Should Banks Be Publicly Traded?

Some people read fiction. Some people prefer non-fiction. I spend my days reading 10-Qs, 10-Ks, balance sheets, income statements and corporate press releases (I find it oddly enjoyable so don't bother asking if I keep one hand on the mouse clicker and one hand on the gun trigger). I used to think I was a fan of non-fiction, but in these days of Madoff and Satyam (SAY), I guess I am a big fan of both. More and more recently, as I’m reading the financial history of a corporation, a thought creeps into my mind: Should this company even be public? Too often my answer is no.

Debate has long been waged in financial circles regarding the best policy approach to the business cycle. Supply-side economics, the Austrian School, Keynesianism, etc. What is the best way to maximize output in an economy while reducing shocks to the system? All too often this debate ends in fewer and fewer answers. The banking crisis is at the epicenter of this debate and raises a very interesting question in my mind: Are financial firms better suited to serve the public and the global economy as private companies?

Banks are the arteries running through the global economy. If they are not functioning properly and making loans the likelihood of a heart attack increases. That heart attack occurred in October when Lehman Brothers (LEHMQ.PK) failed and the global economy came to a grinding halt. Could this heart attack have been avoided if the industry was not so infatuated with their quarterly EPS?

The overwhelming majority of corporations benefit from Capitalism and the free market model. The best thing about the Capitalist model is that it weeds out the weak and allows the strong to flourish (unless of course you hire Hank Paulson and Ben Bernanke to run the show). In essence, Capitalism has flourished because of its Darwinist-like features. But recently we've hit a bump in the road. In their race to the top of the mountain, the banks strayed from their traditional business models and made loans that threaten Capitalism as we know it. How could this happen? How could such a vital industry become so derailed from their traditionally lucrative and simplistic business model? One word: profits.

Being public means you must maximize profits for your shareholders. If you don't, your shareholders will eventually kick you out on your behind (unless your name is Rick Wagoner). In their search to maximize profits the banks took on more risk than they were accustomed to. After all, the competition was steadily increasing EPS and the CEO across the street was making $10MM more than you were so you clearly needed to inject a little nitrous into your business model. In banking, that means taking on more risk and boosting EPS at any cost. So what did they do? They made big bets on a few sectors of the market - primarily housing. This plan worked great for almost a decade. Bank's earnings soared. They were no longer just borrowing from the fed at 3 and lending at 6. They were creating all sorts of products that ensured no one would call them "economic girly men". And the earnings and CEO pay proved it.

But the banks were no longer using cash prudently. They were buying up mortgage firms, pouring billions into buybacks, leveraging up their balance sheets and increasing EPS via any source that gave the firm the appearance of financial strength. Citi (C), the big boring money center bank increased net income from $5.8B to almost $26B from 1998 to 2005. That's over 22% annualized growth for a money center bank. A MONEY CENTER BANK WITH 20%+ COMPOUND ANNUAL GROWTH?! EPS reflected it and so did employee pay at Citigroup and all across Wall Street. The added risks were paying off and everyone including the shareholders were getting rich. Very rich.

But a funny thing happened while Wall Street fell asleep at the risk management wheel: The wheels came off. The car veered. The car crashed. And then it exploded. And then it exploded again. And I'm pretty sure it's getting ready to explode again (as I write this, not to pick on Citi, but the stock is down 20% to an astounding $5.35 per share). There was an inherent conflict of interest in being a public company here. The idea of maximizing profits and keeping up with the Goldmans meant taking on more risk or perishing. It meant that banks were using cash for buybacks at record high stock prices in attempts to increase EPS. It meant that banks were buying up smaller banks to streamline their operations and give the appearance of organic growth. Would these vital institutions have been so imprudent if the public scoreboard over at the NYSE had not driven them to be so greedy?

This all begs the question: Should banks be publicly owned companies? You have to wonder if it's appropriate for such a vital industry to be subject to the pressures of being public. Is the public better served under a model in which these companies are privately owned? I am not implying that a private model would have stopped any of this from happening, but I find it hard to believe that the banking sector would be suffering from such a crippling blow if the bankers hadn't taken on such incredible risks in their quest to maximize profits for their shareholders. Even more interestingly, could a public banking industry actually be increasing the volatility of the business cycle? Perhaps Keynesianism or Austrian economics is not the answer to smoothing out the business cycle. Just maybe the answer is fewer profit based organizations. Maybe...

