Danse Macabre: The Banking and Brokerage Sectors Reel from Crisis to Crisis
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The financial services sector is caught in a death waltz, spun around by bad loans, trapped in the embrace of plunging stock prices, and dizzied by embarrassing scandals. And like Hans Christian Andersen’s little girl with the red shoes, it’s driven to keep on dancing. Nearly a trillion dollars in government bailouts have sunk almost without a trace, leaving global stakeholders desperate to stop the music.
What kind of future can possibly be in store for us? Chastened executives may wince at the thought of government regulators and outside forces reshaping the industry, but transformation is by now a foregone conclusion. The only questions are what types of institutions will live to see another sunrise, and what attributes executives must cultivate to ensure that their companies are among those that endure.
Rapid economic declines have problematized the process of redefining the banking industry. Cuts in consumer and business spending have led to job losses, which in turn have undercut public and private revenue, deepening a cycle of contraction that could last several years, not just in the US, but around the world. Forget about growing profit margins, earnings, and revenue—survival is the name of the game. The securitization and leverage that drove profits for so many banks, brokerage firms, hedge funds, insurance companies, and private equity firms are gone, and regulators have no intention of allowing them back any time soon.
“Every organization has some exposure to this crisis, whether directly or indirectly, through subprime mortgages, collateralized debt obligations, or other instruments,” says Iftekhar Hasan, PhD, the Cary L. Wellington Professor of Finance at the Lally School of Management and Technology at RPI (Rensselaer Polytechnic Institute). “The issue now is how to figure out a way to have a leaner and stronger banking sector in the future. As the government makes decisions about which banks will get money, new banks will be created with the help of the government and by the initiatives of other banks. We foresee a large number of consolidations taking place.”
With so many banks, brokerage firms, insurance companies, and other structurally important non-banks ensnared in the crisis, government regulators and market forces will be working toward stabilization for a good long while. The process begins with billions or trillions of dollars in securities, loan guarantees, and other promises from the government to industry and from some industry players to others. It will indubitably end with increased regulation and with the recognition that trillions of dollars have been lost and billions of dollars of shareholder value have been wiped away.
“Institutions will suffer losses. We may lose some, some may merge, some may be closed down by the government, but by and large we know that we are in a business cycle and business cycles eventually end up with an upturn,” says James Barth, PhD, the Lowder Eminent Scholar in Finance at Auburn University’s School of Business. “We just don’t know exactly how far down we are going to go until we reach the bottom, but we will reach it.” When it comes time for the industry to claw its way out of its own grave, the central struggles will be to redefine business models, cope with new regulations, better manage risks, and compete in the increasingly global economy.
RECESSION OR DEPRESSION?
Without a doubt, this crisis is the closest approach the US has made to a flat-out financial depression since the 1930s. But the government is spending trillions of dollars in an effort to avoid depression and shorten the duration of the recession, which began in December 2007 and was certified in December 2008 by the NBER (National Bureau of Economic Research). The primary response so far has been the financial system stability measures undertaken since March 2008 and the stimulus package passed in February 2009.
The NBER’s official definition of an economic recession is concise and widely accepted: a broad-based contraction in the economy significantly affecting domestic production and employment. Many experts define a recession as two straight quarterly declines in real GDP (gross domestic product). There is no such unanimity with regard to the definition of a depression, however.
The NBER notes that an economic depression generally refers to a period of particularly severe economic weakness. But a depression can also encompass the time spans flanking that period, beginning with the initial decline in economic activity and continuing until the reestablishment of normal economic levels. Other definitions of depression include a fall in real GDP of 10% or more, or a continuing fall in real GDP for at least three years.
For Harry Dent, an author and economic forecaster, a depression is all but inevitable. “This is an extended downturn, a major downturn,” he says. “It’s like Japan in the 1990s and like the US in the 1930s, but with some differences, obviously. We are going to see a shakeout in every industry, but particularly in banking and finance, where we are going down to the companies who are going to be the leaders in the future, and a lot of companies are going to go under.”
He continues, “The strong are going to get stronger and the weak are going to fail and that is exactly what the economy wants after a period of massive and even wild innovation with all the stimulus, low interest rates, speculation, and bubbles.” Periods of economic growth require periods of economic contraction—that’s what the business cycle is all about—and Dent believes that the current downturn will eventually set the stage for another extended period of economic growth.
Because a social safety net buffers the country from the worst effects of economic decline, it is unlikely that a depression, should it occur, will closely mirror the Great Depression. “In the Great Depression, there was unemployment of more than 20%, lines of people standing by ash cans outside of factories,” says Ballard Campbell, PhD, author of American Disasters: 201 Calamities That Shook the Nation. “I’ve never seen that in my life and it is kind of inconceivable to imagine it happening in this country at this stage.”
