Why Buying Banks Is a Horrible Idea

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Let me start by saying that I like banks and bankers, generally. I worked for Barclays (NYS: BCS) UK Retail for a few years and didn't meet a single member of management who was willing to overlook customers' needs. That's not to say that everything that happened was ideal for customers, but they were always in the equation. Having said that, let's look at why investors should be very worried about the future of banks, and the nature of banking customers.

Local boy named king bee
The LIBOR scandal involving interest-rate manipulation has gotten everyone all riled up. But people are riled up about the wrong things. Headline after headline is telling us how badly behaved bankers are, usually throwing out the bottle-of-bubbly quote from the Barclays investigation for good measure. But that doesn't tell me anything about the core problem, or how we're going to do anything other than what we've always done.

What we need to do is to think about the root problem: Banks were incentivized to manipulate LIBOR. As it turns out, banks were incentivized to issue bad home loans. To take on extra market risk. To look the other way when money launderers came calling. So maybe the problem isn't just that bankers are greedy, but that the institution of banking is a place where being greedy is also heavily incentivized. And that problem can be summed up in one phrase: shareholder value.


How did we end up here?
"The ultimate objective of our strategy is to create and deliver long-term sustainable shareholder value." That's a quote from Barclays' 2011 annual report. The problem with that quote is that it's just straight-up wrong. Barclays is a bank, and banks are shepherds of risk. They (should) manage risk in such a way that the company earns a return for taking on the risk of customers. By being better risk managers, the banks should make more money. But CEOs around the world, especially in the financial sector, have traded the idea of running a good company in for the idea of maximizing shareholder value -- which inevitably means they destroy shareholder value.

The underlying problem in the focus on shareholder value is compensation. Bankers are rewarded for creating value, but the biggest value is generated through the largest risks. That means that instead of producing sustainable value, bankers are making risky, short-term-focused transactions. The banks are rewarding them for being bad managers of risk.

It's only now that the world has come crashing down that banks are even beginning to see the value in managing risk again. Bank of America's (NYS: BAC) 2011 annual report says, "We deliver to three groups of customers and clients the leading capabilities they need to manage their financial lives and businesses." This is a better picture than it painted in 2007, when shareholders were still firmly in the focus.

How can banks do well for shareholders?
The system of banks that focus on shareholder value is clearly broken. Over the past five years, big bank stocks are trading down more than 50%, almost across the entire sector. There are some notable exceptions to this trend. Wells Fargo (NYS: WFC) -- which is where I keep my pittance these days -- is roughly flat over the past five years.

Looking at its stated goals from 2007, Wells Fargo's strategy was "to increase the number of products our customers buy from us and to give them all of the financial products that fulfill their needs." That's pretty darn focused on customer outcomes, and the company's stock has beaten our shareholder-focused companies like Barclays, HSBC, and Bank of America.

What alternatives are there?
Talking about how broken the system is doesn't help, unless we can think of a better system to replace it. A good place to start would be with most successful retail companies. Look at Buckle (NYS: BKE) , one of my current favorites. The company has done well for investors over the past five years, with the share-price increase of 72%. That rise has been accompanied by a 71% increase in revenue.

But the company hasn't done this by focusing on maximizing shareholder value.

Instead, Buckle has emphasized its customer-focused, disciplined growth strategy for the past five years. You'll see that focus in every annual report. This focus on customers and growing sustainably is a good place for banks to look -- but it's not going to just happen. Banks have gotten used to growing as much as possible as quickly as possible. While there has to be a change in mentality, an even more important change has to come externally.

The bottom line
I don't like excessive regulation, but the fact is that banks have proved that the incentive model in place gives them no reason to try to play fair. If we truly want to see a change in banking, it's going to have to be an external push. Only then will banks revisit the need to treat customers well, and manage the risk that is in their portfolio. I can't say that I know how that's going to happen, but it's not going to happen without action.

Until it does, I have no desire to be a part of any bank that focuses on increasing shareholder value, instead of on providing customers with good products. Maybe the change is coming, but I have my doubts. For now, I like what Wells Fargo is doing, I like the value it's generated for investors over the past year, and I like that it's done that by focusing on customers. Until other banks figure that system out, I'd stay very, very far away.

There are a few other banks that seem to be doing things right, and the Fool has pulled together a report focusing on one of them. It's a smaller regional bank that our banking experts see as a promising investment. You can get all the details for free in "The Stocks Only the Smartest Investors Are Buying." Download a copy, get the inside scoop, and decide for yourself. Get your free report today.

The article Why Buying Banks Is a Horrible Idea originally appeared on Fool.com.

Fool contributorAndrew Marderowns shares of Barclays, and he banks with Wells Fargo. The Motley Fool owns shares of Buckle and Bank of America.Motley Fool newsletter serviceshave recommended buying shares of Wells Fargo and Buckle. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days. The Motley Fool has adisclosure policy.

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