Monday, April 29, 2013

NCUA, Where are You?

One of the things that comes with combining the roles of credit union industry cheerleader, regulator, and deposit insurer into one federal government agency is that conflicting motivations can lead to inaction, or maybe, confusion.  That may be the case now with the National Credit Union Administration (NCUA).  The agency either has a short memory or is suffering from an acute case of somnambulism.

The Baltimore Business Journal recently reported that the Navy Federal Credit Union, the largest credit union in the United States, is marketing 100% financing, no-money down mortgages.  No down payment, no private mortgage insurance, and jumbo loan amounts up to $1 million dollars.  Here's the press release from the Navy Federal Credit Union hawking the product.  According to the Business Journal article, Navy Federal originated $740 million of these loans in 2012, about 7% of its total mortgage originations.

The credit union touts its lower-than-average default rate, but did anyone in the executive suites of both the Navy Federal Credit Union and the NCUA think about the signal this sends to the national mortgage markets and the potential for creating another slippery slope to national financial disaster?

Need we remind the NCUA that we experienced the most severe housing downturn since the Great Depression due to liberal, sometimes nonexistent, mortgage loan underwriting practices?  Everyone assumed that the never-ending escalator of rising home values would bail out the credits.  What all-seeing oracle in the corporate sanctum of the Navy Federal Credit Union, with apparently extraordinary powers of prophecy and prognostication, can ensure against a double-dip in the current weak real estate recovery?

With all of the concern about home buyers having significant skin in the game and, post-Dodd-Frank, lenders being legally liable for ensuring borrower repayment capacity, why on earth would the NCUA, as credit union regulator and deposit insurer, allow this product to be marketed?  

In early April, Bloomberg News reported that the Navy Federal Credit Union is unlikely to be designated "systemically important" by the Financial Stability Oversight Council (FSOC).  The Navy Federal Credit Union had $54 billion in total assets as of March 31, 2013.  If the FSOC does not designate the Navy Federal Credit Union as "systemically important", it should at least add the NCUA to its list of systemic risks.

Monday, April 22, 2013

Just Too Damn Big!

It's interesting to see the three-way debate occurring on the banking topic of Too Big To Fail (TBTF) and the six-pack of U.S. banks considered to be in that category - JP Morgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs, and Morgan Stanley.

On one hand, you can read an opinion piece titled "Small Banks Will Benefit From Big-Bank Breakup".  On the other hand, you can read an opinion piece titled "Small Banks Will Suffer From Big-Bank Breakups".  And on your third hand, you have the Undersecretary of the Treasury for Domestic Finance, Mary Miller, giving a speech confident that the Dodd-Frank toolkit has made TBTF a thing of the past.

Something is either lost or unspoken in the three-way mega-bank failure debate - containment of the costs of bank failure.  It's not that living wills, the bankruptcy process, and orderly liquidation authority cannot wind-down one or more of any failing so-called TBTF banks by bailing-in shareholders, creditors, and uninsured depositors.  The fact that resolution/liquidation authority is invoked in a bank failure scenario means that the bank has already burned-through higher capital requirements.  So at that point, the issues are, first, how large are the cumulative financial losses sustained by those bailed-in; and second, how will those financial losses be subsequently transmitted through the national and world economies.

Dodd-Frank limits on counter-party exposures only broaden the number of bailed-in entities, and through a negative network effect, we may have replaced the dangers of potential systemic financial collapse with a financial version of a systemic pandemic.  In medical terms, widespread illness instead of death.  There's obviously an improvement in terms of financial system stability, but not necessarily in the cumulative negative economic impacts of bank failure.  To use an internet connection analogy to illustrate a negative network effect:  too many users ( in this case, losers) can cause congestion and slow the speed of the connection and decrease the usefulness for everyone (impact on the national and world 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.

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 economic impacts of bank failure.  That argues for less market share concentration in the market for banking services in the United States and globally.

