Mittwoch, 4. September 2013

A Plea for more 'Normal Banks'

Raiffeisen Austria – a Meaningful Alternative Structure for a Bank?

The intensive discussions currently going on about issues like the appropriate role of banks, how to make banks safer, etc. prompts me to describe my experience with the Austrian Raiffeisen organization. The first 30 of my 40 years in banking, I spent with capital markets oriented banks, i. e. they were public stock corporations owned by shareholders. The last 10 years, I spent with a Regional Bank in the Austrian Raiffeisen organization; a co-op.

To sum it up: until my early fifties, I was convinced that there was only one way to structure a bank; i. e. to structure it as a public corporation with shareholders who, naturally, have an interest in the return which they get on their investment. In the last 10 years of my career, it dawned on me that there is a very, very interesting alternative to that structure.

Raiffeisen has become a brand name in many countries. Their structures may differ from one country to next. I will explain the structure of Raiffeisen Austria and I will attempt to do that in layman’s terms.

Friedrich Wilhelm Raiffeisen (1818-88) is described in history books as a ‘social reformer’ whose primary concern was to eliminate poverty in rural areas of Germany. Some of his principal convictions were: “help only for self-help”; “no give-away’s whatsoever”; “one for all and all for one”. He formed co-operatives in rural towns where the constituents of these co-op’s were those locals who had money and those who needed it. The constituents made sure that the money which was given (deposits) was passed on wisely to those who needed it (loans). Just as simple as that!

Raiffeisen structure in Austria
In Austria, the first Raiffeisen co-op dates back almost 150 years. Today, the Raiffeisen organization is probably Austria’s largest financial organization with over 1.000 banking offices in a country of 8 million. It is structured in 3 hierarchical levels:

Primary level – the independent Local Banks serving their local communities
Secondary level –the Regional Banks, owned by Local Banks and serving the Local Banks
Tertiary level – the Umbrella Bank for all Austrian Raiffeisen banks, owned by Regional Banks

The Raiffeisen organization follows Austria’s political organization: the Local Banks are in virtually every town/city (‘minimum equipment’ for an Austrian town: the mayor, the priest and the Raiffeisen banker). The Regional Banks are headquartered in the respective capitals of every federal state of Austria (9 of them) and owned by the Local Banks. And the Umbrella Bank is headquartered in Vienna and owned by the Regional Banks. In short: it is a pyramid turned upside down.

Historic evolution of the structure
To explain it in simple terms: picture the first Raiffeisen Bank (‘Bank A’) being organized in a small town. It is an autonomous co-op. Instead of tradable shares, the bank issues ownership certificates. These certificates do not pay any interest/dividends. The certificates can only be sold back to the co-op at nominal value, which is very low (say 10 Euro/certificate).

Why would people buy such certificates? Certainly not as an investment because the certificates do not generate any return. Instead, people buy them as a show of solidarity with and commitment to the community. When customers open a new account, they are offered to buy a certificate and since the amount is so small, they may agree to buy one out of a sense of solidarity with and commitment to the community. Many owners of such certificates are probably not even aware that they are ‘owners’ of a bank. The certificate entitles the holder to play an official role in the organization (annual meetings, honorary positions on boards, etc.).

Bank A takes in deposits and makes loans. If they have more loan demand than deposits, they initially cannot meet that demand. If they have more deposits than loans, they have to invest the excess with other banks.

One day (several other Local Banks existed already), it was discovered that Bank A had more deposits than loan demand and that Bank B had more loan demand than deposits. So, Bank A lent its excess to Bank B. As the number of Local Banks increased, they discovered that this exchange of liquidity became a rather cumbersome process. Thus, the Local Banks got together and decided to open, in the regional capital, a subsidiary whose initial role was to manage the cash surpluses/shortfalls among the individual Local Banks. As time progressed, the Local Banks discovered that there were many other activities which could be optimized by pooling them at the Regional Bank. The principal was: whatever the Regional Bank can do better for all than the Local Bank only for itself should be delegated to the Regional Bank. Over time, the Regional Bank assumed responsibility for setting regional policy guidelines, etc.

In short: the Regional Bank became something like a regional HQ except that when the regional managers ‘gave out orders’ to the Local Banks, they were dealing with their owners and not with their branch managers. That tends to have an influence on management cultures.

As time progressed, the Regional Banks discovered that there were functions whose performance could be optimized if they were not handled by every region on its own but, instead, pooled on a national level for Austria (i. e. the securities business). Thus, the 9 Regional Banks formed a subsidiary in Vienna which became the Umbrella Bank for Raiffeisen Austria. Its Supervisory Board is composed of managers of the Regional Banks. When the managers of the Umbrella Bank gave out orders to the Regional Banks, they were dealing with their owners. That tends to have an influence on management cultures.

