What Bankers Should Think About When They Think About Banking

By Markets Fool.com

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The history of banking in the United States is defined by sharp episodes of panic, in which legions of banks fail or are otherwise hobbled, intermixed with periods of calm and prosperity that last just long enough to dull any lessons learned in past panics.

Some of this is the inevitable result of the credit cycle, which, historically speaking, is as American as apple pie and baseball. However, some of it stems instead from a lack of appropriate context and perspective on the part of bankers and investors.

Perspective is worth 80 IQ points
I've heard it said that perspective is worth 80 IQ points. While I doubt that's technically true -- though, to be clear, I don't know anything about measuring IQ -- it's hard to deny that the general sentiment is valid. This is particularly the case when it comes to banking.

One of the principal issues that haunts the bank industry is the failure among its less-experienced operators, not to mention the general public, to appreciate its frailty. Indeed, I don't think it's much of a stretch to say that most people consider banking to be synonymous with boring.

The problem with looking at banking through this lens is that it obscures two of the industry's defining traits. First, banks are among the most highly leveraged financial institutions in the world. And second, albeit as a consequence of the first, banks must constantly negotiate between phenomenal long-term success and abject short-term failure.

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While little can be done about either of these on a broader level, much can be done by individual banks to avoid the fate that, over the long run, is almost certain to befall many competitors. And the best place to start is by approaching the practice of banking from the appropriate perspective.

How banks are like airlines
In my opinion, there are two helpful contexts in which to think about banking. The first, and simplest, is to analogize banking to the airline industry.

On a superficial level, the comparison of banks to airlines follows from the reality that both types of businesses sell commoditized products -- airlines sell plane tickets; banks sell money (i.e., loans). The net result is that these two industries are dominated by low-cost producers who can sell their products for less than their competitors while maintaining an adequate level of profitability.

"Being the lowest cost producer gives you tremendous power because it allows you to price loans at much more competitive rates," Jack Milligan, the editor of Bank Director Magazine, told me in a long and insightful phone conversation about the industry.

Suffice it to say that Jack is right. But what's important for investors and bank executives to appreciate is that the significance of his point goes beyond the obvious. Namely, one reason the industry is so frail is because less-efficient operators, which handily outnumber their more-efficient peers, tend to juice their profits by assuming more risk -- that is, by loosening credit standards and boosting loan volumes.

Columbia business school professor Charles Calomiris touched on this in his excellent book Fragile by Design: The Political Origins of Banking Crises and Scarce Credit (emphasis added):

Given an environment in which risk-taking with borrowed money [is] considered normal, it is easy to understand why some bankers,particularly those who [are] having trouble competing against more efficient rivals, decide that the right strategy [is] to throw caution to the wind.

The consequences of this are disastrous. Among airlines, analogous tendencies have led to reoccurring bankruptcies at many of the leading players -- that is, with the exception of Southwest Airlines, which runs one of the leanest operations in the industry. This is why Warren Buffett once opined that, "despite the huge amounts of equity capital that have been injected into it, the [airline] industry, in aggregate, has posted a net loss since its birth after Kitty Hawk."

And the same is true of banking. Over the past two centuries, the U.S. financial industry has experienced 17 panics. That equates to one every dozen years. And each time a panic occurs, often-irreparable damage is inflicted on lenders that veered too far from the dictates of prudent lending. Thus, Nassim Taleb'sclaimthat "banks have never made money in the history of banking, losing the equivalent of all their past profits periodically -- while bankers strike it rich."

Banking and black swans
It's this vulnerability to irregular but not infrequent panics, in turn, that underlies another way to think about banking. Namely, in most industries, extreme events are the exception rather than the rule when it comes to long-term profitability, but when it comes to banks, the exact opposite is true.

Taleb refers to this as "Black Swan logic," and he illustrates it in his seminal bookThe Black Swan: The Impact of the Highly Improbablewith a hypothetical story about a Thanksgiving turkey:

Consider a turkey that is fed every day. Every single feeding will firm up the bird's belief that it is the general rule of life to be fed every day by friendly members of the human race "looking out for its best interests," as a politician would say. On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief.

Taleb's point as it relates to banks is this: It doesn't matter how much money a bank makes in the many good years when the economy is roaring and few borrowers are defaulting on their loans. What matters most for long-term profitability is how well a bank weathers the short but severe panics which besiege the industry on an irregular but not infrequent basis. It's here where good bankers earn their keep.

You can get a taste for this in the chart below, which shows that the KBW Bank Indexactually decreased over the last full credit cycle -- i.e., between the commercial real estate downturn of the early 1990s and the financial crisis of 2008-2009:

Given this, it should come as no surprise that the history of banking reveals a vast graveyard of once-dominant lenders. The highly esteemed Jay Cooke & Co. went under in the panic of 1873. The Knickerbocker Trust Company failed in 1907. Continental Illinois, the "Morgan of the Midwest," was seized in 1974. The 230-year-old Barings Bank failed in 1995. And in the last cycle, we saw both Wachovia and Washington Mutual, among hundreds of smaller lenders, succumb to imprudent lending in the subprime mortgage market.

The takeaway is that bankers should always assume that the next panic is around the corner and act accordingly. "No one has the right to not assume that the business cycle will turn," says JPMorgan Chase's CEO, Jamie Dimon. "Every five years or so, you have got to assume that something bad will happen."

Prudence and opportunity
At the end of the day, there is no simple and elegant solution to eliminate the considerable risks that haunt the practice of banking. The credit cycle will go up, and it will crash back down, and when it does, it will take the industry's least-prepared operators with it.

Yet, far from lamenting these dynamics, it's impossible to deny the extraordinary opportunities created by them. Indeed, for bankers who perceive the industry through the proper context and proceed in kind, one can't help but embrace the myriad possibilities presented by the failure of those who don't.

The article What Bankers Should Think About When They Think About Banking originally appeared on Fool.com.

John Maxfield has no position in any stocks mentioned. The Motley Fool owns shares of JPMorgan Chase. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.