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The State of the Industry
A Prescription for Regulatory Efforts in the Banking Industry

by Steven Reider

The past weeks have seen the federal government take numerous actions in an effort to build confidence in the financial system. However, many of these actions show an appalling lack of consideration for community banks, as so many proposed solutions benefit large banks to the detriment of well-managed smaller ones that never overextended themselves. The banking system is not in jeopardy, even if several large banks are. While many aspects of the Troubled Asset Relief Program are beneficial, some are ill-conceived and others are based on erroneous assumptions.

For starters, both the government and media need to stop discussing how banks won’t lend; this simply isn’t true. Across the country, hundreds of thousands of bankers will receive their 2009 sales goals in the coming weeks, and almost all of those goals will include loan production targets. Don’t tell the manager of any of America’s 115,000 branches that banks aren’t lending; they are, every day, just maybe against slightly more stringent credit policies. The continued run of statements from Treasury and news articles reporting a complete credit freeze are dissuading consumers from even applying for otherwise available loans, thus amplifying the economic slowdown.

The more stringent credit policies are borne out in higher interest rates, despite the Fed’s best efforts to lower rates. But those efforts are unneeded and unfounded, and the Fed should stop trying to manage interest rates. Interest rates equilibrate risk, and risk impounds uncertainty. If the current uncertain economic environment is riskier than in prior times, we should expect higher rates. Let the market find the rates that equilibrate the level of risk in the environment. The relentless effort to cut the fed funds rate to stimulate the economy just prolongs unrealistic expectations about rates, and does little to change the probability that any borrower will repay a loan. Other than that probability and future expectations about inflation, little else will affect the interest rates borrowers actually pay. Further, we’re still far from a rate level that would weaken the economy. To anyone under 50, ask your parents the mortgage rate on their first home, and the answer won’t be 6%. Rates could rise three percentage points and still be at historically moderate levels.

But while the market seeks equilibrium, the government agencies can pursue several steps to mitigate turmoil while still treating all institutions equitably. Remember, any action that benefits one bank implicitly penalizes all others. The equity stakes that the government has taken in the largest banks give those banks a federal imprimatur of safety, and with the perceived risk reduction, some benefit of the lower capital costs that government-sponsored entities enjoy. This already tilts the playing field in favor of some institutions, rendering it critical that subsequent actions don’t further penalize other institutions. A few suggestions:

  • Don’t raise the deposit insurance ceiling, and certainly don’t eliminate the cap on insurance all together. There has been no great loss in confidence in the banking system that would warrant increasing the ceiling; in fact, healthy banks across the US have received significant "flight to quality" deposits, and numerous banks reported record one week inflows during the worst of the stock market sell-off. There is no need to burden healthy banks, and in turn their customers, with higher deposit insurance expense just to restore confidence in a few large banks that rightfully should be merged out of existence.

  • Embed true risk-based premiums in the FDIC insurance assessment. The current process carries too little differentiation among institutions and is based almost entirely on backward looking measures. Risk premiums need to be anticipatory, based not just on the current state of the bank but on statistically valid random audits of loan portfolios; and with a much greater weighting on the funding side of the equation than under the current CAMELS formulas.

  • And for the largest banks, add a surcharge to their FDIC premium. The recent crisis resoundingly proved that the U.S. government deems some institutions too big to fail. In effect, these banks are granted automatic insurance against their own failure – an invitation to risky behavior – at a cost redistributed to all institutions. Let the largest institutions pay for this insurance, through correspondingly higher contributions to the bank insurance fund.

  • Implement the framework underlying BASEL II. The fundamental goal of the BASEL II agreement is that banks should align the size of their capital bases to the risk level of their portfolios. The BASEL II principals have been criticized as fomenting a capital crisis. Critics charge that if risky banks are forced to comply, they will either need to constrict lending, raise additional capital, or merge with stronger institutions. The first option is criticized as contributing to an economic slowdown, but consider the alternative: banks continue to lend at a rate disproportionate to their underlying capital base. Clearly the worse of the two evils. The second option is criticized as dilutive to current shareholders and as untenably expensive in today’s market. Exactly. Current shareholders were temporarily receiving high beta returns at a low beta price. The market continues to remind us that there are no free rides above the risk – return efficiency frontier. Capital should be expensive for risky firms; if banks want low-cost capital, manage the balance sheet more conservatively. As for the third option, it is criticized only by the proponents of the Bank Executive Full Employment Act. Consolidation is not inherently bad, and for an institution managed so poorly that it can’t raise capital in the private markets, its shareholders and executives deserve to find themselves on the wrong side of an acquisition. Yes, compliance with BASEL II will hurt in the short term. But if our goal is to eliminate future crises rather than just to defer the current crisis, then we must embrace the principles of BASEL II.

  • End the regulatory alphabet soup. When it emerged from the wreckage of FSLIC and the 1980s savings and loan crisis, the OTS may have held some value for institutions seeking to operate under a different business model, with a high concentration of mortgages and a low concentration of commercial loans. Today, the thrift charter is primarily sought as an easy way around interstate branching laws, and a way for non-financial companies to own financial subsidiaries. Similarly, while the dual banking system has endured in American banking since before the Civil War, today the state – national duality, along with the thrift – bank duality, lead to regulator shopping in an effort to find the most lenient oversight environment. Merge the OTS into the OCC, and standardize the regulatory rules of the state banking agencies. I’d recommend just abolishing the state system…but let’s fight winnable battles.
Despite a seemingly endless stream of news reports about troubled banks, there are thousands of profitable banks across the country, including almost 85% of all community banks. Given that record, the most critical recommendation is that policy discussions involve CEOs who are still day to day bankers. I’ve never met Vikram Pandit, so I may be wrong, but I’d guess that he doesn’t attend ALCO or credit committee every week. The inner circle of industry advisors at the Treasury department can’t just include nine CEOs from organizations so big that the CEO is more figurehead leader and corporate strategist than practicing banker.

