The Missing Volkswagen Moment

This discussion applies to those offending large banks operating primarily out of New York, Charlotte, London, Frankfurt, and Zurich; their insurance company accomplices, shadow bank allies, credit rating agency enablers; and the (thankfully only a handful) of their regional bank understudies... all of whom formed the nucleus and spawned the genesis of the financial crisis that ultimately brought on the Great Recession.  

When it comes to the reputation of banking and bankers in the U.S. today, the general public has a bifurcated perception of the banking industry.  They hold generally positive views of community and regional banks, but continue to hold distinctly negative views of our nation's largest banks as a group.  A perception that is likely to linger indefinitely until the previously bad-acting banks create their own "Volkswagen Moment".

By Volkswagen Moment, I mean a purposeful emulation of Volkswagen's frank public response thus far to the deception it perpetrated on unsuspecting diesel engine car owners and government environmental regulators when it was revealed that its engineers purposely installed "defeat devices" in those cars.  The Volkswagen CEO at the time, Walter Winterkorn, admitted to the misconduct; apologized to its customers, employees, and the public; committed to cooperate fully with the authorities; and pledged to make amends for its actions in order to rebuild trust in the company:

“The irregularities that have been found in our Group’s diesel engines go against everything Volkswagen stands for. At present we do not yet have all the answers to all the questions. But we are working hard to find out exactly what happened. To do that, we are putting everything on the table, as quickly, thoroughly and transparently as possible. And we continue to cooperate closely with the relevant government organizations and authorities. This quick and full clarification has the highest priority. We owe that to our customers, our employees and the public. Manipulation and Volkswagen – that must never be allowed to happen again.

Millions of people all over the world trust our brands, our cars and our technologies. I am deeply sorry that we have broken this trust. I would like to make a formal apology to our customers, to the authorities and to the general public for this misconduct. We will do everything necessary to reverse the damage. And we will do everything necessary to win back trust – step by step.

In our Group, more than 600,000 people work to build the best cars for our customers. I would like to say to our employees: I know just how much dedication, how much true sincerity you bring to your work day after day. Therefore, it would be wrong to cast general suspicion on the honest, hard work of 600,000 people because of the mistakes made by only a few. Our team simply does not deserve that."

Now let's look at the role of large financial institutions in the origination and/or distribution of low-doc/no-doc/fake-doc subprime mortgages prior to the Great Recession.   Many of those loans were made to NINAs (borrowers with No Income/No Assets) then packaged into complex and toxic CDO (Collateralized Debt Obligation) securities with integrated or attached derivatives and then marketed to mostly institutional investor chumps.  It was like the Volkswagen "defeat device" deception and misconduct, except that Volkswagen's misconduct is unlikely to drag down the world economy.

While we've had dribs and drabs of muted individual apologies mentioned in passing during press interviews from the Captains of Finance in the major banking centers around the world, there has been no unified, publicly cathartic, apology from the major players involved.  Certainly none as definitive and forceful as that made by Volkswagen.

Instead, the Captains of Finance (and their lawyers) have chosen to fight a long, numbing war of attrition with their checkbooks, forcing regulators and injured customers to spend money and time to flush out their wrongdoings before they ultimately settle things out of court.  This behavior has been wittingly abetted by a U.S. Department of Justice which has held only a handful of small-fry individuals accountable and boasts not a single high-profile banker prosecution.

As the New York Times noted in a 2011 story:

"This stands in stark contrast to the failure of many savings and loan institutions in the late 1980s.  In the wake of that debacle, special government task forces referred 1,100 cases to prosecutors, resulting in more than 800 bank officials going to jail. Among the best-known: Charles H. Keating Jr., of Lincoln Savings and Loan in Arizona, and David Paul, of Centrust Bank in Florida."

Even former Federal Reserve Chairman Ben Bernanke has been recently critical:

  "...but it would have been my preference to have more investigation and individual action, since obviously everything that went wrong or was illegal was done by some individual, not by an abstract firm."

So all that brings me to a much more pleasant part of the discussion, a recent speech by Sabine Lautenschläger, Member of the Executive Board of the European Central Bank and Vice-Chair of the Supervisory Board of the Single Supervisory Mechanism.  The title of her September 28, 2015 speech was: Reintegrating the banking sector into society -- earning and reestablishing trust.

