Robert Wilmers: Reflections on the state of banking and the leadership crisis

Robert Wilmers, the CEO of M&T Bank Corporation, wrote a very interesting shareholder letter in which he looks at 'reflections on the state of banking and the leadership crisis'.

If ever there was a CEO and a bank that should lead by voluntarily adopting ultra transparency and disclosing on an ongoing basis its current asset, liability and off-balance sheet exposure details, Mr. Wilmers and M&T Bank Corporation are it.

Mr. Wilmers' letter touches on many of the topics discussed on this blog and reaches similar conclusions.

Please forgive the length of this post, but ...

As relatively good a year 2011 was for M&T itself, it was far from an easy one.
Indeed, it is difficult, for one who has spent more than a generation in the field,
to recall a time when banking as a profession has been publicly held in such
persistently low esteem....

What’s worse is that such a view is far from entirely illogical, even if it fails to distinguish between Wall Street banks who, in my view, were central to the financial crisis and continue to distort our economy, and Main Street banks who were often victims of the crisis and are eager, under the right conditions, to extend credit to businesses that need it. 

It is no consolation, moreover, to observe that banks and the financial services industry generally were far from alone in sparking the crisis. Nonetheless, it is true, and very much worth keeping in mind, that major institutions in other sectors of the American system – public and private – must be considered complicit, some in ways we are only beginning to learn fully about. 

As understandable as a search for particular causes, or villains, might be, the truth is that the economic crisis that began in the fall of 2007 implicated a wide range of institutions – not only bankers but their regulators, not only investors but those paid to advise them, not only private finance but its government-sponsored kin.

It is very important to specify which investors are included in the list.  The investors who are include among the culpable are the professional asset managers who bought structured finance securities without access to the useful, relevant information that is needed if a buyer is going to know what they own.

The wide spectrum of the culpable has left the U.S. and the world with a problem which, although related to the financial crisis, transcends it and must be confronted: the decimation of public trust in once-respected institutions and their leaders.... 

There is only one way to regain public trust:  true disclosure.

True disclosure, which under the FDR Framework is the government's responsibility to ensure, is access to all the useful, relevant information in an appropriate, timely manner so that market participants can make a fully informed decision.

If you look at all of the regulation spawned by the Dodd-Frank Act, only the regulations dealing with the Consumer Financial Protection Bureau are focused on providing true disclosure.

In telling the story, one must start by looking at the banking industry in which I came of age.  A few generations ago, our leading banks – which were then known as the money center banks – had a clear and respected role in the American economy. They focused on providing pure banking services to corporations, banks, and individuals across the United States.... 

Bank leaders of this era saw public service as part of their obligation to serve the general interest. Notably, during this period, the average compensation in the financial services industry was exactly the same as the average income of a non-farm U.S. worker. 

A wall, prudently erected in the wake of the Depression, kept investment banks apart from traditional banks, which served the needs of individuals and businesses, and from savings and loan institutions, which focused on housing finance. Each served markets in which they specialized and thoroughly understood. 

All this began to change in the 1970s and especially the early 1980s as these banks grew and began a pattern of investing in areas where they possessed little knowledge – a trend, which culminated in money center banks forfeiting their mantle of leadership and tarnishing the reputation of the banking industry as a whole. 

One might trace the beginning of this chain of events to the market dislocations caused by the OPEC-led increase in world oil prices.... In a desire to expand their franchises, money center banks sought alternative investments and extended themselves into unchartered territories.  

Loans to energy companies (“oil patch” loans), shipping firms, and less-developed countries (LDCs) became the flavor of the day....

The fate of such new exotic ventures established an unfortunate pattern that would recur at every turn. 

When the oil price bubble burst in 1982, it triggered events that ultimately led to the outright failure of Continental Illinois, then the seventh-largest bank in the United States. The problems of this era spread, as nearly one-third of all oil tankers were scrapped between 1982 and 1985. Money center banks, which had not only lent heavily to shipping companies but also held equity positions in ships, found themselves in significant trouble. As U.S. interest rates and the value of the dollar climbed during the early 1980s,  

Citibank’s Chairman took the view that “countries don’t go bankrupt” – a hypothesis that was proven erroneous when 27 countries initiated actions to restructure their existing bank debt, leading to devastating implications for their bank creditors. 

