M&T Bank’s annual report to shareholders for the year ended Demcember 31, 2014.
The year past was far from a typical one, either for U.S. banking or at M&T. The evolving nature of financial industry regulation, the attention paid to infrastructure and regulatory compliance, and the uneven character of the economic recovery, all merit attention.
M&T’s 2014 earnings did not match the record level of the previous year. Nonetheless, they remained strong despite elevated expenses, a consequence of investments in our infrastructure and the costs and complexity of responding to evolving regulatory compliance requirements. Our headway in such an environment reflects the core strength and resilience of the company.
Net income prepared in accordance with generally accepted accounting principles (“GAAP”) was $1.07 billion for the past year, down 6% from $1.14 billion in the year prior. Diluted earnings per common share totaled $7.42 in 2014, a decline of 10% from the earlier period. Last year’s net income, expressed as a return on average total assets and average common equity, was 1.16% and 9.08%, respectively. Comparable figures for 2013 were 1.36% and 10.93%.
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Taxable-equivalent net interest income, which is comprised of interest received on loans and investments, less interest paid on deposits and borrowings, was $2.7 billion for 2014, a very slight increase from 2013, owing in part to the continued low interest rate environment, which has remained in place for some 24 quarters. At the end of 2014, total loans were $66.7 billion, an increase of 4% from the end of the previous year. Average interest-earning assets rose by 10% last year, to $81.7 billion. The largest component of that increase was a $4.9 billion or 74% higher level of average investment securities. New regulations require banks like M&T to hold more government-backed securities as a “liquid asset buffer” for times of economic stress. Investment securities made up 13% of total assets at the end of 2014, compared with 10% of assets at the end of the previous year. Those lower yielding investments, purchased with $3.2 billion of borrowings raised in the debt capital markets, were additive to net interest income but negatively impacted our net interest margin. Taxable-equivalent net interest income expressed as a percentage of average earning assets – an important measure of balance sheet efficiency – was 3.31%, a decrease of 34 basis points (hundredths of one percent) from the year before.
As the economy continued to improve during the year, so did the repayment performance of M&T’s loan portfolio. Net charge-offs were $121 million, an improvement from $183 million in 2013. Net charge-offs expressed as a percentage of average loans outstanding were 0.19%, which is the lowest figure we’ve seen since the 0.16% level recorded in 2006, immediately prior to the last financial crisis. M&T’s allowance for losses on loans and leases stood at $920 million as of December 31, 2014, representing 1.38% of loans outstanding. The modest $3 million increase in the allowance from the end of the previous year reflects a provision for loan losses of $124 million for 2014, less the $121 million of net charge-offs.
Income from fees and other sources totaled $1.78 billion in 2014, a decrease of $86 million from 2013. The previous year was marked by net securities and securitization gains of $110 million, as M&T repositioned its balance sheet in preparation for our first-time participation in the Federal Reserve’s 2014 Comprehensive Capital Analysis and Review (“CCAR”) program. Those gains did not reoccur in 2014. Revenues from mortgage banking increased by 10% to $363 million over the past year and trust revenues increased by 2% to $508 million.
As a result of increased expenses arising from our ongoing efforts to upgrade M&T’s bank secrecy and anti-money laundering (“BSA/AML”) compliance program, in addition to other key investments that position M&T for the new regulatory and operating environment, non-interest expenses increased to $2.74 billion last year, 4% higher than $2.64 billion in the previous year. Contributing to the higher level of expenses was a 4% increase in employee salaries and benefits as well as a 9% increase in other costs of operations.
We continued to grow our capital base in 2014. M&T’s Tier 1 common capital ratio, which is the one most closely followed by both regulators and the investment community, increased to 9.83% at the end of the year, an improvement of 61 basis points from 9.22% at the end of 2013, effectively closing the gap with our peer regional and super-regional banks. Our tangible book value per share was $57.06 at December 31, 2014, an increase of 9% from the end of 2013.
M&T Bank: Pardon Our Dust
In the wake of our investments of the past two years, it is tempting to borrow a slogan one sees at stores changing their inventories or displays: “pardon our dust.” It implies that change, in some ways difficult and inconvenient, is underway – but that something better is taking shape. That’s certainly indicative of what’s been going on at M&T.
The year 2014 will be remembered as one in which we turned our focus inward, enhanced our infrastructure and broadened our knowledge base. As discussed in these pages last year, a great deal of work was begun in 2013 to address heightened demands from our regulators. We continued to invest considerable time, money, thought and labor in 2014 to make substantial progress on those efforts, while simultaneously working to build a better, stronger M&T Bank. We have worked on improving technology, risk management and business processes while adding to our ranks of talented personnel. We hired top professionals with expertise in emerging areas of focus. Our technology and banking operations division alone was fortified by key hires with responsibilities spanning development, security, architecture and connectivity. Those additions included a Chief Technology Officer and an Enterprise Security Officer – new positions that embody the changing nature of our bank and our industry. Fundamentally, we know more about more topics than last year, and collectively we are acutely aware of the path required to succeed in tomorrow’s banking industry.