The speech is a must-read for anyone who has thought about this issue, as it presents an excellent analysis of the topic and a useful road-map of recommended actions for bankers (and regulators) to use, going forward, to help rebuild the trust of the public.

However, the effectiveness of these actions will fall well short of their potential in the absence of a critical prerequisite:  a public admission of prior misconduct; an apology to customers, shareholders, and the public; and a commitment to both make amends for the past misconduct and take steps to ensure that it doesn't happen again.

We won't be able to sweep away the lingering public suspicions and the empty feeling of incomplete justice without some kind of collective emotional closure on the painful and costly events of the past.  In other words, the parties involved still owe everyone a Volkswagen Moment.

The Sacrifice of Virtue

Credit: Darren Walsh

  

On May 20, 2015, five multinational banks agreed to collectively pay roughly $5.6 billion in fines and penalties to regulators and law enforcement agencies in the United States and the United Kingdom.  Four of those banks (Citicorp, JPMorgan Chase & Co., Barclays PLC, and The Royal Bank of Scotland PLC) agreed to plead guilty to felony criminal charges of foreign exchange price manipulation between December 2007 and January 2013 (varies according to bank).  One bank, UBS AG pleaded guilty to wire fraud in relation to another matter, but was granted conditional immunity from the foreign exchange price manipulation charges because it was first to report it.  The banks also agreed to three years of corporate probation.

In keeping with the post-Enron C-suite tradition of using one's employees as human shields (by invoking memories of the 2002 demise of the public accounting firm Arthur Andersen) and by frightening regulators with hypothetical systemic apocalypse scenarios; these guilty pleas weren't even signed until the U.S. Securities and Exchange Commission (SEC) provided assurances that certain capital markets waivers would be granted to the banks involved.  Now, the U.S. Department of Labor is being heavily pressured to issue its own waiver as to whether these banks should be allowed to manage retirement accounts.

For the purposes of discussion, let's set aside the accountability that comes from government law enforcement and the inevitable follow-on civil litigation (as being one thing) and focus on our own collective behavior as consumers of financial services (as being another thing).

One would tend to think that in living rooms and in corporate boardrooms across the world, people would be reassessing their business relationships with financial services providers that fail to live up to our accepted standards of business ethics... one basic ethical standard being: not violating our criminal laws.

The American Bankers Association (ABA) stayed mum regarding this legal settlement.  Not a word of this in their Press Room and lists of public correspondence.  A policy of silence and disengagement was apparently chosen as the best way to handle family shame.

The energetic and feisty Independent Community Bankers of America (ICBA), on the other hand, sent this letter to U.S. financial regulators expressing sanctimonious outrage and declaring (once again) a regulatory double-standard in this legal settlement.

But surely, the virtuous members of both banking trade associations also scrambled to reassess any correspondent banking and vendor business relationships with the felon banks?

After all, would an employer hire a job applicant with a recent criminal record?  Would investors trust their personal wealth to a broker or financial advisor with a past criminal record?

Add to all that, the ample pool of alternative purchasing choices.  There are many law-abiding banks in the global marketplace that offer similar or identical financial services.

Sadly, you know the answer as well as I.

Scholars have done marketing research on topics like: Is information about whether a firm acts ethically an important consumer concern?  And, if so, will information about a firm's behavior influence their purchase decision?  You would think, in the abstract, that the answer would be an unequivocal "yes".

A research paper in the Journal of Consumer Marketing indicates that, except in the most egregious cases, "consumers do not wish to be inconvenienced, and ethical purchasing will only take place if there are no costs to the consumer in terms of added price, loss of quality, or having to 'shop around' " ...  "The depressing reality is that many ethical abuses can still continue to be carried out by companies without any negative impact on consumer buyer behavior."

I'm a little disappointed by our sacrifice of virtue, but we all get the point. However, there must be, after all, a ceiling (or is it a floor?) on corporate and individual consumers of financial services being numb and lethargic about business ethics?  Does our passivity also make us enablers?

An attorney once told me about a concept called "Does it pass the puke test?"... behavior so contemptible that it makes you want to throw up.  Apparently, at this juncture, we consumers of financial services have opted for living with a free-floating feeling of nausea about the behavior of bad players in the banking industry.  As the colloquial saying goes... we could taste it in our throats, but managed to keep it down.

