Complexity, Not Size, Determines Banks' Risk to Financial System

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Although M&T's defining character as a bank that serves its communities may be clear to us, it is no longer the yardstick against which we're measured. There are 33 banks with more than $50 billion in assets in the United States; M&T is the ninth smallest of those banks. Because it exceeds that asset threshold, it is held to many of the same standards as banks with much more complex business models and intricate global exposures. We're expected to maintain a regulatory infrastructure on a scale similar to the large banks.

We remain confident that our essential community-oriented business model will continue to serve both our customers and investors well. It is of concern, however, that the distinctive virtues of that traditional model of banking as practiced not just by M&T but the majority of American banks are less than fully appreciated in some important quarters.

The imperative of distinguishing between what might be called Main Street and Wall Street banks has been discussed previously, but it bears repetition, analysis and specific illustration. Simply put, the 6,482 community and regional banks of Main Street have a very different business model than the five large U.S. banks that dominate the activities traditionally associated with Wall Street.

Main Street banks gather deposits and make loans; they are the primary providers of finance to local businesses in the neighborhoods they serve. Loans comprise 61% of assets at regional banks compared with just 31% for the five large, complex and globally interconnected U.S. bank holding companies.

Perhaps no other measure illustrates this point better than the comparison of lending to small businesses. It is interesting to note that last year those five large banks funded 4% of Small Business Administration loans, a subset of loans made to small businesses, while the rest, Main Street banks, funded 96%. Core deposits fund 64% of assets at regional banks; the comparable figure for large banks is just 32%.

Those five large banks have limited branch networks in smaller and rural communities. Just 55% of these large bank branch offices can be found outside the ten largest metropolitan areas, compared with 73% for regional banks.

Beyond these distinctions, the key feature that differentiates the operating model of most large banks is their involvement in the trading and manufacturing of derivatives — instruments that have long bred complexity and confusion.

In fact, five banks accounted for 95% of the $304 trillion of U.S. banking sector derivatives outstanding at the end of September 2014. To put it in perspective, that figure amounts to 16 times the U.S. GDP and 19 times the total banking system assets in the U.S. — eye-popping indeed. Even after the crisis and subsequent adoption of the Volcker rule, the five large banks in 2014 still accounted for 90% of total U.S. bank trading revenue while the remaining 6,482 banks accounted for 10%.

Since their creation in 1848, derivatives markets have been afflicted by speculation, lack of transparency and manipulation. Noting the price distortions that wreaked financial havoc on America's agricultural sector during the Great Depression and caused widespread public hardship, President Roosevelt said, "It should be our national policy to restrict, as far as possible, the use of these [futures] exchanges for purely speculative operations."

The Commodity Exchange Act in 1936 required that futures contracts be traded on regulated exchanges, which facilitated transparent price discovery, identification of buyers and sellers, standardization of contracts and adequate capital to support the fulfillment of contractual commitments. Since the use of swap contracts came into being some 34 years ago, they have been progressively exempt from regulation.

In 2000, the passage of the Commodity Futures Modernization Act effectively removed the swaps market from almost all pertinent federal regulatory oversight and preempted state rules and regulations. The outcome: the bankruptcy of Jefferson County, Alabama, also a consequence of interest rate swaps, which resulted in increases in sewer rates to its citizens of 7.9% annually; losses incurred by the city of Detroit, which later filed for bankruptcy, on swap contracts connected with pension debt; and payments required to be made by the Denver public school system to terminate complex derivative transactions originally executed with the promise of bolstering its pension fund, among many other instances of large scale impact on the taxpaying public.

Use of credit default swaps to place bets that homeowners would default on their mortgages had devastating consequences to the American public during the last crisis. These "naked trades" by parties with no exposures to the underlying mortgage loans significantly outweighed the actual amount of mortgage debt outstanding.

The disruptive forces that exist in the derivatives markets will most assuredly endure. Despite their usefulness as a risk management tool to assist those engaged in commerce and industry, derivatives have been a vehicle for speculation and price manipulation almost since their inception. In the absence of effective regulation, their use for speculative endeavors continues to have the potential to damage our financial system.

It is comforting that in the aftermath of the crisis, government agencies have regained the required authority to supervise this $304 trillion market, particularly as it relates to bank holding companies. An indication of the breadth and depth of the regulatory effort is provided by seven federal agencies which together issued 81 final rules and an additional 35 proposed rules, totaling by one estimate 11,844 pages in the Federal Register over four years. The complexity, opacity and potential of derivatives to again seriously damage our economy are clearly too great to be ignored.

Even with the benefit of the regulatory efforts mentioned above, one of the hallmarks of derivatives remains their lack of transparency. It is difficult for regulators, investors and others to understand the true exposure of the banks that dominate trading in derivatives and the extent of their interconnectedness. Even with an average of 13 pages of footnotes in the financial statements of the five large trading banks, one is left with far more questions than answers.

Although complexity is often equated with size, that equation is a spurious one — one of the largest U.S. banks has an operating model that is much more akin to Main Street banks than the other large banks. Loans to individuals and commercial borrowers comprise 52% of its assets while 62% of those assets are funded with core deposits and 70% of its branches are located outside the ten largest metropolitan areas. Trading activities comprised just 2% of its revenue last year, yet it has $1.7 trillion of assets. It is interesting to note that this bank was the only one among the largest six U.S. banks whose plan to manage an orderly disposition in the event of distress, was accepted by the regulators — an indication of the simplicity of its business model.

It is only logical that the sophistication and granularity of the quantitative modeling and analytical capabilities required to manage a large trading portfolio, where values change on a daily basis, and traders' compensation systems offer large payouts for short-term performance, differ extremely from those required for a regional bank, whose loan portfolios are held to maturity rather than traded on a daily basis, where the quantity of leverage is transparent, the bearer of risk of loss is clearly identifiable and loan officer compensation programs are more mainstream.

Indeed, rules intended to increase transparency, require adequate capital to honor commitments, and ensure identification of the parties involved through a central clearing system so that failures can be resolved in an orderly manner, are not just logical but long overdue.

So the question is not whether, but how. How does one effectively regulate institutions whose defining characteristic is complexity, a feature derived significantly from their domination of the business of manufacturing, trading and selling derivatives in the United States, without burdening the rest of the banking system that is critical to facilitating much-needed economic growth? It seems abundantly evident that in order to maximize effectiveness, regulation should be based on the complexity of business model, and not on the size of institutions.

Robert Wilmers is the chairman and chief executive of M&T Bank in Buffalo, N.Y. This article was excerpted from his 2015 letter to shareholders.

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