Cambridge Winter Center Archives

MATTERS OF SIZE

Sun, 23 Jan 2011 10:47:40 -0500

Small banks face unique business circumstances and policy needs
The Dodd-Frank Act includes a variety of provisions that, in both purpose and effect, create special benefits for community banks. None of those provisions, though, address community banks’ core structural challenge: they are increasingly confined to the most volatile corners of the credit markets.
The crisis magnified -- it did not create -- the challenges facing community banks. Although the variety of bank rescue programs disproportionately benefited the largest “too big to fail” institutions, small banks’ woes did not begin, nor have they ended, with the financial crisis. This is because small banks and their larger competitors are fundamentally different from one another. They do not face the same structural challenges, for they differ in personnel, history, and business strategy.
Legislation should view small and large institutions through distinct lenses. The late 1990’s reforms, culminating in the 1999 Gramm Leach Bliley Act, have not enabled small banks to enter scale-intensive (but capital-efficient) fee businesses -- those benefits have accrued almost entirely to large banks. At the same time, small banks have found it difficult to efficiently originate credit risk for their traditional balance sheet lending.
When making policy, it is essential to understand that small banks and large banks need to be viewed as separate industries that face largely disparate challenges. A combination of market and regulatory forces has increasingly confined small banks to commercial real estate and construction lending. These particularly volatile asset classes make it difficult for geographically constrained firms to safely hold these assets through the cycle. The plight of small banks is different from the immediate challenges facing the largest financial institutions. Policy makers should not expect the same protocol to equally impact these dissimilar entities.

LAUNCH CODES

Mon, 4 Oct 2010 22:05:14 -0400

Guiding Principles for the New Bureau of Consumer Financial Protection
By Tim Duncan
With the enactment of the financial reform bill, the much-debated Bureau of Consumer Financial Protection (the “CFPB”, or the “Bureau”) has come into being – at least on paper.
The CFPB is in some sense experimental. Even if its first Director is top-notch, passionate and has the rare ability to apply common sense to government, he or she will have a formidable challenge ahead. With that challenge in mind, this paper presents a brief description of the nuts and bolts of launching the CFPB and, more importantly, six guiding principles for the CFPB in its critical first year.

Tim Duncan, CFA, is a third-party contributor to the Cambridge Winter Center. He is an attorney, the president of an investment advisory firm, and the chairman of American Business Leaders for Financial Reform. He has been an entrepreneur and senior executive in finance and in financial technology for 25 years.

CAPITAL, CAPITAL, CAPITAL?

Mon, 4 Oct 2010 20:34:57 -0400

The Role of Capital Regulations in Combating “TBTF”
Inadequate capital relative to bank risk certainly contributed to the depth of the financial crisis and cost of government intervention. Emerging regulation aims to eliminate the likelihood of TBTF bank failure by significantly increasing minimum capital levels. Higher minimums will only succeed if (a) banks cannot arbitrage capital rules to circumvent these rules, and, (b) banks do not increase their risk profile in order to generate required returns on higher capital levels. Bank incentives to arbitrage capital and increase risk are driven almost entirely by funding market discipline; bank capital regulation unravels if debt and equity investors demand no additional return from riskier TBTF banks. Basel III represents a sound regulatory approach to ensuring adequate capitalization, but absent significant additional regulatory intervention or firm market discipline, the leverage ratio is easily circumvented by an increase in risk. The ultimate regulatory goal – an increase in capital without accompanying increase in risk – is only achieved with equal parts capital regulation, risk measurement, and properly-functioning markets.

NOW MORE ABSORBENT!

Wed, 25 Aug 2010 14:30:38 -0400

Five Principles to Make “Contingent Capital” More Like Capital and Less Contingent
The Cambridge Winter Center has submitted a comment on the Basel Committee on Bank Supervision’s “Proposal to Ensure the Loss Absorbency of Regulatory Capital at the Point of Non-Viability.”
The “Basel Proposal” relates to hybrid securities issued by banks that are not common equity, but nevertheless have traditionally qualified for regulatory capital treatment. The proposal contemplates requiring “that all regulatory capital instruments include a mechanism in their terms and conditions that ensures they will take loss at the point of non-viability.” That mechanism would involve writing off the principal amount of capital securities issued by a distressed bank, and possibly offering their holders, in exchange, shares of common equity.
In essence, then, the proposal could give life to “contingent capital” instruments -- securities issued by banks that would function like debt in good times, but automatically convert into common equity during bad times.
Cambridge Winter’s analysis suggests that the Basel Proposal has real merit, but that policy-makers should adopt five principles to ensure that such new capital securities do not simply replicate the myriad flaws of existing bank hybrid instruments.

GSE DECISION TREE

Wed, 18 Aug 2010 21:24:26 -0400

A Framework for Evaluating Housing Finance Alternatives
This week, the Administration hosted a conference entitled “The Future of Housing Finance”, which focused in large measure on alternative paths for the housing GSEs. Cambridge Winter’s executive director attended on behalf of the center.
Conference participants expressed a diversity of perspectives, but a rough consensus does seem to be coalescing. This one-page “decision tree” contrasts that emerging consensus from two other points of view (including Cambridge Winter’s), in order to highlight the different implicit premises behind them.
In particular, our analysis has counseled deep skepticism about the notion of too-big-to-fail government agencies serving as effective arbiters of credit risk and pricing. Merely requiring a layer of subordinate private capital (which would be junior to the government-insured tranche) does not solve that problem. After all, the GSEs’ own on-balance sheet portfolios (through GSE common and preferred equity), and AIG’s insurance wrap of “super-senior” private-label tranches, all had the benefit of subordinate private capital. The existence of those private capital tranches did not obviate the need for an effective debt market check on Fannie, Freddie, or AIG’s own decision-making. Government agencies, by definition, lack that debt market discipline, and always will.

VIDEO: THE CORE GSE PROBLEM

Thu, 12 Aug 2010 10:33:55 -0400

Next week, the Administration will host a conference entitled “Conference on the Future of Housing Finance.” Raj Date, our executive director, will attend the conference on behalf of the Cambridge Winter Center.
Ahead of that meeting, it may be useful to watch this 8-minute talk delivered by Raj at the Roosevelt Institute’s “Make Markets Be Markets” conference earlier this year. It recaps the core problem with the GSEs: that their government backing quite predictably neutered debt market skepticism over the GSEs’ credit risk-taking, and, in turn, that absence of debt market discipline inevitably led to disastrous credit decisions.

STARTING OVER

Fri, 6 Aug 2010 14:25:04 -0400

Defining a Post-Crisis Role for the Housing GSEs
This briefing presentation offers a high-level perspective on the core structural problem that doomed Fannie Mae and Freddie Mac’s credit extension programs. In light of that structural problem, it argues that both of the opposing political narratives about the GSEs -- that they were victims of Congressional subprime lending mandates, or that they were the victims of unchecked Wall Street greed -- are off the mark.
It proposes gradually winding down most of GSEs’ credit extension and portfolio functions entirely, and over time building a housing finance system that relies on different sources of liquidity (like bank balance sheets, and covered bonds) and a far narrower range of government subsidies (like VA guarantees, and a subsidized interest rate swap to promote otherwise untenable fixed-rate loans).

INTENDED CONSEQUENCES

Tue, 29 Jun 2010 21:14:39 -0400

The Short Life and Death of the “Bank Tax”
This briefing presentation evaluates a core premise behind the Conference Committee’s elimination of the $19 billion “bank tax” on the largest financial firms.
Critics of the bank tax successfully argued that any attempts to tax large banks would inevitably lead to higher pricing on customers and small businesses.
Lost in the hurried Conference Committee debate was the absence of any empirical backing for the critics’ argument. Indeed, two factors would have likely combined to render the impact on customer pricing trivial.
First, only large banks would have been subject to the tax, so efforts to raise large-bank customer pricing, in many product markets, would have simply caused a market share shift to the smaller banks not subject to the levy. Ironically, the Massachusetts retail deposit business is a clear example of such a market.
Second, even in those product markets dominated by large banks, the bank tax was so small that, even if its burden could have been shifted completely to customers, the impact would have been, in practical terms, undetectable.

TEST CASE ON THE CHARLES

Sat, 12 Jun 2010 22:17:22 -0400

State Street and the Volcker Rule
This briefing presentation argues that State Street, the Boston-based custody bank, is the best litmus test for whether the Volcker Rule has been properly crafted.
State Street matters. Despite its relatively modest size (it is the 19th largest bank holding company), State Street is systemically important given its $19 trillion custody business, which serves as a core part of the “plumbing” of the global capital markets. Notably, custody is a relatively low-risk (albeit market sensitive) business line, and one that, by all accounts, State Street manages extraordinarily well.
State Street embraced higher-risk, off-balance sheet investment management businesses. During the credit bubble, State Street grew a number of higher-risk investment management businesses more typically associated with investment banks or hedge funds -- e.g. the management of cash collateral pools related to securities lending; or the management of off-balance sheet conduits that invested heavily in U.S. consumer asset-backed securities.
Higher-risk businesses pressured capital and liquidity, but taxpayers came to the rescue. As the credit cycle turned, State Street’s non-core investment management businesses -- particularly the conduit business -- pressured the bank’s funding and capital base. The bank ultimately elected to directly support its off-balance sheet vehicles with its own balance sheet. The resultant pressures on both liquidity and capital were mitigated by State Street’s liberal use of taxpayer-supplied rescue vehicles -- including the TARP, TLGP, and CPFF.

GREEK WEAK

Wed, 9 Jun 2010 09:49:36 -0400

Learning from the Eurozone Crisis
In a presentation to the World Affairs Council, Orange County, Cambridge Winter’s executive director describes the continuing Eurozone crisis, and its potential impacts on the still-fragile U.S. economic recovery.
The presentation argues that the American response to the financial crisis -- despite its wild unpopularity and sometimes inequitable results -- might just work. Unfortunately, the weaker Eurozone economies will not be so lucky, and it is quite possible the U.S. will suffer a significant blow to its nascent recovery as a result. U.S. policy-makers may be forced to confront the real need for a second round of politically toxic fiscal stimulus.

TARP JUNIOR?

Mon, 31 May 2010 22:15:33 -0400

Evaluating the Small Business Lending Fund
On May 19, the House Financial Services Committee agreed to a $30 billion program called the Small Business Lending Fund (“SBLF”), which closely follows a proposal made by the Obama Administration in February. Although the proposed bill is intended to help solve what will become a very real problem in the supply of small business credit, its design is likely to fail for the same principal reasons as the Bush Administration’s original TARP Capital Purchase Program.
This presentation, which builds on analysis presented during Cambridge Winter’s testimony before the Senate Banking Committee in March, explains the SBLF’s key structural problems.
Small business credit will become supply-constrained in 2010 and 2011. To this point, declining small business loan volumes have been mostly driven by a natural reduction in loan demand by credit-worthy small businesses, given the severity of the financial crisis and ensuing recession. As the real economy continues to recover, small business credit demand will recover as well, but the supply of such credit will continue to be impaired. Capital market-funded finance companies are retrenching; high-line consumer products appear uneconomic; small and mid-sized banks remain pressured by commercial real estate credit.
The 2008 bank bailout did little to enable small business lending. For better or worse, the major financial rescue programs (e.g. the CPP, TALF, and TLGP) were focused, in effect, on supporting capital and liquidity at the largest banks and shadow banks. They were not especially suited to aiding the small banks that focus disproportionately on small business credit.
Unfortunately, the SBLF will mostly support legacy assets, not new lending. To its credit, the SBLF creates incentives for small banks to accept capital infusions, and to use that capital to extend prudent small business loans. But as the program is structured in the House bill, most small banks would likely gravitate towards increasing small business lending by only 10%, which would mean that more than 80% of the taxpayer-supplied capital under SBLF would support existing asset portfolios, rather than new small business credit.

CAR SALESMEN, LOBBYISTS, AND CHARTS

Mon, 31 May 2010 18:44:15 -0400

Raj Date
Over the past weeks, the politically powerful auto dealer lobby has besieged members of the Senate, requesting a special exemption from a new consumer protection regulatory framework. Although it is not especially clear why it is relevant to the debate, the dealers have insisted, through the use of a widely distributed chart, that auto credit performance has been rock-solid through the crisis. They have also argued that they are “Main Street” stalwarts unconnected to “Wall Street” miscreants.
Data integrity matters; but the integrity of communication about data matters just as much.
This two-page briefing document illustrates the dangers of the deceptive use of data. First, it replicates auto dealers’ presentation of data to Senators; second, it uses precisely the same data to create a similarly deceptive message, but to the opposite purpose; and, finally, it illustrates how an unbiased analyst might present the same data.
Moreover, the document illustrates that Wall Street firms (through the ABS and unsecured markets) in fact fund more than 70% of dealer-originated loans and leases. Together, the funding partnership of Wall Street and auto dealers has been quite successful, accounting for more than half the market.
As it turns out, none of this especially relevant to whether or not auto dealers -- the dominant participants in the $850 billion auto finance market -- should be subject to the same set of rules as smaller participants like community banks and credit unions. (For an unequivocal point of view on that question, please read Cambridge Winter Center’s research note entitled “Auto Race to the Bottom”). But the presentation does, hopefully, illustrate a point that, over the long term, might be just as important: Beware of lobbyists bearing charts.
On a related note, Cambridge Winter was forced to send a letter to Under Secretary of Defense Clifford Stanley, clarifying what otherwise could have been a misleading citation by Senator Brownback, the sponsor of the proposed auto dealer exemption in the Senate.

