Regulatory Reform of The Financial Industry – A Proposal
We are hearing reports that banks are making profits again: a couple of weeks ago, it was Citigroup, JP Morgan, and Wells Fargo, and this week it is Bank of America. What does it mean? Are these signs things are getting better? Banking and insurance as traditionally practiced are good businesses. It is the other things that the large banks and insurance companies got into that have caused the problems. I start with a brief history of banking.
Banking Early On
It used to be quite simple: banks tried to attract depositors by providing:
· various services for checking accounts and
· interest on savings accounts.
Banks made money if they could lend out most of their depositors’ money for a higher interest revenue stream than all their services to depositors cost them. In bankers’ parlance, they made money on the spread (the interest rate on loans minus the interest rate paid depositors).
Banks knew their survival depended on a positive “spread”, so they watched their loans to individuals (including mortgages) and business very carefully. My father was a banker, and I estimate that a third of his staff’s time was spent “working” with those they lent money to. There are still a few banks of this type as we will see below.
The Federal Deposit Insurance Corporation (FDIC) was created in 1933 to insure deposits and regulate banks. It charges a fee to the banks for its services. Its regulators have insisted that banks hold a certain portion of their deposits on hand to cover for deposit/withdrawal fluctuations. The regulators get quite uneasy if a bank’s liquid capital gets much below 10% of deposits.
OK. This seems quite simple and workable. But back in the ‘thirties, the Federal regulators worried that banks could not keep the “spread” positive. That is, they feared that banks would not make enough interest on their loans to cover the interest and the other costs of service to depositors. So they decided to create a secondary market for bank loans. Their reasoning was that with the secondary markets, banks would not have to worry about getting the spread right. Instead, they could sell off their mortgages and make money on sales commissions.
In short, fee income replaced spread income. But this change had one very important unintended consequence: it eliminated bank concern over the quality of borrowers. All that mattered was to have a buyer of loans in the secondary market. This move spawned mortgage companies, organizations with no money of their own to lend out, organizations totally dependent on secondary markets to underwrite the mortgages they wrote.
Back in the ‘thirties, The Feds did two other things to protect banks:
- they developed adjustable rate mortgages, again, to protect the banks’ spreads, and
- they forced banks to sell off their investment arms: why? because it was too risky to have banks buying and selling stocks!
OK. Let us now fast forward to today. Big banks:
- sell loans into secondary markets;
- buy up packages of loans from secondary markets, hold them, repackage them and sell them for commission income;
- sometimes even guarantee them;
- trade stocks and bonds;
- create and trade derivatives; and
- issue credit cards.
And what happened in the collapse? The market for loan packages disappeared – the big banks took massive hits – they had to write down billions on loan packages they could not sell. And these write-downs worried the capital regulators who insist on a certain amount of liquid capital against deposits. How did banks rectify these problems? They had to cut back on making loans, and this affected their income spreads. They also got new capital from TARP.
One more thing before getting to my proposal: let’s compare the activities of a small bank with those of a large bank:
- The Lenox National Bank is located in Lenox, MA. It has 63 stockholders. It makes loans and holds them until they are paid off. President Paul Merlino said they have not had a foreclosure in years. He said the Federal regulators urged him to consider taking TARP funds. He had no interest.
- Citicorp is a big bank. It does everything mentioned above. It has had a lot of foreclosures. It has taken $45 billion in TARP funds and an additional $277 billion in loan guarantees.
The following table provides a comparison of both bank’s income and expenses. Both make money on the interest spread: Citi makes nearly $41 billion; Lenox makes $1.5 million. In 2008, Citi set aside $25 billion for loan losses; for the previous 4 years, it set aside $32 billion for loan losses. The Lenox Bank made no provision for loan losses in 2008. Over the prior 4 years, Lenox made provision for $7,000 in loan losses. In 2008, Citi lost $4.5 billion on its trading activities; the Lenox Bank did not have trading income or losses. Citi lost an additional $1.9 billion on securities while Lenox made $1,000.
|2008 Income/Expense (in $ thousands)|
|Net Interest Income||40,905,239||1,511|
|Provision for loan and lease losses||25,421,616||0|
|Trading Account Gains & Fees||-4,486,752||0|
|Security Gains (losses)||-1,914,933||1|
The American taxpayer ultimately pays for the insurance services the FDIC provides. As depositors, we want our money to be safe. We understand that to be profitable, banks have to make a little more on its loans than it pays us for deposits. That is fine. But we have absolutely no interest on the other activities of the big banks – selling loans, repackaging them, selling them again, guaranteeing them, and trading.
My proposal is that FDIC insurance should only be given to banks that:
- manage their own loans;
- do not engage in trading activities.
In short, I am proposing we go back to the situation as it was in the ‘thirties: banking has to be safe; all peripheral activities such as investment banking must be spun off.
The Bank for International Settlements has worked for more than a decade to develop a new set of standards for the capital adequacy of banks that allows for the riskiness of assets (Basel II). This in turn has spawned the risk management industry. Together, Basel II and its risk management industry is an unworkable joke. I have a couple of friends who are Federal bank regulators. They confess they have no idea what they are doing when it comes to large banks. To get some sense of what they are up against, I urge you to skim through the quarterly report of Citigroup at http://www.sec.gov/Archives/edgar/data/831001/000104746908011506/a2188770z10-q.htm. Scroll down to p. 34 and read to page 42. Enlightening?
In short, there is no way to effectively measure the risks being taken by the large banks. And instead of expanding regulatory activities, I am saying we should make banks simple again: depositors have no interest in the other activities of large banks, so let’s not insure them.
If banks were forced to spin off these other activities and stick to managing their own loans, they would not need all their high-priced executives. Traditional banking is not rocket science.
One might wonder: if banks spin off all these complex activities, who will regulate them? My answer: don’t try: a waste of time. Just require full disclosure. And after that, caveat emptor.