"In financial ecosystems, evolutionary forces have often been survival of the fattest rather than the fittest." So says Andrew Haldane, Executive Director for Financial Stability at the Bank of England. He is right.
Fat is good in finance; the bigger the better, at least if you need to get bailed out.
One of the siren songs heard throughout the debate regarding the ongoing financial crisis is the seemingly obvious idea that "capitalism has failed" and that markets cannot self-police and adjust. This is patently false.
To be clear: we haven’t practiced true, responsible competition and free-market capitalism in the financial services sector for many decades. Many informed participants would observe that our current financial system of national subsidies and cross-border regulatory arbitrage seems designed to favor oligopolies and special interests. Bigger is indeed better, and getting your way via size, in your industry and in Washington, is the playbook of choice.
To put a finer point on this, as a former bank supervisor I recall a meeting with one of the largest banks in the United States, an entity whose leadership was early to recognize that size matters and could be used to radically reshape financial competition through non-organic growth, opacity, and influence. Given the extreme cost consciousness of the chief executive, it was always curious that he chose to keep his national bank charter rather than converting to a state-chartered member of the Federal Reserve system. As a state-member bank, the CEO would have saved around $40 million a year in annual exam fees, given that the Fed doesn't charge fees, and he could have enjoyed a good, collaborative working relationship with the Conference of State Bank Supervisors.
The chief executive of this bank, now retired for many years, however, was quick to point out that while such a move may have made economic sense, it didn't make political sense. Like the Office of Thrift Supervision, whose primary budget was destroyed by the collapse of Washington Mutual, this bank’s primary regulator relied on his multi-million dollar payment to cross-subsidize much additional agency activity. The loss of this revenue would've been devastating for the regulator. This gave the bank added leverage in dialogue with the supervisor — an affordable "call option," as the executive wryly phrased it.
In this case, bigger was better not only for the influence gained on the policy side of the business, but also for realizing the dream of cross-selling multiple commercial, retail, wealth-management, brokerage and insurance products throughout the bank's customer base, often for securitization and gain-on-sale paper profits.
This "bigger is better" view was supported by the notion, held by many academics, that economies of scale would allow for a multitude of virtuous outcomes — outcomes that would improve credit availability, enhance the distribution of equity and debt, produce more efficient pricing for the benefit of customer relationships, and allow for one-stop shopping.
If only this were true. The reality is that many of the large financial organizations aren't only "Too Big To Fail," they are also often "Too Complex To Manage." This is true not only from a financial risk perspective, an area that warrants significant attention and is notoriously complex, but also from the corporate governance, board oversight and business culture perspective.
In fact, one of the most telling signs of potential loss exposure isn't measuring and modeling financial risk but understanding how a firm is governed, the quality of its executive management, and the nature of the firm's compensation arrangements. Although these are more subjective areas of supervisory and market assessment, it is notable that the Corporate Library rated Lehman Brothers' governance practices a "D" in 2004, four years before the firm collapsed. Quite a leading indicator. Even more interesting is that while governance was in the tank, Lehman's risk management was considered to be robust. Similar stories apply to other large firms that failed, or weren't allowed to fail. Truly, governance and compensation arrangements matter. Perhaps compensation rules and governance practices should become a core, ongoing element of the Article IV consultations that the International Monetary Fund holds with member countries each year.
Given that the governance and culture of traditional banks and investment banks are so fundamentally different, one has to wonder if the Dodd-Frank Act erred by not rebuilding the walls between these two industries. Does the Vickers Report, issued in September by the U.K. Independent Commission on Banking, get it right by proposing to ring-fence traditional retail banking from the more volatile and risk-prone investment banking activity?
Only time will tell. But given the watering down of Dodd-Frank's Volcker Rule after lobbying by special interests — and understanding the massive differences between the governance, compensation, cultural and fundamental social roles of investment versus commercial and retail banks – it is hard to avoid the conclusion that a new version of the Glass-Steagall Act will be needed as the crisis continues to season and, ultimately, reassert itself.
Thomas Day is SunGard's in-house expert on risk management solutions and policy across the banking sector. He also serves as the vice-chairman of the board for the Professional Risk Managers' International Association.