RESEARCH NOTE: RESOLUTION AUTHORITY

Fri, 23 Apr 2010 20:13:01 -0400

The Killer G’s: Resolution Authority, Financial Stabilization, and Taxpayer Bailouts

Next week, the Senate will begin consideration of what could be a sweeping overhaul of financial market regulation. One of the Senate Bill’s key objectives is to solve the “too big to fail” problem that plagued policy-makers in 2008.
To date, observers appear conflicted about whether the Bill succeeds or fails on that measure. This research note informs the question, by (1) describing a taxonomy of too big to fail bailouts as manifested during this financial crisis; (2) evaluating whether the Senate Bill, if it had been in place several years ago, would have prevented any or all of those taxpayer-funded rescues; and (3) highlighting an important caveat for policy-makers.
The term “bailout”, as applied to the most recent crisis, refers to three distinct kinds of taxpayer-funded support for private enterprises: “blank check” capital infusions and asset guarantees that supported all of a firm’s stakeholders, like the original TARP’s $10 billion capital infusion into Goldman Sachs; “deathbed conversions” of non-banks into regulated bank holding companies, like the hurried transformation of GMAC; and “last resort liquidity” programs to alleviate the broad-based funding crunch, like the FDIC’s guarantee of more than $50 billion of GE Capital’s unsecured debt.
The too big to fail problem manifests itself in all three categories of bailouts. As currently drafted, the Senate Bill dramatically reduces the problem posed by the first two, and makes some progress with respect to the third.
The “blank check” bailout is, in large measure, eliminated by the plain terms of the Bill’s resolution authority. Crucially, systemically important firms’ shareholders, creditors, and managers cannot wind up better off under the Bill’s resolution authority than they would have under a regular-way bankruptcy liquidation. Neither the pre-existence nor size of a resolution fund alters this fundamental point.
Moreover, because the Bill contemplates heightened prudential standards for even shadow banks that are systemically important, the prospect of moral hazard-inducing “deathbed conversions” is diminished.
The Bill could be stronger with respect to “last resort liquidity”, particularly if policy-makers are concerned about generally available liquidity facilities that disproportionately benefit the largest firms. The Bill might, for example, provide a fast-track legislative check on the Fed’s emergency lending discretion, or inflict greater shareholder pain on a systemically important firm that avails itself of Fed- or FDIC-supplied emergency liquidity support.
The Senate Bill, then, takes a broadly sound approach to ending the too big to fail problem, with a few areas for tactical improvement. Policy-makers should recognize, though, that the power of the Bill’s approach could be eroded by systematic regulatory capture or inattention, particularly at the Federal Reserve.

LOSING THE LAST WAR

Sun, 21 Mar 2010 12:07:05 -0400

Evaluating “Veto” Powers on Consumer Financial Protection

On March 22, the Senate Banking Committee will begin debate over Chairman Dodd’s proposal to reform U.S. financial services regulation. That proposal calls for the creation of a new Bureau of Consumer Financial Protection (“Consumer Bureau”) within the Federal Reserve System. The Cambridge Winter Center has created briefing materials meant to help policy-makers evaluate that Consumer Bureau.
Mostly independent. Despite being housed within the Fed, the new Consumer Bureau would benefit from significant functional and financial independence from the Fed or other prudential regulators. This is a substantial improvement. As the OCC itself last week (unintentionally) demonstrated, bank regulators charged primarily with safety and soundness concerns cannot be expected to oversee consumer protection issues well.
New “Council” has veto power, for no apparent reason. Curiously, the Dodd proposal sacrifices a significant measure of Bureau independence by permitting the newly created Financial Stability Oversight Council (the “Council”) to override Consumer Bureau regulations, if the Council finds, by a two-thirds vote of its nine voting members, that those regulations would threaten the safety and soundness of the banking system, or the financial sector’s stability.
As a threshold matter, it is not clear what problem this veto provision is meant to solve. There is no empirical evidence that the over-protection of consumers ever has created systemic risks. By contrast, there is considerable recent evidence that the under-enforcement of consumer protection can contribute to systemic risks.
Case example illustrates problem with Council “veto”. To evaluate the potential impact of the “veto” provision, it is useful to consider what would have occurred during the credit bubble if the Dodd proposal had been in place at that time.
Most consumer protection problems do not create systemic risks. But it can happen: as illustrated by the proliferation of non-traditional mortgages (especially prime interest-only and Option-ARMs during 2003-2006), products with considerable non-transparent consumer risk can create massive distortions in the credit markets, and artificially inflate underlying asset values as well.
As contemporaneous evidence strongly suggests, at least six of the nine voting members of the Council, if it had existed at the time, would have been likely to vote against the regulation of non-traditional mortgages during the bubble. As a result, Consumer Bureau attempts to better regulate non-traditional mortgages would have been overruled.
Veto provision should be re-evaluated. The veto provision, then, would likely have led to precisely the wrong substantive outcome with respect to the most serious systemic risk created by abusive consumer products and practices during the run-up to the crisis. Policy-makers would do well to re-evaluate that provision in the Dodd proposal.

RESEARCH NOTE: SHADOW BANKING

Wed, 3 Mar 2010 19:20:27 -0500

Out of the Shadows:
Creating a 21st Century Glass-Steagall
Raj Date and Michael Konczal
The Cambridge Winter Center for Financial Institutions Policy, in conjunction with the Roosevelt Institute’s conference on financial regulatory reform entitled “Make Markets Be Markets”, is pleased to present this research note. The piece, which appears as a chapter in the conference’s materials, is co-authored by Cambridge Winter’s Executive Director Raj Date, and Roosevelt Institute Fellow Michael Konczal.
The paper argues that the link between the financial crisis and the relaxation of Glass-Steagall’s constraints is rather more complicated than typically understood.
The Gramm-Leach-Bliley Act, the financial reform legislation passed in 1999, implicitly relied on an internally consistent set of logical premises: (1) that widening the scope of banks’ activities would allow them to reverse a long-term secular decline in competitiveness; (2) that non-depository “shadow banks” should continue to compete in the banking business, because free market discipline would force them to make sound credit risk-return decisions; and (3) that even if shadow banks failed to make good credit decisions, their resulting bankruptcies would not result in taxpayer harm.
To most policy-makers at the time, those premises seemed sound. But in hindsight, all three premises have proven disastrously false in the marketplace.
Except for the few largest bank holding companies, the opportunity to enter the securities business has not made banks any more competitive. Moreover, it turns out that non-banks (e.g. Merrill Lynch, GE Capital, CIT, GMAC, the GSEs) made breathtakingly bad credit risk-return decisions. And the lack of any bank-like regulatory governors on growth allowed leading shadow banks to grow so explosively during the credit bubble that, when they failed, taxpayers were forced by two successive Administrations to support them, for fear of the collateral damage of such large firms’ collapse.
Congress did not create the crisis through the 1999 deregulation. But by focusing on the deregulation of banks, instead of managing the already growing systemic risk of the shadow banks, Congress not only enabled the financial crisis, it may well have hastened it.
In light of that experience, policy-makers should now focus on a new kind of Glass-Steagall -- one that prevents shadow banks from creating the same kinds of risks again.

RESEARCH NOTE: GSE REFORM

Wed, 3 Mar 2010 16:51:59 -0500

The Giants Fall:
Eliminating Fannie Mae and Freddie Mac
Raj Date
The Cambridge Winter Center for Financial Institutions Policy, in conjunction with the Roosevelt Institute’s conference on financial regulatory reform entitled “Make Markets Be Markets”, is pleased to present this research note. A version of this note appears a chapter in the conference materials.
The bailout of Fannie Mae and Freddie Mac may be the most costly element of the Bush and Obama Administrations’ efforts to rescue the financial system. It is tempting to pin the firms’ failures on their mission to promote affordable homeownership. But that would be, in large measure, a misdiagnosis: the subprime fraction of the GSEs’ credit exposure was too small, and the GSEs’ overall credit deterioration too large, to attribute their woes to the affordability mission alone.
The cause of the GSEs’ failure is actually more simple, and decidedly more troubling: the very structure of the GSEs created the inevitability of their ultimate collapse.
Fannie and Freddie’s central concept -- the provision of guarantees on mortgage pools by government-sponsored private firms -- is fatally flawed. Credit markets are prone to cyclical errors, even under the best of circumstances -- that is, even when credit decisions are undertaken by independent, atomized lenders who are checked by attentive and self-interested debt market investors. But Fannie and Freddie, by design, do not labor under those ideal circumstances: they are subject to no meaningful debt market discipline whatsoever, because their investors can and do rely on implicit taxpayer support. Even with the most talented of management teams and the most energetic of regulators, and even without any mission-driven pro-homeownership bias, such a credit decisioning system is doomed to fail.
The GSEs do provide benefits beyond credit extension: liquidity support, and interest rate risk absorption. But those benefits are almost entirely the result of the GSEs’ taxpayer backing, so they can be supplied through more transparent, less costly means. As a result, there is no logically defensible reason for the GSEs’ survival. They should be eliminated.

RESTORING CREDIT TO MAIN STREET

Tue, 2 Mar 2010 13:53:49 -0500

On March 2, the Cambridge Winter Center’s Executive Director, Raj Date, testified before the Senate Banking Committee’s Economic Policy Subcommittee regarding proposals to stimulate small business credit.
Cambridge Winter’s testimony suggests that the small business credit marketplace is reaching a transition point: the point at which credit contraction becomes less driven by a rational decline in the demand for small business credit; and the point at which credit becomes constrained by a structural shortfall of supply.
The crisis has triggered a simultaneous and dramatic reduction in the availability of important nationally marketed lending products (high-line credit cards, cash-out home equity loans), as well as in the credit capacity of large national finance companies (like GE Capital, or CIT). As a result, small business lending is, by default, reverting back to regional and community banks. But, by and large, banks’ capital positions will not be sufficient to accommodate incremental demand.
In that light, proposals to stimulate regional and community banks’ small business lending do seem logical. To evaluate such proposals, including the Administration’s proposal for a Small Business Lending Fund, the testimony suggests three principles: (1) recognize the limits of direct government credit-decisioning; (2) do not disproportionately reward poor performers; and (3) create an explicit link to desired behavior.

THROUGH THE LOOKING GLASS (STEAGALL)

Wed, 27 Jan 2010 14:45:13 -0500

Last week, the Obama Administration proposed two sets of new measures to contain systemic risk: limits on financial firms’ size (as a fraction of market liabilities); and the so-called “Volcker Rule”, which would bar bank and financial holding companies from putatively high-risk activities like private equity investing, managing hedge funds, and proprietary trading.

The Cambridge Winter Center has prepared a presentation that helps policy-makers evaluate the proposed Volcker Rule.

The presentation argues business models that combine elements of the commercial banking, broker-dealer, and proprietary trading business models can pose systemic hazards. But the Volcker Rule focuses on the least problematic of those hybridized activities. For sound market-based reasons, commercial banks are simply not involved in significant levels of private equity or hedge fund-like investing.

By contrast, broker-dealers (or investment banks) are quite frequently engaged in trading and investing for their own account -- both as a necessary consequence of their market-making function, but also as a means to capture incremental value. Because investment banks (appropriately) fund themselves substantially in short-term and overnight markets, allowing them to take on volatile and illiquid assets is systemically dangerous. Indeed, it was the proliferation of such “shadow banking” that was perhaps the single biggest driver of the credit bubble and ensuing crisis and government response. But the Volcker Rule, as currently defined, does not apply to most investment banks. Indeed, if the largest investment banks (Goldman Sachs and Morgan Stanley) were to give up their bank holding company status, the Volcker Rule would leave even them untouched.

The Volcker Rule can be improved, however. First, policy-makers should focus their efforts on preventing too-big-to-fail firms (which are large broker dealers, not banks) from taking on credit and rate risk that their funding structures do not suit; the Volcker Rule should therefore apply to investment banks. Second, rather than trying to define “proprietary trading” (such definitions are hard to create, and easy to get around), policy-makers should adopt a tailored approach to capital requirements. For example, because inventories of securities that are disproportionately large compared to trading flow are more likely to represent proprietary risk, they might carry higher capital requirements.