In today's upside-down world of finance, federal law forbids a person with a criminal record, involving dishonesty or a breach of trust, to work for a bank (without a rare waiver from the FDIC); but, it's OK for a bank with a criminal record to work for us.

FinCEN's Financial Drone Strike

While in Madrid, Spain a couple of weeks ago on other business, morbid curiosity drove me to pop on over to the city's highly affluent and chic Salamanca District to view (figuratively speaking) the smoldering remains of a U.S. financial drone strike.  As I got off the bus, I saw over there by the Hard Rock Cafe, tucked away in a corner off the Plaza de Colón, the head office of Banco de Madrid, SA.

A sad sight indeed.  As I walked over to the small plaza in front of the bank, there was evidence of the removal of the bank's large signage from the building's roof-line.  Gilded lettering, identifying the bank, had been pried off of blocks of granite in the pedestrian plaza, leaving just a faint outline of the bank's name where the harsh sun of the Castillan meseta was unable to bleach the stone.  Like a tombstone without an epitaph, the bank's name remained on the transom above the building's main entrance door.

In front of that main entrance stood a solitary security guard, shooing off inquiring passers-by while allowing other building tenants through the door.  Very few people came or went during the time I spent pondering and reflecting on this situation.

You see, Banco de Madrid (BdM) is a bank in liquidation.  Without advance warning, on March 10, 2015, the Financial Crimes Enforcement Network (FinCEN), an arm of the U.S. Treasury Department, fingered its parent company, Banca Privada d'Andorra (BPA), as a "foreign financial institution of primary money laundering concern" for abetting transnational organized crime in Russia and China, as well as corrupt officials in Venezuela.

Andorra, a tiny sovereign principality high in the Pyrenees mountains, has five banks.  BPA is one of them.  From 2009 to 2014, BPA was alleged to have provided assistance to third-party money launderers, "including professional gatekeepers such as attorneys and accountants", by laundering hundreds of millions of dollars through correspondent bank accounts at four U.S. banks.  In return, BPA's high-level managers accepted payments and other benefits from their criminal clients.

The same day of FinCEN's announcement, the National Andorran Finance Institute (INAF) decided to intervene BPA "to guarantee the continuity of its operations."  Andorran authorities also later arrested BPA's Chief Executive Officer on suspicion of money laundering.

Concurrently, the Bank of Spain also seized BPA's 100%-owned banking subsidiary in Spain - BdM.  Shortly thereafter, a crushing wave of funds withdrawals by customers left BdM unable to meet its obligations in a timely manner.  When Spanish authorities refused to bail out the bank, the bank filed for bankruptcy protection on March 16, 2015.

From a human perspective, there is no denying a degree of unfortunate collateral damage from FinCEN's financial drone strike as it impacted BdM's unsuspecting Spanish bank customers and bank employees who were not involved in aiding and abetting money laundering.  FinCEN noted that "BPA's activity of primary money laundering concern occurred largely through it's Andorra headquarters." FinCEN never mentioned BdM in its news release.

Fortunately, most of BdM's bank customer deposits were insured.  But for the estimated 500 clients with uninsured deposits, they get receivership IOUs.  Those bank employees who are unable to secure new jobs at other banks, will join the swollen ranks of Spain's unemployed.

The take-away?  FinCEN can exert brute force with a blunt instrument against any bank in the world.  It gives new meaning to the concept of "U.S. global force projection"... a term usually associated with our warriors at the Pentagon.

Unlike the genteel megabank check writing-for-wrongdoing exercises engaged in by other U.S. banking regulators, the long arm of U.S. law enforcement, as practiced by FinCEN in its PATRIOT Act Section 311 proceedings, ends in a tightly clenched fist, and sometimes a financial mushroom cloud.

So over there in the center of Madrid's Plaza de Colón, standing on a high marble pedestal, is a larger-than-life statue of Christopher Columbus gazing west towards the Americas.  Maybe he should also be scanning the horizon for FinCEN drones.

