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2 - BANK MANAGEMENT IS CHANGING

Banks are important and can be seen as the veins and arteries wherein blood flows. Without them – life as we know it – is not possible. The banks are the first ones to get in shape, so our modern life can continue.

Noted in 1923 by J. K. Paasikivi (2000) former President of Finland and Bank Manager

Sure, banks are still tremendously important for economic growth!

We will start by highlighting some of the complexities that affect a bank manager’s work, as well as the entire financial intermediation and the banking industry. We will elucidate on what bank management is in practice and how banking has changed the bank actors’ cognitive views. We will try to investigate and identify the typical factors and patterns behind good (right) and bad (wrong) bank management. We refer to right here as meaning legitimate and wrong as in inappropriate. We will study what bank managers themselves think about bank management, and how bank management differs from management in a commercial or manufacturing firm.

Today, in a finance driven world, you may through your e-mail or social media, already have received tens of suspect loan offers from ‘new’ lending firms! Also buy-now-pay-later offers are frequent. For many this is the reality in our finance-driven world! Millions of customers have fallen for the temptation to try a fast loan, which in turn has often caused over indebtedness to increase, lost credit worthiness and increased personal problems!

Banks are special organisations, and both in banking business as well as in management there are “black boxes”. In the first black box there is debt creation, which will generate risk and uncertainty for bank managers. Or to put it another way: will the money be paid back? In the second “black box” there are the balance sheets, in which we can see the capital structure of a bank. And this balance sheet is about five to ten times more vulnerable than the typical capital structure of a manufacturing firm. We are thereby commencing on a journey to discover how bank management has changed with growing uncertainty and vulnerability in both traditional and shadow banking?

Already in the beginning of the twenty-first century, the banker Henry Kaufman (2000: 61) noted that the power and influence of traditional commercial banks, savings banks, cooperative banks, and insurance companies had diminished, while a new breed of institutional participants had come into force. The new breed included the often-reviled hedge funds, although they were neither the sole nor the leading contestants. We were at the beginning of the year 2000, during the peak of the internet or dot-com bubble, where wealth was being created and destroyed, sometimes overnight. The internet bubble that subsequently burst was an overoptimistic belief in information technology (IT), with internet and web solutions for sales, banking and almost all sorts of activities. It soon proved that all the promises made by the so-called dot-com companies were over-optimistic. In fact, most of the new dot-com companies had a hard time trying make a profit. However, “new” types of institutions had already been created in the financial markets during the 1990s, including hedge funds, investment banks, equity funds, etc.

These institutions were distinguished by their emphasis on short-term investment performance, a heavy use of leverage, and a willingness to move in and out of markets – whether equities, bonds, currencies, or commodities – in a relentless quest to maximise returns. In the early twenty-first century, the creation of the shadow banking market in the USA made things even worse and in the aftermath of the 2008 global financial crisis, we were facing a massive printing of new central bank money, this time called quantitative easing (QE). The large-scale asset purchases of bonds and other financial assets (2008–2021) by central banks, is a form of expansionary monetary policy, whereby a central bank expands its balance sheet and buys financial assets (mostly government bonds), in order to stimulate the economy, increase the liquidity in the economy, save banks by increasing their liquidity, or even by buying a stressed bank’s equity. The nuclear cocktail is ready to explode again. So, how should a banker prepare for this transition?

Change, data, methodology and experience

We have worked in different management positions within the banking sector for over three decades, from local banks to the world’s largest investment bank. Although we have worked primarily with banking in Europe, we also have experience from Africa, Asia, as well as North and South America. Another aspect of our work has been to advise bank authorities, the World Bank, EBRD, governments and bank management. We have also had the opportunity to write doctoral dissertations about banking (Kjellman, 1997; Kangas, 2006) as well as articles and books on excellence in banking (Kjellman, Björkroth, Lindholm & Ranki, 2004). This experience has naturally affected our research methods and approaches to the complexity of banking. From a theoretical point of view, we follow in the footsteps of many other great thinkers and argue that Culture plus the environment plus the past plus the present situation plus future (realistic or unrealistic) aspirations will affect the outcome; and that some factors are more critical than others when it comes to the good performance of banks.

