Overprotected from risk?

An elite club of large American banks has been designated as “too big to fail”. These are institutions which are essentially financial utilities and therefore deemed systemically critical. However, the creation of this premier status creates a problem of “moral hazard” in which institutions are protected from the negative implications of their risk taking. Vanessa Drucker reports from New York.

Too big to fail (TBTF), a catch phrase of the season, can be a misleading misnomer. As applied to financial service companies, the term does not necessarily mean too large merely in a capital sense, or even too interconnected. With hindsight, the failure of Lehman Brothers demonstrated that the government did not fully accept in September 2008 that Lehman was in fact a financial utility, a member of an oligopoly whose ancillary businesses perform core lending and banking services.

“General loathing of government involvement in financial markets had allowed banks and investment banks to become financial utilities,” says Peter Vinella, a Manhattan-based global financial services sector leader at LECG, expert consultancy. “I would rather see an acknowledgment that those firms perform a utilitarian function for the common good, not just shareholders.” With a clear recognition that utilities are involved, protections to the financial system could be established to guard against parent company insolvency. Vinella adds, “If Lehman had structured trust accounts, rather than normal operating accounts, assets moving through the system would not have been so confused with those of the parent company.”

TBTF organisations provide a range of utility services. Take prime brokerage, a service offered by about ten major banks. Among them, only a handful, including defunct Bear Stearns and Salomon, and flailing Citibank, allow pledging of fixed income securities. (Initially, prime brokers furnished execution services, but later allowed customers to pledge collateral, such as repos or security lending, to gain leverage.) Since Lehman was not a bank, it could not be a custodian. So, when it went into receivership, the cash and assets belonging to its hedge fund clients were located in other institutions, which froze them, for no reason except their having used Lehman as prime broker.

Or consider how there are about 20 large players in the repo and matched book areas. When it ran a matched book operation, Lehman was not using its own assets or cash, but matching those who wanted to borrow with others who had securities to pledge. It might look like a loan, but did not sit on the regulatory book as such. Large investment banks create huge repo books, many times the size of their own balance sheets, without supplying capital.

As a further example, fewer than 100 firms of any note act as mortgage servicers to commercial loans. Among lending syndicates of, say, 12 lenders to one borrower, the servicing agent may have not even loaned money.

“We have a love hate relationship with utilities,” Vinella continues. When rates are tame, we love them, but when they go wild, we consider nationalisation. Remember that utilities are regulated intensively, to ensure they treat customers fairly, and are accountable like public institutions.

“They also earn a utility-like return for investors,” points out Patrick Daugherty, a Chicago partner at Foley & Lardner. “We may also see talented employees leaving banks if they no longer want to work for a ‘utility’.”

The formation of the TBTF brigade has come about gradually. From 1980-2005, 11,500 American bank mergers took place, averaging about 440 a year and gradually increasing in size. The industry shrank from about 11,400 to 7500 institutions over that period. “In the late 1980’s, an early TBTF study looked at 10 banks with a quarter of all banking assets,” reports Jane D’Arista, from the Political Economy Research Institute at the University of Massachusetts. “By the end of last summer, we had five dominant banks with 97% of all derivative action.” The securities industry is even more concentrated than the banking sector, as the remaining players have become bank holding players or bitten the dust.

Since the 1970s, very large firms have changed their funding patterns, driven by the need to compete in growing global markets. “They fund from one another, not from outside the sector, but within,” says D’Arista. “Their interdependence is exacerbated by also selling financial insurance to each other.”

Increased institutional concentration has led to a small pool of people, who command tremendous authority. In internal discussions, it is probable that one or two leaders at the helm of remaining giant institutions will encourage like-minded thinking rather than debate. Human nature is vulnerable to groupthink in the best circumstances, and more so when a small number of organisations aggregate power.

The rich get richer. Bill Feingold, recently vice president of proprietary convertible trading at Goldman Sachs, discusses how the company was able to produce its latest blowout quarterly results. “Customer trading was mind bogglingly profitable. Larger rivals have gone, while some competition has sprung up in the form of boutique firms which make no pretence of risking their own capital,” explains Feingold, author of The Undoing of Cowardice.

Any firm ready to risk capital, especially one of Goldman’s standing, can tower above the fray. Whereas Goldman might have previously competed aggressively to make 1/16th of a point in spread, suddenly it can earn a full point or more.

“It is disingenuous of Goldman to attribute its quarter’s success to superior employees, rather than to the function of less competition dealing with customer orders,” says Feingold.

