Too Big to Fail Rules Hurting Too Small to Compete Banks
Regulators want safety. Investors want profits. Employees want bonuses.
Stuck in the middle are management teams at the world’s biggest banks, struggling to assure taxpayers, shareholders and traders that their pleas are being heard, Bloomberg Markets will report in its April issue.
More from the 2013 issue of Bloomberg Markets:
In response to regulators, banks have reduced their dependence on borrowed money. To answer investors, they’re cutting costs and exiting businesses that don’t deliver a big enough return on equity. Employees who haven’t lost jobs or fled to hedge funds are getting more of their pay in stock awards that are tied up for as long as five years.
The stakes are high. How executives finesse the competing forces will not only separate winners from losers; it will also determine the safety of the largest financial firms, those deemed too big to fail because their collapse would wreak so much damage that governments would be impelled to rescue them.
Almost five years have passed since governments in Europe, the U.K. and the U.S. used about $600 billion in capital to shore up banks during the worst financial crisis since the Great Depression, and regulators are still trying to ensure it never happens again. If anything, some banks have grown bigger and more complex.
“With all the debating going on, the financial market structure didn’t change very much,” Zhu Min, the International Monetary Fund’s deputy managing director, said in January at a World Economic Forum panel discussion in Davos, Switzerland. “We’re not safer.”
Some say the industry’s biggest banks should be forced to break up. Sanford Weill and John Reed, who created New York-based Citigroup Inc. (C), have said that financial conglomerates could be more valuable and safer if split apart. So have former Merrill Lynch & Co. Chief Executive Officer David Komansky and former Morgan Stanley (MS) CEO Philip Purcell.
Financial-services companies and banks, which took more than $2 trillion of losses and writedowns during the credit crisis, were deemed the least-trusted industries for a third consecutive year in an annual poll released by public relations firm Edelman in January. Almost 60 percent of respondents to a Bloomberg poll conducted in January said they weren’t confident or “just somewhat confident” that the world’s biggest banks were taking prudent risks and conforming to the law.
The industry’s legal bills have ballooned as practices such as shoddy foreclosures, interest-rate manipulation and money laundering came to light. Even CEOs such as JPMorgan Chase & Co.’s Jamie Dimon, whose New York-based bank reported a third consecutive year of record profit, have had trouble managing their sprawling organizations. Dimon has said he was unaware of complicated trading risks that led to more than $6.2 billion of losses last year.
“Who can tell what JPMorgan’s investment office is doing until after it’s blown up? Not even Jamie Dimon, so what chance does a supervisor have?” says Amar Bhide, a professor of international business at Tufts University’s Fletcher School of Law and Diplomacy in Medford, Massachusetts. “So for that reason, one needs serious restructuring of banks.”
The Basel Committee on Banking Supervision, whose first two versions of global financial standards failed to avert crises, established a new set of rules in 2010 dubbed Basel III. At least 7 percent of banks’ risk-weighted balance sheets must be backed by common equity that can absorb losses, up from 2 percent before the 2008 crisis, the committee determined.
Switzerland, home to Credit Suisse Group AG (CSGN) and UBS AG (UBSN), is requiring banks to fund as much as 19 percent of their assets with loss-absorbing forms of capital. The U.K., which took control of four lenders in 2008 and 2009, plans to segregate consumer units from investment banking and trading. U.S. regulators are working on a so-called Volcker rule to restrict banks backed by the government from making proprietary trades, or bets with their own money. Countries in the European Union are weighing how to adopt proposals that would require large retail lenders to wall off proprietary trading.
Although banks will have to spend money on systems to ensure they comply, the rules are complicated, shot through with exceptions and probably won’t change behavior significantly, says Sheila Bair, a former chairman of the Federal Deposit Insurance Corp. who’s now head of the Systemic Risk Council, a private watchdog group.
“I hate to say it, but it looks like change is going to be incremental,” she says. “There’s nothing bold or profound.”