Our data comes from our own experiences, structured and unstructured discussions with bankers, three questionnaires sent to the managing directors of banks, and financial data from banks. Over the years, our meetings and discussions around this book project have resulted in joint publications in scientific journals as well as many individual scientific and newspaper articles; and it has not been an easy job to put this book together. We have eagerly analysed issues like luck, the halo effect, bank platforms, AI and machine learning. However, we have always ended up with a common view concerning the complexity of banking. And hopefully, we have managed to narrow it down to five fairly easy to remember issues of successful banking in the 2020s and beyond.

From a theoretical perspective, we do not wish to lock ourselves into just one approach. Instead, we intend to go in a more holistic direction, partly based on the macroeconomic level of demand, supply and expectations, and on the microeconomic bank level, based on the strategy tripod suggested by Peng (2006). The strategy tripod is an approach that can explain bank and corporate behaviour, based on 1) industry, 2) firms and bank resources, and 3) institutional development. For example, Porter’s (1990) industry-based view asserts that industry factors shape a bank’s competitive advantage in the global market. Barney’s (1991) resource-based view argues that a bank’s internal resources and capabilities determine the bank’s growth and performance. By comparison, institutional factors have often been treated as contextual factors and been taken as exogenous factors by management scholars. As you will see after a while, in this book we have agreed that some factors are more critical than others, thereby drawing on the Critical Factor Theory suggested by Kjellman (1997) and inspired by the late Prof. James “Jim” March at Stanford.

Due to the fact that, we will analyse the changing content of a bank manager’s work and the changing banking industry, it is important to know what the and word means between a bank manager’s work and the transition of banking. The and word here has three interpretations: correlation, causality, and independence-interpretation. At the same time, we can say that this book is about the past, present and future of banking.

The hard core of traditional bank management is to master something that is, in abstract terms, usually called the ‘analysis of credit risks’. It refers to the capability to analyse and screen potential borrowers and to allocate funding and grant loans. It is not, however, enough for a bank manager to find customers, who are willing to take loans. They also need to be able to pay their loans back, with a margin, in an agreed time. Today, the deregulation and printing of money – or quantitative easing – by FED, ECB and other central banks has changed the way we look at money. The speed and amount of money has reached unprecedented heights. Furthermore, the lines between the real and financial aspects of business life have blurred as well.

Another source of risk in the new financial world relates to competitors and counterparts. The fall of Lehman Brothers on 15 September 2008 pushed the entire world into financial turmoil. Predicting the moves of rivals is inherently uncertain, especially when the rivals are also trying to predict our behaviour. Choosing to be different from rival banks implies risk, as well as doing things similarly does. Shadow banking or bank activity outside the balance sheet extended the operations of traditional banks; however the practice also brought in new competitors and risk. It is especially important for management to be able to assess how competitive moves may affect the values of the credits and liquidity of the collaterals. A third source of credit risk comes from technological change. Artificial Intelligence (AI), robot trading, derivative strategies and digitalisation of bank activities will bring in new types of risk, i.e., programming errors, fraud, hacking and new, unpredictable cyber wars.

All of this is connected to a bank manager’s daily work. In addition to the analysis of credit risks and uncertainties, bank managers must carefully control the balance sheets of the bank, because the capital level of banks is historically seen as low and vulnerable.

Bank managers are affected by culture, environment and egos

Bank managers are influenced by the culture and environment that they live in (see Figure 2.1). A bank manager’s life space, based on past experiences, the present situation and future aspirations, will affect the choices they make concerning the bank’s decisions. This line of reasoning is inspired by Lewin’s field theory, which in recent years, has become one of the most popular theories in psychology. We have to recall that bank managers are socially influenced individuals. They live in their current life space and have experienced the past as well as having aspirations for the future for themselves, their families and the bank. These aspirations will be one factor among many other potential factors that will explain how bank managers will lead and act in their banks during periods of growth as well as decline.