Normally, any hedge fund or mutual fund would check in with a couple of broker-dealers to confirm an honest price.

Clients typically hold accounts at 10 to 15 brokerages. It takes finesse knowing how to price merchandise, and not contact too many brokers, to avoid falling prey to front running. Although only one dealer controls an order, word spreads like wildfire, like a house on the market for a long time. In theory, competition should flourish when a few firms are making megaprofits. The problem right now is that so few firms still have the capital to compete with the likes of Goldman.

Now the Obama administration has distinctly labelled an elite club of financial organisations as “Tier 1”, or systemically critical firms. Once an entity has been recognised as TBTF, its newfound invulnerability can provoke a second order effect: moral hazard, by definition, describes the possibility that individuals or companies, who believe they are insulated from risk, may behave differently. They might, for instance, take on added risk, because they believe they have less to lose. “We always had a TBTF policy in effect, although we let some firms fail, which kept the market guessing. The difference before was that we never named or identified anyone specifically,” says Fernando Capablanca, the president and chief executive officer (CEO) of Union Credit Bank in Miami.

In practice, for any firm, the cost of bankruptcy would be a major deterrent to risk taking, and restrain it from taking on incrementally riskier projects, such as mergers or acquisitions. The borrowing cost of funds goes up, if creditors believe an issuer is potentially subject to bankruptcy risk. Now TBTF financial institutions may think that cost has been removed, through various palliatives, cures and preventatives. On the one hand, by mandating increased auditing, capital, liquidity and transparency we should help mitigate that moral hazard behaviour, says Daugherty. However, he points out, some of the cost of prevention has now been passed to taxpayers, as an increasingly expensive bureaucracy is administered at the federal level. Daugherty summarises, “the burden of costs will be mutualised to spare the extreme spike of bank failure.”

Currently, the Federal Deposit Insurance Corporation (FDIC) insures deposits to $250,000 (£152,000) per account, and checking accounts to the hilt, but that latter unlimited government insurance scheme will expire at the end of 2009.

If it is not renewed, Capablanca and his fellow commercial bankers face an uneven playing field. Already he sees his customers beginning to transfer their payroll accounts, which may run to several million dollars, into the larger Tier 1 banks. Ironically, in the early days of the credit crisis, depositors were actually favouring smaller community banks, expressing a preference for “Main Street” versus Wall Street, but that mood is shifting again. “The whole cost of FDIC insurance should be addressed, to remove the bias in favour of larger banks,” Capablanca argues.

While it may seem unfair that surviving Tier 1 institutions devour free lunches, the real issue is how to contain a collapse and prevent another industry-wide crisis. The TBTF group reminds Daugherty of an old proverb: try not to keep all your eggs in one basket, but if you must do so, watch that basket carefully! At least for now, TBTF organisations and senior management endure the scrutiny of life in a fishbowl.

Policymakers meanwhile have put forward a host of suggestions to address the dilemma, most of which seem to be losing urgency with each passing day. Proposals range from breaking up megabanks or outright nationalisation, to increased capital requirements and liquidity, more stringent prohibitions on activities and enhanced scrutiny, stress tests, intensive audits and self audits.

Paul Volcker, now head of the Economic Recovery Board, has proposed that commercial and investment banking activities be separated once again to some degree in a two-tier system, as they were until the Glass-Steagall Act was repealed in 1999. He has reiterated his proposal in various speeches, since publishing them on January 15 in a Group of 30 report. (That same report also contemplated limiting share of bank deposits, constraining the amount allowable for any given institution.) Lynn Turner, former chief accountant at the Securities and Exchange Commission (SEC) from 1998-2001, agrees, “The best bet is to break banks up to avoid inherent conflicts.”

Understandably, banks are lobbying furiously against dissolution, insisting they need to retain their scope of offerings to compete against universal banks in other countries. But banks are not like Humpty Dumpty. Many are sceptical that, even if financial firms were deconstructed, they would eventually be reconstituted. Look at AT&T, they clamour, and at the telephone companies it spawned – for a while. In any event, the Obama administration’s June 17 proposed regulatory reforms have adroitly sidestepped the issue.

In Britain, any debate over a structural breakup is still in its infancy, says Donald Stewart, a London-based partner at Faegre & Benson, a law firm. “Yet we need to do something about international institutions that are exposing our taxpayers to failures elsewhere. As a small island, we can’t afford to bail out some of the world’s largest institutions just because they are headquartered here.” Yet since the country’s number one industry is financial services, it needs full service banks to be a global protagonist. Stewart sighs, “We’re stuck between a rock and a hard place.”