Disclosure: no positions

Comments

[H.J. Huneycutt:]

Interesting thoughts. I'm not sure what the answer is --- would banks be any less-willing to take on imprudent risks simply because they were not traded on a public market? There are still shareholders --- but I guess the theory is that they'll be more rational and patient. There might be some truth to that.

One way or another, I think something needs to be done to radically reform the financial system. Part of the problem is these massive too-big-to-fail banks like Citi. Maybe the Feds should start breaking up all the banks and re-enact policy provisions that essentially limit the banks' sizes.

It's interesting to think that FDIC may be part of the problem, as well. Don't get me wrong --- I think FDIC was a brilliant policy move back during the depression and served a very legitimate function in our society --- but it eliminated some risk for the bank in that depositors were less likely to critique their operations and pull their money out as a result of the banks' lending strategies. I don't think repealing FDIC would be wise, but the banks do need to be held more accountable for their actions somehow.

The other idea is, of course, nationalization. National banks are useful for certain functions, but I don't think it's prudent to nationalize the entire system, especially when de-centralization might be a better solution than centralization.

In any case, good thought-provoking article. Thanks!

Jan 13 09:50 AM

[Cam Hui:]

I have said that investments should be private.

See my full blog entry on the topic here: humblestudentofthemark...

SA article here: seekingalpha.com/artic...

Jan 13 09:54 AM

[Moon Kil Woong:]

There is no need for the FDIC apparently. The government seems to guarantee all money regardless of if there is a payment scheme to cover losses. Lucky brokerages and money market funds. They get a free lunch.

Also, at this rate maybe the Federal Reserve should IPO itself. After all, at this rate it will be the only viable bank left out there. It is pushing for all the rights to do all banking transactions, pay interest on deposits and issue debt (not certain it will get this right yet). There is no need to make this bank public because once it gets these two rights it can make its own money without the need of Congress or the Treasury.

Should banks be public? I think yes if for no other reason to make them more transparent and beholden to the law, even if there seems to be none like there is today. Otherwise you get the type of ridiculous accounting like the Fed TARP program (no accounting).

2008 is the year that the Treasury became most inefficient, wasteful, government institution (replacing the Department of Defense which can't even account for all its assets and spending 5 years later). Not only is it not capable of tracking money it disperses, it doesn't even bother.

It's so nice to know the institution entrusted in watching over the government's money and guaranteeing the stability of the greenback is so competent.

Jan 13 10:42 AM

[TomF75:]

Interesting thought. I find it hard to believe their isn't a market for good ol' fashioned George Bailey style Thrifts. I'd invest in one. Many people on SA have talked about the repeal of Glass-Stegal having led to this. I do wonder considering the law of unintended consequences if NOT repealing G-S would've led to many of our banks being gobled up by large international mega-banks (e.g. Mitsubishi, HSBC, Santander, et.al.). Almost like a necessary evil when you think about it. Food for thought.

Jan 13 10:55 AM

[Jacobs:]

Here's a brilliant article by a writer who found some elements of answer last month...

www.portfolio.com/news...

Jan 13 12:14 PM

[aarc:]

Give them some slacks.

If you fall off a two-story building. Will the people around you immediately start criticizing you because you seem to have lost control of yourself and you can't stand up straight, or you can't even pronounce your name correctly?

Do you think the Fed, the Treasury, and the Banks will be able to account for everything they do while still being swirled around inside a tornado in such a very short period of time?

Can you account for everything you do while you are still in panic state?

Jan 13 01:23 PM

[k9s-4-k8:]

One must look at why banks go public in the first place. Its to grow their business through a large infusion of capital. In theory this should lead to larger profits assuming a sound business model. A large bank using economies of scale can theoretically offer better terms which should also win them more business. If banks remained private, the banking business would remain even more fragmented and less cost competitive. This might lead to a larger premium paid on new loans. Certainly, not a thorough analysis of the pros and cons but something to be considered.

Jan 13 02:39 PM