The business world is being disrupted by the combined effects of growing emerging economies, shifts in global demographics, ubiquity of technology and accountability regulation. Infosys believes that to compete in the flat world, businesses must shift their operational priorities.
Subsequent to my post couple of weeks back on the subject of Universal Banks, rapidly unfolding events in the US have catapulted JP Morgan Chase, Citi and Bank of America as the top 3 banking institutions in the country. With a leadership position across business parameters like Branch network, Deposit base, Credit Cards issued and hmm, Mortgages originated and serviced, these Banks carry an onerous responsibility on their balance sheets now and cover almost the entire US population in their collective footprint!
The unsung hero of all the hectic parleys that culminated in the Universal Bank proposition is the FDIC! This venerable 75 year old institution, a by product of the Depression-era legislation, has played a critical catalyst role in averting a banking crisis for the person on the street. While the more high profile Treasury and Federal Reserve arms of the Government have been publicly making attempts to get consensus on the bail out proposition, the FDIC has been proactively working behind the scenes to identify fissures in the banking system and diligently negotiating with the larger banks to take over their weaker brethren in what the market terms as "shotgun weddings"!
Bank failures can be very expensive, apart from causing an irreparable crisis of confidence in the economy; the ripple effects can cause immense stress to small businesses and individuals, by putting their lifetime earnings at risk!
Read more about the FDICs round-the-clock efforts (and the final 4 am Monday morning deal!) in the most recent Citi - Wachovia merger here.
And do you realize that, in this deal, there is already an implicit bail out package? The Federal Government, through the FDIC has agreed to absorb any losses beyond $42 Bn in Wachovia's $312 Bn asset portfolio, in return for preference shares in Citi. So much for the "noise" around bail outs!
What happens when you neglect an engine that is long overdue for an overhaul? Answer: It breaks down, perhaps bringing an aircraft crashing down to earth.
And in recent days Wall Street, the engine of the world financial economy, has sadly shown that it is far from immune to the banal real-world constraints that the rest of the world is routinely accustomed to living with.
Owing to a heady and overpowering mixture of high expectations and sheer exuberance, many financial industry players were convinced they could defy the mundane aspects of the real world, such as gravity. But magic wands and pixie dust did turn out to be the stuff of fairy tales, after all.
As I wrote 18 months ago in The Long Arm of the Laws of Economics, risk in world financial markets has been underpriced by hiding it away, using increasingly arcane, complex and innovative instruments* such as Credit Default Swaps and Collateralized Debt Obligations. As I wrote,
"While underpriced (Cheap) risk is good for borrowers in the short term, in the long term it can undermine the health of the entire financial system. Thus there are good grounds for apprehension as to the robustness of the world's financial markets."
In fact, the financial media including the Economist and BusinessWeek had been carrying admonitions to this effect this for some time. So if the fragility of the financial system was widely known 18 months ago, it’s a fair bet that the wise and wizened wizards who run the world of finance knew it too. But regulators largely looked on benignly, as did most everyone else. Sure enough, when the risk came home to roost, what resulted was the carnage on Wall Street and its reverberations around the world that we have witnessed in the past 10 days.
I also wrote in another piece, that despite all these excesses, the financial economy is still likely to have a soft landing. This statement was, alas, based on the assumption that the same wise and wizened wizards would not allow things to reach the pass that they have in the past two weeks. Yet what has happened thus far may still be characterized as a relatively soft landing - only events over the next year will tell if this observation was correct.
Very hearteningly, regulators have responded with alacrity and appropriate measures to contain the contagion on Wall Street. One key and very correct consideration that has driven the US Treasury’s actions over the past week has been to prevent the ripple effects from spreading beyond the affected institutions to the broader US financial system, and from spreading beyond US shores to engulf world markets.
Be that as it may, it is now very important that we do not go overboard on the other side, and become overly alarmist. In particular, there are two myths now sought to be propagated by scaremongers of various hues that I think should be jettisoned:
1. Myth: “The free market system is fundamentally flawed”. There are voices emerging which suggest that the current upheavals indicate that the financial industry was always “evil”, and that the US Federal government’s moves last week to strengthen regulation are “proof” that leftist, anti-free market ideology was always correct. This is worse than an over-reaction – it is pure muddle-headed thinking.