PAY DIRT

Sun, 17 Jan 2010 12:57:21 -0500

Why Do Wall Street Bankers Get Paid So Much?
Raj Date1
January 17, 2010

It’s bonus season on Wall Street, and the joyous hallmarks of the season here in Lower Manhattan (e.g., crowds in the usually desolate Hermes and Tiffany outlets) are this year accompanied by the decidedly less festive drumbeat of public outrage over banker compensation.
This is, of course, not the first time since the onset of the financial crisis that bankers’ compensation has come under such close scrutiny. But for the most part, and despite the most tinny of ears, the industry has so far side-stepped any major legislative clampdown on pay practices.2 Without question, though, compensation will invite closer regulatory scrutiny in the future. The Federal Reserve is already working towards better calibrating the impact of compensation practices on bank holding companies’ risk profiles.3
The Fed’s approach, though, has clearly not satisfied the widespread, and profound, sense that something is desperately wrong with financial industry (and, in particular, Wall Street) compensation. For example, the past week has seen the FDIC propose calibrating deposit insurance premiums based on banks’ compensation structures -- despite the arguably attenuated connection between the two, and over the objections of two Board members.4 And it seems likely that part of the political impetus for the Administration’s “bank tax” comes from the unseemliness of the bonus dollars about to rain down on Wall Street.5
Policy motives, it would seem, are beginning to shift from the belated and commonplace observation that compensation schemes had invited imprudent risk-taking during the bubble. Rather, some policy ideas now appear to be grounded, implicitly anyway, in something far more basic: it isn’t so much how bankers are paid -- that is, the system of incentives and the mix of consideration -- it’s that bankers are simply paid too much.6
A Basic Question: Why Are Bankers Paid So Well, Anyway?
In some circles, even asking such questions is somewhat heretical. But, for our purposes, let’s assume that compensation levels, even though they are presumably negotiated between consenting adults, are an appropriate issue for legislative inquiry.
And let’s concede that, by any rational standard, investment bankers’ pay is astonishingly high. Indeed, it is especially astonishing because, unlike some closely related professional species like private equity investors or hedge fund managers, investment bankers do not typically even pretend to risk any kind of “co-investment” with their clients or employers. In the vast majority of cases, Wall Street bankers are simply employees, working for wages. Really, really big wages.7
Finally, for our purposes here, let’s put aside short-term proposals that might or might not be legitimately grounded in retributive motives8, and focus instead on the more fundamental and longer term question of the propriety of high Wall Street pay.
That more fundamental inquiry should start with a fundamental question indeed: Why are Wall Street bankers paid so much, anyway? What are the market structures that enable such stratospheric pay packages? And, given those market structures, if we sincerely wanted to mitigate the tendency towards huge paydays, without resorting to arbitrary caps, how would we go about it?
It’s (Mostly) Not a Market Failure
There is an instinct among self-described free market adherents to declare obviously unpalatable market-based outcomes to be the result of market distortions -- information asymmetry, or agency problems, or externalities, or government meddling, or some other shadowy villain.
Two of those usual suspects are typically blamed for outsized banker compensation. The first is a kind of information asymmetry: it is persuasively argued that bank boards of directors systematically underestimate the risk that executives take on, so they myopically over-reward executive performance. The second putative distortion is a corporate governance problem that is decidedly not confined to financial services: senior executives have considerable influence over boards’ compensation decisions; that is, they have a great deal of say on their own pay.9
As Cambridge Winter Center research has described, board governance problems were especially pronounced at large banks during the credit bubble, as much due to shortfalls in director capabilities as anything else.10 But these governance-related distortions do not, as a logical matter, explain away the vast majority of eye-popping compensation. The pliability of boards might explain the largesse bestowed upon senior executives, but rank-and-file professionals make prodigious sums as well. And risk-return asymmetry might help explain proprietary trading desks’ massive paydays, but bankers who do not traffic in risk (M&A specialists, for example) are paid handsomely too.
It’s (Mostly) Not Supply and Demand
But if market distortions don’t fully explain Wall Street compensation levels, neither do straightforward labor market supply and demand dynamics.
To be sure, the supply of qualified candidates for Wall Street jobs is constrained, particularly during the all-too-frequent paroxysms of anti-immigration sentiment. Bankers must be both numerate and literate, in a way that rules out large swaths of the talent markets that migrate towards engineering, or the law. And, in general, bankers enter the business at the bottom, which means immensely long and tedious hours for new entrants. Given the relative scarcity of people with the basic skills and work ethic required, a substantial wage premium should naturally be expected.
But not this substantial.
Wall Street staff need not be systematically more numerate, literate, or hard-working than, say, physicians. Were this simply an issue of supply and demand, the Wall Street wage premium associated with the scarcity of talent should bear some rough similarity to the wage premium enjoyed by doctors. But it doesn’t. At equivalent points in tenure, investment banking pays vastly more than medicine.
The Perfect Market Structure . . . for an Employee
The reason for this is that the industry structure of investment banking -- unlike that of medicine or engineering or even the law -- almost perfectly maximizes employees’ ability to capture economic rent. Specifically, three structural features enable the annual windfalls so characteristic of the industry.
First, investment banks’ clients rarely apply direct pressure on firms to limit banker compensation -- in contrast to, say, insurers’ relentless pressure on doctors’ fees. Part of this dynamic is fueled by an agency problem: clients’ decision-makers (like institutional money managers) are very rarely paying their own money for investment banking services. And, in important markets like equity underwriting or M&A advisory, client executives are not especially interested in finding bargains on what, to them, can feel like bet-your-career transactions. The plain truth: no one gets fired for hiring a Morgan Stanley banker to handle an IPO.
Second, the nature of most Wall Street businesses is that, while institutional reputations and capabilities are important, those institutional resources are necessarily brought to bear through the skills and personal networks of individual employees. Because employees can (and quite frequently do) take their individual skills and client networks to competing firms, as a group Wall Street bankers are able to extract excess economic value from their firms over time. Compare this to the plight of many engineers, whose value-add is necessarily dependent on tangible and intangible assets owned by their employers.
Third, and certainly most importantly for policy-makers, the sheer size of today’s leading Wall Street firms enables bankers (and, especially, traders) to extract outsized compensation. When applied to a sufficiently large asset base, even razor-thin marginal differences in talent and capability can mean significant differences in nominal returns.
Let’s say Adam the senior credit trader is slightly more clever than his rival Bob, and as a result can be expected to gain, over time, one percentage point annually better returns on risk capital. If his firm only provides Adam with $100 million of capital to manage his positions, his incremental returns over Bob only amount to $1 million per year, and, as a result, his principled argument for incremental compensation would be capped at that amount. If his firm is ten times larger, and, as a result, is able to stomach a $1 billion capital allocation to Adam, his incremental returns over Bob amount to $10 million. It is entirely predictable to expect that Adam would seek to capture some fraction of that $10 million for himself.
Ever-larger firms enable employees to scale putative advantages in talent over ever-larger capital bases, and thereby capture ever-larger compensation for themselves.11 And policy-makers have intentionally created a world in which the largest firms have become dramatically larger over time. Goldman Sachs, for example, ballooned from a $250 billion balance sheet in 1999 to $1.1 trillion by the end of 2007, and even now, after two years of de-leveraging, has more than $850 billion in assets. In turn, the largest firms create a pricing umbrella on compensation, as second-tier and boutique institutions legitimately fear that they cannot compete without at least coming close to the largest firms’ payouts over time.
The emergence of giant banks might or might not be good for clients, shareholders, or taxpayers; but they are unquestionably great for bankers.
* * *
It might be unseemly, but stratospheric Wall Street compensation is the entirely predictable outcome of rational market actors behaving within an industry structure that is almost uniquely suited to the extraction of economic rent by employees.
Most of the facets of that industry structure are not especially susceptible to influence or control by policy-makers. But one facet might be ripe for closer control: the size of Wall Street’s largest players. If policy-makers are serious about moderating Wall Street pay, it is yet more reason to evaluate constraints on the size of our largest financial institutions.

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1 Raj Date is the Chairman and Executive Director of the Cambridge Winter Center for Financial Institutions Policy. He is a former McKinsey & Company consultant, bank senior executive, and Wall Street managing director. The Cambridge Winter Center is a non-profit, non-partisan think tank focused exclusively on U.S. financial services policy.

2 Recall last year’s media attention to AIG’s bonus payments, and the House’s subsequent, abortive “TARP Bonus Bill”. See Raj Date, Outrage Abhors a Vacuum, Cambridge Winter Center (March 22, 2009), available at http://www.cambridgewinter.org/Cambridge_Winter/Archives/Entries/2009/3/22_OUTRAGE_ABHORS_A_VACUUM.html, accessed Jan. 13, 2010.

3 Federal Reserve Board, Proposed Guidance on Sound Incentive Compensation Policies, 74 Federal Register 206 (Oct. 27, 2009), pp. 55227-55238, available at http://edocket.access.gpo.gov/2009/pdf/E9-25766.pdf, accessed Jan. 13, 2010.

4 FDIC, Incorporating Employee Compensation Criteria into the Risk Assessment System, 12 CFR Part 327 (Jan. 12, 2010), available at http://www.fdic.gov/news/board/2010Jan12ANPR.pdf, accessed Jan. 13, 2010.

5 The “Financial Crisis Responsibility Fee” proposed by the Administration would assess a 15-basis point fee on non-deposit liabilities, and would apply to firms with more than $50 billion in assets. By definition, then, the fee would hit hardest those banks that are large and disproportionately fund themselves in the capital markets -- that is, the biggest Wall Street firms. See Fact Sheet on the Financial Crisis Responsibility Fee (Jan. 15, 2010), available at http://www.whitehouse.gov/sites/default/files/financial_responsibility_fee_fact_sheet.pdf, accessed Jan. 17, 2010.

6 With characteristic bluntness, Barney Frank, the Chairman of the House Financial Services Committee, this week made that implicit notion explicit: “There is clearly an overwhelming public justification for the regulators restraining incentive or banning incentive structures that incentivize excessive risk. Now we’ve gotten that, and I want to help put some public attention on that. But the question of the amounts is also a relevant one.” House Financial Services Committee, Press Release (Jan. 13, 2010), available at http://www.house.gov/apps/list/press/financialsvcs_dem/press_01132010.shtml, accessed Jan. 14, 2010.

7 Junior associates at major Wall Street firms routinely earn multiple six-digit sums; junior managing directors should, in most years, make well into seven digits; senior executives and the heads of groups or trading desks will not infrequently earn into eight digits. Historically, most of that compensation, particularly at more senior levels, has been delivered in year-end bonuses. See generally Douglas J. Elliott, Wall Street Pay: A Primer, The Brookings Institution (January 11, 2010), available at http://www.brookings.edu/~/media/Files/rc/papers/2010/0111_wall_street_elliott/0111_wall_street_elliott.pdf, accessed Jan. 14, 2010.

8 For example, Rep. Peter Welch of Vermont has introduced a bill in the House that would apply a 50% tax to bonuses by TARP-aided banks in excess of $50,000. Wall Street Bonus Tax Act, H.R. 4412, 111th Cong. (2009), available at http://www.gpo.gov/fdsys/pkg/BILLS-111hr4412IH/pdf/BILLS-111hr4412IH.pdf, accessed Jan. 17, 2010.

9 See generally Lucian A. Bebchuk, Testimony Before the Committee on Financial Services of the U.S. House of Representatives, Hearing on Compensation Structure and Systemic Risk (June 11, 2009), available at http://www.house.gov/apps/list/hearing/financialsvcs_dem/bebchuk.pdf, accessed Jan. 14, 2010.

10 See Raj Date and Holly Scott Atallah, The Failure of Bank Board Governance, Cambridge Winter Center (Oct. 5, 2009), available at http://www.cambridgewinter.org/Cambridge_Winter/Program_A_files/bank%20boards%20100509.pdf, accessed Jan. 17, 2010.

11 Recall Sherman McCoy’s wife, in The Bonfire of the Vanities, explaining her bond-salesman husband’s job to their daughter: "Just imagine that a bond is a slice of cake, and you didn't bake the cake, but every time you hand somebody a slice of the cake a tiny little bit comes off, like a little crumb, and you can keep that." In today’s market, bigger firms mean bigger cakes, bigger slices, and bigger crumbs.

THE SCALABILITY OF BAD IDEAS

Wed, 6 Jan 2010 21:04:25 -0500

Today, the Cambridge Winter Center participated in a conference on the future of consumer financial product regulation, hosted by the Federal Reserve Bank of New York.
Cambridge Winter’s presentation argues that effective regulation of consumer finance will require mitigation of two persistent market distortions -- an information asymmetry that prejudices customers, and an information asymmetry that prejudices investors. Together, those asymmetry problems enable bad products and practices to scale up quickly, driving good products and practices out of the marketplace. The results are bizarre by free-market standards: products like Option-ARMs can achieve devastating growth and prominence, despite being glaringly poor choices for customers and investors alike.
Mitigating those information asymmetries should be possible within the broad contours of the reform proposals in both the House and Senate -- but doing so well will require further refinement by regulatory agencies.
First, the Consumer Financial Protection Agency, if created, should focus on helping consumers prioritize and focus their evaluation of financial products. The CFPA can and should seek to highlight for consumers where they would be wise to dig deeply, and focus on the fine print -- and where, by contrast, close attention is likely less critical. Importantly, the new agency should not simply repeat the mistake of assuming that mountains of disclosure documents can be rendered effective simply by making those mountains higher. This mission is notably distinct from the notion of designing or mandating “plain-vanilla” products -- a notion that is problematic both in concept and in practice.
Second, regulatory agencies will have to further articulate “risk retention requirements” that are intended by Congress to rein in undisciplined capital markets-funding of dubious financial products. Ideally, the most “skin in the game” required for asset originators or intermediaries should be where two different variables are present: (1) where a firm has significant influence over an asset’s value; and (2) where the nature of the asset itself precludes efficient due diligence by market participants. Taken together, this would mean that the “natural owners” of residual credit risk should not easily be able to slough off that risk onto definitionally ill-equipped buyers.

RESEARCH NOTE: AUTO FINANCE

Mon, 16 Nov 2009 10:43:09 -0500

Auto Race to the Bottom:
Free Markets and Consumer Protection in Auto Finance
Raj Date and Brian Reed
The Cambridge Winter Center for Financial Institutions Policy is pleased to present this research note in conjunction with its ongoing research program on the post-crisis evolution of U.S. consumer finance.
Over the past several months, the Federal Reserve, Congress, and the Administration have been considering ways to strengthen and rationalize consumer protection in financial services. Central to that debate is the proposed creation of a new agency focused exclusively on this issue, the Consumer Financial Protection Agency (the “CFPA”).
Despite pronounced industry opposition, a consensus appears to be developing among policy-makers that the proliferation of dubiously structured and marketed consumer financial products helped fuel an unsustainable bubble in credit and asset values prior to the financial crisis, and visited widespread distress among households thereafter. Proponents of the CFPA argue that it would help prevent similar problems in the future.
Even among proponents, however, there are varying conceptions of the scope and function of the CFPA. One of the most significant variations is in the treatment of auto finance. Specifically, the CFPA as envisioned by the House Financial Services Committee would exclude auto dealers from the CFPA’s coverage. The Administration’s original proposal would have included them.
This research note does not address the issue of whether the CFPA itself is advisable. Instead, it is meant to inform debate on, assuming there is a CFPA, whether auto dealers should be included in its mandate. In particular, it (a) summarizes the structure of the auto finance industry, and the role of dealers within it; (b) identifies the analytical premises for excluding financial services activities from the CFPA’s scope; (c) evaluates, in light of that analytical framework, whether dealers should be exempted; and (d) highlights the likely competitive implications in the industry if the exemption becomes law.

