To be successful, approach banking as a philosophy

You can think about banking as a trade, or you can think about it as a philosophy. I prefer the latter..Banking is the ballet of business. It requires a combination of strength and grace to navigate such highly leveraged institutions through the unforgiving vagaries of the credit cycle. While there are multiple philosophies of banking, the ones that have proven themselves through time are all rooted in this simple observation..To understand banking, one must appreciate its two most peculiar traits. The first, as already mentioned, is the immense leverage used by banks. The typical company on the Dow Jones Industrial Average borrows $3 for every $1 of equity. The typical bank, by contrast, borrows $10 (or more) for every $1 of equity. This is a feature of banking, not a bug. But it makes banks "fragile by design," to steal the title from an insightful book written on banking in recent years..The second trait catalyzes the first. If you run a shoe store, there are only so many shoes you can sell in any given year. Even if you drop the price to $1 per pair, there's still a limit to how many shoes someone can own. However, if a bank drops its credit standards and interest rates far enough, the demand for loans becomes virtually limitless. This makes short-term growth easy, though it often comes at the expense of long-term solvency..Warren Buffett spoke to this in his 1990 shareholder letter. "When assets are twenty times equity, a common ratio in this industry, mistakes that involve only a small portion of assets can destroy a major portion of equity," he wrote. "And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failing that we described last year when discussing the 'institutional imperative:' the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so.".Many banks have succumbed to this volatile combination. "If our lending apparatus had a systemic weakness, perhaps it was the result of our emphasis on growth," wrote Robert Smith in "Dead Bank Walking: One Gutsy Bank's Struggle for Survival and the Merger That Changed Banking Forever." Smith was recounting the downfall of Security Pacific, one of the great California banking franchises, where he served as CEO. "Because growth was a function of the number rather than the quality of loans we made, no one wanted to say 'No,'" he continued. "No one wanted to be the messenger who issued a caution that resulted in a drop in earnings. We'd prided ourselves in growth and frowned upon any gesture that restrained it.".The central question in banking is not just how to avoid a similar fate; it's how to turn the innate fragilities in banking to one's advantage..The answer coalesces around a handful of commonalities of high-performing banks, starting with efficiency. "Being a low-cost provider gives one a tremendous strategic advantage," Jerry Grundhofer once explained. "It allows you to deal with challenges, be competitive on the asset and liability sides of the balance sheet, and take care of customers." Grundhofer would know. He and his brother, Jack Grundhofer, were the architects of Minneapolis-based U.S. Bancorp, the nation's fifth-largest commercial bank, which exited the financial crisis of 2008 with the highest credit rating in the banking industry..If a bank is efficient, more of its revenue falls to the bottom line, translating into higher profitability. Additionally, because efficient banks tend to be more profitable than inefficient banks, the former have less incentive to cut corners in their loan portfolios. If you're already earning your cost of capital and thereby fulfilling your duty to shareholders, there's no reason to chase yield..A second commonality is capital allocation. It's tempting to think that the most successful companies must be run by the most highly skilled operators — folks who can rally their troops, and identify and fix flaws in processes. Yet, the CEOs who have created the most value over time fit a different prototype, as William Thorndike revealed in "The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success." These CEOs are introverted and contemplative, brilliant but understated. They run from the spotlight, not toward it. And they're highly gifted at capital allocation making the most of the money their companies earn..The same is true in banking. After consolidating control of M&T Bank in 1983, the late Robert Wilmers made opportunistic acquisitions in every financial crisis that struck during his 35-year tenure: Black Monday in 1987, the Savings and Loan Crisis of the early 1990s, the Asian financial crisis of the late 1990s, the financial crisis of 2008. Along the way, M&T created more value than virtually every other bank in the United States. Yet, if you met Wilmers, you'd have seen a quiet, reserved man, more at home in a library than a locker room..This brings us to a final commonality: Skin in the game. I once asked Wilmer's successor, René Jones, what the key to M&T's success was. "If I had to boil it down to one thing," he said, "it's that we could get 40 percent of our shareholders seated around the coffee table in Bob's office." When people have skin in the game, they act like owners. It's the difference between renting and buying a car. We care for the things we own. This is as true in banking as it is everywhere else..In banking, there are many ways to skin a cat, as the saying goes. Yet those who have done it best approach it, again, not as a trade, but instead as a philosophy. It is not about mechanically producing widgets; it's about possessing and acting upon a visceral feeling of danger and opportunity..John Maxfield is a scholar, writer and speaker focused on the banking industry. His work has appeared in USA Today, Time, Business Insider, Bank Director magazine and The Motley Fool. To regularly receive John's banking insights and publications (Maxfield on Banks) subscribe at maxfieldonbanks.com. He also has a Substack profile under his name, https://substack.com/profile/133243631-john-maxfield.