There is no denying that the work undertaken thus far has not been optional – it’s work that had to be done. We spent $266 million in 2014 in a broad swath of efforts that will help M&T fulfill its regulatory obligations – an unprecedented amount in unprecedented times. However, our construction efforts have not been limited to regulatory matters, nor does 2014 mark the end of such expenditures. We will continue to invest heavily in data, technology and personnel in 2015 and beyond; these are investments that will enable our colleagues to serve our clients more efficiently while providing the products and services needed to achieve their financial objectives.
The notion of strengthening our foundation is not foreign. There have been seminal moments in our history when we have paused to make significant investments driven by customer needs or movement into new markets. Whenever we grow by way of acquisition, we then busy ourselves by digesting what we’ve become while trying to make it better. Think of the work we’re doing now in much the same way, though in this case we are improving because we expect to continue to grow.
Risk Management Infrastructure: Enhancing our BSA/AML program consumed significant time, energy and money with investments of $151 million last year, in addition to the $60 million spent in the prior year. The systems we began building in 2013 were deployed to great effect this past year. The expanse and depth of our new BSA/AML program is both imposing and remarkable; it ensures that the risk profile of every customer of the bank, old and new, is understood and properly managed.
In 2014, M&T fully implemented a new Know Your Customer program to better assess the potential risks presented by each of our 3.6 million customers and their 5.4 million accounts. This program, which has been in operation for nearly one full year, has been used with 149,065 new customers. We have obtained appropriate additional information, or conducted remediation, as the jargon of BSA/AML would have it, on 671,502 customers and remediated 95% of the existing customers whom our models identified as requiring a higher level of scrutiny. A year ago, the team responsible for researching customers with higher risk profiles reviewed an average of 77 per day; that figure reached a peak of 327, a fourfold increase, stemming from additional resources, as well as enhanced processes and efficiency as the group became seasoned at their task. Our integrated BSA/AML program spans all business units, and no corner of the enterprise lacks oversight or accountability. A rigorous, customized training curriculum was developed to ensure each employee is properly positioned to perform his or her respective duties. Collectively, they spent 91,834 hours in classrooms, person-to-person training and online courses about BSA/AML and related regulations. Each one of our employees understands his or her part in executing this program.
Along with investments in systems and processes, we also invested in talent to support and oversee these efforts. In 2014, 630 colleagues were dedicated to this program, as well as over 300 contractors and consultants; together they occupied nearly 10% of our total office space in downtown Buffalo, where we are already the largest private sector employer.
Our efforts in 2013 were characterized by intensive preparation for the inaugural participation in the CCAR process – which requires each participating organization to project its revenues, credit losses and capital levels under five hypothetical scenarios, two internally developed and three provided by the Federal Reserve. These scenarios include levels of economic indicators such as the real and nominal Gross Domestic Product, the Consumer Price Index, the U.S. unemployment rate, the CoreLogic U.S. House Price Index, the Federal Reserve Board’s U.S. Commercial Real Estate Price Index; interest rates: 3-month Treasury rate, 5-year Treasury yield, 10-year Treasury yield, BBB corporate yield, Mortgage rate, and Prime rate; the Dow Jones Total Stock Market Index and the Market Volatility Index, which may be seen in distressed, recessionary environments.
It was heartening to receive no objection to our first CCAR submission when the final results were released by the Federal Reserve in March of last year. Continued investment in 2014 was devoted to making our methodology more comprehensive and efficient. We are keenly aware that the regulatory bar continues to rise – and what was deemed satisfactory one year may not pass muster the next. Hence, we continued to strengthen intellectual capital by directing talent to the CCAR effort, while adding specialized skill sets from outside the organization where needed. This team, dedicated to stress testing and the capital planning process, now includes 91 professionals – an increase of 32% over the team that supported the first submission.
We continue to work on ensuring that our risk management and capital planning practices are comprehensive, that they permeate all parts of our day-to-day business activities and, therefore, are commensurate with our risk profile. During 2014, 292 individuals across the organization, including the CCAR team, were involved in stress testing-related activities – an increase of 56% over the prior year. Given the quantitative emphasis of the exercise, nearly half of the 75 models that support our work were upgraded in response to evolving standards of the Federal Reserve and self-identified areas for improvement. The key governing committees met 74 times during the year to discuss capital and stress test-related topics, compared to 38 times in 2013 – prior to our initial CCAR submission.
In addition to BSA/AML and CCAR, we have invested heavily to comply with other elements of the Federal Reserve’s enhanced prudential standards for bank holding companies. Our growing Risk Management division – which numbers 727 colleagues – is more than five times as large as it was in 2009 and 56% larger than in 2013 – at a cost of $181 million, an 84% increase over 2013.
New regulatory standards also require more formal, structured risk management governance; which is furthered by the new systems, models, procedures and policies that allow us to better document the process used to manage risk. Taken together, 190 committees produce nearly 7,600 pages of meeting minutes annually – more than twice that of five years ago. Last year, the Risk Committee of our Board of Directors met 18 times, while reviewing 4,445 pages of presentation materials.
