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Wednesday, June 3, 2015

How to Grow a Financial Business: Bubbles vs the Long Haul

I've been struck by the correlation between large shifts in the flow of funds and bubbles, but haven't found data other than for the US and Japan, and those metrics aren't directly comparable. So let me go from the macro(prodential) to the micro behavioral: how can you grow a financial business? There are three ways:

  1. provide better service
  2. price below competitors
  3. take on more risk than competitors

The first provides a sustainable model, exemplified by relationship banking. Because a relationship adds value, at least when backed by comptence, you can charge a premium. As long as you're not greedy, you can also hold onto customers, because there's a sunk cost to a relationship, and creating a new one takes costly time & effort. It's hard to do with large firms, because they need too much money and have too varied of needs. But a good investment bank – think boutiques – can still pull that off. The real niche where this strategy works are community banks, whose customers are too small to play one lender off another, and whose owners/managers have too little time for financial games: they've a business to run. The downside is that a community bank following such a strategy can neither grow quickly nor become too large. That's because from the bank side there's also a resource cost to building and maintaining relationships, and managers need discretion. The first works against growth, while a bank that grows too large needs to systematize lending standards. The really good managers can leave to start their own small banks.

The second strategy is obvious: buying business. That's not so bad when conditions are tight, but that's when bad paper comes to the surface and there are pressures to not grow. So it's really only relevant in an upswing, when volumes are rising but margins are also falling. So to keep growing you have to give money away, and sooner rather than later.

The third aspect, lowering standards, is probably not what a manager pitches to the executive committee, but is a corollary to the second: in order to preserve yields in a business-buying environment, you have to take on greater risk. It helps that in an up cycle risks blur: poorly managed firms do well, or at least well enough. The standard consumer credit rating, their FICO score, just keeps getting better and better as not-very-reliable workers who in a downturn had unsteady income hold onto jobs longer and improve their payment record. You don't need a deliberate game of shading the rating, you just need naivete and optimism on the part of those relying on credit analysis. It helps that those at the working level in finance tend to be young, and don't remember the last down cycle.

My personal experience as a banker was in an up cycle, as the gopher in a team working on eurodollar syndicate loans to Latin America in the late 1970s. Brazil was going to be the next Japan, commodity prices were strong as well, and no one had any experience – the last period of robust international lending ended in 1914. On the surface we were lending to companies for explicit projects, but everything carried a government guarantee, and the Brazilian financiers all came across as competent and experienced, unlike their counterparts in certain other countries.

Margins kept falling, LIBOR + 2%, then LIBOR + 1%, then LIBOR + 0.5%....but we got a management fee, and had funding costs below LIBOR, so that was all right. About the time I was making the decision on whether to head to graduate school I was tasked with calling around to peer institutions to find out the size of their Brazil book and credit ceiling; I had the details for my own bank's position to horse trade. It quickly became clear that all the big players had Brazil paper coming out of every orifice, and were finding it hard to syndicate (unload) onto regional "correspondent" banks, back in the era before interstate banking was allowed. [The only way regional banks could diversify their loan portfolio beyond their local geography was by buying paper from us and our peers.]

Then came Paul Volcker, reflecting Jimmy Carter's determination to tackle inflation. Suddenly commodity prices were falling, Brazil's industrialization strategy hit a wall, and LIBOR peaked at over 20%. On some loans Brazil needed to pay 22% at a time when dollar revenue was plummeting. The big banks managed to tidy over the gap for a couple years, but in effect by mid-1979 the loans that underlay the Latin American debt crisis had already built past the point of no return. My bank managed to survive another decade, but was fatally weakened. Oh, and as ought to be obvious, I decided to head to grad school. Among other things, I'd been the representative for Japanese banks to the IMF-led debt restructuring for Jamaica (also here), an immensely sad experience, and didn't want to do that full-time for Brazil and others.

Meanwhile ... other parts of my bank were making a big push into national accounts (Fortune 100), with similar bad results, while other parts of the US financial system were building up real estate loans, from the entire Savings & Loan sector to big banks like Citi. Had I started elsewhere, I would surely have built up an equally impressive resume printable in red ink. Since then I've been in Japan at the height of their real estate bubble studying urban economics [with hindsight, economics doesn't help much in explaining differential behavior during bubbles], and then was around a couple dot.com executives leading up to the 2000 debacle (on paper I lost a lot of money, but only bought into the market after prices were well below peak). Then there's the more recent real estate cycle, thanks to which I "own" [am beholden to] two houses.

To summarize, growing a financial business quickly is a losing proposition. That such is occurring can perhaps be inferred from the pace of change from old to new sectors in flow-of-funds data. [Still true, in that contingent liabilities are likely underestimated?] If you're looking at a career in finance, and aren't comfortable with making a living forever searching for greater fools, then look for a relationship business. Don't look however to become wealthy.