In 1987, these banks began a delayed acknowledgement and recognition of the losses accruing from loans to developing countries. So great was the reckless foray that a 1993 study conducted by the Federal Reserve Bank of Boston found that had the money center banks truly recognized all the losses inherent in their books in 1984, one major bank would have been insolvent and seven others dangerously close. 

Please note that the regulators also changed in the early 1980s.

As demonstrated by the loans to less developed countries, the Fed adopted the policy of 'hiding' information on the current condition of the banks from the market.  As Mr. Wilmers noted, it is only in 1987 that the banks began a belated acknowledgement of the losses on these loans.

Banks were able to 'hide' these losses because the Fed blessed their hiding the losses and engaged in regulatory forbearance on the LDC loans.

Please note, this regulatory forbearance did not stop market participants from trying to guess exactly what the impact of these bad assets were for each bank.  Market participants did this by accessing market values for these loans through Bloomberg and then guessing at exactly how much and what loans each bank was holding.

Ultimately, the market participants concluded that the banks were insolvent.  The question then became 'would the regulators close them down'.  Clearly, the answer was no and thus was born Too Big to Fail.

At the same time, we also saw confirmation of the idea that an insolvent bank could continue to operate for years while it rebuilt its book equity.

So it was that the underpinnings of recurring crises were introduced as the money center banks searched for new opportunities and Wall Street investment banks became more and more creative in the development of financial products.... 

The decision to live together culminated in a marriage, made possible by the repeal, in 1999, of the Glass-Steagall Act, which had, at least notionally, kept investment and commercial banking separate....

There are two underpinnings of the recurring crisis that need to be emphasized.

First, the role of opacity and the resulting lack of market discipline.  By the 1970s, bank disclosure had regressed.  In the 1920s and 1930s, the sign of a bank that could stand on its own two feet was a bank that disclosed its current asset and liability exposure details.  By the 1970s, banks were effectively 'black boxes' that disclosed broad categories of exposures.

This lack of disclosure made it impossible for market participants to exert discipline on the banks as the information needed to accurately assess the risk of each bank was not available.

Second, the failure of regulators to properly assess the risk each bank was taking and accurately communicate this level of risk to market participants.

As the Federal Reserve Bank of Boston report said: the largest banks were essentially insolvent.  In essence, under regulatory supervision, the largest banks in the US blew up in the 1980s.

Since the response of policymakers was not to adopt more disclosure and bring market discipline to the banking sector, it should have come as no surprise that under regulatory supervision, the largest banks in the US blew up again.

These trends all came together in 2008 with the sub-prime crisis, characterized by Wall Street banks betting on and borrowing against increasingly opaque financial instruments, built on algorithms rather than underwriting. 

Like the institutions of the ’80s, the major banks created investments they did not understand – and, indeed it seems nobody really understood....

Please re-read as there has been no regulatory reform or leadership shown in addressing opacity as it relates to valuing and not pricing in the financial system.

Nor can one say with any confidence that we have seen a fundamental change in the big bank business approach which helped lead us into crisis and scandal. 

The Wall Street banks continue to fight against regulation that would limit their capacity to trade for their own accounts – while enjoying the backing of deposit insurance – and thus seek to keep in place a system which puts taxpayers at high risk. 

In 2011, the six largest banks spent $31.5 million on lobbying activities. All told, the six firms employed 234 registered lobbyists. 

Because the Wall Street juggernaut has tarnished the reputation of banking as a whole, it is difficult if not impossible for bankers – who once were viewed as thoughtful stewards of the overall economy – to plausibly play a leadership role today. Inevitably, their ideas and proposals to help right our financial system will be viewed as self-interested, not high-minded. 

As noted before, however, the major banks were not the only ones implicated in and tainted by the financial crisis. One can, sadly, go on in this vein to discuss a great many other institutions which have disappointed the American public in similar ways, in the process compromising their own leadership status....

So, too, were the good names of credit ratings agencies tarnished – and for good reason – through the course of the housing crisis. These organizations proved to be less watchdogs than enablers, helping to accelerate the financial meltdown, thanks to the favorable ratings they issued for opaque bonds secured by sub-prime residential mortgages – which proved to be no security at all. 