Some European banks have been fully or partially nationalised, including Fortis, Northern Rock, Lloyds and Royal Bank of Scotland. America shows little appetite to follow suit – mere discussion of nationalisation of Citibank or Bank of America plunged the stock market in February. If it did happen, “the government would try to flip them as fast as possible,” predicts Vinella, who recalls a movement to make Bank of New York Mellon governmental shortly after 9/11. Although that company was settling over 80% of US treasury securities in those parlous days, the entire industry balked.

Another tack would be an increase in required capital levels for Tier 1 firms, to “reflect the large negative externalities associated with financial distress, rapid deleveraging, or disorderly failure,” according to the government’s June 17 reform proposal. Should the current 8% capital requirements be boosted? Absolutely, says Turner, who contends that these protected species banks need 10% to 15% cushions. D’Arista offers another angle on capital buffers through leverage reduction. Why not introduce margin requirements on more instruments than stocks, she suggests. “It would protect both the financial and real sectors of the economy.”

Regulators are studying the notion of restricting certain behaviours and activities as another safeguard. Those categorical prescriptions go right to the crux of the delicate balance between regulation and free markets. “Regulators’ roles have been typically to warn or advise, rather than to trump management or boards in decision making,” notes Carol Beaumier, the executive vice president at Protiviti, a consultancy in New York. As an examiner in the Office of the Controller of the Currency (OCC) in the early 1980s, Beaumier recalls how the organisation took some criticism for allowing so many new bank charters. “The right to start a new bank included the right to fail. Our OCC mandate was to protect the system rather than individual banks.”

Whatever rules do take hold, they will have limited impact without an overhaul of the entire culture of regulation across borders, streamlining international standards and practices. While regulators have attracted much blame, “on the flip side, hardly anyone is talking about how we can help them do a better job,” says Beaumier. Government auditors might benefit from improved training. The June 17 proposals advanced the idea of a professional college of supervision, a model promoted by the European Banking Federation.

In general, however, most American proposals have been quite modest in the aftermath of the 2008 meltdown. A dangerous interplay between politicians and the public may sacrifice a rare window for meaningful and effective changes. “Banking regulators have become captive to the financial industry,” comments Turner. “They are making decisions not based on numbers and sound business judgments, but from political motivations. It’s like mixing oil and water.” He argues that today’s regulators lack the backbone to shut down failing firms. Drexel Burnham, once the fifth largest American bank, was driven into bankruptcy in 1990 through its junk bond activities. Richard Breedon, then SEC chairman and Nicholas Brady, then Treasury Secretary, “didn’t think twice about shutting down Drexel and moving its assets quickly into other businesses, in a thoughtful, methodical process,” says Turner.

“The crisis is still quite new, and while the political leadership in the United States has already changed, the habits of the political class have not,” commented James Galbraith at a meeting in July on the world economic crisis, sponsored by the Gorbachev foundation. Galbraith, a professor of government and business relations at the University of Texas, added: “So we have a response dominated by reliance on short term measures, life support for big banks, and a hope that things will return to normal before long.”

The re-election of hundreds of congressmen and administration officials is at stake. Politicians, who can lose their jobs every two years, must raise enough funds for their next campaigns, and that relies on large war chests. Financial firms are active donors. Besides, Turner notes, to land a seat on the powerful congressional Financial Services Committee, requires substantial donations to your party’s re-election committee.

At the same time, the voting public has a poor grasp of market intricacies, especially credit markets. An earlier event illustrates how important public understanding can be, to influence legislation. Recall how the Sarbanes Oxley legislation was first drafted in the spring of 2002, on the heels of the Enron debacle. “Nobody thought it would ever be adopted, but then WorldCom blew up on June 26, and the polls changed overnight,” Turner recalls. While the Enron manipulations had been complex, WorldCom represented flat out fraud and cooked books, themes that were plainer to grasp.

As of now, defanged proposals are missing key elements, such as meaningful derivative and credit rating agency reforms, or board governance. Business as usual is an inadequate response. Tweaks and halfway measures spell cosiness between regulators and banks, as government proves reluctant to step in and close organisations, or replace inept management with fresh boards. Even watered down proposals for reform are faltering, as lawmakers bicker over the future role of the Federal Reserve. President Obama expressed frustration on July 22, warning, “The banks are going to go back to the same things that they were doing before. In some ways it could be worse, because now they know that the federal government may think they’re too big to fail, and so, if they’re unconstrained they could take even more risks.”