Still, banks have pushed back, arguing that some of the rules aren’t necessary and could damage their ability to perform essential functions. They say large financial firms with multiple businesses in many countries -- so-called universal banks -- can be safer than more narrowly focused companies.
Regulators have loosened and delayed some rules, concerned that they might stymie a recovery that the world’s central banks are trying to encourage by pumping at least $5 trillion into the global economy. In January, regulators decided to give lenders until 2019 instead of 2015 to hold enough easy-to-sell assets to survive a 30-day credit squeeze. They will also allow banks to use a wider spectrum of assets, including equities and securitized mortgage debt, to meet the requirement.
“What we will see going forward is regulators will become sensitive to how this is being phased in because we’re seeing repercussions of the regulatory environment in the global economy,” UBS Chairman Axel Weber, a former Bundesbank president, said in January at the World Economic Forum.
Regulators are also considering postponing until 2019 a rule that banks hold collateral against derivatives that aren’t cleared, two people with knowledge of the discussions said in January. And the EU is mulling a one-year delay for lenders to disclose whether they meet a debt ratio, three people familiar with the talks said in January.
“The new regulatory apparatus being put in place in the U.S. and globally are big steps, but we have to see how they’re implemented and enforced,” says Richard Spillenkothen, a former director of banking supervision at the U.S. Federal Reserve and now an independent consultant. “You’ll see permanently reduced returns on equity and less risk taking, but the degree still depends on how vigorously the new rules are applied worldwide.”
Return on equity, a measure of profitability, has plummeted since the financial crisis to less than 10 percent at many firms as capital levels rose and legal costs and slow economic growth weighed on earnings. ROE exceeded 20 percent at some banks from 1997 to 2007. That measure will revert to about 11 percent or 12 percent for U.S. banks, in line with the average of the past 50 years, says Toos Daruvala, a New York-based director in McKinsey & Co.’s North American banking practice.
“What you’re going to see is more and more embracing of the universal-lite model,” Daruvala says. “By that, I mean the universals will want to trim around the edges of their portfolios, both the business mix as well as the geographic mix.”
Global banks such as Citigroup and UBS, each with balance sheets that exceed $1.3 trillion, are retreating from anything that doesn’t produce an adequate return. UBS is cutting 10,000 jobs over three years, or 15 percent of its workforce, as it exits most debt trading to focus on wealth management. Citigroup, the third-biggest U.S. bank by assets, plans to eliminate about 11,000 positions and sell or scale back consumer operations in Pakistan, Paraguay, Romania, Turkey and Uruguay.
“Shareholders may force boards to study more carefully whether such banks should be broken up into stand-alone pieces,” says Bair, the former FDIC chairman. “They may well be worth more if they’re broken up into smaller, easier-to-manage, more-specialized pieces.”
Investors (JPM) such as Joshua Siegel, founder and managing principal at New York-based StoneCastle Partners LLC, see bigger changes at the other end of the spectrum. Small banks will seek mergers because their management teams are aging and new regulations are too costly to bear, he says.
“If you need one major overriding theme of the industry in the next three, five, seven, 10 years: massive consolidation, thousands of banks,” says Siegel, whose firm managed $5.1 billion as of the end of last year and invests in small banks. In the U.S., “I do see probably anywhere from 2,000 to 4,000 banks being swallowed up, and what you’ll see then is a more-concentrated system.”
JPMorgan’s Dimon, a critic of regulations he views as unnecessary or excessive, has recently touted the benefits. He told Citigroup analysts this month that new rules will help banks such as JPMorgan, the largest in the U.S., win market share from smaller competitors, the analysts wrote in a report.
In Dimon’s view, they wrote, the changes will “make it more expensive and tend to make it tougher for smaller players to enter the market, effectively widening JPM’s ‘moat.’”
The new rules, it turns out, may be doing more to shield banks from competition than to make them safer.
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