What Will Become of The Banking Industry’s Battleships?

by Jack Milligan

Lael Brainard, a member of the Federal Reserve Board of Governors, gave a speech earlier this month in which she reported on the efforts of the various bank regulatory agencies to drive the final nails in the coffin of the unofficial government policy known as Too Big to Fail. Brainard intended her remarks to be a progress report, but as I read her speech I couldn’t help but wonder if she hadn’t made the argument — unintentionally, I’m sure – for why some of the largest U.S. banks are using a business model that is trending towards obsolescence or, at the very least, economic unsustainability. And in their efforts to reduce the systemic risk that megabanks pose to the U.S. economy, the regulators and the U.S. Congress may be accelerating that process.

Much has been written about the government’s efforts to prop up ailing banks during the 2007-2008 financial crisis, a rescue mission that was very unpopular with the general public but was probably necessary to restore confidence in the country’s banking system. Banking and finance are the heart of the body economic. Lose the heart and the body dies. The policy of Too Big to Fail starts with the premise that some banks are so large and systemically important that their failure could end up doing great harm to the economy. At various times over the past 30 years or so, this thinking has led to government intervention when large banks have stumbled and the feds have had to bail them out. Critics have long argued that bankers will have little reason to be prudent if they know that Uncle Sam will rescue them if everything goes south.

One of the principal objectives of the landmark Dodd-Frank Act of 2010, which was enacted in direct response to the financial crisis, was to end the policy of Too Big to Fail. One way in which DFA sought to do that was to focus on those banks whose failure would pose a serious threat to the economy and then require them to meet a much tougher set of requirements than the rest of the industry. There are 30 high-risk institutions around the world that have been designated as Global Systemically Important Banks (GSIBs) by the Financial Stability Board, an international body comprised of senior policymakers, central bankers and regulators from the G20 countries, and eight of them are in the United States. This is an exclusive club that no bank wants to belong to, and the U.S. members are JPMorgan Chase & Co., Bank of America Corp., Citigroup, Wells Fargo & Co., Goldman Sachs, Morgan Stanley, Bank of New York Mellon Corp. and State Street Corp.

Dodd-Frank imposes on these eight GSIBs a combination of capitalization, assessment and policy requirements that in theory should make them stronger and, consequently, less likely to fail during an economic crisis. Brainard, who served as the U.S. Treasury Department’s undersecretary for international affairs before being appointed to the board of governors in June 2014, offered an assessment of what has been accomplished to date. I would summarize her report this way:

1. The GSIBs are required to meet several separate capitalization requirements that will be phased in through 2019, and once fully implemented these institutions will have double the capital they held in 2007.
2. Since 2009, large U.S. banks and certain U.S. subsidiaries of foreign banks have been required to undergo annual stress testing under the Comprehensive Capital Analysis and Review program, and for these institutions – including the GSIBs – their mandated capital levels are not a static target but in fact could rise even higher depending on economic conditions.
3. GSIBs are required to meet a 5% leverage ratio regardless of their other capital ratios, which means their Tier 1 Capital must total at least 5% of their consolidated assets, including all off-balance sheet exposures.
4. Beginning in January 2017, banks with $250 billion in assets or greater will be required hold a significantly larger percentage of high-quality liquid assets as a buffer against funding disruptions during times of economic stress. The eight GSIBs also have to go through a more stringent annual liquidity assessment by the Federal Reserve.

Once fully implemented, these changes will theoretically make the eight GSIBs stronger, but whether investors will want to support them at that point could be another matter. The 3^rd Quarter issue of Bank Director magazine, which will be available in early August, will feature our annual Bank Performance Scorecard, which is a ranking of the 300 largest publicly owned U.S. banks. We divide the banks into three asset categories: $50 billion and above, $5 billion to $50 billion and $1 billion to $5 billion. Included in the metrics that we use to determine the ranking are return on average assets (ROAA) and return on average equity (ROAE). The average ROAA for seven of the GSIBs in 2014 (Goldman Sachs did not report an ROAA last year) was 0.79%, which is substandard to say the least. Throw out Wells, which earned 1.33%, and the average dips to 0.70%. The average ROAE for all eight banks last year was 8.30%. Exclude Goldman, State Street and Wells, all of which earned 10% or better in 2014, and the ROAE for the remaining five GSIBs was just 6.58%. And this was five years into the recovery of the U.S. economy!

