NorthWesternFinancialReview.com Blog

It’s crunch time in the Senate for financial industry regulatory reform. Sen. Dodd needs to get his bill passed by Memorial Day for a realistic shot at enactment into law this year.

For community bankers, it boils down to this question: Are the TBTF remedies in the legislation compelling enough for community bankers to accept additional regulatory compliance obligations?

Questions will always surround legislative efforts to resolve TBTF “once and for all.” There were a lot of people who thought we solved that problem in 1991 when FDICIA was passed, and clearly it is a bigger problem today than ever.

Resolution authority on TBTF needs to extend beyond the confines of the traditional banking industry so it can address situations like AIG. The House bill and the Dodd bill does, and that’s a good thing. But there will always be this question: Who exactly will qualify as systemically important? Is it just the 19 original TARP recipients? Is it the top 50 holding companies? Who are the non-bank companies that qualify? Who will pay into the pre-paid resolution fund proposed by the House legislation and the Dodd bill? What if a company that never paid into that fund needs special handling? What if the government decides a company that did pay into the fund shouldn’t be treated special?

And how strong will the resolution authority be if the legislation drops the pre-paid resolution fund concept, as apparently is being discussed in the Senate to win support from Republicans? 

Clearly, the largest banks in the country have a cost-of-funds advantage over community banks. But if the law does in fact end TBTF, will community banks make more money as a result of the new, level playing field?

From the perspective of sound public policy, we need to resolve TBTF, but if we do, I am not sure how much that will improve the lot of community bankers. The American taxpayer will benefit from the resolution of TBTF but only community bankers will pay any kind of a price (that is, additional reg burden). Some bankers will say it is worth that price, but I wouldn’t be surprised if some say it isn’t.

For as long as I have been covering this industry, bankers have told me that the OCC is really not interested in small banks. “They are focused on the big banks,” I have been told many times. OCC leadership obviously has heard this message and they clearly don’t like it. Many speeches delivered by the Comptroller begin with some clarification about all the community banks under OCC supervision.

“Despite my best efforts, I sometimes still confront the stereotype that the OCC is only concerned about big banks. Let me say again, emphatically, that that’s just not true,” Comptroller John Dugan told community bankers in a speech delivered March 19 in Orlando. He goes on to explain that two-thirds of OCC examiners are focused on community banks. He also noted that the agency reaches out to listen to community bankers through a variety of industry events and meetings. “My over-riding point here is that we at the OCC consider community bank supervision as core to our mission.”

Yet, I wonder whether Mr. Dugan really understands community banking. In the remainder of his speech, he talks about bank failures, emphasizing the disproportionate representation of community banks. “195 banks, nearly all of them community banks, have failed since the start of the crisis in 2008,” he says. Furthermore, he notes an “estimated cost to the deposit insurance fund exceeding $58 billion.”

Any community banker would find that observation a bit galling. Citi and BofA both failed on the OCC’s watch, but Treasury stepped in to prop them up so they were never closed. Had they failed, they would have wiped out the FDIC fund completely. I think it is pretty insensitive to talk to community bankers about the problems in community banking without acknowledging the far more severe problems in a sector of the industry where the OCC has much greater responsibility.

In the speech, Dugan noted four things that he believes regulators need in order to be effective: balanced judgment, to provide appropriate guidance, consistency and forthright engagement with bankers. The irony of his third item — consistency — is inescapable. There is nothing more inconsistent in bank regulation than regulators picking winners and losers. Too-big-to-fail pretty much tells community bankers they are a bunch of losers. Dugan is right to say that one of the most important things regulators can do is be consistent; to me, that means ending too big to fail. Not until this policy is ended will it make any sense to compare community banks with the rest of the industry.

Lots of talk about the need to resolve the too-big-to-fail problem in banking at the two big industry pow-wows earlier this month. It was THE topic at the ICBA convention in Orlando, and it was one of the top two industry challenges discussed at the ABA’s Government Relations Summit in Washington, D.C., March 17-18. The other big issue discussed at the ABA meeting was the need to stop reform legislation provisions that would create a new consumer financial protection agency or bureau. (More on that in future posts.) 

ABA brought in several top industry speakers, including a panel of Federal Reserve Bank presidents. Sandra Pianalto of the Cleveland Fed, Jeffrey Lacker of the Richmond Fed and Tom Hoenig of the Kansas City Fed all talked about the need to resolve too big to fail.

