Big banks see need to shrink, but face hurdles
New York/London - When the US Federal Reserve's newest policymaker Neel Kashkari dropped a bombshell with a call to break up big banks on Tuesday, it was met with a predictably indignant response from their lobbyists. One described his comments as “blind”.
But while no one in the executive suites of major global banks would want authorities to force them to split up or downsize, many top bankers acknowledge that their institutions might be better off smaller and simpler. They just worry that any major restructuring could go all wrong because of the way post-financial crisis regulations are applied.
In interviews with Reuters, six senior bankers said they are struggling with the costs and restrictions they face as a result of new regulations, as well as a weak global economy and troubled financial markets. The bankers, who are or recently were in positions ranging from business division head to CEO, spoke on the condition of anonymity so they could be candid without upsetting regulators or investors.
“Fundamentally, the business has to change,” said one veteran banker who was on the executive committee of a major European bank until recently. Big banks' shareholder returns have sunk “too low”, he said.
These problems are not new, but they have fresh relevance as Deutsche Bank AG confronts questions about its capital adequacy, Barclays PLC faces pressure to break up and CEOs of big US banks struggle with a loss of investor confidence in their stocks.
Management teams in the US and Europe are now taking a hard look at dramatic business model changes, but none of the options are particularly attractive, the bankers said.
Merging to cut costs and improve margins is out of the question, given the hurdles banks would likely face from regulators who do not want “too-big-to-fail” institutions getting any bigger. Splitting apart is complicated by capital requirements that would make standalone trading businesses economically unfeasible - and by the fact that there are few, if any, buyers for the assets banks want least.
Some top bankers say they are left with little choice but to muddle through what they fear will be a long, dark period of weak earnings, angry shareholders and gradual shrinkage.
The problem has gotten so bad that Deutsche Bank CEO John Cryan recently said on a public conference call that he'd much rather be CEO of a simpler, retail-focused bank like Wells Fargo & Company, which has only a modest investment banking operation.
“Unfortunately,” he said, “there are lots of things I wish for that are not going to come true.”
Ratcheting up capital
Kashkari's comments, in his first speech as head of the Minneapolis Fed, were surprising because he is a former Goldman Sachs banker, a Republican, and was a senior Treasury official in President George W. Bush's administration during the financial crisis.
They partly echoed the stance of Bernie Sanders, who has also called for big bank breakups and criticised Hillary Clinton, his rival in the struggle to be the Democratic presidential candidate, for being too close to Wall Street. Some of those vying for the Republican nomination have also criticised regulations brought in after the crisis, saying they would repeal the Dodd-Frank reform law.
In an interview with Reuters on Wednesday, Kashkari criticised Dodd-Frank's so-called “living will” rule, which requires banks to show how they can be dismantled in an orderly way if they fail, without creating risk to the broader financial system. Kashkari said he believes the rule would not work in a crisis scenario - that banks would simply be bailed out again.
“I challenge anybody who thinks, in a stressed time, we would put these banks through resolution,” he said. “I really don't think it will happen.”
One way to force large financial firms to break up is to “aggressively ratchet up” their capital or leverage requirements, Kashkari said. He warned, though, that banks would likely fight hard against any such proposal.
Indeed, Tony Fratto, who worked with Kashkari at the Treasury Department and is now a bank lobbyist at Hamilton Place Strategies, said his former colleague's comments were out of touch with reality.
“This is something like re-opening the barn door after the horse is in the stable,” Fratto said. “Love or hate Dodd-Frank, it's simply blind to say that it hasn't significantly improved safety and soundness.”
Out of arrows
Securities analysts and consultants say that banks are in an unenviable position because moves they might have made in the past to improve profitability have been hindered by regulation. As a result, they have struggled unsuccessfully for years to get their returns on equity above single digits.
“In some ways, banks have become bad utilities,” said Fred Cannon, a bank stock analyst with KBW. “With utilities, you have strict regulation in what you can do and charge, but in the end investors get a reasonable return. With banks, that last piece hasn't happened.”
Bank executives have long argued that weak returns are a “cyclical” issue that should go away when markets begin to flourish again. But as the industry approaches the eighth anniversary of the financial crisis's nadir, questions about whether they face a secular rather than a cyclical profit problem have only grown louder. And top bankers are now wondering how they can possibly grow revenue under a sprawling set of global financial regulations that limit what they do, and sometimes conflict with one another.
One common example raised is how new capital rules can penalise banks for being big but also discourage them from getting smaller.
For instance, due to their size, the eight largest US banks must collectively hold $200 billion in extra capital, which weighs on shareholder returns. Included in the capital requirement is a fixed amount each bank must hold to represent “operational risk”.
Although the Fed does not explain exactly how it comes up with that figure, it is not just a function of size: Bank of America must hold 25 percent more operational risk capital than JPMorgan Chase & Company, the biggest bank in the country.
Bank of America has said it's taken steps to address the Fed's concerns by cutting back on certain revenue-producing activities that created operational risk. Nonetheless, the bank says it has so far been unable to persuade the Fed to reduce that capital requirement. Its shareholder returns suffer as a result, because revenue is dropping faster than capital costs.
“Every bank is trying to figure out, with bigger capital requirements and profit pressure, how can they create acceptable returns for their shareholders,” said John Weisel, an Ernst & Young executive who advises global banks on business strategy.
After years of cost-cutting, he said, CEOs are asking themselves: “We've used all the arrows in our quiver, so what are we going to do next?”
European banks are behind their US competitors in addressing a more regulated environment and, in some cases, are flailing around for answers.
Last week, Deutsche Bank shares hit an all-time low on worries that it won't be able to buy back some bonds that can convert into equity. Deutsche regained some value after it outlined plans to repurchase $5.38 billion worth of other bonds, but investors' concerns don't seem to have been entirely assuaged.
Meanwhile, Barclays has come under pressure after a Bernstein analyst wrote an open letter on February 5 imploring CEO Jes Staley to break up the bank.
Rob McDonough, who advises financial institutions on risk management at Angel Oak Consulting Group, says megabanks may have little choice but to get significantly smaller.
“It's too expensive for banks to be big,” he said.