No matter what we call it, we can’t avoid the immense stress placed on private and public finances as job losses depress demand and falling demand depresses imports and exports, feeding further job losses and exerting more pressure on demand. Campbell explains that, because the government is the funder of last resort, “the very time at which there is less money coming into the public coffers is when the demands on government increase.”
THE REGULATORS AND THE RULES
With legislators and consumers howling over the trillion-dollar bailout of the financial institutions they see as responsible for creating the crisis, a tightening and extension of financial system regulation is definitely in the cards. Most industry experts believe the only open questions are exactly what form new regulations will take and whether a new regulatory framework will be created to administer the more robust rules.
“I think it’s pretty clear that there need to be changes because the free market ideology ran rampant,” says Tim Yeager, PhD, associate professor of finance at the University of Arkansas’s Walton Business College. “It’s clear that if you are really going to get results you need a combination of market transparency plus effective regulation. You can’t have one without the other.”
Our current regulatory system is a patchwork of agencies, boards, and departments on the state and federal levels that were created during the past 150 years in response to a variety of crises, including the Great Depression. Because responsibilities overlap between so many agencies, financial institutions have been able to pick and choose among regulators, while oversight has slipped through the cracks.
Whether the Federal Reserve, Treasury Department, or a new super-regulator supervises agencies such as the SEC (Securities and Exchange Commission) and CFTC (Commodities Futures Trading Commission) is less important than the exertion of sufficient political will to overhaul the system, making it more responsive and less reactive to crisis.
Regulation hasn’t kept up with innovation. Still, Morris Goldstein, the Dennis Weatherstone Senior Fellow at the Peterson Institute for International Economics, believes that certain reforms could restrain riskier innovations like those behind the current meltdown. He envisions two key changes: increases in the minimum capital requirements for banks, and the establishment of quantitative liquidity ratios in place of the current principle-based requirements.
“I think you’re likely to wind up with a higher minimum capital requirement, for banks and probably for most systemically important players—but certainly for banks,” he says. “If I had my way, it would be substantially higher. That means you’re going to have lower leverage going forward, slower asset growth, which probably means you’re going to wind up with somewhat less profitability down the road. People want a banking industry that is going to be safer, and higher capital is going to be part of it.”
A specified liquidity ratio is important, Goldstein argues, because it will give banks—and non-banks, if included—a stronger cushion in times of uncertainty and will reduce leverage. Many people expect hedge funds to come under SEC registration regulations; rules to deal with conflicts of interest at credit rating agencies are also on the table. Another widely expected regulatory reform is the creation of some type of clearinghouse for derivatives. And risk management controls are a probable area for increased regulatory scrutiny, says David Thetford, securities compliance principal analyst at Wolters Kluwer Financial Services.
“It’s likely that firms will have to have someone who is in charge of risk management,” he says. “That will be your go-to person who manages the risk management process of the firm. But there will be a risk management structure required—not just one person, but an entire process. And when regulators come in to examine firms, that will be thrown into the mix. They will look at your capital, books and records, advertising and communication, and they will also look at your risk management process. That’s my guess.”
Whatever new regulations are passed, regulators must be given the resources to do their jobs. A Government Accountability Office report published in February noted that any overhaul of the financial regulatory system must give regulators the “independence, prominence, [and] authority” to fulfill their duties; in addition, they must be held accountable for their actions (“Financial Regulation: A Framework for Crafting and Assessing Proposals to Modernize the Outdated US Financial Regulatory System,” statement of Gene L. Dodaro, acting US comptroller general, before the Senate Committee on Banking, Housing, and Urban Affairs; released February 4, 2009).
But RPI’s Hasan is concerned about the human capital aspects of expanded regulatory authority now and in the future. As many of the people at the Treasury Department and the Federal Reserve are given multiple responsibilities, he worries, the progress of the programs necessary for stabilizing the financial system will be slow, delaying the creation of the new regulatory structure.
Of those who agree that increased regulatory scope and strength are necessary, some are dubious that substantial reforms will actually take place. “Unfortunately, I don’t think a lot is going to be done because members of the same old school are being appointed, like Mary Schapiro at the SEC,” says Robert Pearce, JD, principal attorney at the Law Offices of Robert Wayne Pearce and a former SEC attorney. “The first line of defense to all these problems was the self-regulatory organizations, the largest one of which she headed up, FINRA (Financial Industry Regulatory Authority). As well-intentioned as she may be, I don’t think she is going to be the impetus behind any major reforms.”