So it's not that the six-pack of  U.S. mega-banks are Too Big To Fail.  It's not that the TBTF debate is about a glass that is half-empty or half-full.  The underlying problem is that the glass is too big.  If we want to contain the economic damage from the failure of a bank, and limit contagion, the smaller the costs of bank failure, the better.

Of course, there are other relevant issues.  In testimony before the Senate Judiciary Committee, the Attorney General of the United States, Eric Holder said  "But I am concerned that the size of some of these institutions becomes so large that it does become difficult for us to prosecute them when we are hit with indications that if we do prosecute --- if we do bring a criminal charge --- it will have a negative impact on the national economy, perhaps even the world economy.  I think that is a function of the fact that some of these institutions have become too large." 

Set aside the academic economic minutiae-parsing and the tomato tossing by the media and community bank advocates and admit that, even with a Dodd-Frank resolution and orderly liquidation process that works, the overall societal costs of  the failure of a mega-bank continue to be source of high anxiety to most people.  It could be that the globe's largest banks are just too damn big!

Friday, April 19, 2013

A Helping Hand

Last week, I attended the Bank Director Workshop sponsored by the National Association of Corporate Directors (NACD) and the American Association of Bank Directors (AABD) in Ft. Lauderdale, Florida.   I had attended the workshop in previous years as an Office of the Comptroller of the Currency (OCC) panelist on the Regulatory Roundtable part of the agenda, but always had to leave immediately thereafter.  Since according to OCC ethics rules, the unpaid exposure to additional banking knowledge at a conference or workshop is considered a gift to a national bank examiner.  A violation of federal criminal law for which a national bank examiner could be disciplined, fined, or potentially face jail time.  I am not making this up!

However, now retired and graciously invited by accomplished author and AABD Chairman Emeritus, Charles Thayer, I was able to attend the entire bank director workshop program.  The program ranged from a lessons-learned discussion of FDIC director suits; trends in board and executive compensation; audit committee issues; bank merger and acquisition trends; the regulatory roundtable; and an impressive presentation by keynote speaker – Charles Vice, Commissioner for the Kentucky Department of Financial Institutions, and the Chairman-elect of the Conference of State Bank Supervisors.

The responsibilities of a bank director continue to be under-appreciated.   It is (normally) a part-time position that, due to being at the apex of the bank managerial pyramid, is ultimately legally accountable for everything that occurs in the bank.  However, the evolving regulatory burden being shouldered by well-meaning bank directors is usually met with a shrug by others – it is what it is, right?

Last year, David Baris, Executive Director of the AABD, commissioned a study to determine the legal touch-points that apply to bank directors.   The study, Bank Director Regulatory Burden Report, identifies over 800 legislative and regulatory provisions that impact bank directors.   In a statement upon its release, Baris explained “It is evident that no one – not Congress or the federal banking agencies – is evaluating the aggregate effect that legislative and regulatory actions are having on the duties and responsibilities of bank directors.”

Director education is an important way of helping bank directors understand and execute their duties.  Low or no cost director workshops are offered by many of the banking agencies.  OCC also sponsors CEO and director outreach events.  Educational booklets and pamphlets are available.  The AABD also offers its own director education curriculum.

But education is one thing, advocacy is quite another. When it comes to the layering on of additional regulatory requirements, as long as bank directors continue to take it, they will continue to get it.  The AABD is the only organization that exclusively advocates for the interests of bank directors.  The AABD's 2013 Advocacy Agenda is both expansive and aggressive.  I'm not affiliated with the organization, by the way, but applaud its efforts and objectives.

Bank directors will find it wise to take the helping hand extended by an organization exclusively devoted to promoting their interests and help turbo-charge the process of pushing back on the regulatory burden being heaped on bank directors.

Monday, April 8, 2013

Unintended Consequences

Last week, Bloomberg News reported on leaked draft bill language seemingly sponsored by Senators Sherrod Brown (D-Ohio) and David Vitter (R-Louisiana) which would hold all banks to a higher capital standard (at least 10%  tangible common equity for all banks) than the level required by Basel III.  It would also create an additional penalty capital surcharge of up to 5% on institutions larger than $400 billion in assets.