Influence of organizational structure on management cultures
The constituents of the Local Banks (i. e. the ‘owners’) are members of all walks of economic life in the community (small businessmen, farmers, private individuals, etc.). The Supervisory Board of the Local Banks is composed of those constituents. Those constituents are not experts in banking but they do understand that lending has something to do with risk and that running a bank successfully has something to do with operational costs. So they watch particularly these two things: the loans which the  Local Bank makes and the operational costs which it incurs.

The mindset of the local managers is likely to mesh with the mindset of those constituents who appoint them (if not, they will not be managers for very long…). The constituents have a mindset where common sense prevails because that is how they run their own small businesses. Their view is that bank managers are there to gather deposits and to make loans and anything which prevents them from doing that (i. e. from dealing with customers) should be minimized.

The Local Banks are often very small units. The managers are not challenged to ‘manage’. They are challenged to do business. The key measurement is not any ROE (because ROE does not matter when no earnings are paid out) but, instead, the comparison with other Local Banks. And no local constituent is happy when he sees that other Local Banks are more successful in their communities.

The Regional Bank is owned by the Local Banks (based on the principle of ‘one bank has one vote’ regardless of size). The Supervisory Board of the Regional Bank is composed of managers of Local Banks whose mindset has been described above. Thus, the mindset of the management of the Regional Bank meshes with the mindset of the local managers which, in turn, meshes with the mindset of the local constituents.

Initially, the Regional Bank did nothing other than service the Local Banks. As time progressed, the Regional Bank started doing its own business with its own customers but always in cooperation and coordination with the Local Banks (their ‘owners’). For example: a local customer who might be too large to be handled by the Local Bank would be transferred to the Regional Bank for account management but ALWAYS in coordination and cooperation (and with revenue sharing) with the Local Bank.

My initial reaction to the Raiffeisen Structure
Within about a month, it became clear to me that Raiffeisen worked differently from the capital markets oriented banks which I had worked for before. Thus, I made an appointment with the Controller of the Regional Bank (my employer) to ask some questions. The dialogue went something like the following:

Question: If I understand our structure correctly, we own ourselves. There doesn’t seem to be any natural person who has a financial benefit (other than salary) if the bank earns more money. Normally, I would expect to see complete complacency with that kind of a structure. Why do I see more business aggressiveness than I have seen before in other banks?

Answer: You are right. There are no natural persons who, as owners, benefit financially from the performance of the bank. In fact, there is only one hierarchical level where the owners are natural persons and that is at the Primary Level. There, the ‘owners’ are the local holders of ownership certificates of the Local Bank. However, regardless how the Local Bank performs, they receive neither interest nor dividends. Neither can they make money on selling their certificates because they can only sell them back to the organization at nominal value. These constituents get essentially two things for their ownership certificates. One, at least once a year, they are invited to a meeting of certificate holders where they can feel as important members of the business community. Those are typically very special events with lots of recognition and rewards for individual constituents. And, two, the constituents can assume important functions, albeit without remuneration, in the supervision of the Local and Regional Banks. Put differently, they can assume positions of high standing and responsibility.

Question: But how come that the managers and staff at all levels are motivated so much to perform successfully instead of being complacent?

Answer: Because our system does not aim at the financial motives of people. Instead, our system aims at human motives for being successful in competition and for assuming important functions in society. The supervisors of Bank A pain if they see that Bank B is more successful in its market. The same goes for the managers of Bank A. Thus, the supervisors of the Regional Bank are composed of managers of Local Banks who thrive on competition and who make sure that the business practices which work well at the local level are also pursued at the Regional Bank.

Question: If the Local and Regional Banks can’t sell shares to investors, how can they raise capital for growth?

Answer: Remember, no earnings leave the organization; they are all retained and they are our source of capital formation. If there were insufficient retained earnings, our growth would be limited and Raiffeisen would fall behind its competitors. Since neither the Local Banks nor the Regional Bank want to fall behind competition, they are all motivated to generate earnings.

Question: So far, I have not heard anyone mention the ROE. Does the bank not measure ROE?

