Friday, June 26, 2009
Robert Wilmers: Regaining Confidence
By Robert Wilmers, Chairman & CEO, M&T Bank
My focus, above, has been, as it must be, on M&T own situation. But no discussion of an individual bank's results nor strategy can ignore the extraordinary time in which we find ourselves, a time in which there has developed a crisis of confidence in the financial services industry. It is a crisis which has already prompted unprecedented forms of government intervention but calls for more - much more - action to ensure the long-term health of our capital markets. Regulatory reform will simply not be sufficient nor effective if its focus is confined to historically "covered" financial institutions such as banks. Put simply, nothing we do to "fix" our banks will be enough to allow investor and consumer confidence to return. That is so because, over the course of the past three decades, there has been nothing less than a sea-change in the world of lending, a change which has helped create the sorts of risk - and need for regulatory reform - we face today. Indeed, despite the well-publicized problems of specific banks, the so-called financial meltdown we've experienced over the past two years was owed much more to the investments of what can be call a new, shadow banking system - a system which has actually outstripped traditional banking as a source of credit and yet has been beyond the reach of the regulatory system's standards for safety and soundness. At the same time, it influenced the business approach of traditional banks. Yet regulatory has remained stuck in the past as the world has changed around it.
Consider the fact that, in 1978, commercial banks and thrifts held 71% of all private, non-governmental U.S. loans. Since then, the amount of credit extended not by banks but by other parts of the private sector has grown more than three and a half times as much as that provided by the banking system. Indeed, as of the end of the third quarter of 2008, commercial bank loans accounted for just $6.9 trillion of the estimated $20.3 trillion in private U.S. financial sector loans outstanding. This reflects the fact that throughout the 1980s and 1990s, a new idea about lending took hold and grew. Securitized credit outstanding grew nearly 50-fold from 1980 to 2000 - compared to a mere 3.7 times for commercial bank loans over the same period. Its essential idea: that loans could be sliced, diced and packaged in large groups, to serve as the basis of debt to be sold in the securities markets. This new approach began with mortgage-banked securities, but grew to include a variety of assets. The concept was little short of revolutionary. It meant that bank deposits would no longer be the only - or even the chief - funding source for credit. Instead, loans of all sorts would effectively be financed by the capital markets - and packed and sold by Wall Street. In the watershed year of 1998, bank lending was, for the first time, surpassed by what some call synthetic products sold in the capital markets.
Who was responsible for this huge new universe of lending? The answer to this question is crucial in understanding what form new financial services industry regulation must take. The key actors were a vastly increased number of investment firms far outside the purview of federal or state regulators. The number of unique, identifiable hedge funds increased from fewer than 50 in the early 1980s to 22,650 in 2007. In that same period, their assets under management grew from less than $1 billion to $2.1 trillion. The securitized debt in which they were investing proved, we found out too late, to be laced with risky mortgages, bundled into securities which rating agencies - with their own financial incentives to do so - gave their highest seal of approval.
This is simply not clearly understood by the public - which continues to think of banks as the primary source of credit - and has not been well-explained by political leaders. Thus, regulators have continued to fix their gaze - indeed, to micro-manage - traditional financial institutions such as banks, even as the ground has shifted beneath the entire industry. Banks found themselves on an unlevel playing field compared to others under no obligation to make clear the extent to their debt nor its relationship to their liquid assets. Notwithstanding the need to deal with immediate problems, we must not, in the wake of our financial crisis, fail to review and update the rules of the game. Just as the Depression of the 1930s led to the establishment of the Securities and Exchange Commission and the Federal Deposit Insurance Corporation, so must this current crisis spur regulatory innovation. It is no special pleading on the part of a bank chief executive to assert we must restore the balance of regulatory oversight between commercial banks and other parts of the financial services industry. We should do so not in order to be fair to banks but because the nation's problems won't be solved unless solutions are directed at the entire financial system, not just one-third of it.