The financial industry, led by Wall Street has done an admirable job of supporting the capitalist system in producing ever more goods and services that have improved our daily lives. There were excesses as I have noted earlier, but these were partly a result of regulation reaching a low point, turning a half-blind eye to risk. With regulation rebounding to stronger levels, the outlook is much better.
2. Myth: “Innovation is dangerous”. It is trueanother reason for the excesses wasrunaway innovation that produced the increasingly ingenious financial instruments that Warren Buffet has called “Weapons of financial mass destruction”.
However, this is far from sufficient evidence against innovation itself. If we were to shoot down any system or practice on the grounds that it resulted in some excesses, no human enterprise would be possible.
And so, in an enactment of the circle of life, the financial markets will become hale again, perhaps to commit the same excesses at some (hopefully) distant point in future. What is certainly worth keeping in mind however is that if you defy the laws of economics, you may just find the law of gravity catching up with you.
*These complex financial instruments also created a veil of opacity that hid the true extent of risk, and thereby acted as a “levee” that eventually came crashing down.
On April 7, 1998 CitiCorp and Travelers merged, forming Citigroup. Operating in both the investment and commercial banking spheres, Citigroup represented the reemergence of the Universal Bank, a Financial Services supermarket that was rendered extinct by the Glass-Steagall act of 1933.
The Glass-Steagall Act was enacted in response to the Crash of 1929. Large, deposit-holding commercial banks had waded into the booming stock market, underwriting issues and making risky loans (sounds familiar?). When the market crashed and banks failed, deposits were wiped out (there was no FDIC, back then!), kick-starting the Great Depression.
Glass-Steagall changed the face of the banking world. A distinct line was drawn, separating commercial banks from investment banks. Stringent capital requirements and leverage rules governed commercial banks, while investment banks were given room to largely do as they please. Glass-Steagall also marked the creation of the FDIC, protecting deposits of consumers in the event of a bank failure.
Regulatory approval for the Citigroup merger was a harbinger to the repeal of Glass-Steagall; commercial banks wanted a piece of the booming stock market of the late 1990s. The Gramm-Leach-Bliley Act of 1999 marked the official repeal, allowing commercial banks to own investment banks and vice versa.
Until recently, the Universal Banking trend has been somewhat slow to catch on. JPMorgan Chase was formed in 2000, capping a series of acquisitions and mergers, establishing (before last Sunday the 14th of September) the only other large U.S. Universal Bank. Why? Large, bulge-bracket investment banks had been incredibly successful prior to the onset of the credit crisis, a year back. High stock prices scared away potential commercial bank suitors and the wildly successful investment banks didn’t feel the need to take on a commercial bank. Further, in the early months of the credit crisis, large Universal Banks like Citi and UBS came under fire, ostensibly for not being able to manage the complexity of their distinct lines of business.
As we have all learned, rather painfully, a lot can change in a weekend. Independent investment banks are increasingly strapped for cash and collateral, due to the risky bets they have made and merging with a deposit-rich commercial bank appears to be one of the few viable ways to avoid bankruptcy. For many commercial banks, this is an opportunity to add the missing piece of the puzzle: instant investment banking credibility, along with access to high-net worth clientele and top-tier investment banking talent. As I am writing this, I notice a breaking news item about Citi hiring Lehman Brothers’ Head of M&A in a similar capacity at its investment bank!
The quick fire merger between Merrill Lynch and Bank of America is a prime example of this. After years of trying, rather unsuccessfully, to build an in-house investment banking division, Bank of America paid a significant premium for arguably, one of the most recognizable investment banking brands in the world!
Although some questions on the viability of large Universal Banks do persist, the potential synergies are worth a second look. Deposits create a secure base for investment banking activities, along with better opportunities for cross-selling with a one-stop-shop approach. Additionally, middle and back office economies-of-scale offer considerable cost savings. Perhaps most significantly, Universal Banks are positioned to take control of what will likely be the most lucrative piece of the financial sector pie - Wealth Management.