Bank managers can choose between a profusion of change strategies for the banks they run or are part of. Furthermore, bank managers, together with boards of directors and owners, must decide on which banking business areas the bank will act; i.e., 1) traditional or/and 2) capital-based banking and “casino”, shadow banking. We have narrowed the strategic options down to two main potential strategies that a bank manager might pursue: 1a) a traditional long-term strategy, usually with a modest risk for the bank. However, this traditional bank strategy may also include sub-strategies like: 1b) a growth and profitability focused strategy, which is too often applied during good times, and often during bad times leads towards 1c) a merger-focused strategy, in which the bank is fighting for its survival. The second major strategy that a banker faces is to decide how much capital-based banking and shadow banking the bank will be able to indulge in.

Shadow banks are entities such as structured investment vehicles that (like traditional banks) perform credit intermediation services, but (unlike traditional banks) lack central bank liquidity of public sector credit guarantees (Pozsar, Tobias, Ashcraft & Boesky, 2013). Shadow banking is, in essence, any form of non-depository credit intermediation.

Figure 2.1. The bank manager’s decision-making is affected by society, i.e., culture and environment as well as what the bank manager has done before, his current life situation (life space) and his dreams about the future.

Figure 2.1. above represents both the normal banking situation during good times and that of a crisis-pressured banker during harder times, which we saw all over the world after the Lehman Brothers crisis and the shadow banking crisis in the USA. The shadow banking crisis in the USA pushed most of the world into the Global Financial Crisis of 2008, which has been ongoing in many counties in Europe in 2016–21, with speculations about the potential failure of Deutsche Bank in Germany and Societe General in France, just to mention a couple of banks that are considered too-big-to-fall. Thus, there has been an unusually long and unexpectedly deep recession, that has affected the banking industry in Europe and the rest of the world.

The organisation that stipulates the rules for the international banks is the Basel Committee on Banking Supervision (BCBS). It is the primary global standard setter for the prudential regulation of banks and provides a forum for regular cooperation on banking supervisory matters. Many bankers entering into the 2020s are concerned with increasing solvency demands stated in the Basel III agreements, which raised solvency for the banking industry by about 50 percent. As a rule of thumb, one can argue that the new Basel III requirements, currently expected to enter into force in 2022 (it was initially expected to enter into force in 2015), raise a ‘normal’ international bank’s minimum solvency requirement from 2 percent to 3 percent Equity-to-Total Assets.

The official solvency requirements reported by banks, for example Basel II or the Basel II Accord (sometimes also called BIS) place solvency levels at 8 percent. However, that number has little to do with Equity-to-Total Assets, because it depends on the risk level of the banks’ balance sheet. Basel III standards are the minimum requirements which apply to internationally active banks. Furthermore, in some countries Basel III solvency applies to both national and international banks. Many bankers feel that this required Equity-to-Total Assets level is still too low; and we belong to that group. Thus, the new Basel III regulation will, according to our judgement, only have a marginal effect when it comes to preventing a new crisis and potential bank runs!

How should you act as a banker if you want the bank, and the banks’ customers to grow and prosper? That is the main point with this endeavour that has taken us eight years to complete! And yes, we are still puzzled concerning many parts of good and bad banking. However, we have found some of the keys behind good bank management in the Age of Nuclear Finance; a period in banking when things happen both slowly and rapidly. In brief, our findings behind good banking are like a simple Hedgehog strategy: know one thing well! and that thing is to serve your customers in a trust-creating way that is best for the customers!

On the content of a bank manager’s work

“Do not ever grant loans without suitable and certain collaterals. Do not advance and encourage speculation on any habits. Finance only legal and considered transactions”.

(From the memo of the Bank Superintendent of the USA, Hugh McCullochin 1863, which was duplicated in 1988 by Vice Managing Director of KOP Simo Kärävä for the Board of Directors of a bank that did not listen and seven years later ended up in the history books.)