RESEARCH NOTE: CORPORATE GOVERNANCE

Mon, 5 Oct 2009 10:58:08 -0400

The Failure of Bank Board Governance
Raj Date and Holly Scott Atallah
The Cambridge Winter Center for Financial Institutions Policy is pleased to present this research note in conjunction with its ongoing research program on banks’ regulation and governance.
Over the course of the last several months, global financial regulators have signaled their intent to reduce systemic risk by limiting individual banks’ discretion. For example, regulators in both the U.S. and abroad have focused on the need for higher capital requirements, and for more disciplined executive compensation schemes. In general, these new constraints would necessarily reduce the level of free-market discretion traditionally afforded to private sector banks’ boards of directors.
At the same time, two large banks that received significant taxpayer assistance -- Citigroup and Bank of America -- have, presumably through some manner of regulatory encouragement, undertaken a profound re-shaping of their boards of directors.
This research note is meant to inform debate on the need for such new constraints on board discretion and composition, by examining more closely the putative failure of bank board governance. In particular, it focuses on (a) evaluating the performance of banks’ boards of directors during the build-up to the financial crisis; (b) identifying the likely causes of that performance; and (c) highlighting implications for policy-makers.

RESEARCH NOTE: INDUSTRIAL LOAN COMPANIES

Mon, 10 Aug 2009 10:53:08 -0400

ILCs and Shadow Banking
Raj Date
The Cambridge Winter Center for Financial Institutions Policy is pleased to present this research note in conjunction with its ongoing research program on the structure and stability of the U.S. financial services market.
As part of its broad-based proposal to reform financial services regulation, the Administration has proposed the elimination of Industrial Loan Company (or “ILC”) charters. Opponents of the proposal have noted that ILCs have typically been marked by strong capitalization and solid credit performance, and therefore cannot fairly be linked to the excesses of the credit bubble and the ensuing financial crisis.
This note summarizes the recent evolution of ILCs, examines their empirical connection to the credit crisis, and highlights implications for policy-makers.

MISSION: INEXTRICABLE?

Fri, 10 Jul 2009 21:41:47 -0400

A wise man -- I believe it was Spanish-American philosopher George Santayana, or possibly Marty McFly, from the Back to the Future movies -- once sagely observed: “Those who cannot remember the past are condemned to repeat it.”1
With that in mind, I think it worthwhile to examine an important, current public policy debate through the lens of recent history. The question, currently posed in the debate over the Administration’s proposed Consumer Financial Protection Agency (“CFPA”), is simple: should consumer financial protection responsibilities be undertaken by the same regulator responsible for overseeing a bank’s safety and soundness?
The Administration clearly believes that the answer is no -- that consumer protection should be separated, and reside in the CFPA.
Double-Talk from the Bank Lobby
The opposite argument, perhaps not surprisingly, is made by the bank lobby. As the powerful American Bankers Association (the “ABA”) argued before the House Financial Services Committee last month:
Consumer regulation and safety and soundness regulation are two sides of the same coin. Neither one can be separated from the other without negative consequences; nor should they be separated. An integrated and comprehensive regulatory approach is the best method to protect consumers and protect the safety and soundness of the financial institution.2
For anyone who was around consumer finance during the bubble years, this was a striking argument from the ABA. Because during the lengthy, tortured debate between 2004 and 2006 on whether and how federal bank regulators should attend to the explosion in (later, the explosion of) non-traditional mortgages, the ABA -- the very same association, with the very same clients -- made almost precisely the opposite argument:
The [Nontraditional Mortgage] Guidance combines safety and soundness guidance with consumer protection guidance, creating confusion that is best addressed by separating the them [sic].3
Fortunately, the final regulatory guidance essentially ignored this argument, but the lengthy delays attendant to the bank lobby’s fierce opposition meant that effective regulation of bubble-inducing mortgage products arrived almost precisely too late.
Back then, the array of federal bank regulators (the Fed, FDIC, OCC, OTS, and NCUA) charged with safety and soundness were, the ABA claimed, inappropriately trying to combine issues of safety and soundness with consumer protection concerns. Now that the White House is trying to pull consumer protection away from safety and soundness, the very same lobbyists are complaining that this, too, is deeply wrong-minded.
So, which is it? Was the bank lobby making an unprincipled argument then, or now? The answer: both. The ABA was then, and is now, simply making whatever jurisdictional argument suits its perceived short-term interests.
Do not misunderstand my point; the ABA was simply doing its job. It is not the bank lobby’s job to make good policy decisions, nor does the bank lobby necessarily have the foggiest notion of how one should engineer a prudent credit policy, capital strategy, or liquidity plan.4
They are in the business of making arguments, on whatever (sometimes meager) fact base they can cobble together, to support the short-term (and frequently short-sighted) financial interests of their clients. That is their job. They are not elected; they are not officers of the court; they are not looking out for the public good.
Let’s not forget that.
A Framework on Organizational Structure
But we are still faced with the core substantive question: Should we create a centralized entity tasked with consumer protection, or leave consumer protection de-centralized, and resident with the various state and federal safety and soundness regulators?
I trust we can agree on where not to look for guidance on structuring this inquiry. But that doesn’t solve the problem; after all, just deciding to do the opposite of what the ABA recommends is also unprincipled.
Let me suggest an approach that parallels how similar private-sector organizational structure questions are sometimes resolved. Granted, corporate re-organizations are sometimes maligned as pointless exercises.5 But judicious re-alignment of organizational resources can make or break strategic change.6 Virtually every organizational change implies trade-offs; determining whether any given change makes sense is a matter of weighing those trade-offs systematically.
In this context, we should weigh four considerations:
1. Inter-relatedness of missions across regulators
2. Uniqueness of issues across regulated firms
3. Commonality of capabilities across regulators
4. Redundancy of external contacts
This is a reasonably close question, but I believe the right answer is clear.
Starting from the the bottom of the list, it seems that adding a contact point between the CFPA and regulated firms creates interactions that are, inevitably, going to be either redundant with, or require coordination with, existing regulators’ interactions with regulated firms. That is not a crippling problem, of course, but on the margin, the redundancy of external contacts does militate against centralizing the CFPA.
The middle two factors (commonality of capabilities and uniqueness of issues) favor the opposite conclusion -- that is, towards centralizing the CFPA. It is difficult to argue with a straight face that existing regulators have remotely sufficient capabilities to handle consumer financial protection; thus, building strong capabilities at the CFPA can hardly be redundant. Moreover, the relative fairness and transparency of consumer product offers are much more driven by product structures and the markets in which they operate, and much less on the particular vagaries on any given institution’s context. In other words, consumer protection issues at Bank of America look a lot like consumer protection issues at Wells Fargo; and not much at all like, say, asset-liability management issues at either bank.
Mission: Inextricable?
So the swing factor, it would seem, is the level of inter-relatedness between the CFPA’s mission and that of safety and soundness regulators. The argument that the two are inextricably linked is made in various forms, and not just by the bank lobby. Take this recent argument by the FDIC:
The current bank regulation and supervision structure allows the banking agencies to take a comprehensive view of financial institutions from both a consumer protection and safety and soundness perspective. Banking agencies' assessments of risks to consumers are closely linked with and informed by a broader understanding of other risks in financial institutions.7

This argument seems true, but only to the extent that it seems tautological. It is easy to say that safety and soundness and consumer protection missions are closely linked because they provide an integrated viewpoint. But that just begs the question: why, specifically, is an integrated viewpoint important? What, precisely, does it allow you to do differently as a regulator?
The answer, on closer inspection, is that an integrated viewpoint actually isn’t especially critical, or at least not so critical that it cannot be reconciled with inter-agency communication and coordination.
Indeed, the only meaningful linkage relates to the evaluation of consumer credit risk. To the extent that customer-unfriendly product structures and practices invite adverse selection, that certainly informs credit loss behavior in a bank’s consumer portfolio. But unfriendly structures and practices are just part of what drives adverse selection; adverse selection is just part of what drives consumer credit trajectory; consumer credit trajectory is just part of credit exposure more broadly; and credit is just part of safety and soundness evaluation. To bootstrap from consumer protection responsibility to safety and soundness responsibility is an attenuated argument indeed.
To meaningfully link consumer protection and safety and soundness, one would have to be willing to force an institution to offer a product that would be customer-friendly but imprudent. That seems a patently bad idea. (Picture a regulator’s call to Bank of America: “Ken, we know it would further threaten your solvency, but we’d like you to go ahead and increase auto finance approval rates across the board, because customers seem to like getting loans”).
Or, one would have to be able to identify a product or practice that is otherwise unacceptable from a consumer protection point of view, but that would be deemed acceptable because a financial institution’s overall health depended on it. (Imagine a call to Citigroup: “Vikram, we know that universal default re-pricing of credit cards is a bit of a rip-off, but we know you really need the money to help stay solvent, so go right ahead”). That appears, on its face, comical. Indeed, it would seem among the worst dynamics about combining safety and soundness and consumer protection in a single entity.
And yet, there is at least anecdotal evidence that this phenomenon occurs in reality: the co-existence of the two responsibilities causes regulators to gloss over consumer protection when vigorous enforcement would be neutral to, or would impair, safety and soundness.
Take, for example, the practices that persist under the banner of “free checking” in the industry. Those practices (e.g. item sequencing) can seem aggressive to the point of unfairness, but they tend not to get much attention, because on balance, those practices help banks’ safety through fattened fee income streams.
Or, consider how most top banks, at the most frothy point in the cycle, owned affiliated mortgage banking units that offered non-traditional mortgages of questionable customer value and dubious credit quality. Because most of those banks could argue that they were, or could be, selling those loans into still-receptive capital markets, regulators could have been lulled into believing that no major safety and soundness issues existed. As a result, regulators took -- literally -- years to begin addressing a consumer protection problem that ultimately helped bring the real economy to its knees.
* * *
The question of how to structure consumer protection responsibilities is a close one, but the answer is still clear: the CFPA should be structured as an agency independent from existing safety and soundness regulators.
Raj Date is the Chairman and Executive Director of the Cambridge Winter Center for Financial Institutions Policy. He is a former McKinsey & Company consultant, bank senior executive, and Wall Street managing director.
_____________________________
1 Come to think of it, it was probably Señor Santayana who came up with this aphorism before Mr. McFly. The saying is called the “Law of Repetitive Consequences.” George Santayana, Reason in Common Sense, The Life of Reason, vol. 1 (1905).

2 Edward L. Yingling, Testimony on behalf of the American Bankers Association before the Committtee on Financial Services, U.S. House of Representatives, p. 6 (June 24, 2009), available at http://www.house.gov/apps/list/hearing/financialsvcs_dem/yingling.pdf.

3 Paul A. Smith, Public comment on behalf of American Bankers Association regarding Proposed Interagency Guidance on Nontraditional Mortgage Products, 70 Federal Register 77249, p. 7 (March 29, 2006), available at http://www.fdic.gov/regulations/laws/federal/2005/05c23guide.pdf.

4 Even aside from the questionable positions that it was advocating, the magnitude of the ABA’s substantive misreading of the credit bubble is striking:

Much of the tenor of the [proposed regulatory] Guidance is that nontraditional mortgage products are inherently riskier than other products. We believe that is incorrect; rather, they simply present different types of risks that may be well-managed by prudent lenders.
Id. at p. 2. The industry lobby also seemed to have genuinely missed the impact that a stagnant housing market would have on borrowers’ ability to refinance out of trouble:
For example, payment shock would not be an issue if the borrower pays off the loan during the initial period, which is often the case, and lenders should be allowed to recognize runoff rates. Institutions with significant experience with these mortgage products state that a significant segment of borrowers in fact prepay principal at a faster rate than would occur on a 30-year fixed rate loan.
Id. at p. 4.
5 See generally Scott Adams, Dilbert and the Way of the Weasel (2002).
6 See generally Jonathan D. Day, Emily Lawson, and Keith Leslie, How Reorganization Works, The McKinsey Quarterly (June 2003).
7 Sheila C. Bair, Modernizing Bank Supervision and Regulation, Testimony before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate (March 19, 2009).