Near-term prospects for the banking and brokerage industry are hazy at best. Three to five years out is a different story, though, given that recovery must begin at some point. In the near term, nationalization fears dog the industry; in the longer term, there are concerns about whether regulators will put the kibosh on universal banking and how competitive a more regulated, possibly smaller sector will be in the global marketplace. Whether the government will come to the point of nationalizing institutions too big to fail is anyone’s guess, but that’s becoming increasingly feasible as large bank stock prices plummet toward penny stock status. TARP (Troubled Asset Relief Program) 2.0, announced in February 2009, dances around the nationalization issue, but slams banks receiving government funds with tough conditions and imposes a stress test whereby regulators will determine which banks are healthy enough to receive funds.
Once the government has invested trillions of dollars in institutions that are still struggling, the question for Auburn University’s Barth becomes: “If you guarantee everything, should the government simply own these institutions?” Like him, most experts see nationalization as a last resort in which the government would seize banks, clean out their bad assets, and return them to the private sector as quickly as possible. Nationalization or not, increased regulation is likely to crimp the investment and commercial banking industries’ ability to return to the incredibly large profits and ROE (return on equity) they enjoyed during the late 1990s and most of the 2000s. But that’s not a bad thing, according to Yeager of the University of Arkansas.
“The trade-off between more regulation and lower profits is for the public good,” he says. “It’s true that investment banking won’t be as profitable because the ROE will be less, but that is the world we have to live in. We can’t afford a world where the ROE of these investment banks is 35% every year for seven years, then everything blows up and we fall off a cliff. So it’s a trade-off we have to make.”
Jaime Peters, CFA, CPA, a senior banking analyst with Morningstar, agrees with Yeager that ROE for the financial services industry will be lower going forward; she sees the former average of 16% trimmed to about 10%–11% for commercial banks.
All this boils down to a slower-growth industry—if not exactly a return to the business model that banks had before rapid share-price growth and expansion in earnings became the norm in the 1990s, at least a moderation of growth due to decreased leverage and fiercer risk management and regulation. Financial services companies, which used to pay healthy dividends, will not be able to return to that model until they repay the government. Peters doesn’t see a return to the previous trend in dividend growth for five to seven years.
According to a global banking survey conducted by Ernst & Young between May and October 2008, banks are focusing on four areas as they seek to emerge from the financial crisis: tightening internal controls (a priority for 50% of those surveyed), shifting the culture (40%), repositioning employees (23%), and escalating communication (15%) (“Navigating the Crisis: A Survey of the World’s Largest Banks,” 2008). Continued consolidation is also likely to be a theme for the industry for years to come, not only in terms of the number of institutions that exist but also in terms of the types of businesses in which those institutions will participate.
“We will continue to see waves of consolidation, but in the end game there are going to be big acquisitions to absorb some of the losers in the industry, and then massive cutbacks and layoffs,” Peters says. “We are really seeing a rush away from investment banking into very much more traditional banking and brokerage services. We expect to see that trend away from investment banking not only because, obviously, it has been a huge source of pain for the industry, but also because regulators are going to come in and say you can’t take as many risks.”
The universal banking model, which has been the holy grail for many of the largest institutions, may not continue to be viable. Yeager thinks that the key flexibility for the bank of the future will be the ability to pick and choose among commercial banking, investment banking, and brokerage services when constructing a successful financial institution.
“There are natural synergies between investment banking and consumer banking because the same companies that need loans when they are smaller need bond and equity underwriting when they get bigger,” he alleges. “Furthermore, if you look at the academic evidence from the Great Depression, there is not one shred of evidence that the mix of commercial banking and investment banking helped cause or worsen the depression.”
The survival of universal banking depends on how far regulators go in curbing risk and whether the industry can make the model function. Brian Hamburger, JD, of MarketCounsel sees the universal banking model as a failure, mostly because banks haven’t found a way to make it work. “I think that the growth-by-acquisitions game is a zero-sum game and that the hope that you can buy all these assets and integrate different cultures together has failed,” he says. “There have not been any real success stories on a large-scale basis to point to, so banks are going to have to start to get back to basics. There will continue to be some very large banking institutions like we have today, but we are also going to see more locally based operations.”
Former SEC attorney Pearce would like to see legislators reinstate the barrier between investment banking and commercial banking that was dissolved when the Gramm–Leach–Bliley Act was passed in 1996, although he doesn’t expect to see that happen. He believes that the mixture of commercial and investment banking helped create institutions that were too big to fail, forcing the government to spend billions propping up the system.
As for the third piece of the puzzle, brokerage services, Hamburger sees a continuation of the trend toward commoditization of services. The providers who succeed will be the ones who are successful in building relationships.
“Brokerages are going to find themselves much more commoditized on price than they ever were before,” he asserts. “Customers are assuming that quality of execution is there, so they are looking for better prices. When you’ve got a whole bunch of people offering the exact same product in a market where information is relatively transparent, you are going to have some pretty significant challenges differentiating yourself on anything other than price.”