These are investments befitting an institution of broader size, geography and business model than M&T is currently, and which will undoubtedly serve to meet our own operational and strategic needs for years to come. But they are far from unrelated to problems and challenges faced by the financial services industry as a whole – to protect it from the collateral damage that can be inflicted by opaque systems and transactions, as well as from a growing wave of external security threats.
Data, Technology and Cybersecurity: Looking back at the last financial crisis, it is evident that transparency and integrity of data on products, portfolios and services within the banking system and their attendant risks were seriously deficient. In its aftermath, governing bodies are requiring banks to provide data on their operations frequently and often on an “on demand” basis. The magnitude of requests has grown significantly since the crisis and now, in addition to just providing answers, work papers and supporting documentation must be made available as well.
Answers to regulatory-related questions can involve an array of bits and bytes, which can be extremely time consuming to fulfill, coming from different corners of the enterprise. Beyond the demands of regulation, it is also clear to us that in the information age, data is the lifeblood of an organization – for customer service, marketing, finance, risk and other functions.
In 2013, business needs, regulations, as well as common sense, stimulated us to begin implementation of an enterprise data warehouse. Beyond the $25 million we have already invested in getting the integrated warehouse up and running, we will continue to work on making the data it houses much more comprehensive and accessible, spending perhaps an additional $20 million annually for the next three years. It will enhance our ability to analyze data for our own use and to better serve our customers, while allowing us to provide better information to regulators. Today, much of this information is maintained in “vertical silos.”
Banks are increasingly being defined by their “plumbing,” the technology they deploy to serve their customers. In the past year, we have invested in our online banking platform and mobile banking application, enhanced commercial and mortgage lending capabilities and began work on upgrading the operating system that resides on 27,333 personal computers and servers, requiring an investment of $19 million. Investments like these will mean a simpler approach for our clients and an easier experience for our colleagues.
Improving that experience is but one of the priorities for our technology investments. Almost daily we are reminded that the threat of attacks on the systems that have created unprecedented convenience and efficiency, has also left us at risk of novel forms of crime. Indeed, cybercrime is a new global growth industry. A recent report by the Center for Strategic and International Studies estimates that global cybercrime inflicts losses of up to $400 billion each year, which is almost as much as the estimated cost of drug trafficking. In 2013, more than 40 million individuals in the U.S. experienced the theft of their personal information. Cybercrime, it is estimated, extracts between 15% and 20% of the $2 trillion to $3 trillion in value created by the Internet.
A vast apparatus of nefarious, increasingly complex activities continues to manifest itself in a growing number of ways, threatening the viability of the systems the world uses to conduct commerce. From the petty criminal on a home computer, to organized networks of dedicated hackers, to foreign government-sponsored threats, the various forms of cybercrime are growing rapidly. Government Accountability Office (“GAO”) testimony before Congress revealed that in 2007, US-CERT (Computer Emergency Readiness Team) received almost 12,000 information security incident reports. That number had more than doubled by 2009, according to statistics from the GAO, and it had quintupled by 2013. Based upon one study, the number of reported retail customer accounts compromised due to data breaches increased from less than one million in 2012 to over 60 million in 2014. In 2012, M&T reissued 6,955 debit cards to cardholders who had been compromised because of identity theft, either as individuals or because a retailer had been hacked. In 2014, that number had grown to 294,415. Over the same timeframe, the number of cyberattacks on our systems that we have blocked has gone up by 27% and the number of “phishing sites,” those set up by fraudsters to trick customers into believing they are logging onto the M&T website, increased by 36%. A recent article in The New York Times on cyberattacks quoted law enforcement officials as saying that the threat of hacking was particularly acute for the health care and financial services sectors, and that the FBI now ranks cybercrime as one of its top law enforcement priorities. Scarcely a week goes by, it seems, without headlines about a cyberattack on a major U.S. corporation.
The payments system, the infrastructure that enables money to move through a modern economy, is a prime target of cybercriminals. Unfortunately, America has fallen behind much of the developed world in modernizing this core system. Money is increasingly moved electronically rather than through the traditional means of checks or cash. As of 2012, while check transactions in the U.S. declined to 15.5% of non-cash payment transactions, in mature markets like Europe they only account for 4.8%. Technology companies, retailers and service businesses have stepped in to attach to the existing payments infrastructure, providing convenient new ways of making payment transactions to their customers. While the innovation that is happening outside the banking industry has the potential to benefit the public, these non-bank entities are not regulated to the same high standards as banks and, ultimately, it is the banking industry that is held responsible for the safety and soundness of the payments system. As such, it behooves the entire banking industry, behemoth banks and community banks alike, to work together with regulators to ensure that America has a payments system that is highly secure and maintains the public trust, yet is open to many forms of innovation.