A bank manager’s fundamental content in the banking business is to have or borrow money, in order to lend money to customers profitably. As an industry, the banking business is simple. However, in reality, working with money and people is difficult and complex. We try to find the answer to a question: how does a banker get the information needed to decide on lending and to analyse credits and investments? We used to think that a banker had more information on the economy than a manufacturing firm. However, we do not think that is true anymore.

In the operational environment, where a bank manager works daily, there are internal and external actors and factors, which affect the bank’s performance. We assume that the performance of all these actors and factors will be affected by their past, current and future activities. The banks are being pushed and pulled by the past activities of the bank, the current activities and the expected future aspirations of the bank and its Board of Directors, management, customers and owners.

Figure 2.2. The operational environment of a bank manager is affected by interlinked internal and external factors.

In Figure 2.2. above we can see important internal and external factors affecting the space of movement, i.e., the range of freedom in a bank manager’s work. Though these factors are important in the strategy of a bank, the actors and factors are also part of a bank manager’s daily operational work, which is a more relevant part of a bank manager’s activity than strategic work.

We note that far too little has been studied in banking concerning operational risk. The risk Management Group of the Basle Committee on Banking Supervision (2001, 2003) defines operational risk as ‘the risk of loss resulting from an inadequate or failed internal process, people and systems or from external events’. In general terms, this is the risk associated with the possible failure of a bank’s systems, controls or other management failure (including human error). We note that the definition of operational risk given above includes technology risk. There are different operational risk event types. We are interested in management risk, which is the risk that management lacks the ability to make commercially profitable and other decisions consistently. It can also include the risk of dishonesty by employees and the risk that the bank will not have an effective organisation (see Casu, Girardone & Molyneux, 2006: 272–275) (Table 10.3). In Chapter 3, we explain how a bank manager’s moving space can disappear in a decline.

The significant changes that have occurred in the financial sector industry have increased the importance of performance analysis in modern banks. Performance analysis is an important tool used by various agents operating either internally (for example managers) or who form part of the bank’s external operating environment (for example regulators). Casu et al. (2006, 212–213) believed that bank performance is calculated using ratio analysis and made their assessments with the aim of: 1) looking at past and current trends; and 2) determining future estimates of bank performance. Financial ratio analysis investigates different areas of bank performance, such as profitability, liquidity, asset quality and solvency. We think that management is an important part of bank performance. However, many bank researchers say that it is difficult to see how banks are performing and what they are doing in practice.

On Halo Effects and complexity in banking

It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow. Henry Ford (1957).

We can say that bank management, and the complexities of banking, are different in local and shadow banks. Bank managers must remember that the strategy and operations should be appropriate for their banks. It is good to remember that customers are also different in different bank arenas, i.e., they are interested in different services.

Due to banking secrecy, little can be said publicly concerning the black box of financing decisions and performance of loans. A legal framework prevents bank managers from talking about clients and loan decisions. Consequently, a mystique is created, and an illusion of wise decision-making is born! One can “be made” to see things that are not there, i.e., short-term performance illusions or Halo Effects, which can be exploited!

If you see a bank that is performing well, you might think that it is efficient and professionally managed! In many cases it can be precisely the opposite! Lehman Brothers was considered a respectable and well-managed bank … before it failed! Nokia was for a long time the world market leader (40 percent of global markets in mobile phones 2007) and considered a giant that was very well-managed and innovative! Kjellman, Yang, Wu, and Park (2020) noted that then Nokia missed a turn regarding the future in the mobile phones business and almost failed. In 2015 Nokia and Microsoft had 0 percent of the global mobile and smartphone markets! These are examples of Halo Effects! You see and perceive something – like a great leader – that is not there!

Phil Rosenzweig (2007) is considered to be one of the great thinkers concerning the Halo Effect … and other business delusions that deceive managers! We see something that is “not there”. A good example of this is a great leader, who produces a great result for a short period of time. However, in the long run, such a leader may cause the bank to slide into the history books as another failed enterprise. Such delusions in banking are a great problem!