In a recent M&T study, we looked at a sample of 2,679 residential mortgage-backed issues originated between 2004 and 2007 with a total face value of $564 billion. Of that sample, 2,670 or 99 percent were rated triple-A at origination by S&P. Today, 90 percent of these bonds are rated non-investment grade.  

Even the FASB, in their quest for transparency, had engendered an opacity that has done much to scare investors away from the banking industry, because they find its financial statements too difficult to understand. 

The absurdity of current accounting principles was emphasized in the third quarter of 2011, when the value of the debt issued by five of the largest banks decreased $9 billion, and
yet these institutions booked the same amount as profits, representing 44% of
their combined $21 billion in pre-tax earnings. 

For decades, the role of accounting principles was to ensure that a company’s financials properly reflected the performance of the business being conducted. Unintuitive results such as these do little to bolster the dwindling confidence in the American financial system. 

So it is that the crisis was orchestrated by so many who should have, instead, been sounding the alarm – not only bankers but also regulators, rating firms, government agencies, private enterprises and investors....

Your humble blogger did sound the alarm.

One must be concerned that a lack of leadership and trust, and an over-reliance, instead, on the development of policies, procedures and protocols, has created a level of complexity that will decrease the efficiency of the U.S. financial system for years to come – and hamper the flow of trade and commerce for the foreseeable future....

Nor is there any apparent end in sight to the imposition of new directives and rules. The Dodd-Frank Act contains, by one estimate, 400 new rule making requirements, only 86 of which were finalized by the start of 2012 .... By virtue of having more than $50 billion in assets, a measure of size, with no consideration given to the activities in which we engage nor the merits of our actions, M&T has been deemed to be a “systemically important” financial institution and will be subject to higher capital standards as well as costly new liquidity requirements. 

A common feature of many of these new directives is a higher order of complexity than had heretofore been typical, particularly for Main Street banks like M&T which do not engage in excessive risk-taking and rely on fundamental banking services as their primary source of income. 

Utilization of these opaque and intricate methods as a means to prevent a crisis is at best questionable.

Regular readers have seen this argument before as one of the reasons that it is critical to adopt ultra transparency.  Ultra transparency directly addresses the same issues as many of these complex policies, procedures and protocols, but it does so much more efficiently and with much lower cost.

For example, the Volcker Rule.

It is worth keeping in mind that prior to the financial crisis, the Basel Committee had introduced Basel II international banking standards, which among other things
endorsed the use of complex financial models to measure the risks associated with on and off-balance sheet exposures – so-called advanced measurement approaches. These standards proved wholly inadequate in the crucible of the financial crisis. Yet today, despite these failures, models have become more embedded into both regulation and basic accounting, a change which implies substantial increased cost.... 

The proposed Basel III liquidity rules, for instance, call for banks to significantly increase their investments in government securities, leaving less capital for community-based loans which hold the most promise for potential economic progress. 

Such an unintended outcome is reminiscent of that which emerged from the 1992 Basel Accord, providing an incentive to invest in government debt, whether domestic or foreign, and in highly-rated derivative securities of all types including those backed by residential mortgages – all of which turned out to be more, not less, risky. 

The presumption that certain prescribed assets would inherently carry less risk, a thesis clearly disproved in the recent crisis, along with the new proposed minimum level of government bond holdings, would continue the trend of driving resources away from commercial lending – with negative ramifications for fulfilling legitimate credit needs....

The breathtakingly rapid pace of changing regulations makes it challenging for banks and regulators alike to understand the changes, let alone react to them in an efficient manner. The fact that there are so many masters to whom banks today report makes it difficult for one hand to know what the other is doing, whether it relates to coordination among the various regulatory bodies or even among the various divisions within a single agency...

One of the critical advantages of ultra transparency is that it can be easily adopted globally.

Once adopted, prior to imposing a new regulation, a simple question has to be asked.  Does the proposed regulation protect the financial system better than the current disclosure provided under ultra transparency?

We will not, in my own view, be able to make progress absent two key ingredients: trust and leadership. We must again have the sense that leaders, both public and private, will do their best to propose and consider ideas that will serve the general interest, not their own agendas. 

So Mr. Wilmers, are you going to lead the banking industry and voluntarily provide ultra transparency so as to earn back trust?