It has always been our prime objective to secure our clients’ financial assets and the bank itself. Not so long ago, ensuring security primarily involved guards, armored carriers and vaults. We still need them, but the focus has shifted decisively to protecting our customers’ data and M&T’s technological infrastructure from electronic attack. To that end, we added senior cybersecurity experts last year, increasing our staff by more than 20%. We are also partnering with colleges to bring in a pipeline of young talent with the right education in security. We have invested significantly in enterprise fraud technology and enhanced online security – efforts that comprised just a portion of the 46% increase in investment in cybersecurity last year – an investment that will undoubtedly continue to grow in an attempt to stay ahead of rapidly expanding and varied threats. In an era in which the risks of poor cybersecurity are plain, high security standards are no luxury. Indeed, they are crucial to our operations.
New Jersey: There are any number of reasons why it has long made sense for M&T to look to New Jersey should we choose to expand via acquisition. Quite simply, doing so is in keeping with the character of our past three decades of mergers and acquisitions, which have consistently brought us into markets similar to, and contiguous with, those we have served and with which we are familiar – and where a branch network providing our broad range of services would improve the banking options available to households and businesses. By most counts, New Jersey is an attractive market. Its median household income ranks third in the United States, while its median household net worth ranks seventh. Middle market and small businesses, the core of M&T’s clientele, are 20% higher per capita than the national average.
The attractiveness of this market underpinned our August 2012 decision to enter into a merger agreement with Hudson City Bancorp (“Hudson City”), believing that we had identified a transaction which made good sense for both parties – and for New Jersey, where Hudson City’s branch network is concentrated. Although the effort to complete this transaction has proven to be more of a marathon than a sprint, we’re nonetheless dedicated to crossing the finish line – even if it’s a bit farther out than we thought. In December, we announced an extension of our merger agreement – the third time we’ve done so. Still, everything that made our respective organizations a good fit in the summer of 2012 remains true today. Hudson City’s credit culture was always consistent with our own conservative approach to credit. The passage of time is proving that to be even more true; in the two and a half years since we announced the merger, the credit characteristics of that portfolio have improved further. The economic benefits that we expected to accrue to both institutions’ shareholders hold the same promise. Delays are admittedly frustrating, but this is a merger to which both parties remain deeply committed.
Despite the delay, considerable progress has been made in bringing M&T’s community banking model to New Jersey. We opened three new offices there in 2014, in addition to the four already in place. These offices house 129 customer facing employees responsible for commercial banking, residential mortgages, investment securities and wealth management. M&T now has a portfolio of $1.3 billion in loans to small and large companies, commercial real estate developers, auto dealers and residential mortgage customers in the state. It is interesting to note that there are already 34 of our colleagues serving on 83 not-for-profit boards, which is typical of M&T’s community involvement. We are in New Jersey to stay.
So it is that we continue our work in earnest, heartened by the prospects of building a better bank for a better tomorrow. While one can be optimistic, indeed excited, about our future, the realities of the present environment must also be acknowledged. M&T has long been a community bank focused on its customers, employees and shareholders. Our core tenets of serving the financial needs of people in our communities through simple, easily understood products, strong credit standards and an efficient operating model, remain our mission.
Our task now is to complete these transformational efforts and to evolve without sacrificing those guiding tenets that are our hallmark. Rest assured that we will go about them diligently like every other endeavor in our history. We remain confident in M&T’s ability to adapt, even as the environment changes around us.
M&T Bank: Complexity Not Size – Contrasting Business Models
Although our defining character as a bank that serves its communities may be clear to us, it is no longer the yardstick against which we’re measured. There are 33 banks with more than $50 billion in assets in the United States; M&T is the ninth smallest of those banks. Because it exceeds that asset threshold, it is held to many of the same standards as banks with much more complex business models and intricate global exposures. We’re expected to maintain a regulatory infrastructure on a scale similar to the large banks – in a sense constructing a super highway to get through a small city. In this context, it seems worthwhile to point out that M&T’s estimated annual cost of regulatory compliance rose to $441 million, 16.3% of our total operating expense, an amount that is over four and a half times the level of a mere three years ago. The number of regulatory exams at M&T in 2014, conducted by nine different government agencies, was over 45% higher than in 2012. Our total operating expenses, which excludes intangible amortization and merger-related expenses, increased by 5% in 2014, outpacing our peers significantly, which in turn has led to substantial erosion, temporarily one hopes, of our traditional operating efficiency advantage.
We remain confident that our essential community-oriented business model will continue to serve both our customers and investors well. It is of concern, however, that the distinctive virtues of that traditional model of banking as practiced not just by M&T but the majority of American banks are less than fully appreciated in some important quarters. The imperative of distinguishing between what might be called Main Street and Wall Street banks has been discussed previously in this Message, but it bears repetition, analysis and specific illustration. Simply put, the 6,482 community and regional banks of Main Street have a very different business model than the five large U.S. banks that dominate the activities traditionally associated with Wall Street.