Answer: We think that the ROE is important but we also think that the ROE is the result of something and cannot be meaningfully managed in and by itself. That’s why we don’t talk about the ROE, even though we look at it. And we do show ROE in our Annual Report. We believe that a good ROE is the result of having done the right things. For us, ‘doing the right things’ in banking means having your risk and operational expenses under control. Thus, we focus on managing the quality of our risk and the level of our operational expenses. The most important ratio for us is the cost/income ratio. The most important analysis for us is the analysis of our risk portfolio – the risk rating and the level of risk provisions we make. We at the Regional Bank follow the following guidelines: of our operating revenues, no more than 40-45% should go into operating expenses; another 25-30% into risk provisions and the rest into capital formation and dividend pay-out to Local Banks.

Question: Why does the Regional Bank pay out dividends to Local Banks?

Answer: It’s a bit of a feel-good mechanism. Our dividend improves the earnings of the Local Bank and they look good vis-à-vis their constituents. Our dividend also increases their equity which enables them, in turn, to put more equity back into the Regional Bank (which equity, in turn, generates more dividends…).

Question: I see virtually no focus on structural optimization. In fact, it seems to me that there is quite a bit of double-effort inherent in the structure of having Local Banks and a Regional Bank. Why is there no focus on optimized organization?

Answer: Yes, there is some double-effort. We monitor it but we are not unduly concerned about it. Our philosophy is not to maximize short-term. Instead, we optimize longer-term. We have a strong belief (and everyone in the organization shares it) that every individual and every unit of the bank has to achieve a satisfactory operating profit. Note, I said ‘satisfactory’ and not ‘maximum’ operating profit.  If two units happen to work with one and the same customer and both achieve a satisfactory operating profit in the process, we are better off having two units than only one. Generally, the customer feels better serviced as well. Put differently, if we eliminated one of the two units, the customer could feel that, while it is a benefit for us, it is possibly a disadvantage for him.

Question: How can a system work with so many stand-alone Local Banks, many of them of extremely small size?

Answer: They are ‘stand-alone’ mostly on the outside. That’s what the customer sees. The customer does not see where the internal administrative functions are performed. The customer of the Local Bank does not see that his account statement is prepared and distributed by the Regional Bank. He does not see, or at least we hope he doesn’t see it, that most of the administrative functions of the Local Banks are pooled.

Question: With so many Local Banks being involved in the supervision of the Regional Bank, how can that work in practice?

Answer: It works because we all share similar values, the values of Raiffeisen. There is very little room to depart from those values. Suppose the managers of the Regional Bank decided to become ‘professional managers’ like in a capital markets oriented bank. They might invite a consulting firm to advise them how to optimize structures. They might make a PowerPoint presentation to their Supervisory Board. And then? Remember, that Supervisory Board consists of local managers with the mindset of local managers. They wouldn’t understand the PowerPoint presentation. Instead, they would probably begin to wonder whether they had the right kind of managers at the Regional Bank. Also remember, if the management of a centralized bank makes one very bad decision, the consequences run through their network of branches and subsidiaries. Our structure does not allow ‘one very bad decision’ to be made by only one management. The risk that all managers support the same ‘one very bad decision’ at the same time is very small.

Question: With so many entities, how can one control risk effectively?

Answer: Every bank in the system is liable for every other bank. Before one depositor loses money, the entire Raiffeisen organization would have to disappear. The Local Banks are liable for each other and for the Regional Bank, and vice versa. That motivates everyone to watch what everyone else is doing. The auditing arm of the Raiffeisen organization is completely separate from the banking arm. It audits the Local Banks as well as the Regional Bank. Furthermore, the Regional Bank with its greater professional expertise monitors closely the performance of the Local Banks. The Regional Bank cannot ‘dictate’ any measures to the independent management of the Local Bank but the Regional Bank can make conditions for ‘continued support’ of the Local Bank. One condition might be the replacement of local management.

What is the role of the Umbrella Bank? (Raiffeisen Bank International)
With so many Local Banks and 9 Regional Banks, what can an additional Umbrella Bank possibly do?

Traditionally, the principal role of RBI was to make sure that the full spectrum of international services could be offered by every single Raiffeisen Bank, even in the smallest town of Austria. Then followed other services which were deemed to work better when pooled at the national level (Leasing, Fund Management, Investment Banking, etc.). Also, the larger Austrian corporations preferred to do business with a bank headquartered in Vienna and with direct international competencies.

During the 1980s, RBI ventured into Eastern Europe with a small subsidiary in Budapest. After the fall of the Iron Curtain, Eastern Europe exploded for RBI. Today, RBI is the largest banking group in Eastern Europe with subsidiaries and national banking networks in all countries. In many countries among the top-3 banks; in some countries even the No. 1.