Traditionally, the cornerstone of the banking business is trust. Typically, banks in earlier times focused on strategies based on asset growth. Measured by the balance sheet, they strove to become ever larger. Big is often perceived as more trustworthy, and a manager of a bigger bank is perceived as being better than a manager of a small bank! In reality, this is often a Halo Effect! This is because small banks are generally safer for depositors than big banks! However, not many depositors look at things that way!

The trust of a bank is measured daily by the solvency and equity in the bank’s balance sheet. The financial highlights in a bank’s balance sheet are funding, lending, net interest income, operating result. Other important highlights in the balance sheet are the structure of the balance sheet, financial solidity, credit losses, bad loans and the number of offices and employees.

To fully understand the banking business and the advantages of the intermediation process, it is necessary to analyse what banks do and how they do it. The main function of banks is to collect funds (deposits) from units in surplus and lend funds (loans) to units in deficit. Deposits typically have the characteristics of being small-size, low-risk and high liquidity. Loans are of large-size, higher-risk and illiquid. Banks bridge the gap between the needs of lenders and borrowers by performing a transformation function which includes:

1 size-transformation,

2 maturity transformation, and

3 risk transformation.

Banks perform this size transformation function to exploit the economies of scale associated with the lending/borrowing function. As a result, they have access to a larger number of depositors than any individual borrower. Banks are said to be ‘borrowing short’ and ‘lending long’, and in this process they are said to ‘mismatch’ their assets and liabilities. This mismatch can create problems in terms of liquidity risk, which is the risk of not having enough liquid funds to meet one’s liabilities (see Casu et al., 2006: 7).

In recent decades, conglomeration has become a major trend in financial markets, emerging as a leading strategy of banks. This process has been driven by technological progress, the international consolidation of markets and the deregulation of geographical or product restrictions (see Casu et al., 2006: 449, 25). We think that in the management of shadow banks the conglomeration strategy is more typical than in the capital-based markets.

About the banking business

The business models of banks have changed after the Post-Crisis Age, in the 2010s. The banking industry has entered a period of slower growth than earlier. New regulation and a supervisory environment have been major driving forces in the future evolution of banks and their business models and strategies. We can see that new regulatory requirements have induced slower growth in banking, higher costs, and more banking fees. Low interest rates, in combination with regulation pressures have impacted differently on different banks, according to their business profiles (see Ayadi, Arbak & DeGroene, 2011).

Financial deregulation essentially consists of removing controls and rules that in the past have protected financial institutions, especially banks. However, in many cases deregulation is initiated less by a desire to benefit consumers than by a need to improve the competitive viability of the financial industry. The barriers between banks and non-bank financial institutions have disappeared, allowing, for example, for the rise of universal banking activity. One consequence of the process of deregulation has been the increased perceived risk within banking business. Banks can minimise the risk of individual loans by diversifying their investments, pooling risks, screening and monitoring borrowers and holding capital and reserves, as a buffer against unexpected losses.

The aim of banks is to cross-sell an array of products and services to meet customer needs and to generate more fee and commission income. People usually say that banking services are complex. After bank deregulations in the 1980s and 1990s, not to mention the clustering and reselling of subprime mortgages in the early twenty-first century, we note also that bank managers have done complex things in banking. In the history of banking, we have seen that many famous bank managers have taken a complex world and simplified it, for example what occurred at Wells Fargo, Handelsbanken and Kvevlax Savings Bank. Collins (2001: 96) argued that simple strategies are the best, even if strategies alone cannot explain success. However, we argue that in banking, bank managers used to make simple bank services too complex and that was a huge mistake! especially when they ran out of trust! New instruments and advanced calculation methods have been used to avoid risk, increased taxes, etc.

Bank managers conduct banking by using their banks’ balance sheets to try to enhance business in the banking market. The banks also provide asset management, pension savings, clearing services, insurance services and basic legal services. This can be done either by the bank itself or by a business partner. A manager must focus on the elements that drive firm performance, while recognising the fundamental uncertainty at the heart of the business world. The table below presents the central assets and liabilities in the balance sheet of a traditional bank, compared with that of a shadow bank.