Main Street banks gather deposits and make loans; they are the primary providers of finance to local businesses in the neighborhoods they serve. Loans comprise 61% of assets at regional banks compared with just 31% for the five large, complex and globally interconnected U.S. bank holding companies. Perhaps no other measure illustrates this point better than the comparison of lending to small businesses. It is interesting to note that last year those five large banks funded 4% of Small Business Administration loans, a subset of loans made to small businesses, while the rest, Main Street banks, funded 96%. Core deposits fund 64% of assets at regional banks; the comparable figure for large banks is just 32%. Here at M&T, some 69% of our assets are simple lending agreements made in the interest of funding commerce and industry as well as the personal needs of individuals, particularly mortgages for their homes and financing for their automobiles. Core deposits fund 75% of our assets. Those five large banks have limited branch networks in smaller and rural communities. Just 55% of these large bank branch offices can be found outside the ten largest metropolitan areas, compared with 73% for regional banks.
Beyond these distinctions, the key feature that differentiates the operating model of most large banks is their involvement in the trading and manufacturing of derivatives – instruments that have long bred complexity and confusion. In fact, five banks accounted for 95% of the $304 trillion of U.S. banking sector derivatives outstanding at the end of September 2014. To put it in perspective, that figure amounts to 16 times the U.S. GDP and 19 times the total banking system assets in the U.S. – eye popping indeed. Even after the crisis and subsequent adoption of the Volcker rule, the five large banks in 2014 still accounted for 90% of total U.S. bank trading revenue while the remaining 6,482 banks accounted for 10%.
The American public’s relationship with derivatives is long and well chronicled. Since their creation in 1848, derivatives markets have been afflicted by speculation, lack of transparency and manipulation. Noting the price distortions that wreaked financial havoc on America’s agricultural sector during the Great Depression and caused widespread public hardship, President Roosevelt said, “…it should be our national policy to restrict, as far as possible, the use of these [futures] exchanges for purely speculative operations.” The Commodity Exchange Act (“CEA”) in 1936 required that futures contracts be traded on regulated exchanges, which facilitated transparent price discovery, identification of buyers and sellers, standardization of contracts and adequate capital to support the fulfilment of contractual commitments. Since the use of swap contracts came into being some 34 years ago, they have been progressively exempt from regulation. In 1993, they were officially excluded from the purview of the exchange trading provision of the CEA with its attendant requirements of transparency and adequate capitalization. It is no surprise this was followed by events such as the bankruptcy filing of Orange County, California in 1994, after losing $1.5 billion on poorly understood interest rate swaps, and losses through derivatives by such major corporations as Gibson Greetings and Procter & Gamble. In 2000, the passage of the Commodity Futures Modernization Act effectively removed the swaps market from almost all pertinent federal regulatory oversight and preempted state rules and regulations. The outcome: the bankruptcy of Jefferson County, Alabama, also a consequence of interest rate swaps, which resulted in increases in sewer rates to its citizens of 7.9% annually; losses incurred by the City of Detroit, which later filed for bankruptcy, on swap contracts connected with pension debt; and payments required to be made by the Denver public school system to terminate complex derivative transactions originally executed with the promise of bolstering its pension fund, among many other instances of large scale impact on the taxpaying public.
Use of credit default swaps (“CDS”) to place bets that homeowners would default on their mortgages had devastating consequences to the American public during the last crisis. These “naked trades” by parties with no exposures to the underlying mortgage loans significantly outweighed the actual amount of mortgage debt outstanding. In 2014, we saw that such wagers were alive and well in other areas of our economy and continued to provide participants with lucrative opportunity for speculation. As a well-known electronics retailer teetered on the brink of bankruptcy, bets made on its eventual fate through the medium of CDS stood at $23.5 billion, dwarfing by 16.8 times the $1.4 billion in debt that the company actually owed to its creditors. These wagers, on whether and when the firm would default on its debt, were facilitated by hedge fund managers, who first sold high premium insurance to those who believed that the company’s demise was imminent. Then, they turned around and provided temporary life support in the form of “rescue financing” to keep it alive long enough to pocket the premium. Lack of transparency in these markets makes it very difficult to ascertain the true economic motives and exposure of any parties involved with CDS. One can only sound a sigh of relief that those involved were outside the banking industry, were adequately capitalized and were not wagering with depositors’ funds. Such was not the case in 2012, when one of these same hedge fund managers was on the winning side of the “London Whale” trades that resulted in notable losses for one large bank and sparked outrage from regulators and the general public.
The disruptive forces that exist in the derivatives markets will most assuredly endure. Despite their usefulness as a risk management tool to assist those engaged in commerce and industry, derivatives have been a vehicle for speculation and price manipulation almost since their inception. In the absence of effective regulation, their use for speculative endeavors continues to have the potential to damage our financial system.