I know what you are thinking. What prevents another Crash of 1929 situation, where out-of-control Universal Banks begin to fail? Stronger, more comprehensive regulation surely does help and despite suffering considerable mortgage-related losses, both Citi and JPMorgan Chase remain in relatively good shape. The modern Universal Bank also has access to a broader range of fundraising activities, making it easier to raise capital in tough times. However, as with any entity, the success of modern Universal Banks depends mostly on successful management as opposed to mere regulation. Strong leadership and well thought-out risk mitigation strategies will determine the success of the Universal Banking movement.
Just after I posted this, on late Sunday (September 21st) night, Goldman Sachs and Morgan Stanley, the last two independent investment banks on the Street, decided to turn themselves into full fledged bank holding companies - read here! So the Glass Steagall Act era truly ends today!
Fannie Mae and Freddie Mac - Flattened by the Credit Crunch?
Life used to be very simple in small towns across the US before the so called "Credit Crunch" came forth…
Joe Buyer and his wife Kim Buyer have a kid and want a new house to raise a family.On a Tuesday afternoon they meet with their local bank’s loan officer, who stamps his approval on a mortgage that Joe and Kim may or may not be able to afford.The loan officer forwards the loan to his bank’s treasury department, which eventually flips the loan to the Federal National Mortgage Association (affectionately known as Fannie Mae).The cash proceeds from the sale of the loan are used to make more loans to other Joes and Kims.The profits from all of these loans are used to purchase “safe and stable” investments—like Fannie Mae preferred stock.
We all know the not-so-storybook ending to this scenario. What was once a win-win for all involved parties (new house, soaring profits, high stock price, great CEO bonuses) has now turned into a situation where literally everyone loses (no house, no profits, crashing stock, CEOs fired). With the recent announcement that the United States Treasury has taken over Fannie Mae and its fellow Government Sponsored Enterprise (GSE), Federal Home Loan Mortgage Association or Freddie Mac, hopefully this tragic tale can find somewhat of a bitter-sweet twist!
Though most view the bailout as a positive (stock markets around the world soared on the following day), there are bound to be casualties. Those hit hardest will likely be smaller regional banks, with large percentages of capital tied up in Fannie and Freddie preferred stock.
Community and Thrift Banks across the US – like Midwest Banc Holdings, Gateway Financial and Cascade Financial, names that many of you may not recognize or read about in prominent newspapers - all hold millions in Fannie and Freddie preferred stock. The value of these preferred securities is now a fraction of par and financial institutions that hold Fannie and Freddie preferred stock will likely be forced to take a large impairment charge. The US Treasury and Federal Reserve have hinted at some sort of support for Capital Restoration (through the now famous "back-stop" mechanism), but that is probably not going to happen without a lot of debate and pain to the tax-payer! The dénouement of the Fannie and Freddie tale is going to be played out across the smaller towns and communities of the US, where Regional Banks and Thrifts form the bulwark of the local economy.
Cut to Wall Street: For a large bank like JP Morgan Chase this isn’t a big deal, projected write-downs are only about 5%-6% of the investment bank’s estimated 2009 profit-per-share. But, for a smaller bank that doesn’t have a comparable capital base, a large write-down can be a crippling blow. Analysts believe that many smaller banks will have to raise capital, and some may even be forced to find a buyer.
In hindsight, many of these problems could have been prevented through specific interventions by the Risk Management function at Banks and Financial Institutions. The US subprime crisis, arguably, has its roots in deteriorating underwriting standards. It was exacerbated by lax credit risk measurement for retail mortgage lending (if you are the analytical type, read a related article that I had co-authored last year as part of FINsights, Infosys' Journal of Thought Leadership for Banking and Capital Markets). Better and robust risk management systems and processes will need to be implemented on priority across Regional Banks in the US. While Basel II touches the top dozen or so Banks in the Country, it is probably relevant to cascade down appropriate flavors of the Regulation to the smaller entities as well. Above all, there is that element of folksy, old fashioned common sense that needs to be brought to bear in good measure, while lending – always keep a safe margin on the collateral that is being provided!
Fannie and Freddie themselves needed to have focused on managing risk exposures better, given their GSE mandates. There are various theories out there about how they could have stayed much "lower on the risk curve" by sticking to their core and guaranteeing mortgages without necessarily owning them – but enough has been said over the past 48 hours or so since the storied "bail out"! Do you think the US Government takeover of Fannie and Freddie is a step in the right direction? I would love this debate to continue and look forward to your comments.