If the regulators want to understand how a policy will play in implementation, invite comments from community bank CEOs who still understand the details of each line of their financial statements. Even though they lead smaller banks, these CEOs are no less able than their money-center bank counterparts. In fact, in the second quarter of 2008, FIVE THOUSAND FOUR HUNDRED AND NINETY EIGHT banks posted higher returns on assets than Bank of America. I didn’t arbitrarily choose B of A just to prove a point: 5,031 banks outperformed JP Morgan Chase in the second quarter; and even Wells Fargo, often cited as the best performing of the large banks, was unable to match the returns on assets posted by over 2,200 community banks.

Finally, there are some macroeconomic imperatives to revive the economy. First, it is time for meaningful fiscal policy: if we’re going to stimulate the economy with fiscal intervention, let’s effect meaningful social policy in return. In an uncertain economy, rebate checks are too likely to end up in a mattress or paying down credit card debt, and while the latter may be noble and needed, both actions bring limited multiplier effects. If the government perceives benefit in transferring cash to consumers, let’s create a twenty-first century version of the Works Progress Administration, only this time funding projects to pursue alternative energy technology and infrastructure repair.

Before anyone cries “government boondoggle”, remember, the immediate impact on the federal budget is no different than tax rebate checks. Either way, the federal government is writing large checks. But a new WPA would direct cash to specific uses insuring that 1) the funds go toward high multiplier job creation and capital assets; and 2) that the country realizes a socially beneficial return. Yes, it’s government intervention, supposedly anathema in the United States, but now that we’re over one trillion dollars into bailout expenses (really: add together TARP at $700 billion, the $150 billion in special projects added into TARP to get it passed, $85 billion to AIG, another $38 billion to AIG, the Fannie and Freddie rescues…and you sail past the trillion barrier), it’s safe to conclude that the intervention train left the station so long ago that we can’t even see the station in the distance anymore. Besides, the first WPA brought us LaGuardia Airport, Atlanta’s sewer system, hundreds of schools and libraries, and through the similarly designed CCC, thousands of national park trails and over three billion trees. None of these are bad things, LaGuardia at 6 p.m. on a weekday notwithstanding.

A new WPA could fund hundreds of very intelligent people at Los Alamos, Sandia, Livermore, Oak Ridge, and other federal laboratories, to explore alternative energy sources that can yield economic prosperity without environmental destruction. We could rebuild the entire Louisiana coastal wetlands system. Lest you think that would only benefit Louisianans, note that wetlands dissipate hurricanes, and recall your shock when you visited your local service station after hurricanes Gustav and Ike pummeled the oil refineries in Lake Charles and Baton Rouge. We could rebuild dozens of bridges like the I-35 span in Minneapolis, only this time before they collapse and claim lives. Projects such as these would benefit the populace, yet remain beyond the funding ability of the private sector – precisely the type of projects that warrant direct government investment.

But while pursuing fiscal stimulus, don’t forget to also bring monetary policy into the discussion. Though President Nixon famously observed in 1971 that “We are all Keynesians now”, conservative apostle Milton Friedman first uttered that lament in 1965 in a Time magazine article. The article noted “Now even businessmen, t raditionally hostile to Government's role in the economy, have been won over—not only because Keynesianism works but because Lyndon Johnson knows how to make it palatable. They have begun to take for granted that the Government will intervene to head off recession or choke off inflation, no longer think that deficit spending is immoral. Nor, in perhaps the greatest change of all, do they believe that Government will ever fully pay off its debt.” Since then we’ve seen an ever-expanding national debt, and even the allegedly small-government Reagan years saw massive increases in federal spending.

Eventually, the continuous operation of the Treasury’s printing presses, amplified by the billions being spent each week in pursuit of the war in Iraq, will manifest itself in the inflation rate and in the value of the currency. Yet the issue rarely enters the political discourse. Sixteen candidates from the major political parties entered the primary debates, and exactly one – Republican skewing toward Libertarian Ron Paul – ever mentioned the value of the dollar or the money supply during the dozens of debate events. I don’t advocate a pure monetarist approach, but our leaders need to give greater consideration to U.S. monetary policy options and their implications.

The economy is in trouble, as are some large banks. But the business of banking remains sound, and few banks that practiced true banking are in any jeopardy. To the community bankers who still took time to get to know their customers and who learned about a customer’s business operations or personal balance sheet before extending a loan, the greatest threat to their continued success is rewarding their competitors’ undisciplined pursuit of poorly understood business lines with favorable treatment. Like a parent who gives more attention to the child who acts up than the child who consistently behaves well, the government is favoring the biggest banks in spite of their consistent disregard for the most fundamental concepts in bank management. We may need government intervention to stabilize these banks, but those banks need to pay for that stabilization in a way that neutralizes any advantages that would accrue relative to community banks.

Let the government stimulate the economy in a time-tested method, through direct investment in communities. The banks that have been the backbone of those communities for generations – the community banks – will then realize the benefit of those investments through increased deposits at their institutions. These bankers will in turn do what they’ve always done: reinvest those dollars in their communities, using the sound, responsible lending practices every banker learned in their first week of credit training. From that return to basics, a stronger, more stable economy will reemerge.

Comments? Thoughts? Click here to send an e-mail to Steve. Thanks for reading.

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