G-SIB Failures: Either Way, You Pay

Credit: Thierry Cheverney

I have been reading the public responses to the November 2014 Financial Stability Board (FSB) consultative document on "Adequacy of Loss-Absorbing Capacity of Global Systemically Important Banks in Resolution"   This consultative document frames the broad outlines of what will eventually constitute the international framework for the bank "bail-in" process.  A process meant to (hopefully) minimize the impact of a bank failure on financial stability, (hopefully) eliminate future bank bailouts by governments, and (hopefully) do away with the "too big to fail" concept.

In its most general sense, the idea of a "bail-in" is to have Global Systemically Important Banks (G-SIBs) maintain a layer of  Total Loss-Absorbing Capacity (TLAC)-eligible liabilities in an amount sufficient to convert (some or all) of the bank's obligations to unsecured and uninsured creditors into a confidence-inducing chunk of bank equity capital.  The debt-to-equity conversion would be triggered should the bank's existing shareholder's equity cushion be depleted by losses.  

Think of the G-SIBs as the supertankers of global banking and their skippers, our Captains of Finance.  Many years ago, changes were made to the structural integrity of our global fleet of petroleum supertankers.  Most of the fleet transitioned from single-hulled vessels to double-hulled vessels in the interest of greater public safety.

TLAC works in much the same way - the first hull (and line of defense) is shareholder capital, the second hull (and line of defense) are the monies owed to unsecured and uninsured creditors that can be converted to equity capital.

It's the intent of the FSB to identify a TLAC of sufficient thickness to help avoid a financial Exxon Valdez disaster - a supertanker that lacked a double-hull at the time of its grounding in Alaska in 1989.

The consultative document proposes a minimum TLAC requirement of approximately 16-20% of risk weighted assets and 6-8% of total assets or at least twice the Basel III leverage capital requirement, excluding any Tier 1 common equity used to meet any applicable capital buffer requirements.

The public responses, which come from banks, trade associations, academia, rating agencies, and others, are supportive of the "bail-in" idea in general, but differ on interpretations of the proper size of the TLAC cushion, eligible TLAC debt instruments, and the issue of pre-positioning TLAC  - both from a home country/host country perspective and from the perspectives of single point of entry (SPE) resolution and multiple point of entry (MPE) resolution.

There are two things that make me uneasy about the proposed bail-in regime.  One is the compartmentalized approach regarding bank insolvency and the other is this annoying hallelujah chorus that is proclaiming the end of costs to taxpayers by eliminating government bank bailouts of G-SIBs.

Bail-ins for G-SIB leviathans will likely shift the costs to taxpayers from one government expense bucket (targeted bank bailouts) to a different government expense bucket (economic stimulus programs).  Because of the immense size of the G-SIBs relative to any measures of GDP (country, regional, global), the losses sustained by a G-SIB failure will likely be destabilizing to real economies. When it comes to a G-SIB resolution, government pays, either way.


A compartmentalized approach

It is important to remember that banks can fail in two ways.  First, there is the classic equity insolvency.  Losses erode the shareholder capital of the bank until the point where government authorities trigger their on-the-shelf resolution plans and wind down the affairs of the bank.

The other bank failure vector is a liquidity insolvency.  A bank is unable to meet funding demands and the central bank (as lender-of-last resort) cannot continue to support the bank's liquidity due to lack of eligible collateral or it unilaterally decides to terminate lifeline funding to the bank.

TLAC deals with the classic equity insolvency.  It doesn't appear to me to deal with the potential of liquidity insolvency.  And most important, it doesn't discuss the calculus of the critical dynamic inter-relationships between capital and liquidity in times of financial stress.  Mandatory liquidity coverage ratios will buy time, but are not themselves a solution.

A key question: Will market participants lend funds (without asset pledges) to a "bailed-in" bank absent government guarantees, when there might be marketplace uncertainty about how deep the bank's capital hole really is?

In the fog of a financial crisis, transparency and truth are always the first casualties.  Information is incomplete, rumors abound, and it always takes some time for the second shoe to drop.  And like all rational players (who tend to prefer pleasure to pain), institutional funds providers, honoring their own fiduciary responsibilities, might just stand on the sidelines.