“Too big to fail is the central issue that reform needs to face,” Lacker said. He explained that ten years ago, 45 percent of the liabilities in the financial system were perceived to be guaranteed, either implicitly or explicitly, by the federal government. Today, he said, it is 58 percent. While the percentage has increased, the actual percentage of assets with an explicit guarantee has dropped to 22 percent today from 27 percent in 2000, he said.

“We know that too big to fail won’t go away without legislation that brings it under the rule of law,” Hoenig said. Too big to fail results in a “tremendous mis-allocation of resources,” he said. Furthermore, Hoenig explained that too-big-to-fail banks have a cost of funds advantage over community banks. Read Hoenig’s comments here.

While ICBA and ABA agree on the need to resolve too big to fail, they differ on whether the largest banks should be required to pre-fund a pool of money that regulators could use to unwind a systemically important financial institutions that gets into trouble. ICBA wants to see the largest banks put $50 billion into a fund in advance, while ABA argues that pre-paying such a fund only institutionalizes too big to fail. A banker put the question to Pianalto at the ABA summit.

“The issue of the fund, I don’t have a specific answer. The fund would come from those institutions that are too big to fail. The issue is open for discussion,” she said. “If you have an appropriate supervisory structure in place to begin with, then you won’t have to deal with that question.”

Politicians and pundits criticize bankers for making too few loans, for tightening credit too much. At the same time, most examiners are urging caution on lending. Few examiners are telling bankers to go out and make more loans. Most bankers say that when the examiners come into the bank, they are quick to criticize, even the loans that seem very sound.

The leaders of the regulatory agencies are aware of this dichotomy. FDIC Chair Sheila Bair and Comptroller John Dugan talked about this in Orlando last week. Bair referred to this join statement issued by the regulatory agencies and the Conference of State Bank Supervisors, which encourages banks to make loans to credit-worthy small business borrowers.

“The statement recognizes the importance of small businesses and the fact that some are experiencing difficulty in getting credit,” Bair said. “It clearly states that financial institutions that extend credit using prudent lending standards will not be subject to supervisory criticism. I know that there are concerns about examiners being overzealous in adversely classifying loans and applying capital requirements … What I want you to understand is that we hear your concerns. We are trying very hard to achieve a balanced approach to supervision during these challenging times.”

Dugan also acknowledged tension between advocates of increased lending and those focused on safety and soundness. “These hard times have produced a very difficult regulatory climate, for both community banks and their supervisors,” Dugan said. “A number of bankers and their trade associations … have complained that regulatory measures have been too stringent … At the same time, others have criticized regulators for being too lenient with troubled banks …”

Dugan said he has given his examiners a four-part message for dealing with this dilemma:

First, it is critical that examiners strive continually for professional judgment that is balanced.

Second, as significant issues arise, we can and should do more over time to provide appropriate guidance.

Third, in the expectations we communicate to banks and the actions we take, we need to be consistent.

Fourth, our examiners and their supervisors need to engage bankers forthrightly and address the specific concerns that [bankers] raise. Read the entire speech here.

It is difficult to argue with these four points, although the third point is a little hard to swallow. Certainly as long as too-big-to-fail is the official policy of the Treasury Department, action by regulators will not be consistent across the industry. Bair in her speech made a big deal out of the too-big-to-fail problem. Although Dugan mentioned too-big-to-fail in his speech, he did not go into depth about it.

More from the Sheila Bair speech in Orlando:

“Job number one must be to level the playing field once and for all and to put an end to the doctrine of too big to fail,” she said to applause. “Too often in the past … we saw large, systemically important institutions exempted from the type of supervisory sanctions that community banks face very day.” Listening, I got the sense that this really ticks her off.

In “On the Brink,” Henry Paulson described some of the conversation surrounding the rescue of Citibank in November of 2008. In his entry for Saturday, Nov. 23, he writes:

No one seemed more frustrated than Sheila, who at first suggesting using the FDIC’s normal procedure for handling Citi … That morning she said she wasn’t sure that Citi’s failure would constitute a systemic risk. She felt that Citi had enough subordinated debt and preferred stock to absorb the losses. She spoke as if Citi were just another failing bank and not a world leader. “So” she said, “why not let them go through the receivership process?”

Paulson said the suggestion made his jaw drop; of course, they didn’t go that route.

