Breaking Up the Banks

By Roy C. Smith 

from Financial News, Nov. 10, 2014

Last month, William Dudley, president of the NY Federal Reserve hosted a “Workshop on Reforming Culture and Behavior in the Financial Services Industry” for about 90 invited senior bank executives, regulators, prosecutors, and academics. This was the concluding paragraph in a lengthy and thoughtful analysis of the dangers of sharp-edged, aggressive “trading cultures” at banks

… if those of you here today as stewards of … large financial institutions do not do your part in pushing forcefully for change across the industry, then bad behavior will undoubtedly persist.  If that were to occur, the inevitable conclusion will be reached that your firms are too big and complex to manage effectively.  In that case, financial stability concerns would dictate that your firms need to be dramatically downsized and simplified so they can be managed effectively (emphasis added)… The consequences of inaction seem obvious to me—they are both fully appropriate and unattractive—compared to the alternative of improving the culture at the large financial firms and the behavior that stems from it.  So let’s get on with it.  

In other words, if the banks did not change their cultures to prevent “bad behavior”, Dudley warned, they would leave their regulators, alas, no choice but to break them up. 

There is no doubt that in the last decade almost all the major US and European capital market banks were involved in instances of shabby and sometimes illegal business practices, gamed the system to evade the rules and, in the high spirit of the trading culture, did what they could to “rip out the eyeballs” of their “counterparties.” 

Such actions are not to be excused, but the perception of cultural decay and rampant misconduct truly exceeds the reality.  The crash occurred after decades of industry deregulation, consolidation and innovation encouraged by regulators that were inspired by Alan Greenspan to believe that increased competition in financial markets would lower the cost of capital to market users, and that the markets themselves would constrain banks behavior. Consequently, the markets became enormous – the value of securities outstanding in 2007 reached an extraordinary $200 trillion – and liquidity events arising from sudden shifts in such a large market could be overwhelming, as we discovered in 2008.

After 2008, however, it didn't take long for governments everywhere to blame the financial crisis, and the many troubles that ensued from it, on the greedy and reckless cultures of the banks. 

But, how bad was it really, when prosecutors could find no evidence of illegal actions by any senior bank officers, despite extensive investigations. Indeed, most observers of the period now recognize that the banks, notwithstanding their turbo-charging of the mortgage business, were not alone in bringing about the crisis. Regulators and other government officials contributed significantly to the financial meltdown, before, during and after the crisis.

Six years after the event the cultures of the large banks have changed, as Mr. Dudley surely knows. They may not have been fully brought to heel, but certainly they have been defanged. 

Almost all of them have changed top management, purged their ranks of securitisers and others associated with the mortgage business, reduced trading activities, modified their compensation systems, and have tried to persuade shareholders, rating agencies and creditors that they are now better managed, less risky and fully reformed.  

The banks have also had to adapt to the greatest regulatory onslaught since the 1930. One recent report showed that the six largest US banks had already spent $70 billion in complying with all the new rules that affect them, But, unlike the 1930s, banks have also had to cough up $150 billion of shareholders’ capital to settle government lawsuits..

Despite their efforts at reform, most of the large capital market banks’ shares still trade at or below book value and their returns on equity capital remain below its cost.  Such a condition does not bode well for their economic viability or competitiveness  

Indeed, Mr. Dudley really should be more worried about the long-term viability of these banks, which are crucial to the financial system, than the nature of their cultures after all the changes already imposed. 

Further, it is hard to see how the financial system would benefit by converting bank  cultures into ones that are residually risk averse and afraid of getting into trouble.  

When Dodd-Frank was passed, it was criticised for many things, but praised for one – it did not arbitrarily force all large banks to chop themselves up or reintroduce Glass-Steagall to force all of them to leave the securities business.

Its authors understood that the burden of compliance would be high, and may change the industry considerably, but how any individual bank would respond to the new rules was to be left to the bank itself. 

Undoubtedly, some said, the new regulations would result in banks breaking themselves up into more flexible and economically viable units.  One such option was to spin off highly capital-intensive investment banking units, tailoring what remained into a basic, national commercial bank, like Wells Fargo.

So far this hasn't happened. Some banks have pulled back from capital markets, but none have gone so far as to break themselves up.

Knowing this, maybe Mr. Dudley is sending a message that ultimately the banks are going to have to do what the Fed wants them to, which for some of the largest and more complex, is to act more quickly and radically to simplify their basic business models. 

Dodd-Frank has given the Fed a lot of power over banks, and much of it is now being applied on a discretionary basis. It conducts annual stress tests that include qualitative factors that must be met in order to pay dividends and repurchase stock. The Fed also must approve banks incentive compensation plans and their “living wills” for banks to be in good standing (it recently rejected the living wills of 11 major banks, forcing them to resubmit them). 
Now, after Mr. Dudley’s remarks, it appears that the Fed can use any instance of “bad behavior” to determine that a bank is not well managed, “dictating” that the Fed force the bank to “dramatically downsize and simply” itself. With numerous investigations of post-crisis conduct still ongoing (LIBOR, FX), the possibility of more bad behavior surfacing is not insignificant. Such behavior does not have to be proven, or recent, for Mr. Dudley to act.

Though Dudley’s threat was forcefully made, it would be momentous and unprecedented for the Fed openly to force a bank to break up. But the power to do so under Dodd-Frank is certainly there, though the process is complex and can be appealed. 

Mr. Dudley’s cultural workshop may actually be less about culture and more a subtle warning to those banks the Fed considers to be moving too slowly in transforming themselves into the well-managed entities it wants.  Those banks know who they are.  As Mr. Dudley says, they need to “get on with it.”