The paper obliquely hints at these difficulties, when the authors say:

"Resolution is not resurrection.  But nor is it insolvency: the institution or successor institution (e.g., bridge institution) has to meet at least the minimum conditions for authorization in order that supervisors may allow it to continue performing authorized activities, in particular critical functions.  Moreover, the reorganization or solvent wind-down that will be necessary following resolution may require a level of capitalization above that required by supervisors so that counterparties continue to trade with the resolved firm and provide funding to it."

Size Matters

Second, the hallelujah chorus ignores the implications of the total cost of a G-SIB failure.  It's not that living wills, the bankruptcy process, and orderly liquidation authority cannot wind-down one or more of any failing G-SIBs by bailing-in shareholders, unsecured creditors, and uninsured depositors.

But at the bail-in point, how large are the cumulative financial losses sustained by legacy shareholders and those now bailed-in?  And second, how will those cumulative financial losses be subsequently transmitted through the national and global real economies?

Remember the sub-prime Collateralized Debt Obligations (CDOs)?  Risk managers were patting each other on the back because they had sliced and diced these financial instruments and thought they had diversified away the risk by distributing the risk to thousands of investors all over the world.  So instead of a few big losers, the smaller distributed losses dragged down economies all over the globe. Sub-prime lending triggered, not only a recession, but this era's mother of all recessions - the Great Recession.

As a point of reference, a May 2012 working paper produced by the research department of the Federal Reserve Bank of Philadelphia pegs the damage (total write-downs) from sub-prime CDOs at $420 billion.

At year-end 2014, for example, the two most complex G-SIBs, JPMorgan Chase and HSBC Holdings, had total Tier 1 capital of $187 billion and $153 billion respectively.  Just pause and reflect for a moment on the size of these numbers.  These sizable Tier 1 capital numbers, when translated into potential bail-in-able dead-weight losses (not even considering the contagion/propagation effects of investor debt leverage) could, individually or collectively, induce recessions in the real economy.

To paraphrase Ross Perot, what you would likely hear "is the giant sucking sound" of aggregate economic demand dropping due to understandably defensive financial behaviors on the part of the injured legacy shareholders, the new bailed-in shareholders, and some portion of the now understandably frightened creditors in the G-SIB.

So either way, government pays for G-SIB failures.  In a bail-in, TLAC regime, government expenditures will likely be in the form of economic stimulus or rehabilitation programs instead of targeted bank bailouts.  Remember, the world has experimented with the bail-in concept during the banking crisis in Cyprus in 2013.  The deep scars from that country's economic upheaval have yet to heal.

It is the size of the cumulative loss to the bailed-in shareholders, creditors, and uninsured depositors that needs to be reduced in order to limit the impacts to the real economy of G-SIB failure.  That argues for less market share concentration in the market for banking services globally.  If we want to contain the economic damage from the failure of a G-SIB, and limit the costs to government, the smaller the all-in costs of G-SIB failure, the better.  Until G-SIBs get smaller, either way, government will pay.

"All for One, One for All"

(An Encore)

Sadly, passing with scant notice by the banking industry media this month was an important 2015 news release by the Office of the Comptroller of the Currency (OCC).   The news release heralded the distribution of an OCC white paper titled: "An Opportunity for Community Banks: Working Together Collaboratively".  The paper presents the OCC's views on collaborative efforts by community banks and also describes how community banks can pool resources to obtain cost efficiencies and leverage specialized expertise.

"As diverse as community banks are, they share the same commitment to supporting the communities they serve.  With this in mind, the OCC sees an opportunity for community banks to share resources and expertise to the mutual benefit of all involved.

Some community banks may have excess capacity or may have developed platforms or expertise that enable them to provide shared services to other community banks that may not have sufficient resources or demand.  Other community banks may look to collaborate with fellow community banks that share the same core values as a cost-effective way to meet growing demands while retaining their individual identities."

In today's world of continually narrowing net interest margins and the shrinking availability of "sugar high" one-time gains opportunities (like releases from loan loss reserves, profits from investment portfolio securities sales, and 'ringing the register' on deferred tax assets), the inexorable additional step (absent sale of the bank) has to be an increased focus on the control of non-interest expenses.

A ever-increasing part of those overhead costs, in these these post-PATRIOT Act/post-Dodd-Frank Act days, is the cost of regulatory compliance and the almost unavoidable expenditures (for community banks, at least) for the army (yes, it's an army these days) of regulatory compliance cling-ons --- bank consultants (guilty as charged) .