It is comforting that in the aftermath of the crisis, government agencies have regained the required authority to supervise this $304 trillion market, particularly as it relates to bank holding companies. An indication of the breadth and depth of the regulatory effort is provided by seven federal agencies: the U.S. Securities and Exchange Commission, the Commodity Futures Trading Commission, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Federal Housing Finance Agency, and the Farm Credit Administration, which together issued 81 final rules and an additional 35 proposed rules, totaling by one estimate 11,844 pages in the Federal Register over four years. The complexity, opacity and potential of derivatives to again seriously damage our economy are clearly too great to be ignored.
Even with the benefit of the regulatory efforts mentioned above, one of the hallmarks of derivatives remains their lack of transparency; it is difficult for regulators, investors and others to understand the true exposure of the banks that dominate trading in derivatives and the extent of their interconnectedness. Even with an average of 13 pages of footnotes in the financial statements of the five large trading banks, one is left with far more questions than answers. For example: How does the value of the derivatives change over time? Who are the counterparties and what is their level of creditworthiness? How do the counterparties’ risk exposures interconnect them with each other in different global markets? How will the payments and the associated sequence work in the case of a default? Can such mind-boggling numbers even be managed or do the derivatives portfolios ultimately manage us?
Although complexity is often equated with size, that equation is a spurious one – one of the largest U.S. banks has an operating model that is much more akin to Main Street banks than the other large banks. Loans to individuals and commercial borrowers comprise 52% of its assets while 62% of those assets are funded with core deposits and 70% of its branches are located outside the ten largest metropolitan areas. Trading activities comprised just 2% of its revenue last year, yet it has $1.7 trillion of assets. It is interesting to note that this bank was the only one among the largest six U.S. banks whose plan to manage an orderly disposition in the event of distress, was accepted by the regulators – an indication of the simplicity of its business model.
It is only logical that the sophistication and granularity of the quantitative modeling and analytical capabilities required to manage a large trading portfolio, where values change on a daily basis, and traders’ compensation systems offer large payouts for short-term performance, differ extremely from those required for a regional bank, whose loan portfolios are held to maturity rather than traded on a daily basis, where the quantity of leverage is transparent, the bearer of risk of loss is clearly identifiable and loan officer compensation programs are more mainstream.
Indeed, rules intended to increase transparency, require adequate capital to honor commitments, and ensure identification of the parties involved through a central clearing system so that failures can be resolved in an orderly manner, are not just logical but long overdue. So the question is not whether, but how. How does one effectively regulate institutions whose defining characteristic is complexity, a feature derived significantly from their domination of the business of manufacturing, trading and selling derivatives in the United States, without burdening the rest of the banking system that is critical to facilitating much-needed economic growth? It seems abundantly evident that in order to maximize effectiveness, regulation should be based on the complexity of business model, and not on the size of institutions.
M&T Bank: A Tiered Approach To Regulation
While banks’ business models are different, government’s regulation of them is similar. At the same time, compliance has become ever more central to the business of banking.
When the Dodd-Frank Act was written, the principle that size correlates to riskiness was not outlandish. After all, it was the failure (or potential failure) of the largest institutions that threatened the financial system and the economy at large. Size makes for a simple, perhaps too convenient barometer – a bank either has over $50 billion in assets or it doesn’t. The complexity and systemic importance of an institution, on the other hand, is far more difficult to ascertain. To avoid subjective debates about which regulations should apply to which institutions, using size as a primary determinant was, perhaps, a practical starting point. However, it is now time to review the objectives of the enhanced prudential standards and allow for the varying supervision needs of organizations with differing levels of complexity. After all, the goal of legislation and regulation is to protect consumers and the economy while facilitating commerce, not hampering it. Indeed, further adaptation of the regulations may be in store based on recent comments made by a member of the Board of Governors of the Federal Reserve System. In suggesting the possibility of a “tiered approach to regulation and supervision of community banks,” the Governor noted, “[such banks] have a smaller balance sheet across which to amortize compliance costs.”
Adoption of a “tiered approach,” based on complexity as opposed to simply size, would be a welcome change while preserving the core intent of the Dodd-Frank regulations to minimize risks to U.S. financial stability. Banks over $50 billion in size are required to go through semiannual stress tests, as well as to annually create so-called Living Wills – instructions on how to effectively wind down an institution if the capital and liquidity rules are insufficient to prevent its demise. Many CCAR standards are better suited to assess, monitor and estimate complex exposures and activities such as trading, derivatives and counterparty risk, which carry a higher level of volatility in stressed environments. Using a standardized approach across the entire banking industry in these areas creates a risk that banks with simpler business models are not rewarded with lower infrastructure cost. As an alternative to the current approach, the annual CCAR exercise could be replaced with a review of the capital planning program through the normal supervisory teams dedicated to institutions with lower risk operations. This would allow for a more customized approach to determining capital planning and adequacy, commensurate with the complexity of the bank.
For the most part, regional and community banks do not exhibit the maze of interconnectedness through derivative transactions that characterize the largest banks, and have much simpler legal structures, which make them much easier to deal with in case of failure through the traditional and time tested FDIC process. A publication of The Clearing House Association noted, “If you were to add up the legal entities of all of America’s regional banks, the total would still be less than the number of legal entities under America’s single largest bank holding company.” Simple regional banks could be required to update their plan for disposition only if a significant acquisition or other change meaningfully altered their legal structure.