Table 2.1. A simplified ordinary bank balance sheet compared with a shadow bank balance sheet

Traditionally, deposit customers have been very important for a bank manager, because deposits as well as lending services are cheap and long-standing for the bank.

Forms of asset versus liability management

Modern banks have become more likely to undertake co-ordinated management of both sides of the balance sheet, rather than focusing on just the asset side. The main concerns and objectives of a bank manager on the asset and liability sides are summarised in Table 2.2. below (see Casu et al., 2006: 226).

Table 2.2. Forms of asset management versus liability management

Asset management	Liability management
Maximise return on loansand securitiesMinimise risksAdequate liquidity	Maximise return ininterbank marketMinimising costs of deposits

The co-ordinated and simultaneous decision in financing investment is the essence of asset-liability management. What is asset-liability management in practice? Sinkey (1998) identified a three-stage approach to balance-sheet co-ordinated management. Stage 1: global or general approach, stage 2: identification of specific components, and stage 3: balance sheet generates profit and loss account. Policies to achieve these objectives should include:

 Loan quality,

 Matching maturities,

 Generating fee income and service charges,

 Control of non-interest operating expenses,

 Tax management, and

 Capital adequacy.

It is important to look at and manage both sides of a bank’s balance sheet. For modern banks, the goal is to manage assets and liabilities in a way that maximises profits while being generally ‘safe and sound’. Prudence banking is needed due to the special role that banks have in the economy and the potential ‘domino’ effects that a bank’s failure may cause to the financial sector as a whole. In doing so, bank managers rely on information revealed by periodic financial reports produced by various accounting systems.

We believe that the information bank managers have about the banking business is not as realistic as the information that a manufacturing firm has. The basic risks of the banking business are still the same ones that affect the lending and the funding of lending. The risks are related to real estate, venture capital and risk business, the maturity of funding, the marginal of rent interest, competitors, and the technological skills of the banking industry and the managers themselves.

More about the complexity of banking

The strengthening of credit risk and liquidity management are pivotal in banking because the capital structure of a retail bank is about five to ten times more vulnerable than a typical capital structure of a manufacturing firm. We have seen difficult and complex problems, and some these problems are external while others are self-inflicted internal bank problems at the level of the banks and bank managers. Here we constitute some banking business complexities, which have different effects for banks and for bank managers in banking arenas. We believe that there are more external complexities (out-bank) for banks than internal ones.

External complex challenges for banks:

 uncertain economy,

 unfair competition,

 unclear and disloyal governments and other authorities,

 spontaneous bank mergers,

 shadow banking; new unknown competitors,

 payment platforms,

 new bank technology, and

 other challenges.

Internal challenges for bank managers:

 bad and untruthful customers,

 compliance problems,

 lending to new and unknown customers,

 unclear papers and illegal decisions,

 difficult to forecast the economy for bank and possibilities of customers, untruthful managers/colleagues and employees,

 complex bank service products, and

 other internal challenges.

There are many other complex issues in banking. However, these rules of thumb may help you as a bank manager to reduce some of the complexity issues. In order to help your customers, you may like to refer to the following guidelines:

 Indebtedness of households should not be too much over 100 percent of disposable income of five years.

 A magnificent lifestyle and too many credit cards is not recommended.

 Too high prices of real estates, should raise concern.

 Unexpected changes in the values of firm assets are common so a lower valuation is recommended.

 Credits for unknown projects of firms is not advisable!

The competition situation and different levels and dimensions of banks will affect how a bank manager conducts his/her operational work. Still, the complexity and interaction between different factors and measures are, in reality, hard to understand. It is a difficult area to master and obviously a great field of tension. The seeds of crisis can often be found in the fact that this is an area where you can easily go wrong. All the participants in the financial industry, from central bankers and authorities to bankers and customers, have repeatedly taken wrong turns throughout history! – and we can expect them to do that again!

However, let’s start with an overview of the financial market structure and the functions of Financial Intermediators.