REGULATOR UNBOUND

Thu, 2 Jul 2009 17:12:18 -0400

This week, the Administration submitted to Congress draft legislative language that would create a new, powerful regulator to promote transparency, simplicity, and fairness in consumer financial products. The new regulator, dubbed the Consumer Financial Protection Agency (the “CFPA”), would integrate the existing, fragmented approach to federal consumer protection efforts, and be armed with reasonably expansive rule-making, supervisory, and enforcement powers.
Given the manifest failings of the existing regulatory architecture, it is difficult to muster credible arguments against a substantial change. Perhaps understandably, then, the usually powerful bank lobby has mustered only formulaic policy arguments against the CFPA -- the old standby’s of any regulated industry seeking less regulation: assertions that better regulation would reduce innovation; that adhering to regulation would raise consumer costs; that a focus on fairness would reduce access to consumers that the legislation is intended to benefit. These are arguments so routinized in our broader policy discourse that one could have written them well before the Administration’s proposal was unveiled. Indeed, perhaps that is the case: mid-summers in our nation’s capital are notoriously unpleasant, and one cannot much fault bank executives and lobbyists for wanting to be at their beach homes, and not fighting a Beltway battle that is almost certainly doomed in any case.
So, barring some odd twist of fate, the CFPA, in some form, will likely be a part of the financial regulatory landscape going forward. Given that, it is best to turn our collective attention to how to structure the new agency to best avoid the problem that seems to have beset its predecessors in consumer financial protection -- the problem of agency capture.
WWGSD? Agency Capture in Financial Services
Agency capture is a well known problem, and one not confined to financial services. The phenomenon takes various forms, but its central problem is simple: over time, regulatory agencies tend to become more philosophically aligned with the powerful firms they are meant to regulate, and tend to exhibit a persistent bias against the more atomized constituent interests they are meant to protect.
The impact of this phenomenon should be painfully obvious to anyone who has invested in the U.S. financial services sector over the past two years. Investor returns in banks, sadly, have been less driven by fundamental strategic and financial strength, and more driven by the nature and magnitude of federal intervention and subsidies. Success in investing, then, has mostly been driven by success in predicting federal regulatory responses. And the best way to predict federal regulatory responses, right up until the Obama Administration’s regulatory reform proposals in June, has been to determine what policy decisions would most benefit the largest, most powerful regulated firms. (Back when I counseled clients on financial sector investments, during the last Administration, I occasionally urged them to ask “WWGSD?” -- or “What would Goldman Sachs do?” -- to be able to divine how a Paulson-led Treasury Department would dole out taxpayer subsidies. This was, in retrospect, depressingly good advice).
The influence of large private firms on their regulators should come as no surprise. The firms themselves, of course, are merely seeking their own self interest; we should expect nothing less. And regulators, alas, are human beings; we should expect nothing more.
Gauging the CFPA’s Vulnerability
Although specific personnel decisions are premature, it is a reasonably safe bet that the CFPA’s staff will also consist of human beings. Indeed, many of that staff are, presumably, currently in the employ of agencies that have failed mightily in their consumer protection responsibilities. Given that, it is prudent to gauge the CFPA’s own future vulnerability to agency capture.
To do so, we can evaluate each of four risk factors that have helped enable agency capture among financial services regulators in the past: regulator shopping; funding dependency; “revolving door” employment; and over-reliance on industry expertise. While the CFPA, as contemplated by the Administration, appears reasonably well inoculated versus the first two, it risks capture, over time, through the third and fourth.
Regulator Shopping, and Funding Dependency
First, let’s consider the problems of “regulator shopping”, and “funding dependency”, for which the OTS provides a useful and recent example.
The Administration’s overall reform proposal contemplates, in effect, shuttering the OTS and folding its responsibilities into a re-named OCC. Virtually no one is objecting.
Indeed, by any objective standard, the failure of the OTS to safeguard the safety and soundness of thrifts is nothing short of astonishing in its scale. The list of the largest OTS charges just a few years ago looks, now, like the ’27 Yankees -- quite frightening, and quite dead: Washington Mutual, Countrywide, AIG, IndyMac, and BankUnited among them, plus the likes of Sovereign, now a headache for a large Spanish bank, and Golden West, which was acquired by Wachovia and became the proximate cause of that bank’s collapse.
The federal savings bank (“FSB”) charter, which the OTS stewards, and which the Administration would abolish, had been on the slow road to irrelevance for quite some time. Between that slow attrition, and the natural market consolidation among large firms, the OTS’s universe of regulated thrifts had by 2006 become highly concentrated in a handful of relatively large thrifts. Those large firms had the ability to convert from an FSB to a different charter (and a different regulator); and if they did, the OTS would become irrelevant faster.
Moreover, because the OTS was dependent on assessments upon FSBs for much of its operating budget, the threat of losing large thrifts to another regulator was a near-term existential threat, not just a long-term threat to its stature.
As a bureaucracy that was concerned, as they all are, with its own institutional relevance and survival, the OTS had a strong incentive to stay in the good graces of those firms it was supposed to be regulating. Not surprisingly, then, the OTS took a systematically permissive approach to thrifts’ risk-taking in the build-up to the crisis. This is how, at precisely the time that home values seemed most hyper-inflated, Washington Mutual began retaining (as opposed to selling) its subprime credit risk. This is why, as Angelo Mozilo’s Countrywide faced the scrutiny of an increasingly skeptical Fed and OCC, the firm sought refuge in the comforting arms of the OTS.
Thankfully, the Administration’s proposal for the CFPA steers clear of these potential mishaps. One of the many attractive features of the CFPA is that it would supervise virtually any institution that participates in consumer financial services. A regulated firm cannot simply opt out of CFPA coverage, and opt into supervision by a more permissive regulator. This inability to escape CFPA regulation also takes pressure off of funding dependency issues, and the Administration’s approach to funding the agency through a combination both Congressional appropriations and user assessments -- though still quite high-level -- seems reasonable to mitigate agency capture risk as well.
Revolving Door
A third driver of agency capture is the “revolving door” between regulatory agencies and their charges. In theory, if a regulator’s staff members are recent alumni of private regulated firms, or are looking to eventual employment with private regulated firms, their supervisory zeal is likely to be tempered.
This is as much a problem with the proposed CFPA as it is with other financial regulators. The desire to serve the public does not necessarily insulate professional staff from all-too-human, conscious and sub-conscious biases in this regard. The SEC’s numerous failures in the run-up to the crisis (e.g. letting broker-dealers’ leverage run wild; letting the Madoff scheme go on for years) can likely be attributed in part to this issue. Indeed, agency capture is perhaps the only systematic way to reconcile such broad-based SEC failings with its seemingly talented, credentialed, and driven staff.
A relatively straightforward restriction on departing CFPA employees’ ability to work with the CFPA on behalf of a new employer, within some window of time, would likely remedy this agency capture threat. By contrast, it would seem a poor choice to refuse to hire staff from regulated private firms, particularly at the CFPA’s outset. This is a new agency, with an expansive and important scope; it should not cripple its hiring efforts.
Over-Reliance on Industry Expertise
The final risk factor is the most problematic for the CFPA, and warrants the most significant change to the Administration’s proposal.
Regulators risk being captured when, in order to discharge their basic supervisory and rule-making duties, they rely on special insight or institutional capabilities that are uniquely within the control of their charges. Take, for example, the Clinton-era decision to, in effect, minimize capital and liquidity requirements with respect to OTC derivatives, including credit default swaps. In retrospect, that seems nothing short of insane. But at the time, the magnitude of the cost and administrative friction associated with incremental regulation was best estimated (and, as it turns out, probably exaggerated) by industry participants, and not at all by regulators. And because regulators, just like the rest of us, don’t like to appear naive, they systematically toed the broker-dealers’ line -- that is, their agencies were captured by industry interests.
There are two ways to remedy this problem. The first is to build agencies’ independent research capabilities. The Administration proposal succeeds in this regard; it certainly contemplates a robust research function for the CFPA, and one that (at long last) focuses on how actual consumers, in real life, interact with financial products and their marketing. This is long overdue.
The second approach is more nuanced: policy-makers should tailor regulators’ scope to duties that are both necessary, and reasonably manageable given their own independent capabilities. After all, if we force a regulator to accomplish some lofty goal, and that lofty goal simply cannot be accomplished without a close and symbiotic relationship with private firms, then we should not be especially disappointed if those private firms steadily co-opt the regulator’s staff. Such mandates, in effect, set a regulator up for failure.
The Administration’s proposal is deeply problematic on this score, in one specific dimension: the CFPA’s responsibility to set standards for “plain-vanilla” products.
It could be that the existence of Fannie Mae and Freddie Mac have deeply confused policy-makers about the ease with which viable product structures can be formulated in a vacuum. It’s easy to develop a Fannie or Freddie product -- they’re artificially under-priced with respect to both credit and rate risk, and senior funding comes guaranteed courtesy of the eternal generosity of the American taxpayer.
Developing products in the real world, without unending taxpayer subsidies, is hard: it requires an iterative, disciplined approach that combines marketing, credit, and capital markets analytics. The Administration is essentially asking a brand new agency to take on that responsibility, despite having no day-one access to high-priced talent, historical loan-level data, proprietary marketing channels, customer base, brand, or profit motive. It cannot be done, at least not without essentially relying entirely on private market partners. And that kind of hand-in-glove partnership invites the kind of agency capture that has already doomed existing regulators’ efforts.
Given the obvious institutional hazards of asking a regulator to get into the product development business, it’s useful to ask what, precisely, the Administration was trying to accomplish with its “plain-vanilla” mandate. Presumably, the answer is that we are trying to create a choice architecture that pushes consumers to choose simpler products, which they are more likely to understand.
But if that is the goal, there is no need for the CFPA to be the one developing the plain-vanilla products. Instead, the CFPA should impartially gauge products structures according to published set of criteria.
The criteria are subject to debate; here is how that debate should resolve itself. The CFPA should use a three-part test: (1) transparency (based on how this product is marketed, does a consumer know what he’s getting?); (2) fairness (in a normative sense, is this an arguably fair deal for the utility received?); and (3) suitability (is this product at least arguably a good idea for the kinds of customers who will actually acquire it?). Truly egregious products will get an “F”, and should not be permitted. All other products will be awarded a letter grade of “A”, “B”, and “C”. That creates an incentive for private firms to compete to innovate and create customer-friendly products (that is, the “A” graded products).
With this calibration scheme in place, then, there is no need for the CFPA itself to get into the business of product design. A taxpayer-funded regulatory agency should not be forced to do bank managements’ jobs for them. The CFPA can accomplish its desired ends through more pragmatic, less intrusive means.
So eliminating the CFPA product development duties would have at least two direct benefits: mitigate the risk of agency capture; and spur private party innovation of customer-friendly products.
There is a third, indirect benefit as well. To the extent that the CFPA actually succeeded in developing spectacular financial products, the relative ease of offering them would iron out differences and local customization in product structures across the market. (This, in practical terms, has already happened in the mortgage market today, courtesy of Fannie and Freddie). But if product development and customization is not a differentiator among private players, then operating scale, massive brand spending, and funding cost advantages will necessarily determine winners and losers. And that will further accelerate the dominance of the largest, too-big-to-fail banks over the steadily shrinking population of community banks.
We have already lived through the hazards of a highly consolidated banking market; we shouldn’t be actively making those hazards worse.
* * *
The CFPA is a major step in the right direction. Let’s not set it up to fail.

Raj Date is the Chairman and Executive Director of the Cambridge Winter Center for Financial Institutions Policy. He is a former McKinsey & Company consultant, bank senior executive, and Wall Street managing director.

