Author: David Korslund

There is often a discussion that banks are too big to fail or too big to jail. And lots of evidence that both of these simple expressions are true as we see many banks that should fail but are bailed out by their governments to avoid the damage to the real economy from their failure. Or banks that have obviously crossed legal boundaries but receive neither institutional or personal consequences as the risk of jail or criminal conviction would also lead to consequences for banking licenses that would negatively impact the real economy. But I have often thought there is a third expression too little used: Too big to sail.

A new book by Christian Dinesen, Absent Management in Banking would seem to provide strong historic evidence of this expression. I have only had a chance to read a review of it in the Financial Times but from that review a few key remarks can be extracted. As noted in the review, Dinesen concludes that in recent years for banks “growth was unmanageable.” The review also traces some of the recent problems to a combination of “the introduction of morally hazardous limited liability through the retreat from partnership together with the liberalisation of markets” which I believe is a solid analysis. This combination has proven very problematic whereas one or the other of the changes might have been much less damaging.

In conclusion the review notes Dinesen’s view that the regulatory approach did not “simplify (the banks) to make them more manageable.” Along with the reviewer, I believe this “analysis bears thinking about, though many will find the prescription uncomfortably radical.” Time to order the book and get even more insight for how the banking system should be restructured to meet the needs of society.

Berkshire Hathaway, the company run by Warren Buffett, has significantly reduced its investments in US banks in a recent filing as reported in the Financial Times. Assuming that Berkshire Hathaway invests based on its analysis of the future prospects of the companies in its portfolio, this shift would suggest concerns regarding the future profitability of US banks. Undoubtedly this thinking is based in part on the likely impact of COVID-19 on bank profitability. The Financial Times on 10 August published a somewhat detailed analysis of this impact and the prospects for banks resulting from COVID-19. In general the story is not a pretty one made even worse by the lack of certainty. Clearly banks face a very challenging and uncertain environment due to the impact of COVID-19.

Perhaps what Warren Buffett is thinking is that it is time to be cautious with banks. A lesson for others?

Paul Krugman on 13 August in the New York Times provides a very helpful history lesson. Although his column focused on recent remarks from President Trump regarding a “war on the suburbs,” he incorporated very helpful historical context on the US housing and mortgage markets. Citing Richard Rothstein’s “The Color of Law,” Krugman notes: :”F.H.A. guidelines specifically cautioned against loans in communities in which children might share classrooms with other children who ‘represent a far lower level of society or an incompatible racial element.’ ”

The power of that policy was enormous as the F.H.A. and mortgage insurance from the V.A. were covering more than 50% of US mortgages by 1950. This insurance was in essence not available to people of colour or in communities that were not White. As a substantial source of wealth creation post World War II came from home ownership, it is clear that the financial institutions that were helping White people acquire homes were also preventing Black people from access to this same source of wealth accumulation.

As banks consider their role in addressing the issue of inequality of opportunity, they also need to consider how to make amends for their participation in the creation of that inequality. And they also need to review their current policies and practices to ensure that there are not other ways in which they continue to use their financial power and less than transparent processes to continue practices of discrimination.

There have been many articles, some cited in this blog, on the trend of European banking consolidation. The typical approach to consolidation is through mergers and acquisitions among market participants. But a recent article in the Financial Times shows that market exits will also lead to consolidation. Although the article focused on the exit of ABN Amro and BNP Paribas from commodity finance, their move is indicative of what other banks in Europe are likely to do as well. Lacking scale and/or competitive advantage banks will begin to exit activities where they will never be able to earn an acceptable return on the capital deployed. These exits will also drive consolidation in the European banking market.

With a bit of pain in my heart from my years of working at ABN Amro, a Financial Times article earlier in the week further emphasised how this consolidation will take place. As noted in the article, ABN Amro stated about its exit from Commercial and Investment Bank (“CIB”): “Over the years, CIB has been unable to generate the required profitability at an acceptable risk level.” The challenge facing ABN Amro in large scale commercial banking also faces many of its European peers. But there has always been pressure to maintain those activities to meet the needs of country specific large commercial clients. The question is whether a local bank is really needed to meet the needs of those clients, especially in competition with truly global banks with a broad product range. ABN Amro has decided the answer to that question for the bank. Will others in Europe be following?

Sometimes when reading an article, I find buried within a long story a hidden gem of insight for the banking world. This most recently occurred whilst reading in the New York Times about a conflict between the German government and Cerberus Capital Management regarding the strategy for Commerzbank – an investment held by both of them. Cerberus is also an investor in Deutsche Bank. In the article it stated: “Cerberus’s attempt to wring some profit out of the two banks pits it against a German banking system structured to provide cheap credit to industry, not returns for investors.”

For those of us with an Anglo-Saxon background, it is too often assumed that the only strategic approach for any company is to maximise financial returns. However, when it comes to banks, it should be realised that profits for banks come from reduced profits or financial well-being of the bank’s clients – individuals and enterprises. It is generally a zero-sum game with money either being made by the bank or its clients. Whilst it may be possible that some banking products actually create new wealth, it is much more likely that the profits come not from economic value added activities but stripping out profits from the real economy.

Clearly the German banking system has been built on the premise that clients should be the beneficiary of the banking system and not a source of unreasonable levels of profit. There are of course many follow on issues to address such as:

• What level of profitability in banking is required to attract the needed capital to support the banking system?
•  Do banks in systems focused on client well being end up being more inefficient due to lack of financial focus?
• What financial products actually create economic value in the real economy?

These are all good questions but the decision to position the German financial system as a support to the real economy rather than a stand alone profit opportunity is a valid one. Perhaps it is also a decision that has led to a very strong business climate in Germany for small and medium enterprises leading to economic growth and health.