A year and a half later, clearly, Bair still doesn’t like the idea that some banks get special treatment. “It is time to get serious about establishing a credible, pre-funded resolution authority for giant banks and non-bank financial institutions,” she said in Orlando. She said she likes the provisions in the House bill and the Senate proposal for dealing with too-big-to-fail institutions. “We would finally have a mechanism under which large, complex institutions could be closed if necessary without wreaking havoc on the rest of the financial system,” she said.

More from Hank Paulson’s book, On The Brink.

His entry for September 25, 2008 gives us a glimpse of what happened when Washington Mutual failed. It was the biggest bank failure in history. Paulson explains that through an FDIC-facilitated transaction, JPMorgan paid $1.9 billion for WaMu which had $307 billion in assets. The condition of the bank had deteriorated rapidly, with depositors withdrawing $16.7 billion during the 10 days prior to closing.

Here’s the really interesting part. Paulson says six month earlier JPMorgan had wanted to buy WaMu, which was known to be having trouble even then. The Office of Thrift Supervision, WaMu’s regulator, declined JPMorgan’s overtures and worked out a deal with a private equity firm for a $7 billion capital infusion. “This decision proved to be a mistake: an acquisition by JPMorgan would have stabilized the bank,” Paulson writes.

This kind of guidance is a big black mark against OTS, and maybe a few lawmakers are keeping this in mind as they work on the industry reform legislation to merge the agency out of existence.

Here is how Paulson concludes his thoughts on WaMu:

JPMorgan’s purchase cost taxpayers nothing and no depositors lost money, but the deal gave senior WaMu debt holders about 55 cents on the dollar, roughly equal to what the securities had been trading for. In retrospect, I see that, in the middle of a panic, this was a mistake. WaMu, the sixth-biggest bank in the country, was systemically important. Crushing the owners of preferred and subordinated debt and clipping senior debt holders only unsettled the debt holders in other institutions, adding to the market’s uncertainty about government action. Banks were even less willing to lend to one another. In the future, I concluded, we were going to need to go beyond the standard FDIC resolution process for a failing bank.”

So is a $300 billion bank too big to fail? Paulson would seem to suggest it is. Later in the book, when regulators are discussing Citigroup, Paulson reports that FDIC Chairman Sheila Bair suggests they let the bank fail and handle it through the normal failed bank resolution process. Of course, they don’t take her advice. Clearly, there is tension at all levels between those who would give the largest banks special treatment and those who would treat them like any other bank.

Here is a healthy dialogue taking place among residents of Northfield, Minn., a vibrant community about 45 minutes south of the Twin Cities. The main point of discussion concerns the degree of transparency under which banks should operate. There are some participants in the discussion who say the local banks should be more forthcoming and there are those who say the banks have been sufficiently communicative.

Let’s remember that banks already are one of the most transparent businesses out there. Very detailed information is published quarterly about every FDIC-insured bank in the country. Those numbers reveal a lot, and in fact, at NorthWestern Financial Review magazine we use those numbers all the time to cover the industry. Furthermore, publicly-held banks are subject to additional disclosures required by the SEC.

I would argue, however, that banks deemed too-big-to-fail should be subject to an even greater level of tranparency. If taxpayers are on the hook, we have a right to know what’s going on at the bank on a day-to-day basis. That means public access to loan files and the investment portfolio. The public should be able to see what kinds of risk the institution is taking, both in the form of lending and in the form of other investments.

You cannot make the same argument for community banks, however. If Citibank gets into trouble, there is an impact on the taxpayer. If your local bank fails, there is no impact on taxpayers. This is an important point. When a small bank fails, no one with deposits of $250,000 or less lose any money. In many cases, even if deposit accounts exceed that amount, the depositor retains the entire account balance. The FDIC handles failed banks and the cost is charged completely to the deposit insurance fund, which is industry-funded. It is not taxpayer funded.

Even now, when the FDIC fund balance is technically negative, it is important to realize there is a lot of money in the fund. A reserve within the fund is established for projected future losses. The reserve balance is subtracted from the fund balance, so the actual balance of the entire fund is higher than the reported balance. Furthermore, banks prepaid three years’ worth of insurance premiums on Dec. 31, 2009; standard accounting practices prevent the FDIC from booking that money as income right away, although the money is available right away. The point is, the failed bank resolution process is entirely industry-funded for banks that are not deemed too-big-to-fail.  