To finance that expansion, RBI could no longer get by with only the equity provided by the Regional Banks. Today, RBI is a publicly traded bank with about 25% of its shares traded publicly. While still under control of the Raiffeisen culture, it is quite noticeable that RBI now has public shareholders who want a (short-term) return on their investment: RBI focuses on ROE and it works with management consultants from time to time…

In terms of structure, RBI is the ‘grand-daughter’ of Local Banks (via the Regional Banks). The East European subsidiaries of RBI are ‘great-grand-daughters’ of local Raiffeisen Banks. The significant benefit of that is that, ultimately, RBI can fall back on the deposit base of over 1.000 Local Banks (which act like a vacuum sucker of deposits).

Example: after Lehman, some of the East European subsidiaries of RBI faced liquidity squeezes. They needed funding from RBI. Since RBI acts like a wholesale bank, it did not have much of a deposit base on its own and the interbank market had dried out. Nevertheless, RBI could draw on the resources of its owners, the Regional Banks. Since the Regional Banks did not have much of a deposit base on their own, either, they had to draw on the Local Banks, their owners. And the Local Banks had the largest share of deposits of any Austrian banking group. No better way to show the advantages of a bottom-up organization than that!

Business philosophy of Raiffeisen
As explained in great detail, one will never hear a Raiffeisen banker say something like “our primary responsibility is to earn an adequate return for our shareholders”. Instead, a Raiffeisen banker will say something like the following: (I have heard it on innumerable occasions)

“Our principal purpose is to provide our customers with the financial resources so that they can take advantage of their market opportunities and grow. Our growth and success depends on the growth and success of our customers. Our business is not simply the lending of money. Instead, it is the providing of financial resources. In most cases, the making of loans will serve that purpose well. In some cases, our customers may be better served if we offer them other forms of financing. Where we offer Private Equity, we don’t do that with an exit to third parties in mind. Instead, we do it with a view that the customer will benefit from that equity so much that he can eventually repurchase it out of his own means. In other cases Leasing may be the best way to provide financial resources to our customers. Or Factoring. Or whatever. It is the providing of financial resources which is what we are here for.

Our customers may not really ‘need’ us in good times but in bad times they must be able to rely on us as a provider of financial resources. In order to be a reliable financial partner, we must adequately provide for risks long before they occur. When we attend the first bankers’ meeting after a company has announced problems, we see a lot of bankers who are nervous. They are nervous because they have not made any loan loss provisions yet. Their mindset is that, whatever is decided, it should not harm their P+L. Thus, their focus is on getting their money back as soon as possible, even if that means damaging the company. Our view is that the greatest damage for all occurs in the case of bankruptcy. Thus, wherever and whenever there is a reasonable hope that the company can survive with our help, we have to provide that help. In the end, we will most frequently be better off financially and we will certainly be better off in terms of market reputation.

We are not an end it and by itself. Instead, we can only exist because some people have money and others need it. Thus, if we occupy ourselves with ourselves, we are defeating the purpose. We cannot secure our well-being on our own. We need the market and customers for that. What counts, above all, is customer satisfaction and we are monitoring that carefully and continually.

Finally, successful banking is not only about risk but, equally importantly, about costs. Operating costs, that is. The more we spend on operating costs, the less we have available for risk provisions and equity formation. As long as we keep our operating costs in the range of 40-45% of revenues, we are in good shape. That cost/income ratio is the most important yardstick which we are tracking through the entire organization all the time”.

The first Annual Report came out after I had been with the bank for about 9 months. The first number I looked for was the ROE. I wanted to see how low it was when a bank was not managed with a view towards maximizing ROE. Interestingly, the ROE was about 12% and it had been in the range of 10-12% in the years before. Not quite the 25% which Josef Ackermann promised his shareholders but, then, very close to the 12% which Deutsche Bank had actually averaged during Ackermann’s tenure.

There can be no question that in a globalized world with globalized corporations, banks have to be more than local, regional or national co-op’s if they are to service their customers well. A publicly traded stock corporation seems to be the only way to structure such a bank.

The question is one of mindset and culture of a bank. A capital markets oriented bank will communicate well with a capital markets oriented customer. They are both driven by the same mindsets and culture (they ‘speak the same language’). A capital markets driven bank and a middle-market entrepreneur may become a poisonous combination because they are driven be different mindsets and cultures (they hardly ever ‘speak the same language’).

My conclusion is that for that segment of the economy which is not driven by a capital markets mindset and culture, the organizational structure described above is a most interesting alternative to that of a public stock corporation. And, if it is works well, it can work extremely well for all sides. Much better than a public stock corporation ever could in that market segment.