Reforming Too Big to Fail

By Bill Apfel, CFA
From the Winter 2013 Edition of Values

Thirteen billion dollars and counting. That’s the settlement assessed J.P. Morgan—the bank once judged to be the country’s best managed. Is this fair? Perhaps. On the one hand, J.P. Morgan and its predecessor companies abused the trust of their clients, creating loans that were doomed to fail and packaging those loans for sale to ill-informed investors. Especially notable among a host of other infractions, the “London Whale” fiasco raised further concerns regarding management oversight. On the other hand, J.P. Morgan was among the few banks that had the wherewithal to withstand the financial tsunami of 2008, acquiring—at the urging of regulators—the collapsing Bear Stearns and Washington Mutual. Those acquisitions are now the source of a large share of the bank’s problems.

But investors—and citizens—should not be distracted by the enormity of the fine. Assessed five years after the financial crisis, we doubt it will change much about the way major financial institutions are run. Think of it like a traffic ticket that someone else will pay—in this case J.P. Morgan shareholders. It might inspire greater caution, but it’s unlikely to change the incentives that motivate managements, or lead to a more economically stable and socially constructive financial system.

The big issues confronting the proper role of banks in our financial system were starkly revealed during the financial crisis. They have two closely intertwined aspects. First, banks simply lent too much money to too many people who were unlikely to ever fully repay their loans, mostly for home mortgages. This drained the financial resources of millions, impoverished many, and crimped the prospects for a robust recovery. Second, bolstered by funding from federally insured deposits and the implied guarantee associated with the non-deposit borrowings of “too big to fail” institutions, banks—especially the largest ones—multiplied the riskiness of their assets in search of ever greater profit. Meanwhile, the cushion most institutions kept to guard against a deterioration of those assets shrank as reported profits grew. When asset prices faltered and losses mounted, the banking system teetered on the brink of catastrophe. Only massive government bailouts prevented a collapse of the financial system.

Why have so many of our largest banks failed to act more responsibly in recent years? Here we must consider their unique place in our economy. More directly than other public corporations, banks are required to serve social as well as shareholder interests: They are the transmission vehicle for monetary policy and make possible the intermediation of funds from savers to borrowers. So that they can fulfill this social purpose, their deposits are federally guaranteed. In addition, banks are given wide access to the Federal Reserve’s power to lend. These policies are intended to ensure stability. In practice, however, the unique advantages granted banks have sometimes encouraged risk-taking that generates short-term profits but contravenes their public purpose.

How should this necessary, but conflicting, dual role of banks be managed? Plenty of creative ideas have been offered, and Dodd-Frank, the most comprehensive overhaul of bank regulation since the Great Depression, is now law. But progress has been worryingly slow, and the basic outlines of a new financial architecture remain murky. Even as we engage portfolio companies to improve their practices, these structural challenges require a wider perspective.

We offer three basic principles that we hope will survive the current wrangle over the details of banking reform:

  • A strict interpretation of the “Volcker rule” makes sense, barring banks from using deposit funding to support risky activities unrelated to their core functions of making loans and providing cash management and investment services. Such activities should be spun off into independent companies where capital is provided without explicit or implicit government guarantees.
  • Close supervision of lending remains a necessity. Because bank shareholders and bondholders benefit uniquely from government guarantees and Fed access, bank practices should, in a manner analogous to other public utilities, be tightly regulated. Abusive practices, like those identified at J.P. Morgan, have no place in institutions that enjoy government guarantees. Lenders must be encouraged to think long term. Regulations should require banks and their executives to share in the long-term risks, as well as the profits, of the loans they originate. Improved transparency is a linchpin of better oversight, enabling investors as well as regulators to judge management performance.
  • No matter the supervision, some banks will make poor investments and their solvency will be threatened. Rules requiring larger capital cushions have already gone far in strengthening the financial system. Future buyers of bank bonds must once again be expected to bear the risk of management missteps. An orderly process should be established for converting bank debt into equity before a potential failure requires deposit guarantees to be activated.

Will these sorts of structural reforms hamstring our dynamic economy? We don’t think so. The lessons of 2008 are clear. The health of the economy depends upon a stable banking system that turns secure savings into loans that are profitable in the long run and make sense for their borrowers. Investors who seek higher returns through riskier strategies must not be backstopped by explicit or implied government guarantees. Should investors conclude that such changes will make banks poor investments? Just the opposite, we suspect. Bank stocks have rarely earned high valuations on current earnings precisely because investors doubt their stability. Steady profitability should be well rewarded.