Banks with assets greater than $50 billion are required to hold large stocks of liquid securities under the Liquidity Coverage Ratio (“LCR”) rule to satisfy hypothetical funding needs calculated using standardized assumptions provided by the regulators. Unlike large trading banks with volatile balance sheets that rely upon short-term wholesale funding, the balance sheets of regional and community banks are predominantly funded with stable core customer deposits. Given the lower liquidity risk presented by regional banks, it would seem appropriate for the LCR to substantially differentiate them from trading banks with respect to the amount of securities required to be held, and the granularity, frequency and amount of data to be provided to the regulators. Such a tailored approach would satisfy the objective of improving the banking system’s ability to withstand increased liquidity needs during stressful economic environments without placing an outsized burden on Main Street banks.
At the heart of the last crisis were incentive compensation systems that encouraged traders to take on undue risk, to earn large sums of money, without having to forfeit any previously earned compensation on trades that subsequently turned out to be excessively risky. In 2014, the average salary and benefits per employee at the five large trading banks was $212,665. While at the rest of the domestic banks with total assets of over $50 billion it was $101,724, or 52% less. One large institution’s personnel earned $379,402 per person or nearly four times more than the rest of the banks that did not specialize in Wall Street activities.
Given compensation systems with huge payouts at trading banks, regulators have rightly enacted a series of rules to ensure that incentive programs do not tempt employees into actions that expose banks to undue risk. However, while these policies are essential to preventing excessive risk-taking by traders, the rules are burdensome for regional bank employees who have little ability to take risk positions that could bring down the bank. By way of example, last year, 2,461 individuals, or 16% of M&T’s employee base, fell within the purview of these provisions, requiring that their compensation packages be subject to heightened review. Allowing regional banks to restrict the applicability of these provisions to their executive management team and a handful of other employees, would reduce the burden of compliance, and focus more scrutiny on those individuals within the company who actually have the ability to subject the organization to material risk.
While these are a few examples of what could be done, it is time to review all the impediments to community lending and economic growth that regulations predicated on size, rather than complexity, have created for the banking industry. Complexity, not size, is the defining contributor of significant risk to the financial system and taxpayers. The enhanced prudential standards adopted by the Federal Reserve in February 2014 are not only a logical consequence of the recent financial crisis – they were necessary. Now, regulators and industry together should assess what we have learned since the crisis in an effort to hone the effectiveness of regulating complexity, without burdening simpler business models with disproportionately higher costs of compliance. After all, our economic recovery is still very uneven, and people and communities are still suffering; regional banks need to be supported in their efforts to encourage the type of activity that fosters local economic growth.
M&T Bank: Economy – The Best Of Times And The Worst Of Times
As focused as one must be on the bank’s business and internal operations, one must not forget the larger economy which we are chartered to serve. For some, it is true; the economy has turned, at least for now. To an extent, the financial crisis may seem like a faded memory. On an annualized basis, U.S. real GDP growth has topped the 3% long-term average in four of the past six quarters – the strongest period of sustained growth since 2006. U.S. private sector employers created 2.5 million jobs in 2014 – the strongest year-over-year increase since 1999. The low interest rate environment established by the Federal Reserve, along with the efforts of ordinary people trying to minimize their financial risk, have reduced household debt service burdens to generational lows.
Despite these ostensibly positive trends, for far too many Americans the recovery is something about which they read – a phenomenon affecting other people in other places. While metropolitan areas are doing much better, rural areas continue to struggle. Over the past decade, U.S. employment growth has varied widely between larger urban areas and rural communities. Collectively, U.S. metropolitan areas experienced a 12% increase in private sector employment from 2003-2013 while non-metropolitan areas recorded just a 5.4% gain. This trend can also be seen in upstate New York, where from January 2003 to November 2014, private employment in metropolitan areas rose by 2.5% compared to just a 0.2% increase in non-metropolitan areas.
More worrisome is the impact of the current, uneven recovery on the economy’s future. Tomorrow’s generation faces a number of headwinds that will forestall their ability to contribute to the next wave of economic growth. Aggregate student loan debt stands at more than $1.1 trillion, trailing only mortgage debt as the largest form of consumer indebtedness. One consequence of this rising student debt burden is deferment of home ownership – the percentage of 18-to-34 year olds who own homes has continued to decline and stands at 13% compared to over 17% before the crisis.
Contrary to their portrayals in popular media as a group of swashbuckling entrepreneurs, Millennials have actually become less inclined to launch new businesses – the percentage of business owners in that demographic has not been this low since the early nineties. Since 2007, the average net worth of those under 30 has fallen by almost half. Young people who are now entering the workforce with limited professional, financial and entrepreneurial opportunities may unfortunately be losing the most vital and economically productive years of their lives. It follows, then, that the total rate of business creation from 2012 to 2013 continued the downward trend that started in 2011. These are not the signs of the kind of America for which we strive and aspire – one in which opportunity, prosperity and growth are broadly shared.
