Big Banks Shift to Lower Gear

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want to grow even bigger!

Break-Up Proponents

Among those now advocating the breaking up of big banks is Sanford Weill, who, ironically, earlier led the charge to end Glass-Steagall so he could merge insurer Travellers, which he headed, with Citigroup. In fact, the Gramm-Leach-Bliley Act that killed Glass-Steagall was dubbed the “Citigroup Authorization Act.” In announcing his reversal in opinion in July 2013, Weill said, “I think the earlier model was right for that time. I think the world changed with the collapse of the real estate market and the housing bubble and what that did because ofleverage ofcertain institutions. So I don’t think it’s right anymore.” He also said, “I am suggesting that they be broken up so that the taxpayer will never be at risk, the depositors won’t be at risk.” And he admitted, “Mistakes were made.”

Others advocating the break-up of big banks include Philip Purcell, the former CEO of Morgan Stanley, Sheila Bair, the former head of the FDIC, John Reed, who ran Citigroup before it was merged with Travellers, Thomas Hoenig, former Kansas City Fed President and Dallas Fed President Richard Fisher. A number in Congress are also on board including Sen. Ron Johnson from Wisconsin.

Like unscrambling an egg, it’s hard to envision how big banks with many, many activities could be split up. But, of course, one of the arguments for doing so is they’re too big and too complicated for one CEO to manage. Still, there is the example of the U.K., which plans to separate deposit-taking business from riskier investment banking activities – in effect, recreating Glass-Steagall.

In any event, among others, Phil Purcell believes that “from a shareholder point ofview, it’s crystal clear these enterprises are worth more broken up than they are together.” This argument is supported by the reality that Citigroup, Bank of America and Morgan Stanley stocks are all selling below their book value (Chart 5). In contrast, most regional banks sell well above book value.

Big Banks

Push Back

Not surprising, current leaders of major banks have pushed back against proposals to break them up. They maintain that at smaller sizes, they would not be able to provide needed financial services. Also, they state, that would put them at a competitive disadvantage to foreign banks that would move onto their turf.

The basic reality, however, is that the CEOs of big banks don’t want to manage commercial spread lenders that take deposits and make loans and also engage in other traditional banking activities like asset management. They want to run growth companies that use leverage as their route to success. Hence, their zeal for off-balance sheet vehicles, proprietary trading, derivative origination and trading, etc. That’s where the big 20% to 30% returns lie – compared to 10% to 15% for spread lending – but so too do the big risks.

Capital Restoration

The strategy of big bank CEOs seems to be to fight break- up proposals tooth and nail in the hope that as memories of the 2008-2009 bailouts fade, so too will interest in reducing their size. Furthermore, the vast majority of banks, big and small, have restored their capital. Most banks are comfortably above impending capital requirements. At the end of the first quarter, 98.2% of all FDIC-insured institutions representing 99.8% of industry assets (and therefore all the big banks) met or exceeded the requirements of the higher regulatory capital category.

Nevertheless, the FDIC and Federal Reserve are planning a new “leverage ratio” schedule that would require the eight largest “Systemically Important Banks” to maintain loss-absorbing capital equal to at least 5% of their assets and their FDIC-insured bank subdivisions would have to keep a minimum leverage ratio of 6%. This compares with 3% under the international Basel III schedule. Six of these eight largest banks would need to tie up more capital. Also, regulators may impose additional capital requirements for these “Systemically Important Banks” and more for banks involved in volatile markets for short-term borrowing and lending. The Fed also wants the stricter capital requirements to be met by 2017, two years earlier than the international agreement deadline.

The number of institutions on the FDIC’s “Problem List” fell to 411 and the assets of those banks dropped to $126.1 billion in the first quarter. Bank failure numbers have yet to return to pre-crisis levels, but have dropped considerably since the 157 peak in 2010 (Chart 6). Similarly, the percentage of institutions with quarterly losses continues to fall
while the percentage with quarterly earnings increases exceeds the pre-crisis
level (Chart 7).

Big Banks

Big Banks

More Regulation

Despite the improving financial status
of banks, especially larger institutions,
their push back against being dismembered has been met with more regulation. The unvoiced strategy in Washington seems to be, if the big banks
don’t agree to be broken up, they’ll be regulated to the point that they wish they
were, or at least to the degree that individual failures are much less likely
and far less damaging if they do occur.
Slowly but surely, they’re being busted back toward spread lending and other traditional commercial banking businesses and bereaved of many risky but highly-profitable activities – highly-profitable until adjusted for risks. Consider the higher Basel III capital requirements, the pressures to orient executive compensation toward long- run risk-adjusted profitability and away from short-run speculation, the divestiture of non-core bank assets, the Volcker Rule, the selling ofbranches and subsidiary banks, etc.

Late last year, the FDIC prepared a plan to unwind large banks on the edge of collapse without taxpayer bailouts. The FDIC would keep parts of the bank open, prioritize payments to creditors and recapitalize the firm. “Unsecured creditors and shareholders must bear the losses of the financial company without imposing a cost on U.S. taxpayers,” said FDIC Chairman Martin Greenberg.

All of these new regulation proposals strike us as fighting the last war. With all the Dodd-Frank and other regulations now in place and the losses, chastisements and embarrassments of bankers, mortgage lenders, homeowners, etc., it’s unlikely that a repeat of the 2008 financial crisis and the speculation that spawned it will occur any time soon. That doesn’t mean that financial bubbles are extinct, but that the next one will occur in a different area that is outside the scope of the regulatory reaction to the last crisis. Besides, all those super bright, million-dollar per year guys and gals on Wall Street can figure out how to beat most $100,000 regulators any day!