To be fair, the profitability of some of these GSIBs last year was negatively impacted by restructurings or multi-billion dollar legal settlements with the regulators for past sins. But what happens in 2019 when all of the heightened capital requirements have kicked in? My guess is that their investment returns will still lag the rest of the industry, as they did in 2014. Capital is a double edged sword. It makes you safer but too much of it can depress your equity returns. The regulators are most concerned about the economy and the U.S. taxpayer, but publicly owned banks have shareholders and they expected to be rewarded.

Jamie Dimon, the chairman and CEO of JPMorgan, has defended his bank’s business model, which is to be all things to all people (or at least pretty damn near). JPMorgan has a major investment bank, a very large corporate bank, a significant branch banking franchise scattered throughout the United States that operates under the Chase brand, and a big presence in national consumer product businesses like home mortgages and credit cards. Citigroup and Bank of America are more similar than dissimilar to JPMorgan in this regard. With an ROAA of 1.33% and ROAE of 11.72% in 2014, Wells is an outlier – at least for now.

Will this universal banking model be economically sustainable when JPMorgan, Bank of America, Citigroup and perhaps even Wells Fargo must bear the full weight of the heightened capital requirements in 2019? Remember also that the GSIB’s compliance costs are astronomical because of all the new regulations that have gone into effect since the financial crisis, and because they are under the constant watch of the regulators.

The evolution of the GSIBs to a more rigorous regulatory structure has occurred while another industry trend of potentially great significance has been unfolding. The 3^rd Quarter issue of Bank Director will also contain a 20-page special section, entitled “The Fintech Revolution,” that explores how the emergence of financial technology companies like Lending Club and Kabbage is beginning to redefine the delivery of consumer and small business loans at a cost that most traditional banks can’t begin to match.

It will be interesting to see how the universal banks respond to the growing competition of fintech companies, which focus on many of the same product categories. The development of this alternative lending market could turn out to be a sideshow since the fintech industry needs to demonstrate that it has staying power through at least one full economic cycle, but it highlights one of the universal banks’ most pronounced weaknesses, which is a reliance on expensive brick-and-mortar distribution, which drives up their costs compared to their fintech competitors.

Here is how all of this comes together for me. First, the high capital requirements and elevated compliance costs are a constant headwind that all of the GSIBs – and particularly JPMorgan, Citi and Bank of America – will struggle against, forcing them to extract an extra measure of profitability from their business models just to compensate for that. Secondly, fintech companies are beginning to change how consumer and small business lending is done in the United States. This change is driven to a large extent by the increasing comfort level that a wide demographic cross-section of Americans have with doing financial transactions online and with their smart phones. I suspect that the universal banks will have a difficult time adapting their branch-based systems to this emerging phenomenon, and might have to accelerate their own shift to digital and mobile distribution while deemphasizing the branch.

It may take years before these factors have their full impact on the universal megabanks, but I think the long arc of history is moving away from them.

Students of naval history know that World War II signaled the beginning of the end of the battleship as the dominant weapon system at sea. Magnificent vessels like the USS Missouri, which represented the height of battleship design when she was commissioned in June 1944, were surpassed by submarines, which relied on stealth, and the aircraft carrier, which projected American air power throughout the Pacific Theater. The Missouri continued in service until her decommissioning in 1992, but she had been built for an era that no longer existed. The photo at the top of this post shows her being towed back to her berth in Pearl Harbor after undergoing maintenance and preservation repairs in 2009. Today she is a floating museum. I wonder if some of our largest banks will suffer a similar fate.