Can Anyone Manage the "Too Big To Fail" Banks

An interesting article: “Once Unthinkable, Breakup of Big Banks Now Seems Feasible,” (http://dealbook.nytimes.com/2011/07/27/once-unthinkable-breakup-of-big-banks-now-seems-feasible/?pagemode=print) appeared in the New York Times on Thursday.

The basic question posed in the article: “Lawmakers and regulators have failed to remake our system with smaller, safer institutions.  What about investors?”

Our largest banks are not performing that well.  Shouldn’t stockholders demand better performances?

In terms of Return on Shareholder’s Equity (ROE), Wells Fargo has been at the top of the list of the Big Four.  With the exception of 2008, Wells has earned an ROE of around 10 percent, give or take a little. 

JPMorganChase has not done as well since it was attempting to play “catch up” with the others in the Big Four in the middle 2000s.  Other than in 2008, it has consistently improved its performance with some analysts arguing that it will earn around an 11 percent ROE in 2011.

Citigroup and Bank of America are lagging substantially behind these two.  Citi seems to be recovering from the disasters of 2007, 2008, and 2009, but its performance is still far from stellar.  Bank of America is…terrible.  Both companies will probably not see a 10 percent ROE for many years. 

The point the author of the above article, Jesse Eisinger, is trying to make is that such terrible performances should be met with shareholder demands to restructure in order to improve performance.  Of the four, Citigroup has made the greatest effort to do this but it is an indication of how badly the bank was managed that even this effort has left a lot of work still to be done. 

Bank of America seems to be in a daze.  I don’t think anyone there knows what they are doing.

JPMorganChase, having survived the financial collapse as well as anyone, is trying to expand into areas round the world in which it has not previously been competitive. 

The question proposed by Eisinger is a good one.  Given the performances of these organizations, shouldn’t the shareholders demand some leadership that would rationalize these organizations and get them back on the track to earning competitive returns, which in my mind is an ROE, after taxes, that exceeds 15 percent?

How has the market reacted?  Well, the only bank whose stock price trades above book value has been Wells Fargo trading at about 1 ¼ times book.  JPMorganChase trades at book; Citigroup trades at about ¾ book; and Bank of America trades at around ½ book.

The banking industry, led by these four banks, spent the latter part of the twentieth century building up financial conglomerates through mergers and acquisitions.  The push was to build, build, build.  Financial performance came from financial engineering and financial innovation.  Increased risk taking and greater and greater financial leverage were the games to be played.  Off-balance sheet accounting became a way to hide risk and to “jack up” returns.

As former Citigroup chairman and CEO “Chuck” Prince is famous for saying, “If the music is still playing, you must keep on dancing.”

The problems that accumulated due to the merger and acquisition binge that took place before the financial crisis hit was exacerbated from actions taken after the financial crisis hit by the acquisitions these organizations made in cooperation with the federal government.  Need one mention the acquisitions of Merrill Lynch, Washington Mutual, and Bear Stearns, among others?

Conglomerates, generally, have never had a history of being great financial performance.  Just putting together different kinds of businesses without any reason, without the possibility of achieving any synergies, has not produced exceptional results.  In most cases the resulting performance of such combination is abysmal.

Given this belief, one really needs to ask a question about the “quality” of the performances recorded before 2007.  The amount of accounting tricks, off-balance sheet “slight of hand”, failure to mark-to-market underwater or bad assets and so on sure made some of these banks look like they were really something.

Yet, when things got tough all this “magic” went away.  Banks even stated that some of the calls for accounting “sanity” caused them all the troubles they ran into.

Again, “If you say the problem is out there, that is the problem.”

In my view, the regulators are never really going to get these organizations under control, make them economically sound.  The pressure to do this must come from the owners, the shareholders.

Eisinger presents three reasons why this is unlikely.  First, a large number of bank owners (institutions) tend to be “passive and conflicted.”  Second, top managers get paid for running larger institutions.  If the banks became smaller, top executive salaries would decline.  Third, the growth in world trade requires large banks to support the large, multinational corporations. 

To me, the only true test is performance.  Can large, multinational banks earn a return that justifies people and institutions investing in them?  Can they earn a 15 percent ROE after taxes through achieving sustainable competitive advantage?  Or, do they need to take on excessive business and financial risk accompanied by accounting “gimmicks” to earn such a return?

I have three immediate responses to this.  First, financial regulators and legislators can never do the job we would like to think they might do.  For one, they are always fighting the last war.  They are still trying to prevent a 2008-2009 crisis from happening again.  In addition, given the changes taking place in information technology, it will be extremely difficult to keep up with everything that is going on in the banking system thereby making these institutions even harder to regulate.

Second, the number of “banks” in the banking system is going to continue to decline.  Small- and medium-sized banks are going to find it harder and harder to find niches that are not being eroded by the Internet, mobile devices, and non-banking organizations.  My prediction has been that America will have less than 4,000 banks in five years and this trend will continue. 

Finally, the best thing that Congress and the regulators can do is to require more openness and transparency in the banking system.  We have seen what accounting tricks, lack of disclosure, and failure to record realistic asset values can do to “pumping” up the banking system.  Required greater disclosure can go a long way toward investor understanding what a bank and its management are doing. 

Also, other tools can be used to bring market instruments into the picture as an early-warning system like the one recently proposed by Oliver Hart and Luigi Zingales in the journal National Affairs, and “To Regulate Finance, Try the Market” in Foreign Policy.

The regulators are not going to correct the “Too Big To Fail” problem.  Maybe the owners of the “Big” Banks should correct the problem.