So it is that we need a new generation of regulation to extend the time-honored principles of safety, soundness and transparency to what has become a virtual casino of lending. All the players must be included. Investment banks, hedge funds, and other investment vehicles - who are the ones who sparked the securitization boom - must be overseen. The rating agencies which enabled the lending casino to operate by certifying as top quality what turned out to be high-risk bonds, must operate under a new business model: they must be paid by those who might purchase bonds, not by those issuing them. They, too, must be regulated. Complex derivatives, such as credit-default swaps - which ostensibly provided insurance for high-risk investments - must be brought out of the shadows, into a public clearinghouse, such that markets can know their magnitude and extent. (The market for credit-default swaps is estimated to have grown from $500 billion in 1998 to $54.6 trillion in 2008.) At the same time that huge flows of capital must come under a broader regulatory regime, so too, must all players. The activity of U.S. mortgage brokers, for instance - whose number increased from 9,000 in 1988 to 54,000 in 2005, played a key role in the subprime debacle and must have some sort of supervision.
We are neither fond of regulation nor quick to call for more of it. But it is neither consistent nor wise to subject banks to regulation that can only be called intrusive and excessive while the rest of the financial services sector operates in a Wild West environment. There is simply no justification for the exclusion from regulation of any major pools of capital which, if poorly managed, could threaten the smooth functioning of the financial system as a whole.
Apart from the extension of regulatory oversight to what has become a vast shadow banking system, so, too, must we bring common sense to accounting as it affects all financial institutions. This must include, first and foremost, the re-examination of the appropriateness of so-called mark-to-market accounting for balance sheet purposes, in periods of illiquid markets, The ability to reasonably determine the fair value of certain assets in times of economic uncertainty is, at best, severely limited - when those that previously made markets in such assets, for all practical purposes, have gone fishing. No serious observer, however, believes that the long-term value of securities which continue to perform is as low as mark-to-market rules would dictate.
The fact that we must "mark to market" current securities which were highly rated when we bought them, with the intention of holding them for the long haul and which, indeed, continue to pay returns forces us to maintain additional capital. Moreover, marking to market leads to a false picture of our health, as measured by the tangible common equity ratio. It is worth nothing that if such requirements were imposed on the loans we make each day to our customers the entire commercial banking system would have already collapsed, for a loan made today, to even the highest-rated borrower, can only be sold at a considerable discount to its face value, in today's dislocated markets. Such irrational rule making inhibits us from doing exactly what government asserts is the use to which it wants public funds it has injected into the banking system to be dedicated: lending. We will not, however, lend for the sake of lending, especially to those with poor credit histories. We know all too well the consequences of so-called well-capitalized institutions extending credit to borrowers without ability to repay. That's how we got into this mess in the first place.
It is important, moreover, to keep in mind that mark-to-market accounting has not, historically, been standard practice. Indeed, for more than 60 years after the Depression era, the Securities and Exchange Commission resisted adopting such "fair value" accounting, out of concern that such numbers were more subjective than reliable. Having seen its effects, we need not be adverse to reform out of fear that such change would undermine accounting integrity.
Similarly, it is past time to adjust the approach to loan loss reserve requirements imposed by the Securities and Exchange Commission - and which led the banking industry to enter a recession with the level of reserves close to an all-time low. Concern about such phenomena as earnings-smoothing, which preoccupied regulators earlier in the decade, are far removed from our present situation. Indeed, the idea that we should worry about banks putting too much into their loss reserves is hard to understand today. Regulators must recognize that loan loss provision is a matter of judgment; there is simply no way to assess a portfolio of loans and be able to know - with scientific precision - which loans will perform and which will not. Sound judgment will likely lead to a conservative approach - but it is just an approach which regulators have discouraged because of an exaggerated fear of earnings manipulation. It is worth keeping in mind that loan loss reserves are clearly disclosed - such that investors can make up their own minds about the judgment of management. Armchair quarterbacking by regulators has been ill-advised, never more so than now.