Fed Proposals

Meanwhile, the Fed and the Office of the Controller of the Currency, another bank regulator, in March 2013 told banks to avoid funding takeover deals that would leave companies with high debts. But since then, “judging from aggressive market data, it appears that many banks have not fully implemented standards set forth” in March 2013, said a senior Fed official recently. In March of this year, the OCC said there would be “no exceptions” to the guidance for newly-issued loans. These junk “leveraged” loans have seen a rapid reduction in investor-protecting covenants that moves them back to previous day’s levels that proved disastrous when the 2008 financial meltdown hit.

In a similar vein, the Fed’s point man on regulations, Gov. Daniel Tarullo, said recently that after reading accounts of the role that money market and other short-term markets played in the financial crisis, a “broadly applicable” minimum margin requirement makes sense. Fed Chairwoman Janet Yellen also backs new rules for short-term funding to mitigate risks to the financial system.

The final version of the Volcker Rule has been delayed by haggling over the difference between genuine hedging of customer assets and proprietary trading with bank assets. The Volcker Rule isn’t expected to be implemented until 2015 and promises to be very specific as to what is and what isn’t a hedge. Meanwhile, Wall Street houses such as Goldman Sachs have exited their in-house trading.

More Examiners

Regulators are adjusting their staffs to better understand and control financial institutions’ activities. The New York Fed roughly doubled its supervision staff since the crisis and has between 15 and 40 overseeing each of the largest bank holding companies. The OCC, which regulates banks with national branch networks like JP Morgan and Wells Fargo, has upped its staff examining large banks by 20% since 2007, with up to 60 at the largest institutions. These examiners have access to computer systems and can attend internal strategy meetings and readily meet with bank executives and board members.

At the same time, the heat is on banks to beef up their compliance. Regulators are concerned that banks don’t comprehend their own operations, including measuring risks and planning for future crises. The OCC recently said that only two of 19 banks have met the standards it laid out after the crisis. Among other things, it wants two independent directors on boards of national banks and independent officers to track and monitor all business lines.

Large banks are hyping their compliance staffs. JP Morgan plans to add over 13,000 people and the industrywide hiring effort is creating a war for talent with escalating pay levels. Similarly, bank risk officers are multiplying like fruit flies as the OCC warns that “credit risk is now building after a period of improving credit quality and problem loan cleanup.” At major banks, their numbers are rising over 15% annually.

Wells Fargo now has 2,300 in its risk management department, up from 1,700 two years ago and the department’s budget has doubled to $500 million. In contrast, the bank’s total workforce has remained flat. Goldman Sachs put its chief risk officer on the 34-person management committee for the first time in the firm’s 145-year history. Senior risk officer pay is up as much as 40% from a few years ago and equal to the compensation of chief financial officers and general counsels. Earlier, they were paid a third less.

Large banks are being pushed by regulators to specify in writing which risks and how much they’re willing to take to meet financial goals. Risk officers are being urged to examine big losses or big profits for signs of undue risks.

The efforts of regulators and risk officers may be having significant effects. At the end of 2013, the five largest banks had $793 billion in equity capital to protect against losses, up 19% from $667 billion in 2009. At the same time, their value at risk, in effect their exposure to losses on any given trading day, fell 64% from $1.05 billion to $381 million

Who’s The Toughest?

Then there is the war among regulators to be the toughest. They’re chastised in and out of Washington for leveling billion-dollar fines that are still just a cost of doing business for major banks, for letting them off with mere “we neither admit nor deny” statements and for not sending individual bankers to jail. The relatively new SEC Chairwoman Mary Jo White promises to be a lot tougher, but the results are yet to be seen. The OCC recently detailed risk management standards for banks with over $50 billion in assets, which puts the monkeys on the bank board members’ backs and requires banks to have independent audit and risk management offices that can take their concerns directly to the board.

Then there’s the game of one
regulator trying to deflect
pressure by saying that other
regulators are lax. The SEC
has criticized the Financial
Industry Regulatory Authority, which it oversees, for being
too lenient in its sanctions. In
the five years since the financial
crisis, FINRA did not
discipline any Wall Street
executives and imposed fines
of $1 million or more 55 times
compared with 259 times for
the SEC. FINRA regulated
4,100 brokerage firms and over 600,000 brokers and collected just $74.5 million in fines last year compared to $3.9 billion for the SEC. Note, however, that the SEC, not FINRA, takes the most serious fraud cases while FINRA concentrates on lesser infractions such as operations breakdowns where penalties are smaller.


Dodd-Frank has bereaved banks of much of their origination in trading in futures, options and other derivatives. Derivative trading is largely being transferred to exchanges that guarantee fulfillment of the contracts as opposed to the highly-profitable over-the-counter derivatives that banks trade but with which investors or speculators have to look to counterparties to be good for losses. This is the “counterparty risk” problem. Still, the seven largest banks still accounted for 98% of the $215 trillion notional value of derivative contracts as of March 31 (Chart 8), 85% of which were interest rate contracts (Chart 9).

Big Banks

Big Banks

Still, regulators are concerned with derivatives. Those from 10 European and North American countries recently released a report that said many large banks and their regulators are still not ready to deal with difficulties in the huge derivatives market. They lack the

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