risks.

To limit their risk-taking — without taking too big a bite out of profits — Krawcheck is proposing sweeping changes in the way banks compensate executives, pay out quarterly dividends and conduct their board meetings.

She suggests, for example, that top executives should be paid partially in bonds because she believes stock-based compensation encourages them to take risks that might drive up the stock price in the short term but lead to problems down the road.

She also argued that managers should not be judged — and compensated — solely on the basis of earnings. Quarter to quarter, earnings can be affected by a range of factors that include the rate environment, one-time events such as loan sales and wild revenue fluctuations from certain business lines, such as trading.

"Perhaps the most crucial metric is customer satisfaction," she wrote. "More business from happy customers represents quality earnings. Continuing business from unhappy customers who feel stuck — because of the increasing prevalence of fees to close accounts, the time needed to retype automatic bill-payment addresses at another bank, and confusion about whether another bank's products are equivalent — represents a real risk for today's banks and a real business opportunity for competitors and new entrants."

Many industry observers have speculated over the years that Krawcheck would one day wind up as the CEO of a top financial firm. Indeed, shortly after she was hired at Bank of America in mid-2009 it was widely rumored that she was on the short list of candidates to replace Ken Lewis as CEO. (The job eventually went to Brian Moynihan.)

Krawcheck has yet to land a job since Moynihan ousted her in a management shake-up last summer, but she remains one of the financial industry's most influential women.

In her op-ed, Krawcheck said that banks' biggest problem these days is not regulation, but governance.

Currently the key tool regulators and boards use for keeping risk in check is the capital ratio, but Krawcheck says that is inadequate because there are simply too many capital ratios — GAAP capital, international (or Basel) capital, economic capital — to track.

"Boards need simple and commonsense — but powerful — tools to cut through the complexity and push management behavior in the direction of responsible risk taking," she wrote.

Aside from changing the way executives are compensated, Krawcheck also suggests that dividends should be paid out as a percentage of earnings, not as a set dollar amount. In her view, banks are too slow to cut dividends when times are tough and wind up sapping capital "when they most need it."

"This approach would provide a capital buffer by naturally reducing dividends in a downturn (even as boards and management failed to foresee the downturn's length and severity) and would pass strong earnings along to shareholders during an upturn," she wrote. "The additional layer of protection would have been meaningful in the most recent downturn."

Krawcheck also said that boards should spend more of their time scrutinizing the business lines that produce the highest returns. Most board meetings tend to focus on governance issues, business updates and dealing with problem business lines, "with well-performing business segments given an affectionate nod," Krawcheck wrote.

She noted, however, that certain well-performing lines — think collateralized debt obligations or subprime mortgages — often crash eventually largely because boards ignored their inherent risks.

"Boards should also prioritize their business-line review according to capital consumption," Krawcheck wrote. "Spending time on the businesses that use the most capital, and working to reduce the need for that capital by controlling risk, will deliver a higher payoff."