April 11, 2019

Are banks your best friends?

Before I start, my aim is not to criticise banks but to highlight that their economic interests are not structurally aligned with those of their clients. Their motivation is to make a profit from the money they manage. Banks are fundamentally important economic players that everyone needs. However, a sensible private client must have a form of control. Here’s why:

1-    The investor’s perspective

During my last ten years in the family office space, I have regularly come across people telling me that they do not touch their liquid asset portfolios. That is their bank’s responsibility and they trust them enough not to question anything (as long as the return is positive). This way, they can concentrate on what they enjoy doing but, at the same time, are they burying their heads in the sand?

A family’s objective is to preserve wealth and ensure that the next generation can retain, at the very least, the same wealth level. To do so, they need to deploy money because of its time value[1]. This means investing. Investing requires a set of rules which Warren Buffet reduced to two. Rule No. 1: never lose money. Rule No. 2: never forget Rule No. 1.

To achieve such a goal, and to eradicate the curse of losing wealth within three generations, wealth holders have to think carefully about their appropriate risk level. This depends on their current asset mix, cash flow requirements, future liabilities and duration, and should lead to a well-diversified[2] strategic asset allocation. In fact, 70% of returns are driven by strategic asset allocation. The remaining 30% depends on how the retained banks and selected investment managers perform and, of course, how their contribution may be offset by fees[3].

 

2-   The bank’s economic incentive

Let’s have a look at what drives a bank’s profit.

Banks are intermediaries whose initial function is to make money by borrowing money from savers and lending it to borrowers at a higher interest rate. This is what economists call interest rate intermediation margin.  

Viewed in that context, a bank’s goal is to maximise its interest income with the return on asset (ROA) being a key performance indicator. Therefore, the return a client receives from her bank is a fraction of the return the bank has generated, depending on how much a bank finds acceptable to hand back. In light of this, a client’s and a bank’s interests are essentially opposed. And this misalignment has been worsening.

Banks have been competing hard to try to become dominant players in their sector. They have been seeking to “increase their balance sheet” as the conventional view holds that the bigger the balance sheet, the bigger the control. This is why banks have entered into multiple activities (investment banking, trading, asset management to name a few) to enhance their return on assets. In order to grow, they also have to bear new costs such as hiring certain skills, perhaps super-star traders or corporate financiers, just to maximise ROA. However, those accrued costs and risks are passed onto clients.

Banks set up structures that tie in clients. These structures ensure clients buy as many products as possible from them and that such products generate enough volume that fees can be charged. However, banks do their best to ensure that they are not the ones to bear the brunt if things turn out badly. Long gone is the time of merchant bankers who would bleed alongside their clients.

A bank's goal can be summarised as capturing the largest amount of a client's assets and locking them within, but also moving them around, their own systems. This way they can maximise fees and let others bear the extra risks and costs required to maximise such fees.

 

3-   How does that affect investing?

This means the cost of investing is driven higher and clients bear more risk than expected. How? By keeping investors:

  1. Trading. Nobel Prize winner William Sharpe demonstrated that market timing is an illusionary way of enhancing returns. Market timing would need to be right 74% of the time to beat buy-and-hold investors. Since trading is about timing, which indicators should investors rely upon? How long can investors wait to make up their mind? Who is the ultimate winner in such a trading approach? The bank.

  2. Investing in their buy list of funds and structured products. These products generate trading fees, management fees and distribution fees that come out the investors’ pockets. These products are meant to, and will probably, generate returns for investors but in a way which may be substandard.

  3. Deterred from moving to third-party solutions.

 

The current regulatory contexts combined with the current low yield will further this ambivalence and interest misalignment. Indeed, new regulations mean new costs. Low yields mean lower ROA. The combination of the two mean banks must find ways to compensate for these and maintain their profitability targets.

Many opt for the solutions of putting clients into one-size-fits-all fee-heavy funds or fund-like products, or forcing relationship managers to focus on raising fees while cutting costs altogether. Some banks are reducing their budget for investment information tools and no longer provide their clients with up-to-date prices when transacting. Others may be inciting trading floors to increase mark-ups on services delivered to investors. All these initiatives share the same goal of increasing returns, and these returns come from one pot: investors’ wealth. Investors are faced with taking more risks to sustain return expectations while banks are taking limited risks.

 

4-   Next steps

To avoid such conflicts of interest, many families set up their own family office or use third-party family offices. It is a very appropriate way to access knowledge and bring independence to the way assets are managed. Nonetheless, it can prove insufficient. Indeed, using third party intermediaries poses the risk economists call the “agency risk”[4], which in turns leads to a fiduciary risk[5].

However independent from banks a third person may be, their interests may not be fully aligned. Dr Saskia Kalb and Frans Peeters explain this in their article “Family Office Psychology” published in the Family Office Magazine last year. It is a matter of realigning and co-owning fiduciary best interests. This may be solved with strict KPI and management objectives. Something easier said than done, especially when using a multi-family office. The aforementioned article even suggests having an independent controller or advisor to regularly assess fees structure, performance and risks.

In fact, this is all about investors (in this case, families) having the diligence to put together a system that objectivises the quality, the relevance and the value of the services they receive. It is about them controlling how well their fiduciary interests are protected for their sake and the sake of forthcoming generations. The system must be: accurate to effectively support constructive discussion and save precious time; coherent to facilitate informative comparisons between different periods; regular to monitor the value of decision-making; and efficient to ensure any corrective action takes place with the minimum of disruption. If this system can help aid the co-operation between family principals, family officers and other trusted advisors, all the better. The table in the Appendix may be of help. (Full disclosure, I am CEO of Finlight, a platform that helps end-investors achieve the goals listed above).

However, whatever your way of working, it’s important that investors understand the natural misalignment between their objectives and those they entrust their money to.  So, I conclude with saying, of course, banks are your friends and partners but make sure you understand their economic incentives. You are responsible for looking out for your own best interests. As Mark Twain is presumed to have said:  “It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so.

By Jean-Bernard Tanqueray

  

Appendix

References

[1] Money has a time value because of inflation and monetary policy. £1 today is worth more than £1 tomorrow. The only way to protect the value of today’s £1 is to invest it in a way that yields an interest at least equal to inflation net of all costs.

[2] Jack Meyer, Harvard University fund: “The most powerful tool an investor has working for him or her is diversification. True diversification allows you to build portfolios with higher returns for the same risks. Most investors are far less diversified than they should be”.

[3] https://investor.vanguard.com/investing/how-to-invest/impact-of-costs

[4]The risk that the management of a company will use its authority to benefit itself rather than the shareholder. (https://financial-dictionary.thefreedictionary.com/agency+risk)

[5] The risk that funds are not used for the intended purposes; do not achieve value for money; and/or are not properly accounted for. (https://europa.eu/capacity4dev/file/10207/download?token=v3oOtbsk)