From Herding Cats to Regulating Banks

Too Big to Fail, Too Small to Succeed, or Just Right to Be Merged with JPMorgan

May 14, 2023

The Scheme for Safer Banks

Decades of exponential increases in regulations, the plethora of new laws and international accords to better control banking and financial systems and bring improved financial stability have not made the banking sector more stable. Bank failures and their impact have not stopped despite the aims of politicians. Regulations could never prevent bank failures. Failures are a part of the business of banking. They have and will always be how banking works, unfortunately. Failures have occurred for hundreds of years, and they will continue in the future.

That said, the decades of reforms marched forward with the goal to raise capital requirements aiming to reduce the potential or impact of failures. However, all the “expert” created regulations has done little to make the banking system safer. On the other hand, it has resulted in negative unintended consequences that simply defer the inevitable occurrence of a broader systemic failure that will make the Asian Financial Crisis of 1998 and the Global Financial Crisis of 2008 look merely like playground scuffles.

Let’s Look at the Trends

Up through the 1970’s US banking was heavily regulated that even included restrictions on setting deposit and lending rates. In 1980, the US passed the Depository Institutions Deregulation and Monetary Control Act[1] that set off a banking boom. The 1980’s were a time when everybody wanted to be in finance after graduating university. Wall Street and banking were kings. Hollywood even caught the trend boosting the mystic that a banker was the thing to be and where the money, prestige, and sophistication lie. This was not just a US phenomenon, but also globally. News articles abounded saying that the US economy had transformed fully into a financial services economy having finally shrugged-off the 1970’s dirty industrial-based economy.

The economic concept was that an industrial base was no longer needed as the core of a major developed country. Simply intermediating finance, moving money around, was sufficient.

Let China, Brazil, Mexico, and other countries handle the old, outdated dirty work that added little additional value to economic development. The industrial revolution was surpassed by the finance revolution. On the back of this theory, everyone wanted to run a bank or become bank-like. Old industrial firms like General Electric were soon earning more profits from their finance activities rather than their production.

Over the 5 years from 1986 through 1991, 1,169 new banks were chartered in the US. Although due to mergers (and some failures), the total number of institutions still dropped from 14,025 to 11,851 in this period. Total assets and deposits of these commercial banks nonetheless grew significantly from $2.94 trillion and $2.28 trillion to $3.43 trillion and $2.69 trillion respectively. An average institution had $210 million of assets in 1986 against $5.4 billion in 2022. This increase was not simply linked to growth of the US economy as GDP rose only around 6-fold from $4.6 trillion in 1986 to $26.1 trillion in 2022 while the commercial bank average asset size grew around 26-fold over the same period.

The Potholes (or Sinkholes) in the Road

While the banking super-highway seemed smooth for most of the 1980’s, the concept of a “rolling recession” or “regional recession” arose for the first time in the US economy between 1986-1991. The collapse in oil prices in 1986 hit Texas and the oil patch causing a major hit to local financial institutions, mainly savings and loan associations (S&Ls), with many failures resulting. The national view was that while this was bad, it was regional only.

Many S&L failures occurred as the regional economy was oil-based and as S&Ls were generally small (due in part to the concept of unit banking and inability to offer services across state lines) so they were not able diversify their risks. I must add to this a hardy dose of fraud that occurred causing several failures as clearly greed follows the money and in the 1980’s that money was in banking.

Large banks, with their increasing focus on becoming full-fledged financial conglomerates focusing only on investors and shareholders, created a merger and acquisition explosion in the 1990’s seeing over 6,000 mergers. Banks in this period moved away from simply managing net interest margins to a focus on risk-adjusted return on capital (RAROC). The Gramm-Leach-Bliley Act of 1999[2] solidified the new role of mega-financial institutions by loosening the wall between banks offering traditional banking and the insurance industry.

The first one-trillion-dollar financial institution emerged being Citibank, actually Citigroup, from the tie-up with Travelers insurance.

Large banks were no longer in the $100 billion range but pushing over $1 trillion in assets as we entered the millennium. Woe to the poor community bankers trying to compete with their few billion dollars of resources.

To further visualize the result of the decades long shift and ill-placed dominance of the new economy from production to mega-finance, even the headquarters of large banks shifted across the US. None of the top 10 mega-banks were headquartered in California any longer, despite it being the largest state in the US, and Charlotte, North Carolina became a new banking hub.

