Boomer Banker

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.

An in-depth article on 23 June 2020 by Robert Armstrong highlights the great risk in the US economy from too much personal leverage. The impact of COVID-19 on the ability of people to survive as their sources of livelihood are substantially interrupted is clearly detailed in this article. Unlike the virus itself, the impact is not likely to be immediately visible but over time the impact on asset quality for financial institutions that have provided the loans to these individuals will be felt.

A few days later, Rana Foroohar in the Financial Times of 28 June 2020 focused on the impact of COVID-19 on small businesses. Her sobering analysis correctly notes that the real damage from COVID-19 will not be felt by the larger corporations and banks initially but rather by the numerous small entrepreneurs that have always lived a more precarious existence. Although individually these entities are not critical, collectively they have significant influence on the real economy. Their challenges will work through the economic system impacting larger corporations as well as banks of all sizes. As with the entrepreneurs, smaller community based banks are likely to be impacted first but that impact will work its way through the banking system.

These challenges will be a major risk for the economic recovery from COVID-19 and should not be underestimated. The question for many banks should be how can they support these critical entities whilst also maintaining credit standards. A truly difficult dilemma facing the banking system and the economy.

I would like to share my blog today with good friend and colleagues. Over the years I have had the pleasure to work with George P. Surgeon, Laurie J. Spengler, Darrin L. Williams, Radek Halamka, and Nathan Pittman. They are publishing today an interesting paper on raising equity for community development banks in the US. In their words:

Why have Community Development Financial Institutions (CDFIs) captured so many headlines these past few weeks? Because they are on the front-line responding to the economic repercussions of COVID-19 in disinvested communities across the country – communities that are out of reach by the big banks and out of sight to many. CDFIs were there providing responsible finance to these very communities before the global pandemic hit hard, and they will be there after the pandemic recedes. CDFIs demonstrate – then and now – the vital role of our local financial infrastructure to the health, stability and long-term viability of local communities. Perhaps their role has taken on even more relevance in the wake of COVID-19.

But to continue to play this vital role, CDFIs need greater levels of core equity capital – not only attractively priced debt – to leverage their balance sheets and make loans to small businesses, provide mortgages to families and meet the financing needs of the communities in which they live and operate.

Southern Bancorp commissioned this paper to trace the evolution and successful implementation of a new capital model Southern developed for community development banks, a subset of the CDFI universe. This new capital model allowed Southern to succeed in the largest capital campaign in its history. The new capital model has laid the groundwork for Southern and other community development banks to access the capital markets and raise larger amounts of core equity capital in the future.

As we face the urgent task of rebuilding local communities emerging from the Covid-19 crisis, this new model for equity investment in community development banks could not have come at a better time. We hope that sharing Southern’s experience will accelerate the capitalization of community banks and all CDFIs. The time to support these community first responders is now!

One of the interesting differences between European and US banks after the 2008 financial crisis was the strength with which regulators forced them to address capital concerns. In general the US regulatory system forced substantial improvements in capital on US banks. European regulators, under substantial political and industry pressure, were much less aggressive in this area. It has been my thesis that the European approach which on the surface seemed to be helpful to the banking industry instead placed the European banks at a long term competitive disadvantage to the US banks. Taking the pain of capital raising upfront positioned the US banks for growth as well as lending to support their local economies. European banks faced instead a long term challenge of providing the credit that would help the European economy grow.

It was therefore with interest that I read an article in the Financial Times that suggested there may be a softer approach in the US as banks face the impact of COVID-19 on their capital. It was noted that US banks have paid almost twice as much in dividends as they earned in the first quarter of 2020. Of course it is possible to pay more dividends than earned for a short period of time but it is not a sustainable strategy. It is hoped that this is only a temporary occurrence and the article suggests that the FDIC is already focusing on the long term consequences of this non-sustainable dividend policy. But the key lesson is capital is critical to banking success – especially if banks will be able to provide the credit to the real economy to address the challenges of COVID-19, environmental degradation and social/economic/racial inequality.

Black Lives Matter has brought to the fore a discussion on institutional racism. But how does that actually work? An excellent article in the New York Times highlights the challenges of banking for minorities with a focus on black clients. This article documents how individuals of color face significant barriers in getting basic banking services. The article shows how efforts to prevent fraud are too often used to make it difficult for black clients to receive basic banking services. And with police occasionally being called, the very real threat of physical harm to the client exists.

Perhaps even more shocking is that there is no requirement that banks are required to handle all clients equally regardless of race. Since banks were not specifically included in the Civil Rights Act of 1964, it is nearly impossible to hold banks responsible for racist actions. Of course large banks note their commitment to equality and provide diversity training. But in the case that starts the story, Wells Fargo seeks to avoid any damages. They argue “that because she was eventually able to cash her check, a judge should dismiss (the case).” As a matter of law that may be correct. But is it right?