The capital standards "shall reflect the historical equity ratios chosen by large depository institutions before the advent of the Federal Reserve, federal deposit insurance, and the income tax encouraged depositories to favor more more highly leveraged deposit and debt funding."  So basically, the 19th Century railroad tycoon-era bank capital ratios in existence when bankers wore vests, pocket watches, and either sported pince nez eyeglasses or monocles.  It's back to the future, folks.

The Brown-Vitter draft also opts out of Basel III altogether, prohibits affiliate transactions in large banks, prohibits government support to non-bank affiliates, repeals Section 806 -Financial Market Utilities - of the Dodd-Frank Act (considered a back-door bailout), and ends the systemic risk exception established by the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA).  During the recent financial crisis, the FDICIA systemic risk exception was invoked for Wachovia, Citigroup, and for the establishment of the FDIC's Temporary Liquidity Guarantee Program.

The draft bill text can be found on Quartz.

First a couple of disclaimers, I am not enamored with Basel III in its current form.  It is an overly complicated, over-engineered structure that just begs to be gamed by the banks subject to its provisions.  It's complexity will create a growth industry in even more finely-parsed regulatory interpretations and more steady work for consulting firms.  Its own complexity dooms it to irrelevance as times and circumstances change.  Someone should have listened to Einstein when he said "Everything should be made as simple as possible, but not simpler."

On the mega-banks, I'm no advocate.  I believe a handful of the largest of them have become too large to properly manage, regulate, and supervise.  This belief also applies to the Federal government generally.  I remember a TV pundit years ago say  "Government is like alcohol.  It is medicinal and salubrious in moderate quantities, but in immoderate quantities, it creates dependency."  That thought could be extrapolated to the Too-Big-To-Fail banks.  We have become dependent on their continued existence because we fear the consequences of withdrawal.  I prefer the clean surgery of traditional anti-trust breakups - Standard Oil in the 1911, A.P. Giannini's  Transamerica in 1952, AT&T in 1984.

Focusing only on the (up to) 5% penalty capital surcharge part of the draft bill language, affecting a half dozen of the largest banks, the mechanism chosen by the drafters has the potential to raise systemic risk in the banking system, impose serious explicit and opportunity costs on both borrowers and savers, and may costs jobs as large banks reconsider the status of their present legal form and jurisdictions.  Higher capital requirements also mean less lending and economic development.

First, on increasing risks to the banking system and costs to borrowers and savers.  I hope you will agree that extra/excess capital has a cost.  Like any merchant, when the cost of one of your business inputs rises, you could pass those costs on to the consumer (raise loan rates or lower deposit rates), reduce overhead costs, or accept reduced profitability.  The ability to pass on costs by raising prices is constrained by the elasticity of demand for your products and market structure of your industry. A monopolist would have little problem passing  increased capital costs along in the form of higher prices  The banking industry in the United Sates, however, is more like an oligopoly.

According to the FDIC, in 2011, there were 7,357 banks and thrifts.  Of those, 107 (1.5%) were banks and thrifts over $10 billion in assets.  Those 107 banks and thrifts represented 80% of industry assets.  The top four banking organizations (JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo) alone accounted for 44% of industry assets. 

If we believe economic theory on oligopolies, the largest banks, having roughly half of the industry's market share, are market price leaders in terms of sending product price signals to the rest of the industry.  A prime or base rate, for example, might have a spread of 3.5 or 4 points over the fed funds rate, rather than the present 3 point spread.  However, those banks may be constrained in their pricing behavior, to a large degree, by the next tier of banks, the smaller nationwide and regional banks.  Those banks, who themselves constitute about a third of the market, would likely wholly or partially offset the ability of the largest banks to fully pass on capital costs to borrowers and savers by offering more competitive pricing themselves.

