Stanford Finance Professors Want Big Banks to Rely on Their Own Money to Prevent Another Crisis

Holly Martins

By Holly Martins
Posted on Wed Aug 13, 2014, Last Updated on Wed Aug 13, 2014

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The American banking industry may be on the brink of its biggest changes since the 2008 financial crisis. But among the different players involved — industry, government, public — there’s a disconnect as to what’s going on, what’s at stake, and what needs to be done.

Stanford Finance Professors Want Big Banks to Rely on Their Own Money to Prevent Another Crisis

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The ongoing battle over the Volcker rule

The banking industry is reportedly lobbying the Federal Reserve for a delay of up to seven years in the “Volcker rule,” which would require banks to sell their investments in private-equity and venture-capital funds.

The rule essentially prohibits banks from making speculative bets with their own money. The Volcker rule has been the subject of an ongoing philosophical debate by top educators at the Stanford University Graduate School of Business. Paraphrasing the analysis of MIT Professor Simon Johnson, the academic argument at Stanford cuts to the heart of the real economic and political issues at stake in banking regulation.

Darrell Duffie, a Stanford finance professor, argues that the Volcker rule will significantly undermine liquidity in debt markets in the short run. He also says the rule probably will increase financial stability risks over time, and potentially raise funding costs for non-financial companies. He proposes dropping the rule in favor of making sure banks have sufficient capital.

Three other Stanford finance professors — Anat Admati, Peter DeMarzo and Paul Pfleiderer — agree on the importance of increasing capital and support the Volcker rule. They believe there is virtually no chance the largest banks will have the ability to grow capital anytime soon.  These professors, who are experts on liquidity issues, believe the implications of inadequate capital trump everything else.

Admati and her colleagues reject vague assurances from big bankers that “we’ll have more capital” because these banks fight strenuously against higher capital requirements. Less equity and more debt means higher payoffs when things go well, but also means bigger losses when mistakes are made or when traders are unlucky.

Too big to fail

Big banks benefit from downside protection provided by the government. This is what it means to be “too big to fail.” Global banks have become a form of government-sponsored enterprise — and it is natural that the people running them want their subsidies to continue and even increase over time.

Duffie prefers to focus on liquidity and argues that the Volcker rule will have two main effects. First, in the short run, very big banks will do less market creation, which will reduce liquidity. Second, over time, new market makers will enter the business, but they won’t be banks and so not subject to the Volcker rule.

The Admati team focuses mainly on the incentives for big bank executives and their ability to keep equity levels low, and see this as the weakness of our system. The big banks lobby constantly to persuade policy makers to keep these subsidies in place.

President Obama chimes in

President Obama recently suggested the government would be paying more attention to regulatory oversight and promoting change in the culture of banking.

In the wake of the financial meltdown, Obama said, the “goal [of Dodd-Frank regulations] was to prevent another catastrophic financial crisis.” But, in his mind, those regulations did not do enough to change risky banking practices.

“More and more of the revenue generated on Wall Street is based on arbitrage – trading bets – as opposed to investing in companies that actually make something and hire people,” Obama said. “We [need to encourage] a banking system that is doing what it is supposed to be doing to grow the real economy… [not taking] big risks because the profit incentive and the bonus incentive is there for them. That is an unfinished piece of business.”

But how much the industry is to be regulated is still the subject of debate by bankers, economists, politicians and activists. Another question is whether blanket banking regulation may already be harming the roots of the industry. And amid all the talk, the industry shows less concern for regulation than for trying to guess “what the customer  wants.”

The impact of blanket regulation on community banking

The perspective from Main Street is entirely different from that of  Wall Street or Pennsylvania Avenue and gets far less attention.

Community bankers say banking regulations that Congress created to deter and punish Wall Street’s misdeeds have had much greater impact on their 7,000 local institutions than on the “too big to fail” banks.

Community banks didn’t cause the financial crisis, they say, because of their business model, which is based on customer relationships rather than transaction volumes. But community banks are still being forced to pay a penalty in regulatory costs to comply with rules aimed at preventing a repeat of the bad behavior on Wall Street.

FDIC data show that large banks have both the lowest credit quality and the lowest cost of funds in the industry. Community banks rank the highest in both categories even though they have had to compete for years against the megabanks’ access to cheaper money in pricing loans.

Community banks must also compete against the big lenders’ lower comparative costs in handling regulatory paperwork. The megabanks also benefit from what’s calculated as an $83 billion annual taxpayer subsidy, the value of implicit guarantees by the U.S. Treasury. It’s been characterized  as “a major driver of the largest banks’ profits.”

Community bankers say they should be putting their capital to work in the small towns, rural communities and middle-class urban enclaves they know well. Instead, they are focusing precious human resources on time-consuming paperwork and compliance measures.

How the industry views its challenges

A new survey shows the corporate banking industry is now looking beyond regulation to focus more on customer concerns.

In polling 100 senior banking executives — mainly from the country’s top 100 banks — auditing firm KPMG finds the industry’s next transformative stage will be driven by customer demand, as opposed to regulatory change, which had driven significant changes to their business models previously.

According to KPMG’s survey, executives indicate that banks are more focused than ever on finding ways to improve the customer experience—including developing new strategies, and investing in and upgrading technology.

While banks look to transform themselves, they also are faced with focusing on different customer segments. When asked which customer segments present the greatest growth opportunity, 27 percent of the bank executives cited the top 10 percent of income earners, up from 25 percent in last year’s survey.

The unbanked and underbanked represent the fastest growing customer segments — nearly doubling in survey responses from last year. Twenty three percent chose the underbanked, up from 12 percent in last year’s survey and 13 percent cited the unbanked, up from 5 percent last year.

The nontraditional competitors, such as retailers, have already started gaining market share from this market segment.



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