In light of the problems associated with mark-to-market-accounting and the formulaic approach to loan loss reserves - not to mention the regulatory failure which allowed a now-infamous $50 billion investment "Ponzi" scheme to go undetected - the time would seem right for a thorough review of the policies and procedure of the SEC. Regulators should take stock of their own performance - and, in that context, it is well worth nothing the concentration of problems which surfaced in the past year in institutions overseen by the Office of Thrift Supervision (OTS). A handful of major thrift institutions regulated by the OTS accounted for the lion's share of payments to depositors which had to be made by the FDIC. Indeed, just four large thrifts accounted for $355.6 billion or 95.6% by assets of the failures in 2008.
This poor quality of oversight has led to sharply-increased-premiums for FDIC member banks such as M&T; we anticipate paying an additional $37 million in such premiums in 2009 over and above those we paid in 2008. It is worth considering whether to abolish the OTS and fold its duties into the portfolio of another, more effective agency.
At the same time we consider long-term regulatory changes, we continue to be confronted by an immediate crisis. It is crucial to make sure that the extraordinary steps being taken to address that crisis do not actually make things worse. The record to date is not altogether reassuring. Consider the Troubled Asset Relief Program, or TARP, the so-called bank "bailout" through which the federal government has injected capital, in exchange for preferred shares in 364 commercial banks and thrifts, including M&T, whose FDIC-insured institutions hold two-thirds of all bank and thrift assets. TARP funs had brought with them to lend at a time when there is limited loan demand - and when we have already added $2.4 billion to our loans in the past year. Indeed, we have not been alone in doing so. For the 12-month period ending September 30, 2008, total loans held by U.S. commercial banks increased by $562 billion. In contrast, over the same period, credit provided by issuers of asset-backed securities, major players in the "shadow" banking industry, fell - by some $320 billion. It may appear that banks are not lending - but that impression is the result of near-collapse of what I have called the shadow banking industry.
It is, in other words, exactly wrong for public officials and the press to complain that the injection of government funds - through the TARP - has not solved our credit crisis because banks are not doing their part.
But when the public complains about banks and the TARP program, it may really be making a broader point. The emergency program was sold as a way to help the little guy - and the large number of homeowners who are in trouble are seeing precious little relief. Finding a way to provide that relief will not be easy, in substantial part due to the complex structure of mortgage-backed securities, on the one hand, and the way mortgages are serviced by independent institutions, on the other - not to mention the financial meltdown which has hit middle America. It's an imposingly complex problem whose solution will demand changes in rules, regulations and even laws - and both creativity and competence in the government approach to helping those in distress.
It's good to see the new Administration working hard, and with imagination, on the problem. As officials do so, however, we hope they keep in mind that the banking industry whose help they will need includes more than just a handful of large institutions. A quasi-oligopoly has emerged among commercial banks - indeed, the top four banks now have a larger percentage of total assets (52%) than all others combined. That's both impressive and distressing. And indeed, these four, together with two other institutions which were granted a fast track to bank holding company status, have received $165 billion or 54% of all TARP funds. Including three other, non-bank institutions that participated, the total increases to $229.8 billion or 75.3% of TARP funds distributed to date. It is these same few institutions or those that they acquired in the past year, or those that have gone bankrupt during the same period, that totally dominated the shadow banking market through their leadership and creativity. It is also their compensation policies that have sullied the reputation of the other 8,341 banks and thrifts in the U.S. that have done the right thing, day in, day out, in their communities. Indeed, one has to raise the question whether allowing the creation of a banking oligopoly is prudent public policy, particularly as it is logical to assume that by dint of size these same institutions would provide leadership to the industry. If past is prelude, one must question whether they will provide the moral tone that leadership demands and what our society expect of its banks.
The goal of public policy in this time of crisis must not be to preserve specific financial institutions - but to restore health to the financial services industry as a whole. We are optimistic that the team assembled by the new Administration in Washington can do just that. We all shape the hope that a thoughtful approach, one which recognizes the changes that have occurred over the past two decades and that revisits the structure and regulation of our financial system, will help restore confidence in our markets It is such confidence on which M&T - and all America - will depend.