It is against such a backdrop that one must weigh the unintended consequences of regulation, which burden the institutions that power the core of our local economies in America. One cannot question the applicability or utility of these regulations in improving transparency and reducing opacity in the financial services industry. However, there is a need for balance, where supervision is commensurate with the complexity of an institution’s business model.
It is hard not to see the situation in this way: regulators, under the most extreme sort of pressure from elected officials, train their sights on traditional banks, while capital heads elsewhere and with it, the sort of risks Dodd-Frank was meant to mitigate. At the same time, the traditional, so-called real economy recovers in fits and starts and American businesses and consumers struggle to get the credit they need. M&T has been and remains dedicated to serving those credit needs. Doing so will depend, in part, on a supportive regulatory environment, one that is simpler and more predictable, tailored for different types of banks, and premised on a balance between costs and benefits – not for banks or banking but, rather, for the American economy as a whole. The time has come to allow America’s community banks to serve their traditional roles of taking deposits and making prudent loans to the friends and neighbors they know, and not allow misplaced animus and a one-size-fits-all approach to regulation to hinder the American economic recovery finally underway.
In thinking about the banking industry in the overall context of the economy, we should pause to remind ourselves of history. Just as John Maynard Keynes presciently saw that the draconian terms of the Treaty of Versailles could be the harbingers of international instability – and which opened a Pandora’s Box from which came economic stagnation, hyperinflation and social instability – so must we be open to similar possibilities when it comes to financial regulation. An overly harsh undifferentiated response could plant the seeds of new problems. As a long time banker, I am hopeful for a return to an intelligible milieu where banks are able to energetically fulfill their roles as facilitators of commerce and of the quality of life in the local communities across our country.
Those of us in the industry share the common goal of legislators and regulators, to create the safest financial system in the world. It pains me to see excessive regulation that might stifle innovation, drive society’s best and brightest away from our industry or discourage bankers from fulfilling their role in the economy out of fear of being inordinately fined and sanctioned. Much of what has been done is right, but it can be made better and more effective. The whole system will be better off if all constituents can get past their entrenched positions to just “make it right.”
M&T Bank: Our Colleagues
Once again, the 15,782 M&T employees I’m proud to call colleagues demonstrated an ability to adapt to changing circumstances and rise up to conquer new challenges. We asked more of our employees than ever before and they delivered in a way that inspires awe, gratitude and respect. A talented legion of veteran M&T colleagues aided by a corps of newly hired reinforcements worked tirelessly to build a better M&T, often working late into the night or through to the morning no matter the day of the week. Even a historic November storm that battered our home market just before Thanksgiving, dumping almost eight feet of snow in some of our communities and rendering roads impassable, could not keep employees from the office – dozens of the dedicated stayed in downtown hotel rooms and made sure the work got done, not because they were asked to, but because they have a deep, inspiring sense of personal responsibility.
Of course, our colleagues’ extraordinary efforts were not limited to the office. We refer here to their commitment, as citizen volunteers and leaders, in our communities. Time and again, they band together to help friends and neighbors – through work in schools, churches, civic organizations, environmental initiatives and many more organizations too numerous to list. The colleagues whom I thank here do not understand such service as a burden, nor as unrelated to their ordinary activities – it is a part of who they are and what they do. Their selfless work defines our company and goes to the heart of what M&T is and will continue to be: a community bank predicated upon the notion of the collective success of our clients and our colleagues. They are the face of our bank – for our customers and for our communities. They act as owners – in no small part because many are – and their sense of ownership is evident in the quality of and dedication to their work.
M&T Bank: A Personal Note
Following the Annual Meeting of the Shareholders on April 21, 2015, Jorge G. Pereira will retire as the Vice Chairman of the Boards of Directors of M&T Bank Corporation and M&T Bank. I would be remiss not to offer my special thanks to Jorge for his service. Jorge joined the boards of what were then known as First Empire State Corporation and M&T Bank with me in 1982, and although not an employee or member of management, he has been my close partner and colleague over the past 33 years. At the beginning of that partnership, it was his faith in me that helped provide the combination of confidence and guidance that I needed in my new role as chief executive. Over the years, I was fortunate to be able to rely on his judgment and wisdom; he helped to shape and refine our vision of M&T as a bank whose business would be built on communities and customers, employees and shareholders. In his service on the boards, Jorge gave of his time in a wide range of roles. As M&T’s largest individual, non-management shareholder, Jorge added an independent voice to the board’s consideration of executive compensation and corporate governance matters, while serving as the lead independent director. We have been supremely fortunate to draw on Jorge’s advice and guidance, not least during the challenging years of the past decade. We extend our heartfelt gratitude for his long service, wise counsel and valuable contributions to the success of this company. I will miss him as a colleague – but continue to cherish him as a friend.
Robert G. Wilmers
Chairman of the Board
and Chief Executive Officer
March 5, 2014