So while I cannot think of a public policy reason smaller banker should be required to make greater levels of disclosure, I do think the managers of those institutions have an interesting question on their hands. How much should they disclose about the condition of their bank? Each manager is likely to come up with their own answer; some might choose to reveal more than the requirements of the Call Report, and others might choose to reveal nothing more. Customers might react differently to each choice; clearly, anticipating customer reaction is one of the key factors bank managers would have to take into account when making such a decision.

Many of the community bankers I interviewed last year said flight-to-safety inflows and new business from customers moving out of big banks were causing deposits to swell. Looks like they weren’t alone. This Bloomberg/Business Week analysis of Q4 earnings indicates that the top-10 banks expanded their deposit bases for the first time in four years.

“JPMorgan Chase & Co. posted an 8.1 percent rise to $938 billion, the biggest gain, led by increases in deposits from corporate clients…U.S. Bancorp said deposits rose 7.9 percent after the Minneapolis-based lender acquired $15 billion in deposits from FBOP Corp., which failed in October.”

The 40-biggest U.S. banks reported an average 8-percent rise in deposits.

Speaking of the former FBOP Corp., check out the Feb. 15 edition of NorthWestern Financial Review for firsthand testimony on that company’s complicated demise.

President Obama will deliver his state of the union address this evening. The longer he talks, the less effective he will be. At this point, we don’t need more talk; what we need are meaningful actions.

The president, for example, is going to tell us that he is implementing a spending freeze, but this will do virtually nothing to reduce our deficit, given that all the big-spending programs will be exempt and the ones that will be included have incredibly bloated budgets already. More words, Mr. President, just don’t do any good. Take some real deficit-reduction actions, tell us about it after you’ve done it, and then we will all feel a little better.

The president may say something this evening about financial services industry reform in the context of improving the economy. But, here again, I wish he would just keep the words to a minimum. I appreciate the fact that the president says he wants to end too big to fail, but until some actions are actually taken to end it, I am tired of all the words. President Bush (the first one) was ready to end too big to fail also in the early 1990s, and that led to the passage of FDICIA, but as we have seen in the last 18 months, that piece of landmark legislation did not solve the problem as advertised.

Changing the rules governing the banking industry will do nothing to give the economy a boost. The business sector simply needs clear signals that the market will be allowed to work. Inconsistent government intervention in private commercial affairs has made it impossible for business people to predict what the business environment will be like in the near future, so they are less willing to venture out with new enterprises. They are hunkering down.

But at this point, of course, it would be very hard to believe that the Obama Administration has any interest in backing off. So for tonight, I really prefer fewer words. Some big actions in the next few months — like figuring out what to do with Fannie and Freddie — would go a much longer way toward restoring confidence than even the most eloquent of speeches this evening.

The president indicated in his weekly address that it was good to see banks paying back their TARP obligations (with interest) but “not good enough.” He scolded as audacious those who say “that it’s somehow unfair, that because these firms have already returned what they borrowed directly, their obligation is fulfilled.”

Leaving aside questions of whether it’s fair to change terms after repayment, or whether banks should cover the shortfall caused by non-bank TARP recipients, there is still the question of likely effect. In his earlier post, Tom conceded “a certain intellectual appeal” in the proposed fee. Mike Moebs, principal at a Lake Bluff, Ill.-based financial services consultancy, said that “for all the wrong reasons” President Obama may be doing a good thing by taxing big banks. “If the big guys are beyond their economies of scale, why not use the price mechanism?” Moebs said.

“In Great Britain they’re taking the likes of the Royal Bank of Scotland and Barclays and saying to Royal Bank of Scotland, you’ve got to get rid of 900 branches by the end of the first quarter of this year; Barclays, you have to get rid of 1,000 branches. That’s more of a hatchet-type of approach…but Obama is stepping in and saying, I’m not going to face those social and political consequences; I’m just going to tax you guys–and I’m not going to tax the small [banks]. So your prices for your services have got to go up, and the small guys [will] have a competitive advantage. Now, if you big guys don’t bring down your cost, the small guys are going to win.”

The tax could cause big banks “to reduce [their] long-term average cost of operation, which is what the economy of scale is, and get it back down [to where} the small guys [are],” Moebs said.

Meanwhile, the president discussed additional big-bank reforms today.