Change Your Bank Before Shareholders Make You Do It

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Many blame the current banking industry malaise on the economy. Its problems, however, involve deeper structural issues.

The industry is mature and suffers from overcapacity. The paradox of banking is while it has consolidated in number, capacity has actually increased. Additionally, growth has fallen, margins have slipped and stock prices have plunged. For example, the 2011 SNL bank index fell by over 22% compared to a 2.1% gain in the broader S&P 500. Understandably, shareholders are unhappy.

Few banks have developed a response to the problem hoping current conditions are temporary. Most banks are still trying to be what they were — leveraged real estate lenders — even though that no longer works given current market realities. In fact, McKinsey estimates returns on equity will fall to 7% or worse by 2015 unless something changes. This fact underlies the collapse in the industry’s stock prices relative to the broader economy.

The industry is run by managers who are unable or unwilling to cope with change. This resistance is reinforced by poor governance and misaligned compensation. Many managers have meager stock holdings in their institutions. Consequently, they have more to gain by retaining their salaries, even after change in control adjustments, than in improving shareholder value.

These zombie banks, those who are unable to grow due to continuing profitability challenges, can survive, but not thrive. Their ROE are far below their cost of equity. Consequently, they have become value traps destroying shareholder value. Their low returns reflect flawed business models and unattractive industry conditions.

The situation has become so egregious at some institutions that activist shareholders are beginning to challenge management for realistic plans to maximize shareholder value.

Value creation depends on the bank's management team, reflected in their strategy and asset combination. Activists seek to dismantle infrastructure and asset combinations established to support weak legacy businesses. They target profitable underperforming institutions with large value gaps. Value gaps represent the difference between the bank's as-is going concern value represented by its current stock price, and its break-up or third-party sale value. The gap is a value opportunity which management has failed to notice.

Regulatory complications can impede activist efforts. Nonetheless, once a foothold is obtained, even below regulatory thresholds, activists can publicize the development to attract others and initiate proxy contests concerning strategy and capital management. Activists are messengers whose influence varies. Their shareholder value message, however, remains the same.

Managers should not passively wait for this development. They should become their own activists by proactively taking the necessary steps to unlock shareholder value by closing value gaps.

They must resist the temptation to engage in counterproductive delaying actions. Chief among these are misguided growth and overpriced acquisitions to increase earnings. Next, legal actions such as poison pills and staggered boards are of questionable value and only highlight governance issues. Finally, accounting changes like reserve releases and tax rate adjustments to manage earnings should be avoided.

Shareholder value is not a strategy. Rather, it is a consequence of strategy which focuses on major value drivers. These include internal improvements, like cost reductions and capital management to return excess capital to shareholders. This requires envisioning the bank not as it is, but as it should be.

Engage in an active review of your portfolio of business activities. The objective is to divest units whose sell-by-dates have expired. Legacy businesses in which no competitive advantage exists, such as mortgage origination, could be monetized by putting them up for sale. Other considerations include going private or outright sale of the bank. In fact, bank activists could serve as a catalyst for increased bank mergers.

Bank managers and directors failing to consider such actions may face increased shareholder litigation risk from major shareholders. Recent SEC rule changes opening up director nominations may accelerate this risk. Shareholders, the forgotten stakeholder in post crisis banking, are rediscovering their rights.

The way forward involves aligning managements and shareholders' interests through improved incentive compensation. This is best achieved by increasing management shareholdings and tying bonuses to major restructuring events. Directors cannot expect management to operate against their own self-interests. Therefore, they need to engage management in the process of improved value management through tough realistic targets linked to significant incentives. Admittedly, this is difficult. As John Kenneth Galbraith noted, when confronted with the need to change or prove change is not needed, most people get busy with the proof. The status quo, however, is no longer an option. The new golden rule is to act before being acted upon.

Joseph V. Rizzi is a senior strategist at CapGen Financial Group, a private-equity firm. He spent 24 years at ABN Amro Group and LaSalle Bank.

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