HAMMER, AND FICKLE

Thu, 25 Jun 2009 17:08:51 -0400

Last week, the Administration issued a much-publicized white paper laying out its proposals to reform the structure of financial services regulation. Debate over the various elements of the Administration’s plan is likely to be both protracted and fierce; battle lines inside the Beltway are already being drawn.
The white paper is an excellent starting point for that debate. But despite its seeming comprehensiveness -- the paper is, after all, nearly 90 pages long -- the proposal advances truly significant reforms with respect to only two out of five structural pillars of the U.S. financial services market. Its proposals on those two pillars (consumers, and bank management teams) seem reasonable, and in some cases, bold and compelling. We should not understate the potential power of some of those bold policy “hammers.”
Strangely, though, the Administration proposal is affirmatively milquetoast with respect the three remaining pillars of the financial services market (bank boards, debt markets, and regulators). Effective reform will require a more aggressive approach.
The Role of Regulation and Governance
Before delving into the reform proposals themselves, it is useful to agree on a mental model for the appropriate role of regulation and governance in the financial system.
The financial markets -- including both the banking system and the “shadow banking system” -- are, at their heart, private sector mechanisms by which capital is allocated and priced. That capital allocation and pricing occurs every day, in millions of atomized transactions, each typically struck between two seemingly arms-length, independent counter-parties: firms’ management (that is, the human and technological decision-making apparatus of banks, finance companies, hedge funds, and the like) and customers (that is, corporates, small businesses, and consumers). The terms upon which those transactions are struck, taken in aggregate, represent a market-driven consensus on the appropriate balance of risk and return in the financial system.
But there are two profound problems with this market-driven balance: moral hazard, and information asymmetry. The result is the seeming clumsiness of the invisible hand in financial services.
First, moral hazard afflicts both counter-parties in a typical credit transaction. Both management teams and customers have a shared bias towards a higher ambient level of risk. As has been much noted recently, bank executives tend to be rewarded, both financially and psychologically, when high risk bets pay off, but they do not suffer commensurate negative consequences when high risk bets fail. They are, after all, playing with the bank’s money, not their own.
Although it is less remarked upon, customers have the same kind of bias towards higher risk and higher leverage. If a bank is willing to lend you $475,000 to buy a $500,000 house, you have all of that house’s appreciation to gain, but only $25,000 to lose if you are willing to walk away and default. Like bank executives, consumers are playing (mostly) with the bank’s money, not their own. Granted, customers tend to be less explicitly mercenary than commercial enterprises about this heads-I-win, tails-you-lose proposition, but they absolutely (and rationally) tend to err towards greater leverage, and greater risk, when it is made available.
The second distortion is the inherent information asymmetry between lenders and borrowers. This tends to manifest itself in two ways, both of them gruesome.
When borrowers have material information about their own creditworthiness that lenders lack, the result is typically “adverse selection,” which results in too much credit being extended to risky borrowers. To see this in action, and if you dare, take a look at the credit performance of the Golden West-Wachovia-Wells Fargo option-ARM portfolio.
In other cases, lenders have superior information. For example, although banks know, empirically, the rate at which credit card customers will trigger over-limit fees, individual customers systematically (and drastically) underestimate the frequency with which those fees will be incurred. Because of that underestimation of the true costs of the product, consumers tend to borrow more than they would if they were privy to perfect information. In the case of American consumers (as opposed to commercial customers), this tendency is further reinforced by a notable deficiency in average financial literacy. It is difficult for a consumer to conclude he is taking too much risk in his mortgage if he can’t quite figure out how much he is paying in the first place.
Taken together, the distortions created by moral hazard and information asymmetry generate a significant pro-risk bias for both bank management and bank customers. Given that, it should not be surprising that they will, if left unchecked, systematically introduce more risk into the financial system than would decision-makers without such biases. And, therefore, it should not be especially surprising if such an unchecked system periodically blows up, leaving bewildered and beleaguered taxpayers to pick up the pieces.
This mental model of the financial system makes clear the need for appropriate checks on risk-hungry bank management and customers. Those checks are, in theory anyway, provided by the three other pillars of the system -- the three sets of watchdogs: bank boards, debt markets, and regulators. It is useful to think of these watchdogs as patrolling concentric circles.
The interior circle: Banks’ boards of directors, as the stewards of shareholder interests, should rein in management teams’ risk-taking when it advances management’s interests over shareholders.
Next: Debt markets (that is, banks’ creditors and uninsured depositors) should rein in bank boards from taking risks that promote equity holders’ upside over debt holders’ safety.
And, the ultimate line of defense: Regulators should rein in the combined activities of all of the aforementioned actors (customers, management, boards, and debt markets), when they work to promote their own upside over the safety of insured depositors and the system’s stability at large.
The credit bubble, and the ensuing financial crisis, were the result of a simultaneous catastrophic failure of governance and regulation. Despite the popular outcry about the avarice of bank executives, and growing backlash about irresponsible borrowing, the fact is that both executives and customers behaved in precisely the way that they always behave if unconstrained: they sought to take on more risk, and more leverage, wherever it was available. But all three watchdogs -- bank boards, debt markets, and regulators -- were sound asleep.
The Hammer . . .
The Administration’s proposal takes a reasonable approach to two of the five actors just described.
Consumers. Perhaps most striking is the approach to consumer protection. As I’ve described in the past (in an essay entitled “Blazing Toasters”), the proposed Consumer Financial Protection Agency represents a much-needed strengthening and unification of what otherwise has been a fragmented, expensive, and haphazard approach to supervising the kind and quantum of risk that bank managements and consumers would otherwise introduce into the system. At the same time, by preventing an abusive and predatory race to the bottom, the new agency would actually encourage product innovation.
Indeed, if anything, I would argue that the Administration has not gone far enough: the new agency should not just preempt existing federal consumer protection efforts, but also state regulators, whose efficacy at consumer protection has been inconsistent at best.
Bank Executives. The approach to controlling bank management teams’ risk asymmetry is also well reasoned, and judicious in that it does not attempt to do too much through the blunt instrument of compensation curbs. I have argued in the past (in an essay called “Outrage Abhors a Vacuum”) that executive compensation reforms should be based on generalized principles that align management interests with those of shareholders, and that apply to all financial institutions (not just TARP recipients) because they are all subject to the risk asymmetry incident to FDIC insurance and other taxpayer subsidies. This is the general approach favored by the Administration’s white paper.
. . . and the Fickle
Unfortunately, the Administration’s proposal does little to improve the performance of the three systemic watchdogs -- and in some ways makes the situation worse.
Bank Boards. The white paper is almost totally silent on reforms that would improve the performance of banks’ boards of directors. This is odd. After all, it was bank boards that enabled management teams to take on risk to shareholders’ detriment; it was bank boards that pursued ill-timed dividend policies and stock buyback programs that eviscerated capital levels; it was bank boards that gave the green light to M&A deals that turned winning firms into losers overnight.
This question of improving board performance is not trivial. The right approach is likely to involve tweaking incentives (many academics have pointed out the pernicious influence of typical compensation practices); building capabilities (Bank of America’s board until this weekend included two famous career military officers -- why?); and changing reporting structures (bank boards have virtually no visibility into firm performance without management intermediation). Doing nothing at all, however, is not at option.
Debt markets. Of course, even a top-tier bank board will seek to take on risks that benefit equity holders, to the detriment of debt holders -- after all, directors work for shareholders, not bondholders. That is why efficient financial services markets require active, at-risk debt investors to check banks’ risk-taking. During the credit bubble, this ceased to happen.
The debt markets’ failure to discipline risk-taking behavior can be ascribed to three kinds of problems. First, creditors -- especially in the inter-bank market -- were crippled by the opacity of certain derivative exposures, especially over-the-counter credit default swaps. Second, debt investors, particularly in the asset-backed markets, relied almost entirely on the judgments of credit rating agencies, which proved eminently fallible. And finally, the debt markets relied heavily on the generally implicit government guarantees standing behind firms perceived as too big to fail.
Containing contagion through derivatives. Thankfully, the Administration has withstood the initial wave of broker-dealer lobbying with respect to OTC derivatives. The white paper contemplates bringing much transparency to execution, settlement, and clearing in the OTC derivatives market. Indeed, it might fairly be argued that most of the benefit of those proposals would be gained with a more targeted approach that focuses purely on inter-dealer credit derivatives, or on credit derivatives more broadly but not rate derivatives.
Overhauling the role of rating agencies. The proposal is less promising, at least at this early stage, when it comes to credit rating agencies. In fairness, the problem of rating agencies is an especially thorny one, and the white paper does flag ongoing efforts to reform agencies’ (i) incentives (they are traditionally paid by issuers, but purport to provide opinions that guide investors); (ii) disclosure practices (for example, rating agencies probably should have mentioned that the robustness of structured credit ratings is fundamentally worse than for single-name corporate ratings); and (iii) structural role (the white paper advises that regulators should reduce their reliance on rating agency judgments in their supervisory activities).
The last of these efforts -- hemming in the very role of credit rating agencies -- is the beginning of the structural reform that is necessary. Let me offer a simple guide for further delineating their proper role.
Rating agencies are not wholly abominations. By providing scale for buy-side investors, in theory they should mitigate the information asymmetry between investors and issuers, thereby yielding better market-driven pricing for securities. Their downside is also -- especially in retrospect -- quite clear. By concentrating what otherwise would be atomized risk-return decisions among debt investors, rating agencies radically tempered the ability of debt markets to provide discipline on financial risk-taking.
Defining the right role for rating agencies should come down to determining where that downside of decision-making concentration is exceeded by the upside of scale economies.
I have a hypothesis on what that analysis will yield: The right role for rating agencies is in those markets where their opinions are based on privileged access to issuers that institutional investors cannot themselves efficiently replicate. The wrong role is in those markets where their opinions take widely available data, and simply perform assumption-driven modeling exercises.
In other words, I suspect we will find that rating agencies should be a shortcut to scale, not a shortcut to judgment.
Ending implicit government support. The proposal almost entirely punts on the issue of implicit taxpayer guarantees. Indeed, by creating a new class of too-big-to-fail firms (the “Tier 1 FHCs”), the proposal risks replicating the disasters of Fannie Mae and Freddie Mac. The reason Fannie and Freddie were able to grow so large, even as their risk-taking seemed so facially problematic, is that debt investors were willing to funnel liquidity to them, confident that the U.S. taxpayer would foot the bill when things went wrong. And, of course, to debt investors’ satisfaction and the taxpayers’ chagrin, they were right.
Without coming to some conclusion about the future role of Fannie Mae and Freddie Mac, it could (and it should) be difficult for Congress to sign up to create more risk of quasi-GSEs in the form of Tier 1 FHCs.
Fannie and Freddie are two of the largest financial institutions in the history of the world. The notion that we can somehow reform the broader system, without any real conception of their role, is misguided.
Regulators. The approach to the ultimate watchdogs -- regulators -- is a bit of a mixed bag. We should recognize that this is an exercise in constrained optimization; any proposal would have been certain to have clear advantages and disadvantages. In this way, the white paper does not disappoint: It is both very good, and very bad.
First, let’s recap the positive features.
Most critically, the proposal gets the most demonstrably flawed agencies out of the business of bank regulation. It effectively consolidates the OTS into the OCC, and reaffirms the termination of the SEC’s disastrous Consolidated Supervised Entity Program. No regulatory body covered itself in glory in the run-up to the crisis, but the SEC and the OTS were truly astonishing failures. The SEC, in a move that seemed bizarre even at the time, allowed its largest charges to load up on liquidity risk, and run some 30-to-1 leverage. Not surprisingly, one of the largest of those investment banking firms (Lehman) collapsed; two others were forced, with taxpayer-financed sweeteners, into the hands of commercial banks (Bear, Merrill); and the other two (Goldman, Morgan Stanley) received a dead-of-night reprieve from the Fed by being designated bank holding companies. The OTS’s track record is just as dreadful: its largest charges included such luminaries as AIG, Washington Mutual, Countrywide, and IndyMac.
Second, the regulatory proposal eliminates some of the more glaring and damaging loopholes in bank holding company supervision, including thrift holding companies and industrial loan companies. Contrary to the baffling assertions of Senator Bennett (from Utah, the home of most of nation’s industrial loan companies) that “there is not a single ILC that contributed to the crisis,” the ILC loophole allowed firms like Merrill Lynch and GMAC to build huge balance sheets with the help of FDIC-insured deposits, all while avoiding holding company supervision by the Fed. They are both now, to greater or lesser degree, wards of the state. (For a discussion of GMAC in particular, see my essay entitled “Dead Bank Walking”).
These are obvious strengths of the Administration’s approach; but the weaknesses should be obvious too.
Much criticism has already been leveled at the proposed role of the Federal Reserve Board in supervising systemically important firms (the aforementioned “Tier 1 FHC’s”). Congressional leaders from both parties appear concerned about the Fed’s past track record and current capabilities to take on such a role, and about how that role might complicate its primary responsibility as the (mostly) independent steward of monetary policy. Those are legitimate concerns.
Even if we were to craft a palatable balancing act between the Fed’s historical role and its new responsibilities, though, the Administration has failed to simplify the regulatory regime over which the newly empowered Fed would preside.
Other than the demise of the OTS, the alphabet soup of federal regulators would remain more or less intact under the proposal. And, strangely, the proposal would roll back the preemptive powers of some national bank regulation, thereby adding the complexity of 50 states’ regulatory schemes. The net effect will be to increase the number of regulators in our already embarrassingly balkanized framework.
This is a problem in every way.
First and most obviously, multiple parallel regimes create nooks and crannies in regulatory coverage. There are, literally, thousands of very clever professionals in investment banks and law firms who make shockingly good livings taking advantage of such regulatory interstices. It may be politically expedient, for example, for the Administration to propose retaining both a CFTC and an SEC, but no amount of “harmonization” -- as the white paper prescribes -- will prevent arbitrage by smart practitioners. And if one could, in unprecedented fashion, truly create harmonized regulatory schemes between otherwise rival bureaucracies, then the argument for maintaining them separately would only weaken further.
Second, multiple regulatory agencies with overlapping authority waste time and energy in jurisdictional squabbles. To make policy changes, redundant agencies must work together, and the process of coming to consensus can take, quite literally, years -- even as the markets evolve ever faster. The white paper itself points out a painful example of this: the snails-pace development of final federal regulatory guidance on “non-traditional mortgages,” which arrived in the middle of 2007, exactly after most of the subprime, Alt-A and Option-ARM horses had already left the barn and attacked all the other farm animals. (On a related note, this is why, as discussed above, the proposed CFPA should preempt all state and federal authorities on consumer protection issues).
Third, sustaining a patchwork of agencies will make it difficult to upgrade regulatory capabilities. Recall that, beyond the abstractions of their institutional histories and arcane legislative provenance, these agencies function through the judgment and energy of actual people. Regardless of the shape of our regulatory structure, if our goal is to regulate better, we will have to recruit, develop, and retain talented regulators. These are not easy jobs -- at least not when they are done right. By creating multiple, low-prestige, sub-scale regulatory fiefdoms, we have made it nearly impossible to programmatically attract the best and brightest.
* * *
Last week’s white paper is a solid starting point, but we must be more expansive -- that is, we must strengthen all three watchdogs, not just regulators. And we must be more bold -- that is, we must be willing to face the issues that we know to be politically challenging. The Administration has shown the courage in other contexts to take on real issues, despite profound political complexity. This should be no different.
Raj Date is the Chairman and Executive Director of the Cambridge Winter Center for Financial Institutions Policy. He is a former McKinsey & Company consultant, bank senior executive, and Wall Street managing director.

