Demonstrators in front of the Federal Reserve Bank of Boston
Saturday – Oct. 8, 2011
Once upon a time, maybe 30 years ago, there were lots of strong, well capitalized commercial banks. They were highly regulated and rarely failed.
They had strong capital positions and low leverage (by today’s standards) of maybe 9 or 10X. A well performing bank earned 1%+ on total assets and 10%+ on equity. They loaned out perhaps 80% of their deposit base to local or regional customers. They rarely funded themselves with “hot” money. They paid solid if uninspiring dividends to the little old ladies and local businessmen who owned their stock.
There were thousands of these banks from the largest cities to the most rural area.
They operated in virtually protected franchises as hostile take-over, or virtually any take-over for that matter that didn’t involve a failing bank was not an option. Banking regulators simply wouldn’t allow it. Branching was severely restricted by state statues, protecting smaller banks from intense competition from major metropolitan area banks. There was plenty of credit available and plenty of banks from which to choose.
Banks developed their own specialties in order to effectively compete. Bank of Boston had vast trading contacts in Latin America. Irving Trust was the largest commercial factor in America. Morgan Guaranty was the premier corporate bank. Citi was NYC’s largest retail bank. Regional banks dominated their geographic areas as branching restrictions kept others away. North Carolina was one of the very few states that allowed state-wide banking which nurtured North Carolina National, First Union and Wachovia.
Continental Illinois of Chicago – Once America’s 7th largest bank
The largest commercial bank failure during that period was Continental Illinois of Chicago. Illinois was a “unit” bank state – no branches were allowed. Continental Illinois was housed in one building in downtown Chicago. As a result of the Illinois branch restrictions, Continental had a relatively small retail deposit base. It funded itself each day in the money markets. considered a somewhat risky strategy at the time. When it ran into credit difficulties because of the Penn Square debacle its sources of funding dried up. Penn Square was a shopping center Texas bank originating “petroleum” loans which the new Petroleum Department at Continental was eagerly buying up. The loans all turned out to be dogs. Continental Illinois was seized by the FDIC and liquidated. It was not too big too fail even though it was one of the largest banks in America.
The real estate crisis before the last real estate crisis brought down a few banks – Republic of Dallas, Texas Commerce, Maryland National – but nothing that would threaten the stability of the banking system as a whole.
The system worked fine even if it could be criticized as dowdy .Banking was not the most exciting profession to be in. It was highly regulated. Commercial banks could not do what investment banks did and vice-versa. Commercial banks could not underwrite secutities and investment banks had to operate without FDIC insurance. Neither could own an insurance company.
Then came deregulation.
Branching and nation-wide banking came into existence. With it came the hostile take-over. Glass-Steagell was revoked under Clinton, erasing the clear spheres of operations between commercial and investment banks.
Suddenly there was money to be made in bank stocks.
It all began in 1988 when Bank of New York put a take-over offer in front of the Board of Irving Trust. Irving rejected the offer. BONY sweetened it. It was rejected again. Irving was counting of the Fed and regulators to do what they had always done – reject hostile takeovers. But. under Reagan, the wind of change was in the air. Wall Street smelled blood, money and defeat for Irving. After battling BONY for a year Irving lost in court and the Regulators gave approval. The rout was on. Chairman Rice of Irving Trust caved the day after losing in Court and Irving was acquired. Rice immediately retired.
The next catastrophe was the merger of Citibank and Travelers Insurance – consummated even before Glass-Steagell was revoked. Sandy Weill and John Reed both knew it would be – after all – the fix was in.
Thus was set in motion the creation of the banking system we have today. Plenty of money was made by Wall Street, bank stockholders and insiders holding shares and options, including me. Venture funds began buying up bank stocks with the sole purpose of selling off to the highest bidder. The major regional banks were acquired and disappeared along with thousands of jobs.
“Growth, growth, growth!” was the mantra. “Marketing” rather than credit worthiness became the norm as loans were marketed as if selling soap. Credit insurance from AIG made it possible to shovel billions of dollars into mortgage assets without worrying about the loans themselves – after all, they were insured by AIG or some other sterling counter-party and carried a Moody’s / S & P investment grade ratings. The sellers and buyers of these poor quality assets turned a blind eye as the sellers paid the rating agencies and the agencies came up with the right rating.
Trading rooms and investment banks moved from customer based activities to “own account” trading activities. After all there were enormous profits to be made especially when betting other peoples’ money.
Within all of the major banks which got in trouble during the last banking crisis there were those who had serious doubts about how business was being conducted. “Nay-sayers”. “Old fashioned”. “Not up to date”. They were ignored. There was no money in their Cassandra prognostications; not for “business development officers”, executive management or shareholders.
What was the matter with the old system? Not much. It just wasn’t sexy.
Deregulation, the revocation of Glass-Steagell and the cowboy mentality of growth and consolidation brought us to where we are. Bank shares were bought up by funds whose only interest was to sell the bank at a profit.
So now we have perhaps a dozen “too big to fail” financial institutions. If they are too big to fail then they are too big not to be very strictly regulated or broken up.
And next time they can’t meet their obligations they should be nationalized.
What distinguishes a successful bank? Good loans on it’s books.
The most important thing for running a successful bank, in other words, is not originating bad loans.
That’s it. It’s not about hedging. It’s not about creating a diversified business model with credit cards and investment banking units. It’s not about making smart acquisitions. What matters is the quality of the assets that a bank originates and holds onto.
The most successful banks over the last few years have not been the universal banks like Citigroup and Bank of America which have seen their share prices decline steeply over the past 5 years due to bad loans and imprudent acquisitions.
Instead, they’ve been the stodgy, old-time lenders like U.S. Bancorp. that never abandoned their focus on the principal functions of banking, gathering deposits, and writing good loans.
In the future the government should seize those that can’t meet their obligations, take them through bankruptcy and sell off the viable pieces.
And the rest of the banking sector should be re-regulated.
It’s not too late.
But hey, what do I know. I’m just a retired old banker living in Florida.