The Death of Community Banking

In the US during the late 1980 and early 1990’s large banks were considered those that had assets in the $100 billion range. Community banking was important, being institutions with no more than around $10 billion in assets but with most holding significantly smaller. Community banks were vital to the economy and particularly in suburban and rural areas as the concept was that they knew the local areas better and were more willing to invest in local businesses since larger banks only had local branches with decision-making centralized in some distant processing center. In fact, during the 1990’s whenever banks failed or particularly when major banks continued to buy each other out or merge into larger institutions, community banks were often the beneficiaries of local deposit flight. Customers flocked to them as the remoteness and perceived aloofness of the large banks brought about disdain.

Yet, regardless of the flight of depositors to community banks, they had trouble competing with the tumor growth of the large banks.

In 1992 there were 13,914 institutions in the US with no more than $10 billion in assets, the Fed’s definition of a community bank, versus only 4,555 such community banks in the 4^th quarter of 2022, a 67% decline. In 1994, 70% of deposits were held by community banks with 30% held by banks with over $10 billion in assets. There were only 64 banks with over $10 billion in assets. Yet, as of 2^nd quarter 2022, community banks held only 15.9% of deposits and the 161 banks with over $10 billion in assets now held 84.1% of deposits.

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The Endless Regulatory Seesaw

As the bank de-regulation boom inevitably ended, regulators and politicians jumped on the wave of negative public sentiment against greedy bankers by imposing new regulations. This was not only a US trend but also internationally. The Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA)[3] was imposed in 1990 and the Basel[4] 1 Capital Accord, the first in a series internationally agreed regulatory accords used to establish common methods for imposing capital on banks, was effective in 1992. These actions were pursued to re-regulate banks with the aim of preventing the failures, losses and frauds that occurred from, what one might say, giving banks too much de-regulation previously. Bankers became hated, the villains in society. Yet, the regulatory seesaw continued through the 90’s with episodes of de-regulation and re-regulation. In 1994 de-regulation once again was the hit song as the Riegle-Neal Interstate Banking and Branching Efficiency Act[5] was passed that amended the Bank Holding Company Act of 1956 allowing for interstate branching and more competition. Then in 1998 further regulation was put in place when Basel 1 was amended to add a method to calculate capital requirements for market risk. This was colloquially referred to as Basel 1.5.

Did increased regulation work?

From 1986, the start of the oil-patch crisis and rolling recessions, through 1991 there were 2,123 bank failures. Fifteen percent of banks failed over the 5-year period with $656 billion of assets and $535 billion of deposits involved. Nearly one-quarter of the US banking sector’s assets passed through this resolution process. A colossal and shocking proportion for a banking system that is supposedly so heavily regulated.

Want to guess what happened next, regulatory side?

Who answered more and tougher regulations? Anybody? Well…Wrong! As the economy recovered from the rolling recessions in the later 1990’s and the tech boom set in, regulatory reform resulted in a bout of de-regulation.

In 1999 the Gramm-Leach-Bliley Act was passed. This was a major reform aiming to increase competition (better for the public?) with the goal of also trying to improve risk management. Banks could diversify activities further, bringing US banking closer to the Universal Bank concept found in Europe and elsewhere. Much controversy was raised at the time as a key part of the Act was to essentially set in law that the prior merger of Citigroup and Traveler’s Insurance was now legally permitted.

We have reached Banking System Nirvana

From 534 bank failures in 1989, the highest since the depression, the annual number declined to just 8 in 1999. This trend continued through 2007 with only single digits of annual bank failures. In fact, in 2005 and 2006 there were no failures. The Fed, bank regulators, politicians and economists took credit for this “achievement”. In fact, numerous statements and discussions were had that banking, through imposition of modern regulation and supervision, finally was fully safe.

Banking, the core of which was founded in Florence back in the 1400’s and where the world suffered for over 500 years due to its flaws, has now been reformed.

A new world order was achieved where few if any failures would ever occur providing for perfect financial stability and economic prosperity for all. The deposit insurance fund (FDIC) would never again be drained. The taxpayer would never have to bail out bankers. We have achieved financial system Nirvana through regulatory reforms and the advancement of risk management techniques like Value-at-Risk (VAR). The pinnacle of regulatory reforms can be high-lighted by the 2004 imposition of the massive 251-page Basel 2 Capital Accord[6] bringing in new, higher capital requirements, minimum risk management standards, the ability to use internal quantitative models to “more precisely” measure risk, creating the concept of a Systemically Important Bank (SIB) and imposing governance and transparency standards through market discipline.