BLAZING TOASTERS

Fri, 19 Jun 2009 15:46:54 -0400

The Administration’s white paper on financial services regulatory reform includes a much needed re-think on consumer protection, in the form of a Consumer Financial Protection Agency (“CFPA”). And not a moment too soon.
The CFPA proposal generally echoes a bill introduced by Senators Durbin, Schumer, and Kennedy in March, which in turn was built on a years-old proposal from Harvard’s Elizabeth Warren. The CFPA, as contemplated in the Administration’s white paper, would be charged with establishing minimum standards for the safety of financial products like credit cards and mortgages, and would be focused especially on identifying and stamping out deceptive and fraudulent practices. In most ways, the institution’s mandate would be analogous to the Consumer Product Safety Commission. As the three Senators argued in a letter to Secretary Geithner, “there is no reason for us to have regulations that prevent toasters from exploding into flames, but no protections to prevent mortgages and credit cards from doing the same.”
The proposal is generally a good one. But it is not ambitious enough, especially in two respects: (1) the CFPA should preempt other regulators on consumer protection issues; and (2) the CFPA should be concerned with minimum standards, but also should rank acceptable financial products into broad tiers of relative safety.
Innovation and Preemption
Opponents, thus far, have mustered what seems a half-hearted and formulaic argument against the proposal: that by introducing a new bureaucracy that is the ultimate arbiter of product safety, we would effectively iron out differences in product structures and pricing, and thereby dampen innovation.
Almost precisely the opposite is true.
First, and most obviously, the existence of minimum standards does not make innovation impossible. We have minimum standards on practically every consumer product -- from automobiles to the aforementioned toasters -- but innovation appears to proceed apace. You would be surprised what toasters can do these days.
Indeed, the difficulty for principled innovators in consumer financial services, especially in recent times, has been that it has been difficult to engineer new, improved product structures or features that can economically match the value captured through questionable, customer-unfriendly practices engaged in by competitors. Take the prime credit card business, for example. If all the large incumbents (JPM Chase, Bank of America, Citi) were willing and able to use 0% teaser rates, coupled with hair-trigger universal default re-pricing, it was, practically speaking, impossible to compete with them on the basis of other product innovations. The economic value of that customer-unfriendly practice was a killer advantage; it stifled the need or potential for innovation.
Minimum product standards, then, don’t necessarily crowd out innovation. By contrast, by providing a clear set of boundaries, they can prevent a race to the bottom in customer practices, and thereby clear the field for value-added innovation.
A more reasonable objection to the CFPA is that it would be merely additive to the existing thicket of state and federal financial regulators, rather than replacing them.
The Administration has tried to steer a moderate course here; it should have been immoderate.
The white paper expressly points out that, while the CFPA would assume consumer protection responsibilities from federal agencies, it would not reduce any existing state regulators’ authority in consumer protection issues. As a result, it creates further administrative hoop-jumping, and thereby does create some destructive friction on innovation.
The fact is that most regulators are, recent experience would suggest, dreadful when it comes to consumer protection. It was not by accident that Countrywide decided to re-charter its depository away from the OCC, towards the OTS, when the Fed and OCC began raising real consumer protection concerns about non-traditional mortgage structures. It was not by accident that as the Fed and OCC were raising those concerns, the SEC-regulated Merrill Lynch was, amazingly, buying the subprime and Alt-A lender First Franklin at an eye-popping valuation. In a similar vein, it was state regulators’ profound failure to monitor mortgage brokers that helped propagate toxic product structures across the nation.
The simple reality is that the industry suffers not from too much regulation, but from too many regulators. And, when it comes to consumer protection, many of those regulators are demonstrably not institutionally competent. The CFPA should preempt them all. The result would be more clarity, less regulatory arbitrage, and less administrative burden.
Los Angeles Restaurants
The CFPA proposal could also be improved with a more fundamental shift in its mission. The agency should certainly be concerned with minimum standards, but it should also develop and promulgate a perspective on the relative safety of various financial products.
It is in this way that the analogy of the Consumer Product Safety Commission fails us; let me suggest a different one.
Since 1998, restaurants in Los Angeles County have been required to post a large placard in their front windows, showing an “A”, “B”, or “C”. Those letter grades correspond to the establishment’s scoring in routine health department inspections. Unlike the historical practice of merely publishing minimum standards (that is, if a restaurant was below the minimum, it was shut down -- else, from the restaurant-going public’s point of view, nothing happened), the Los Angeles approach made more transparent the fact that while lots of restaurants meet some minimum threshold of hygiene, some are more hygienic than others.
The same approach should be applied to financial products.
There should, of course, be minimum standards (like with ones that prevent toasters from bursting into flames). But that is not enough.
To explain why, it’s worthwhile exploring why the notion of minimum standards so captures the imagination of policy-makers. The reason is a largely mythical narrative -- the myth of the hoodwinked consumer. In this narrative, consumers are fundamentally logical economic decision-makers, who, if they had full disclosure of contractual terms, would unerringly choose prudent product structures at attractive economic terms. If one chooses to embrace this narrative, then the fact that consumers quite frequently embrace objectively dreadful products (payday loans, option-ARMs, NSF-laden “free” checking), suggests that they must have been misled. Thus, by merely stamping out misleading and deceptive practices by adopting minimum standards, consumers will make better choices.
It is certainly true that deceptive sales practices are a major problem in consumer financial services. But they aren’t the main problem. The main problem is that consumers -- who, as it turns out, are human beings -- are, in general and on average, incapable of adequately weighing abstract financial risks and rewards. Perhaps the most telling example is banks’ “free checking” offerings, which, in an Orwellian twist, aren’t free at all, because they tend to generate significant fees through non-sufficient funds (“NSF”) penalties on overdrafts. Consumers are aware of NSF fees; they just systematically underestimate how often they will incur them.
This is where the proposed CFPA could help. By virtue of its access to industry data and its institutional competence, it could assign financial products a simple letter grade (I rather like the Los Angeles County approach for restaurants, but there are presumably others). That would, at minimum, cause consumers to pause and more deeply examine products that, for most, tend to lead to trouble, even if they are fully disclosed and fairly marketed.
At the same time, the availability of a hierarchy of passing grades would allow the CFPA to encourage and reward especially consumer-friendly product structures, while not ironing out innovative product wrinkles.
It is precisely that outcome that we should desire.

Raj Date is the Chairman and Executive Director of the Cambridge Winter Center for Financial Institutions Policy. He is a former McKinsey & Company consultant, bank senior executive, and Wall Street managing director.

DEAD BANK WALKING

Thu, 28 May 2009 17:05:16 -0400

I am told that print media outlets are in real trouble. That’s too bad, because it means that relatively few people were able to join me in the unintentional hilarity that was Ally Bank’s full-page, color newspaper ads last week. Among various pronouncements that it is a better, more customer-friendly bank (perhaps too low a bar in the first place) Ally helpfully points out that “we never forget it’s your money, not ours”.
You can say that again.
As it turns out, Ally Bank is the new name for GMAC Bank, the firm that was waved into the banking system by an uncharacteristically jolly Federal Reserve last Christmas Eve, and soon thereafter was showered with a $5 billion capital infusion under TARP, plus a variety of taxpayer-backstopped funding alternatives. Now that the “stress tests” have predictably found a still-yawning capital shortfall of $11.5 billion at GMAC, taxpayers are ponying up an additional $7.5 billion in capital and $7.4 billion in debt guarantees.
In fairness, the Treasury Department is coming off a few real successes, some of them -- like the “stress tests” -- helping to undo the worst excesses of the frenzied Paulson-era bailouts.
The continuing life support extended to GMAC, though, is a major mistake: It creates enormous risks to taxpayers; it is a needlessly indirect subsidy of auto sector jobs; and, worst of all, it re-animates perhaps the most dangerous “zombie bank” in the industry.
Taxpayer Risk: Defeat from the Jaws of Victory
Oddly, before this latest twist of bailout fate, federal regulators (the FDIC, anyway) had more or less dodged a bullet with GMAC.
GMAC is a huge institution. It has some $179 billion in assets (plus $136 billion in off-balance sheet loans), the vast majority of which are auto and mortgage loans. As you might imagine, this is a difficult time to own an enormous portfolio of consumer loans and leases.
And GMAC’s portfolio seems especially bad. This is a firm that for years appeared to provide below-market, medium-term loans “secured” by fast-depreciating cars and trucks; when -- surprise, surprise -- that seemed insufficiently profitable, GMAC sought to fuel growth through subprime and non-traditional mortgages originated, for the most part, through brokers. The inevitable result of that disastrous foray is well documented: GMAC’s far-flung mortgage operations have lost $9.2 billion over the past two years. (To put the enormity of those losses in context, the FDIC reported this week that the entire banking industry made only $7.6 billion in profits last quarter).
The good news, from the public’s perspective, was that the FDIC had kept the taxpayer’s exposure reined in -- even today, only 13% of GMAC’s consolidated assets are funded by deposits at its subsidiary bank. Given that relatively small exposure, the bank subsidiary’s (relatively) clean asset base, and the fact that depositors rank higher in the capital structure than, say, unsecured creditors or equity holders, it seemed that the FDIC had managed to keep taxpayers out of danger.
Unfortunately, Treasury and the FDIC have managed to snatch defeat from the jaws of regulatory victory. Since last Christmas Eve’s surprise gift of bank holding company status from the Fed, GMAC has managed to secure $12.5 billion in capital from the taxpayer, plus $7.4 billion in debt guarantees from the FDIC. In other words, after years of the FDIC’s ensuring that taxpayers were insulated from the inevitably disastrous results of GMAC’s lending practices, the government has now reversed course and intentionally put taxpayer money at risk.
And the magnitude of that risk is breathtaking, as a few data points will underscore. First, the sheer size of GMAC is troubling. Its on- and off-balance sheet assets are considerably larger than the sum of the assets of all 305 banks on the FDIC’s “problem bank” list at the end of Q1. The sum of committed taxpayer equity investments in GMAC -- $12.5 billion -- is 2.5 times the cost of last weekend’s BankUnited failure. Worse still is the prospect that GMAC’s “Ally Bank” marketing scheme might actually succeed, thereby generating incremental FDIC-insured deposits to support GMAC’s dubious loan portfolio. If GMAC were to achieve an industry-average deposit mix, it would mean an incremental $95 billion in deposits. If it were to fail at that point -- which would be deeply unfortunate but not especially shocking -- it could mean a $20 or $30 billion hit to the deposit insurance fund. To calibrate, recall that healthier banks, which of course would be saddled with replenishing the fund, last week screamed bloody murder at new FDIC assessments that will raise only $6 billion for the fund.
Unnecessarily Indirect Subsidy
Given the risks attendant to the bailout, a reasonable person might question why taxpayers at large (or, perhaps more accurately, their children and grandchildren) should be forced to subsidize GMAC and its corporate parents -- the odd couple of the teetering-on-bankruptcy General Motors and the monstrously successful private equity firm Cerberus Capital Management (whose Chairman just happens to be a former Bush Treasury Secretary).
More cynical observers might suspect a case of bipartisan political patronage. But I don’t think so. I believe the taxpayers’ elected representatives in the Congress and the last two Administrations honestly think they are saving systemically critical U.S. auto sector jobs by bestowing continuing economic benefits on private, politically entrenched special interests.
I would humbly suggest, however, that it might be more straightforward and less damaging simply to create a direct subsidy. After all, the entire point of propping up GMAC, presumably, is that it will continue to provide consumer and dealer financing at below-market rates, to such a degree that consumers will buy American-made cars that they otherwise appear unwilling to purchase.
If that is the market distortion we are trying to achieve, there is a simpler way. Simply hand auto buyers a check (or, more likely, a refundable tax credit) of $1000 or $2000 to buy an American car. Given the magnitude of the GMAC bailout, the government can hand out rather a lot of $1000 checks and still be ahead of the game.
I am no particular fan of taxpayer giveaways. But at least with a direct subsidy, it’s obvious what Congress is doing. And, more importantly, we would avoid resurrecting GMAC, which is quite possibly the worst of the “zombie banks.”
The Trouble with Zombies
There are two breeds of zombie bank, both of them dreadful for the broader economy. GMAC manages to be dreadful in both ways.
The first, garden-variety zombie is a bank with unrealized losses that dwarf its capital position. Such a bank stumbles around the financial landscape, unwilling to lend actively, because it is desperately trying to husband capital ahead of the inevitable realization of embedded losses in its credit portfolio. As the “stress tests” made clear, GMAC is certainly fits this zombie definition, with capital levels fully $11.5 billion short of that required under the tests’ adverse scenario (a scenario that, as unemployment levels continue to climb, looks less adverse all the time).
Indeed, even after being stuffed with taxpayer-supplied capital, GMAC will still not be able to serve as an efficient credit intermediary. This is, quite simply, a bank with no credible track record as a lender. Indeed, it is almost precisely the opposite of what policy-makers should want in a bank: it has shown the ability to make astonishingly bad credit risk-return decisions, in multiple asset classes, through comically bad distribution channels, for many years in a row.
GMAC is a zombie in a second, even more dangerous way. Recall the real problem with zombies in movies is not so much what they do to themselves, but what they do to the living. The same is true with zombie banks like GMAC.
Given its track record, GMAC is unlikely to raise significant funding without a government backstop (either through FDIC-insured debt, or FDIC-insured deposits). But by consuming investor appetite for such bonds and deposits, and indeed by driving up the cost of such funds because of its own desperation, this zombie bank leaches out profitability that would otherwise be captured by more strategically viable enterprises. Consider, for example, that “Ally Bank” is, today, advertising 1-year CD rates at 2.80%, which is roughly double the cost of funding earnings assets for other large banks during Q1.
Competing with desperation pricing like this is especially problematic for community banks, which rely on deposit funding far more than their larger brethren. Competing with zombies will, on the margin, drive down community bank net interest margins, and thereby reduce their rate of organic capital generation.
In other words, by keeping zombies like GMAC alive, we are slowing the pace at which troubled but viable institutions heal themselves. That slows the banking recovery, and the broader economic recovery as well.
GMAC has done enough damage; it is time to let it fend for itself.

Raj Date is the Chairman and Executive Director of the Cambridge Winter Center for Financial Institutions Policy. He is a former McKinsey & Company consultant, bank senior executive, and Wall Street managing director.