But it is also possible that this next tier of banks might also collectively (but not collusively) prefer to harvest a healthy portion of the potential gains from a price increase, while still also positioning themselves as a slightly more competitive offer in the marketplace for loans or deposits.  To the extent the next tier collectively decides to ride on the coattails of some portion of a first tier banks' price increases, those costs are borne by borrowers and savers.  But nevertheless, the ability of the largest banks to pass on the full costs of the higher penalty capital requirements is limited, to some unknown degree, by the structure of the U.S. banking market. 

So, while not having fully recouped the full increase in the cost of capital, what is a bank subject to the higher costs of a penalty capital surcharge to do?  The temptation is to reach for yield through "down and out" banking - down the credit quality scale and out along the yield curve (or also out of local markets, out of historic product lines, and out of the country).  So a panoply of systemic credit, interest rate, and liquidity risks could, counter-intuitively, actually increase under Brown-Vitter's penalty capital requirements.

And, finally, since other countries are unlikely to reciprocate with their own version of 19th Century capital standards, bank boards of directors involved have an obligation, perhaps a duty, to consider the best interest of bank shareholders relative to determining the bank's ongoing official domicile, legal forms, and the distribution of its jurisdictional presences.  Regulatory arbitrage cannot be ruled out.  

It's possible that the (up to) 5% penalty capital surcharge is meant to create an incentive for the voluntary breakup of the six banking organizations affected.  Why dither with an incentive if you can issue a breakup mandate?  A breakup could actually be win-win for everyone.  According to the Economist magazine, John D. Rockefeller profited handsomely from the breakup of Standard Oil as its pieces were worth far more apart than together.  The shareholders of these six banking organizations could reap similar benefits.  A piece of a Vampire Squid, anyone?   

Tuesday, April 2, 2013

“Nervous” Money Matters

A part of last week's blog post talked about the potential benefits of allowing national banks to secure private deposits as another means to help make uninsured "nervous" money a bit less nervous.

Then along comes the banking crisis in Cyprus and the rule book gets a re-write.  Or maybe it was already re-written and someone forgot to tell us about it.

Last week, the European Union (EU), in collusion with the International Monetary Fund (IMF), did just that with an orchestrated sneak attack on bank deposits in one of its member countries - Cyprus.  The EU and IMF insisted on the confiscation of funds from all levels of the domestic funding structure of the two largest banks in Cyprus – Bank of Cyprus and Laiki Bank -- as a condition for financial assistance.  It was only the principled and courageous intransigence of the Cypriot Parliament that insured depositors were saved from the tax levy, really a deposit-for-equity swap.  Depending on which bank the uninsured deposits hailed from, estimated losses range from at least 60% to a total loss.

Cumberland Advisors posted a nice commentary today ( ) on the topic of contagion. Their commentary is balanced, reasoned, and concerning. There are other commentators out there though, who are shrieking 'domino effect'!

It's understandable that deeply-indebted governments, and their reluctant saviors, would attempt to avoid using sovereign borrowing capacity to backstop their banking systems by using creditor bail-ins rather then TARP-like bail-outs.  It also appeals intellectually to the Prussian caveat emptor and market discipline wings of our party.  And that's fine if banks produced things like widgets and gadgets.  A few less widget and gadget producers, no sweat.

But the foundation of banking is an emotional intangible - confidence in the stability of banks and the banking system.  Without that confidence, you return to the financial panics which we thought we had eliminated with the creation of a lender of last resort and a deposit insurer in the early 20th Century.  Back then, panics moved at the speed of horse carriages or automobiles, today they can move at the speed of light.  Do we really want to explore terra incognita with the present weakened state of the global banking system?

My take on it is that the attempted confiscation of insured deposits in the developed world means that we can no longer use terms like... unimaginable.. inconceivable... implausible... when we talk about the safety of insured deposits. This is what the combination of desperation and faulty logic has brought about.   It is going to be one of many sad legacies of the continuing European financial crisis.

And if we can't use those terms any longer when talking about insured deposits, then it is not a stretch to posit that the anxiety level for uninsured deposits escalates even further.   Individual bank funding volatility becomes a larger problem when heightened anxieties, real or imagined, drive deposit placement decisions.