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The Banker's Nemesis: Warren Buffett's Critique of the Banking Industry

The Banker's Nemesis: Warren Buffett's Critique of the Banking Industry

After the collapse of Silicon Valley Bank and Signature Bank, investors were in shock. But the Oracle of Omaha quickly assured them their deposits are safe - even offering to wager them with a $1 Million bet! Buffett pointed the finger at "messed-up incentives and poor communication" that has caused this turmoil, along with lack of penalties for bank leaders. 1. Hubris As soon as there's unrest in the banking industry, it can be tempting to blame bank CEOs and board members. Unfortunately, that is not an effective solution: rather, its source lies deeper within industrial civilization itself. Modern society is overpopulated, leaving its citizens struggling with an array of ailments. War and hunger, pestilence and sudden deaths, torture and madness - these have all become part of human experience - but this is not due to nature itself but instead caused by modern economic growth which encourages exploitation and corruption. Classically, in Greek mythology's Nemesis myth, Prometheus defied nature by breaking its laws, incurring unforseen cosmic punishment that manifested as physical pain for himself and those closest to him. Ancient Greeks saw Prometheus' story as an unavoidable warning of cosmic justice. Ancient civilizations also understood that hubris can lead to disaster. Tantalus, for instance, who stole Ambrosia - the divine potion that gave immortality to gods - from its divine provider experienced an endless cycle of thirst and hunger after becoming corrupt with power; ancients believed he had inflicted upon himself an everlasting curse of "tantalising" nemesis. Moderns understand that hubris can lead to devastating results in economies and societies alike. The global financial crisis of 2008 was precipitated by reckless and irresponsible behaviors on the part of banks, governments, consumers and others - much of it caused by hubris: thinking financial markets self-regulate while central banks can control inflation with interest rate manipulation alone. In an interview with Benzinga's PreMarketPrep show, the Oracle of Omaha and Charlie Munger discussed openly the issues facing banking industry in an open and honest fashion, emphasizing that citizens shouldn't panic following regional bank collapses. They emphasized that the government will continue to guarantee deposits that exceed the $250,000 federally insured limit. They criticized a shift on Wall Street that began after former Treasury Secretary Robert Rubin campaigned to end Glass-Steagall, an antitrust law that barred commercial banks from owning riskier investment institutes. This allowed for giant financial institutions that are too big to fail and encouraged risky bets that would ultimately be covered by taxpayer bailouts. 2. Mismatch of Assets and Liabilities Mismatch between assets and liabilities is a financial risk that affects any institution with significant debt exposure, from banks to sovereign governments. A mismatch may arise due to various factors such as interest rates, cash flows, maturity dates, currency conversions or conversion rates between two different currencies - among many others. Liabilities outweigh assets and cause insolvency, according to The Oracle of Omaha. He assured depositors their money was safe but cautioned about endorsing the overall health of banking sector with his million-dollar bet; not going too far in backing his claim by citing recent failure of Silicon Valley Bank as evidence of such mismatch between assets and liabilities. SVB had difficulty due to having too many loans concentrated in one industry and region, meaning if either experienced setbacks it could result in huge losses for them. For this reason, banks strive to diversify their loans across different industries and geographies so as to achieve an equilibrium between long-term investments and short-term ones. One problem associated with this is that deposits have shorter maturities than loans, so their prices can change much quicker when interest rates fluctuate up or down, potentially leading to assets being repaid at a rate lower than what their loans charge, leading to lost revenue for banks. Banks often experience liquidity issues due to mismatches between assets and liabilities, especially as deposits can often be quickly withdrawn whereas loans cannot be called back - an issue which could prove catastrophic in an emergency situation. Buffett was unhappy with how politicians, regulators, and media handled the collapse of SVB and other regional banks. He blamed poor messaging that unnecessarily scared depositors. Furthermore, he called for changes to bank regulation incentives to avoid such disasters in future. 3. Incentives Financial industry employees have come under greater scrutiny since the financial crisis, and with good reason. There is growing recognition that incentives based on loan volume or performance could cause frontline bankers to take riskier lending decisions; to prevent such mistakes compensation should align with an organization's overall business strategy and culture. Unfortunately, creating the appropriate incentive scheme requires much more than increasing employee pay alone: many factors must come together, including who distributes incentives why and who receives them. One way of creating the appropriate incentives is through financial means, but this approach has its drawbacks; such as encouraging unethical behavior, turnover, and diminishing intrinsic interest in work. Another solution could be setting clear rules which don't depend on financial incentives available to managers but could create opportunities for legal or regulatory arbitrage that compromise a bank's culture. Banks strive to increase expected profits by seeking investment projects with economic returns greater than that of a safe asset like Treasury bonds, while avoiding riskier ones with lower returns. To accomplish this goal, employees who have personal investments (their compensation) at stake work tirelessly in search of profitable investment opportunities. An effective compensation policy rewards employees who identify worthwhile projects while penalizing those who don't, while still creating positive incentives. But it is also important to recognize there are other means by which to reward employees without creating detrimental incentives. Buffett suggested it is time for banks to return to "old values." That means depositors should be made whole, stockholders should take losses on investments made during 2008's global financial crisis and debt holders should bear losses as well. An aggressive punishment system might send the message that irresponsible behavior won't be tolerated and could discourage excessive risk taking, keeping banking industry operations within reasonable parameters; otherwise we risk another and more costly crisis in its place. 4. Poor Communication Miscommunication and misinterpretation of emails, regulations or instructions; poorly drafted contracts; or incompetent team members all pose threats of costly mistakes and productivity losses that are all too real despite being less noticeable than catastrophic bridge collapse or natural disaster events. One of the primary sources of poor communication lies within individual human feelings and biases, which often prevent us from effectively communicating. People may twist information to suit their agenda, or leave out important details so as to not hurt feelings or embarrass themselves; the end result being an irreparable breakdown in communication which leads to conflict, rumors and gossips. Poor communication in banking can have severe repercussions, particularly with regards to new products and services. Irene Etzkorn pointed out in her blog post for The Financial Brand that many banks are overwhelmed by policies, procedures, guidelines and instructions which do not impact directly upon consumer experience, leading to confusion that leads to frustration and ultimately dissatisfaction among their clientele. Poor communication takes many forms. This may include not following through with instructions, and having unclear or ambiguous communication that leads to deceptive practices. As evidence of this, the Federal Reserve has filed several UDAP (Unfair Deceptive or Abusive Acts and Practices) complaints against banks who fail to clearly explain terms and fees associated with their products. Buffett offered his take on the challenges facing banking during an appearance on Benzinga's PreMarketPrep show. He noted how Silicon Valley Bank and Signature Bank's failure had alarmed depositors; but assured them their money is safe with FDIC protections. He further noted the "woeful incompetence" of some executives at failing banks and called upon board members to hold them accountable. While most of his bank stocks had already been sold off, he remains cautious regarding their future holdings until it becomes evident that these banks are properly run.

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