STRESS RELIEF

Mon, 20 Apr 2009 16:57:40 -0400

Financial markets are awaiting Treasury’s two-part communication on large bank “stress test” results with equal measures of curiosity and dread. On April 24th, apparently, the Treasury plans to provide a written description of the stress tests’ methodology; on May 4th, at some level of abstraction, the results of that methodology for the largest 19 U.S. banks will be revealed.
Market observers and participants have heaped criticism on the stress tests. Indeed, it is difficult to find any especially vocal supporters of the concept, or at least the concept as executed to date. The critics fall into two categories: those that question the substantive merits of the tests; and those that question how the results of the tests can possibly be disclosed without further and needlessly de-stabilizing the banking system.
Both sets of critics are wrong.
Although the undertaking surely has flaws, even a flawed effort has the potential to remedy the most profound strategic errors of the haphazard bank recapitalization effort. The challenge for the Administration is to communicate the tests’ results in a way that captures that potential for redemption, instead of muddying the waters further.
Redemption for TARP’s original sin
Although the Administration does not describe the stress tests in this way, the initiative has the potential to help undo the most profoundly damaging strategic errors of the original Paulson capital purchase plan.
The original TARP capital effort -- the capital infusions first “forced” on the largest nine banks last fall -- failed because of a misguided desire to treat all banks the same way. Every large bank, whether seemingly sound or obviously distressed, took the same proportion of taxpayer capital, under the same terms, and at the same pricing. And, apparently out of a desire to obscure the otherwise obvious troubles of weaker banks, no capital recipients were forced to be more transparent about the depth of their potential credit deterioration.
This willful abdication of the basic principles of risk-based pricing led to the worst of all possible outcomes.
The strongest banks haven’t much changed their approach to doing business, because capital wasn’t a binding constraint in making their lending decisions in the first place. The weakest banks, which are still by and large led by the same management teams as before, did not through the introduction of taxpayer capital magically transform into good credit risk managers. And, because those weak banks’ loan portfolios are precisely as opaque and risky as they were beforehand, private capital is no more likely to invest in weak banks now as before the taxpayer was forced to invest in them.
So nothing has really changed: stronger banks remain strong, but haven’t changed their behavior; weaker banks are still struggling, and have no obvious prospects for private market relief. But hundreds of billions of dollars in taxpayer money has been invested, and political goodwill has gone up in smoke.
The stress tests won’t be perfect (no forward-looking exercise ever can be), but they absolutely should help solve this fundamental problem. By appropriately calibrating capital infusions to capital need, taxpayer capital isn’t unproductively deployed into strong institutions that don’t need it. And, by adding some transparency to otherwise opaque bank portfolios, the prospects of private capital investment -- even into weaker institutions -- become more realistic.
Substantive concerns are real, but not fatal
We should not dismiss out of hand, of course, the range of substantive objections to the tests. They come in three basic varieties: (1) the stress tests aren’t sufficiently conservative; (2) the stress tests are analytically doomed to fail because the assembled regulatory teams have inadequate capabilities, time, or bandwidth; and (3) the stress tests are redundant.
The first point certainly has merit. The stress tests model capital positions under two scenarios -- a base case and a more adverse case -- of GDP growth, unemployment rates, and home price appreciation. Given that the “adverse” case seems to assume economic deterioration (e.g. average 2010 unemployment of 10.3%) that looks a lot like buy-side base case assumptions today, it is a fair criticism that the “stress” in the stress tests isn’t stressful enough. One would hope, however, Treasury’s explanation of the tests’ methodology on April 24 will at least point towards how investors and taxpayers should think about the sensitivity of capital levels to these critical assumptions.
The second objection is that the team supervising the initiative (if persistent rumors are to be believed, mostly Fed staff from outside day-to-day supervisory functions) is not up to the task. This argument might also have merit, but it is not clear what policy-makers should do as a result. After all, our regulatory bandwidth is the victim of decades of mismanagement: regulators are famously overburdened; dramatically ill-compensated versus their charges; and fragmented across an array of competing regulatory bodies. The Administration appears serious about remedying this set of problems over the long term. Sadly, taxpayers have not been asked to backstop the financial system over the long term; they have already been asked for staggering levels of support now.
The third objection -- the redundancy argument -- was perhaps most famously and colorfully described by Wells Fargo Chairman Richard Kovacevich in a speech at Stanford in mid-March. “We do stress tests all the time on all of our portfolios,” Mr. Kovacevich pointed out. “We share those stress tests with our regulators. It is absolutely asinine that somebody would announce we’re going to do stress tests for banks and we’ll give you the answer in 12 weeks.”
It is certainly true that stress testing has been part of the overall regulatory milieu for a decade; and it is certainly true that most banks conduct stress tests on their capital positions.
It’s just that, in general, they don’t appear particularly good at it.
Indeed, FDIC data demonstrate that over the past four years -- despite the absolute inevitability of an eventual credit downturn (they’re called credit cycles for a reason) -- banks as a whole allowed their tier-1 and tangible common equity ratios to decline steadily. In other words, as the credit environment became increasingly volatile and risky, banks responded by reducing their buffers to that volatility and risk.
Of course, not all bank management teams were uniformly inept in this regard. This is, presumably, what makes the stress tests frustrating for institutions that were relatively well managed. But that is more reason, not less, to support the notion of stress testing: Stress tests debunk the unproductive fiction that all banks are similarly situated.
How to talk about stress test results
That brings us to the tactical question of how to communicate stress test results without inadvertently setting off another round of panic across the financial markets. Here are the five core themes that the Treasury must take care to underscore.
First, depositors are safe. Even if a handful of large banks appear undercapitalized, the FDIC is fully capable of and committed to protecting the value of FDIC-insured deposits.
Second, banks are welcome to raise capital in the private markets to address identified shortfalls. But those efforts almost certainly will fail, so the Congress and taxpayers should be prepared for the need for government capital investment, and also be prepared to see the government’s preferred equity stakes converted into common shares.
Third, banks that are under-capitalized got that way, and stayed that way, at least in part through severe mismanagement. As the new, largest shareholder in such banks, the taxpayer has a right to find better managers. But taxpayers should realize that top talent typically does not work for free. And Congress should realize that futile post-hoc saber-rattling (like the House’s AIG-inspired TARP bonus bill) is decidedly unproductive.
Fourth, the Administration remains committed to private ownership of banks. That means we should seek to divest the taxpayer’s equity positions as soon as practical. It also means that banks with a capital surplus versus the stress test results should be free to return taxpayer capital, without further onerous hurdles.
Fifth, banks and their primary regulators should have been using stress test methodologies to calibrate their economic capital requirements all along. The fact that they had so profoundly underestimated downside scenarios is what makes government intervention necessary now. Crafting a more robust regulatory architecture is a necessary part of ensuring we don’t find ourselves in the same position again during the next credit cycle.
The stress tests are a big step in the right direction; the Treasury should take advantage.

Raj Date is the Chairman and Executive Director of the Cambridge Winter Center for Financial Institutions Policy. He is a former McKinsey & Company consultant, bank senior executive, and Wall Street managing director.

GOLIATH 1, DAVID 0

Fri, 10 Apr 2009 16:41:16 -0400

Every spring, like little pin-striped swallows returning to Capistrano, members of the Independent Community Bankers Association flock to their annual convention, where they complain, loudly and bitterly, about the myriad real and imagined forces relentlessly pushing small banks into oblivion. I spent my entire banking career in and around big banks, not small ones. So I must confess that I typically used to feel something like amusement at this annual spectacle.
This year, though, the community bankers have a point.
And, if anything, they aren’t making that point as persuasively as they could. Sooner than they would like, American policy-makers are going to have to make a decision about the appropriate ongoing role of community banks -- because at current course and speed, the combination of credit pressures and government rescue measures will drive a great many of them out of business. So far, in public policy matters, the score is Goliath-Banks 1, David-Banks 0.
Let’s first review the facts. The U.S. banking industry has been in a more or less monotonically consolidating phase for the better part of two decades. The number of FDIC-insured institutions has declined from more than 13,000 to a little over 8,000 in the 15 years from 1993 to year-end 2008. Today, the top 25 banks in the country hold more than 90% of the industry’s assets; the other 8,000 combined (which, for ease of reference, I call community banks) account for the remaining 10%.
But that long, steady decline was just the preamble for the next few years.
Evolutionary biologists have identified multiple “mass extinction events” over our planet’s history, when huge numbers of species vanish, in a dramatically non-linear way (think dinosaurs, and comets, and the collision thereof). Well, the banking sector is about to have a mass extinction event of its own, and the victims will be community banks. As bad as the credit environment feels right now, most observers agree that conditions will get considerably worse in commercial real estate lending before things get better. And, pound for pound, community banks are well more than twice as exposed to commercial real estate loans than their larger brethren.
As much as $700 billion of these loans are on community bank balance sheets, with likely eventual loss content of some $50-$100 billion. At the pace we are going, the taxpayer’s ability and (especially) willingness to support banks will have been exhausted by big-bank bailouts by the time (later in 2009 and into 2010) these small-bank loans start going bad in large volumes. Wishful thinking isn’t going to change that fact; we should prepare for it now.
Notably, though, practically every bailout tactic implemented or proposed to date disproportionately benefits large banks and quasi-banks, at the expense of smaller institutions. Rather than cataloging each of the alphabet soup of programs, it is more useful to describe the three basic strategic forces at work, and how -- if left unchecked -- they will hasten the destruction of a vast swath of community banks across the nation.
First, for all their arguable benefits, the liquidity-enhancing rescue programs devised by the Treasury, Fed, and FDIC systematically have undercut the one great strategic advantage of small banks: persistent access to low-cost funding. Despite all the scale, technology, and brand advantages of big banks, historical FDIC data demonstrate, again and again, that smaller firms have been systematically able to build better deposit franchises (that is, more deposit growth, with better duration, for lower prices) than big banks. I used to make a reasonable living dreaming up all manner of analyses to demonstrate why this is true, but most small businessmen, I suspect, can tell you why, for free: small banks are structurally better tied to their communities, they provide more attentive service, and they can and do identify and reward good front-line employees (customer service representatives, branch managers, field loan officers) better than big banks do.
But by effectively providing a liquidity backstop for all market participants -- through programs like the otherwise wildly popular TLGP (in which the taxpayer, via the FDIC, effectively guarantees unsecured debt issuance by banks) -- government policy has suddenly diminished the strategic and financial value of community banks’ core deposit franchises. For a modest fee, big banks that had run risky liquidity profiles (e.g. Citigroup, Bank of America/Countrywide/Merrill Lynch) are suddenly able to issue unsecured debt with the full backing of the FDIC -- as are finance companies (like GE Capital, or American Express), or even broker dealers (Goldman Sachs, or Morgan Stanley), which all have been hurriedly waved under the protective aegis of the banking system by the Fed.
Policy-makers, in effect, have decided to give to big firms, for very close to free, a strategic advantage that small banks have literally spent years and much effort cultivating.
Second, the Treasury, Fed, and FDIC are artificially propping up the kind of non-bank capital market vehicles that pushed community banks to the periphery of lending in the first place. After all, community banks today focus heavily in the woefully volatile commercial real estate arena less because they enjoy rolling the dice on commercial real estate cycles, and more because they cannot compete with non-bank or off-balance sheet structures that had grown to dominate large segments of the credit market. Community banks couldn’t possibly compete with the funding subsidies enjoyed by Fannie Mae or Freddie Mac. They couldn’t possibly compete with the regulatory capital relief afforded to big credit card issuers like Citigroup or Bank of America that securitize credit card loans. They couldn’t possibly compete with hyper-leveraged finance companies like GE Capital, or CIT, or GMAC.
But the combination of government actions to date has, if anything, perpetuated this marginalization of community bank lending. Fannie and Freddie have become even more dominant in mortgage lending, because now their taxpayer backing is explicit, not just implicit. Big credit card banks -- amazingly -- continue to enjoy capital relief from securitization, and the securitization markets themselves have been propped up by the taxpayer through TALF. And, as mentioned above, when non-bank finance companies inevitably ran into catastrophic liquidity troubles they were backstopped by new government funding programs (like TLGP, or the Fed’s asset-backed commercial paper program) and quickly allowed to re-charter as banks and handed taxpayer capital under TARP.
Government rescue efforts, then, are unwittingly reinforcing the walls that prevent the market’s most efficient liability gatherers -- small banks -- from participating in the largest spread-generating asset businesses, from conforming mortgages to credit cards.
Third, the government’s efforts to cleanse bank balance sheets -- the centerpiece of which is the Public-Private Investment Program -- is almost certain to help big banks and especially Wall Street broker dealers (e.g. Goldman Sachs, Morgan Stanley), but will do virtually nothing for community banks. The reason is simple. Under the PPIP, the taxpayer (through the FDIC and the Fed) will extend a subsidy to hedge fund investors, thereby artificially increasing the price at which those investors are willing to buy “legacy” (formerly known as “toxic”) assets. Securities (especially those held by Wall Street firms) are typically carried on balance sheets at mark-to-market values, so even a modest increase in bid price will immediately enable capital-generative sales of legacy securities. By contrast, loans (which are the lion’s share of community bank balance sheets) are not marked to market; they are held at original value less some reserves. Given the relatively low level of those reserves (2-3% for most banks), it is difficult to conceive of a funding subsidy big enough to bridge this gap in valuation, so sales of legacy loans by community banks would destroy capital, not generate it. Few sales of legacy loans will occur, therefore, and community banks will remain freighted with toxic (sorry, “legacy”) commercial real estate loans.
This is the same reason, by the way, that FASB’s much-trumpeted relaxation of mark-to-market accounting rules will benefit big banks and broker dealers more than smaller firms. Broker dealers have disproportionately huge securities portfolios; community banks do not.
So the overall pattern is clear: a series of large, expensive government rescue efforts will disproportionately help big banks, big broker dealers, and big finance companies -- but not community banks. And given that markets are still competitive, providing taxpayer assistance to bigger firms will allow those large firms to, on the margin, out-compete their smaller brethren.
Should we care? After all, community banks, definitionally, are small, even in aggregate.
I suspect that the answer is that we should care. A lot.
We are already feeling the effects of a vast credit pull-back in small business and middle market commercial lending. Relying on finance companies, and big banks, and broker dealers to reverse course and fill this void is not a prudent course. Those large market participants, unfortunately, tend to rely on credit-scoring methodologies, and on off-balance sheet leverage, that are either demonstrably problematic, or altogether non-existent.
By contrast, the best community banks reflect a back-to-basics approach to commercial credit, and one that might well be the only viable approach in the near term. We should not overstate this point -- many community banks, like many big banks, seem irretrievably incompetent when it comes to making credit risk-return decisions. But the fact is that though community banks may have been a small factor in the credit markets’ recent past, they may well prove to be a necessary part of our immediate future.
Moreover, the crisis has driven home that while there are some economies of scale in the banking business, there are major dis-economies too (ask any of your friends at Citigroup). Although the Administration sounds serious about better regulating and mitigating systemically important risks in the future, most of its tangible moves to date have done the opposite: they’ve artificially created more consolidation, not less.
Policy-makers would be well advised to take heed of these facts while they still can. We’ve been feeding Goliath too long; David’s going to need a bigger slingshot.

Raj Date is the Chairman and Executive Director of the Cambridge Winter Center for Financial Institutions Policy. He is a former McKinsey & Company consultant, bank senior executive, and Wall Street managing director.