A LEANER BUSINESS MODEL
On the micro level, individual institutions will need to decide what business practices and service lines work for them and to implement those strategies as efficiently as possible. Mike Nichols, chairman of the American Society for Quality, insists on the importance of making strategic decisions about what businesses fit with a particular institution, rather than following the crowd. But he notes that while seriously strategizing about which businesses to pursue is a prerequisite, proper follow-through is equally vital.
“This is a critical time to make sure that you’re executing your strategy flawlessly,” says Nichols. “Now it is important to look at all of your processes, look at where you are not meeting customer expectations. If you can execute flawlessly in this environment as opposed to the competition, customers are going to come to you. Because, frankly, they’re scared. And when you have a nervous customer base like this, they are going to look for institutions that appear safe, and have high quality.”
John Jackson, CEO of Lending Cycle and a former bank executive vice president, believes there is much room for improving efficiency in banks’ lending cycles, from loan application to approval. “In banks, I’m seeing an incredible amount of redundant processes because banks are using systems that are 20 years old for keeping track of what they are doing with loans: the rules for lending, collection, and other tasks,” he says. “It’s hard for banks to have good oversight of the lending process internally because there are so many moving parts, and when you are dealing with old systems it’s hard to get the information you need in one place to make timely decisions or react to a problem.”
Improved corporate governance is now a major imperative for banks. Boards of directors, audit committees, and top executives must be more aware of the lines of business the institution pursues and how those contribute to overall profitability, as well as the risks that the organization is taking or avoiding. With executive compensation a huge hot-button issue, boards will be under tremendous pressure to justify compensation systems and demonstrate links between compensation, long-term profitability, and organizational goals.
A major issue in bank consolidations is communication lacunae between disparate computer systems and applications. When a bank is acquired by another bank with a different system and a different culture, major information gaps result. US banks’ eternal failure to address this problem goes a long way toward explaining why the megauniversal banking model has consistently flopped in this country. Our customers have never fallen for the idea of doing all their financial business at one institution.
“Consumers are used to having their brokers, their bankers, and their insurance guys,” says Morningstar’s Peters. “We really haven’t had a true universal financial services bank since Citi sold Travelers, and that was kind of an admission that this isn’t working. There was a lot of talk about cross-selling, but not a lot of it ever occurred.”
Hamburger puts it more bluntly: “People hate their banks and brokerage firms,” he says. “This is a major distinguishing characteristic that everyone has missed.”
If customers didn’t like or trust their financial institutions before this crisis, their antagonism has only heightened since they perceived their taxpayer dollars going into an emergency bailout and emerging in the form of exorbitant bonuses. That has accelerated their penchant for developing personal relationships with the institutions and individuals with which they do business, rather than succumbing to the allure of a well-known name. The large wire houses are no longer the dominant game in town for financial advice, and their best producers are going out on their own, Hamburger says. Many of these advisors have successfully parlayed their strong personal customer relationships into ready-made client bases for their new endeavors.
The same holds true for the community banking model that seemed outmoded even a few years ago. “If you know your local banker, and this is a guy or woman you can sit down with and they will listen to your personal issues and they can help craft solutions to help you, I think people will pay for that,” Hamburger avers. “I think that is the only type of situation where people are going to be willing to pay for services beyond the basics: where there is a relationship.”
As for future business models for investment banks, the World Economic Forum, in a report entitled “The Future of the Global Financial System” that was issued shortly before the January 2009 Davos Conference, identified five types that are likely to emerge following the financial crisis:
- Scale globals will be the largest institutions and will provide major liquidity across the globe; many will be universal banks.
- Focused regionals will focus on regional markets, picking and choosing among banking services that best suit their markets.
- Private banks will return to their original focus on high-net-worth individuals, families, and small businesses.
- Merchant banks will concentrate on advisory and corporate finance lines of business.
- Alpha risk takers, the hedge funds and private equity firms, will continue to capitalize on arbitrage opportunities and other instruments that hold out potential for high returns.
Exactly which banks will emerge from the crisis is anyone’s guess. But the industry will survive in some form, with substantial help from the government, simply because the economic system needs banks and banking services to function.
“The fact of the matter is that if we don’t fix the banks, the stimulus package won’t even matter,” says Peters. “You can’t have a working economy in this day and age without a working banking system. As much as it might pain the taxpayers to see the banks bailed out, it needs to be done. It is crucial that the government and the banks work together to figure out a way so that we have a working banking system. No matter what it looks like, it’s got to be there.”
–Amy E. Buttell was a journalist working in Erie, Pennsylvania and is a graduate of Mercyhurst College with a certificate in accounting.
This article was originally published in the Fall 2009 Issue of the Investment Professional.