I repeat, while it took 500 years, the world now believed that bank failures, apart from those caused by fraud, were a thing of the past.

Systemically Important or Simply Too Big to Fail?

An important concept arose during regulatory reform of 2004 under Basel II being a Systemically Important Bank (SIB). The underlying concept is that for banks that are large and vitally important to an economy would be designated as SIB. In doing so, the rules required more rigorous standards such as holding more capital. The aim was that with an SIB designation and the higher standards applied, that these important institutions would be less likely to fail. SIBs were selected based on various criteria (a key one is assets size) and it was expected that no more than a few were identified as such in a country. In the US, 30 banks are designated as SIB currently. While SIBs are held to higher regulatory and capital standards, they also benefit from an implicit designation that they are “too-big-to-fail”. Non-SIBs could fail without intervention while SIBs essentially were guaranteed a taxpayer bail-out due to their importance to the financial system.

For decades much was said about avoiding the moral hazard dilemma for the banking system.

Raising deposit insurance coverage levels, guaranteeing all deposits, government “temporary” nationalizations, or one-off bank bailouts were frowned upon. Moral hazard was to be eliminated through a Laisse-faire approach where one should assess a bank’s overall safety and take the risk in your hands if you deposit any amount over the FDIC limit. However, on the other hand, the rise of the regulatory SIB designation now codified that certain banks can legally be bailed out.

Moral hazard became part of the rule not the taboo.

Regulations implicitly “solved” the moral hazard dilemma for the largest banks regardless of the causes of their failure by making taxpayer support legal.

However, supporters of the new reforms will say that since regulations are stricter, no failure will occur and therefore the moral hazard issue will not apply. Yet, simply regulating-away moral hazard though defining a SIB does not eliminate the underlying concern. Every bank now wants to be a SIB. Why would they not since they can benefit from the implicit taxpayer backstop?

The Intended Consequence of Legalizing Moral Hazard

The regulatory imposition of the SIB is problematic. As I noted earlier, banks are rapidly consolidating and becoming larger and more concentrated. Community banking is dying. Diversity is gone. The consolidation trend is not only the result of the sector gaining economies of scale but equally because politicians and regulators hoped to prevent failures by imposing more complex regulations and capital requirements that essentially just incentivized banks to merge and become larger. When the US experienced bouts of banking crises, politicians and regulators heavily utilized bank assumptions and deposit sales to prevent liquidations and tapping into the FDIC fund or worse, heading to Congress for taxpayer money. If that occurred, then the robustness of the thousands of pages of complex banking regulations and competence of its drafters and regulators would be questioned. Perhaps some elected official loses re-election being blamed for causing a crisis and bailing out their buddies! This consequence was to be avoided at all costs.

Thank you for reading On the Edge with Enza. This post is public so feel free to share it.

It's NOT the economy Deposit Insurance, Stupid!

The intended consequence of additional heavy regulation imposed to prevent bank failures caused the unintended consequence of increasing the size of banks and system concentration. A more concentrated banking system with fewer and larger banks has made the system less safe. Failures of large banks still occur as is evidenced by the recent failures of Silicon Valley Bank, Signature Bank and First Republic Bank. Larger banks cannot be easily resolved with simple deposit pay-offs by the FDIC due to implications for financial system stability and a lack of insurance reserves.

The growing US banking sector concentration with larger, more dominant institutions builds pressure like in a volcano before its eruption. It defers an inevitable and larger eruption later. Around 20 banks were designated SIB in 2012 and 30 are tagged as such today and the number will certainly grow controlling most US banking assets. The odds increase exponentially for a bigger failure in the future that will have greater systemic implications and the need for government (taxpayer) support. The increase in moral hazard in the US banking system is not due to any rise in the level of deposit insurance.

The moral hazard increase is directly attributed to the exponential rise in ill-crafted regulations, government wavering between bouts of de-regulation and re-regulation and the interlinked self-interests of politicians, embedded regulatory self-centeredness and Bank-Street (a.k.a. Wall-Street).

The rise of SIBs, the decline of independent community banks, the use of upstream acquisitions versus liquidations upon failures, all contributed to greater systemic risks. Concentration reduces the ability of banks to focus by sector, properly support lending to the real economy creating jobs, supporting ventures and start-ups and reducing the need for industrial offshoring. It is clear, unfortunately, that a system with ever-larger banks, growing concentration and with a further dwindling number of community banks is what is in store.

Larger systemic, taxpayer funded bailouts are coming and in the meantime the banking public, small businesses, and innovation will suffer further.