The US Department of Labor in June issued a new rule related to the use of ESG factors by pension funds in their investing process. As reported in the Financial Times of 1 August, this new rule would require the fund managers “prove that they were not sacrificing financial returns by putting money in ESG-focused investments.”  The stated intent of the Department of Labor is to protect investment returns for the ultimate beneficiary – the pension holder. This rule illustrates the difficulty in creating new paradigms in the investment world. It would be just as sensible for the Department of Labor to issue a rule that required investment firms to prove they were not sacrificing financial returns by NOT looking at ESG factors. That of course has not been the status quo but research increasing shows that ESG factors, properly evaluated, can provide better investment decisions.

Cyrus Taraporevala, CEO of State Street Global Advisors reacted quickly with a solidly written commentary in the Financial Times. He stated: “We at State Street agree with regulators that managers investing assets on behalf of pension plans covered by Erisa, the US private pension law, have a fiduciary duty to maximise the probability of attractive long-term returns. That means considering the range of all risks and opportunities that have a material effect on returns.” He goes on to provide further evidence that ESG factors are an important part of any long term investment process.

At the same time the need for quality in ESG reporting and analysis can not be underemphasised. All investment managers must be able to have good information that reflects truth – and not social or environmental whitewashing of the facts. Sarah O’Connor in the Financial Times highlights a case where an apparent strong performer on ESG issues turned out to be less solid than thought. She notes that relying on rating agencies for assessing ESG factors can not substitute for solid research by the investment manager.

Clearly ESG driven investment management is the future. Rules to make it more difficult only preserve the errors of the past. But smart investors also need to do their own due diligence.

Axel Weber, Chair of UBS, argues on 28 July in the Financial Times that a Big Bang is needed for European banking consolidation. His arguments are quite strong as he notes the lack of cross-border banking integration in Europe leads to banks being less able to meet the needs of the economy and support its healthy and sustainable growth. Weber correctly notes that increased integration of banks in Europe would make them more formidable competitors, especially with the US banks that have a historic advantage of operating in a large and integrated economy.

However, I suspect there is a bit of a Freudian slip in his use of the words “Big Bang” as they are linked to the changes in the London investment banking market many years ago in 1986. Whilst that regulatory change led to significant increase in investment banking activity in London including strong outposts of US investment banks, it is not clear that it has led to improved support for the real and sustainable economy. The idea of a European Big Bang to encourage stronger European banks may actually be a call to further increase investment banking activities rather than creating banks that can fully meet the needs of European clients – individuals and enterprises.

But in spite of the less than ideal wording, the creation of true European wide banks with a focus on meeting client needs remains an attractive proposition. The key will be ensuring that the regulatory approach allows for consolidation without losing the focus on meeting the needs of the clients and communities which the banks serve. Again an area where the emerging lessons from the US are not always an attractive story.

After the financial crisis of 2008, the US regulators moved quickly to force banks under their regulation to improve their capital ratios whilst European regulators took a much softer approach. There is some evidence that the focus on strong capital in the US allowed the US banks to more quickly return to lending supporting the real economy. European banks and politicians had pushed for a softer approach but that did not lead to strong banking support for the economy.

With COVID-19 now impacting banks, it is interesting to see the reaction on both sides of the pond – nearly the opposite of the prior experience. As noted in the Financial Times on 28 July, the European Central Bank has clearly told banks under their supervision to continue to build capital in part through dividend restrictions. But in the US the regulators and banks have been using emergency legislation to support the economy during the impact of COVID-19 to loosen the tighter restrictions that came about in 2008. The New York Times noted that the Senate Banking Committee is seeking to include regulatory relief under pressure from both the regulators and the large banks.

I wonder why the strong results from an earlier focus on healthy capital is not being considered in this change? Will these changes turn the tables on the relative strength of US and European banks?

As the US financial system works to address the financial challenges of COVID-19, it is very clear that bigger is not better. The New York Times on 23 June 2020 featured an article on Cross River Bank. What makes this bank even more interesting is its business model that partners with a variety of fin-tech firms to serve customers. The article notes that Cross River has had challenges over the years with some of its activities, but its model is one which should be considered as an alternative. Cross River was able to provide more than 106,000 small businesses with access to the Paycheck Protection Program for a total of $4.7 billion. As the lending should ultimately be repaid through the government program, the primary risk is likely to be operational to ensure that the loans were properly made and that they should be forgiven under the program.

Two recent articles in the New York Times provide substantial food for thought for bankers. It is increasingly recognised that racism exhibits itself in many ways and often not directly. If racism is to be addressed comprehensively, it is necessary to look at the many ways in which it becomes embedded in our economic, political and social systems. The financial system is one where attention needs to be paid.

In an editorial comment on 26 June 2020 in the New York Times, Angela Glover Blackwell and Michael McAfee argue that “Banks Should Face History and Pay Reparations.” Whilst one does not need to accept fully their proposed solution, they provide a very substantial historical record of how banks have been complicit in reducing wealth accumulation for blacks. This record includes not only finance for the development of slavery but ongoing discrimination continuing through the present that has been a significant impediment for accumulation of wealth by the black community. The end of slavery in the US in the 1860s did not end the impact of racially discriminatory actions.

On 30 June 2020 an article in the New York Times provides the story of Wole Coaxum. He left a Managing Director role at JP Morgan Chase to set up Mobility Capital Finance. This entity focuses on getting financial products and services to the unbanked and underbanked – often individuals and entities of colour. Similarly Maria Blow built and sold a business focusing on alternatives to payday lending. She is now working at MasterCard’s Center for Inclusive Growth. These are concrete examples of how banks can, and should, address racial discrimination.

These effort are very challenging but the financial system needs to find ways to support racial justice. Doing nothing is not an acceptable option.