Oh, and let's not forget that army's camp followers - the inevitable information technology (IT) expenditures that often dwarf the consulting fees.

In this OCC paper, we have a major federal bank regulator acknowledging the burden and encouraging banks to seek cost-saving opportunities by leveraging the power of further collaboration... and then outlining the ground rules for doing so prudently.

Waiting for the Federal Reserve to "normalize" interest rates in order to kick start industry net interest margin expansion (and bank profits), in the population of banks that are asset-sensitive, could be like waiting for rain during a drought.  The path to that interest rate normalization in the United States, seemingly visible on the horizon a few weeks ago, could now be extended given the tit-for-tat central bank beggar-thy-neighbor actions taking place in Europe and Japan.  

Two years ago, the Federal Deposit Insurance Corporation (FDIC) also noted these cost burdens in a series of community banker interviews.  Back then, I commented that the full realization of the benefits of legal cooperation among community banks had yet to be achieved.  Now the OCC has surfaced the issue once again.

So here is the earlier blog post:

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March 14, 2013

I wanted to comment on the recent FDIC Community Banking Study.  It's a very nice piece of work, highly recommended.  Its data-driven triangulation of the profile of the community bank population should help immensely as opportunities, costs, and regulatory burdens for community banks are debated and deliberated upon in policy circles.

The community banker interviews, discussed in Appendix B of the study, haven't received much banking media attention, but deserve to be highlighted.  The study's authors conducted interviews with nine community bankers to understand what drives the cost of regulatory compliance.  While that may be a small sample size, the collective opinions of these nine community bankers merit attention.

Here are some clips:

“Most of the interview participants stated that no one regulation or (supervisory) practice had a significant effect on their institution.  Instead, most stated that the strain on their organization came from the cumulative effects of all the regulatory requirements that have built up over time.”

“Most of the interview participants indicated that they consider regulatory compliance as part of the normal cost of conducting business.  Consistent with the notion that these costs were a normal part of business, the interview participants noted that their overall business model and strategic direction had not changed or been affected by the regulatory compliance cost issues.”

“While the primary goal of the interviews was to identify what drives regulatory compliance costs at community banks, two related themes emerged.  A majority of the interview participants discussed their increasing reliance on consultants and their dependence on service providers....

...Many of the interview participants stated that their increasing reliance on consultants is driven by their inability to understand and implement regulatory changes within required timeframes and their concern that their method of compliance may not pass regulatory scrutiny...

...With regard to dependence on service providers, each of the interview participants noted that they had contracted with at least one firm to provide products and automated processes that provide a cost-effective means of complying with certain regulations.  While these service providers are considered beneficial to their bank's operations, interview participants noted that these firms have few incentives to make timely changes to their software to meet new regulatory requirements.  These time delays could affect their bank's ability to comply with new or changed rules.”

One option community banks might consider to deal with the increasing reliance on consultants and the concern about service provider responsiveness is confederation. Confederation describes a type of organization which consolidates authority from other independent and autonomous bodies.

In the community bank context, it might be a central organization that uses the collective leverage of its members to drive down consultant costs, be a clearinghouse for compliance solutions, or possibly promote standardized compliance solutions among its members.  A confederation has the potential to use its muscle to improve servicer responsiveness or, in some cases, potentially replace vendors entirely and provide those services to members on a not-for-profit basis.

One example of a confederation in another industry is the Independent Grocers Alliance (IGA).  The Independent Grocers Alliance was started in May 1926 when a group of 100 independent retailers organized themselves into a single marketing system.  Contrasting with the big chain grocery store business model, IGA operates through stores that are owned separately from the brand.  But like the big chain stores, IGA provided their local members with common branding, technical support, a distribution network, and the leverage of the consolidated buying power of its members.

Today, IGA has expanded into the world's largest voluntary supermarket chain with more than 5,000 member stores worldwide.

To varying degrees, and in several respects, banking trade associations have taken many of the steps toward stronger confederation among community banks.  Some have subsidiaries that provide compliance management consulting services and certain vendor platforms.  But as the comments made by these nine community bankers seem to indicate, there are opportunities for further advancement.