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Herb Allison's Interview on megabanks


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Herb Allison recently spoke to American Banker about his new e-book, "The Megabanks Mess." Here is an edited transcript of the interview:

Q: You wrote this paper, which became an e-book, during the summer of 2008, before the collapse of Lehman, before TARP, before the bailouts of AIG and Citi and Bank of America. What were you initially planning to do with it when you wrote it?

 

Allison: To be accurate, I wrote most of it that summer. The e-book includes more recent events and quotes. But the basic themes were all in the early draft in the summer of 2008. Back then, I didn't contemplate releasing it as an e-book. I was thinking about having it published as a long article somewhere. I didn't intend to write a 200 or 300 page book. I didn't think that this discussion really needed that. But that plan was interrupted when Secretary Paulson asked me to take over Fannie Mae. I didn't feel it was appropriate for me to publish anything related to financial policy while I was serving in Washington running Fannie Mae and then TARP.

 

Q: You started at Merrill Lynch in the early 1970s. What are the biggest ways that the culture of Wall Street has changed in those last 40 years?

 

Allison: Some of that's outlined in the e-book. In the early 70s the financial industry was much simpler and slower changing. Regulations like Glass-Steagall had segmented the industry into product areas such as commercial banking, investment banking, securities brokerage and insurance. There was much less competition for business. Regulations prevented companies from competing with firms outside their product segment. Banks were prohibited in some states from expanding beyond a single branch, or across state lines. Pricing was regulated in ways that assured high profit margins. For example, commissions on stock trading were fixed by the New York Stock Exchange. Interest rates on bank deposits were held down by Regulation Q. Banks and investment banks had steady business from clients they viewed as house accounts. In Wall Street's culture back then, investment bankers considered it impolite or even crass to compete for each other's clients.

 

The forces of change began building in the mid-70s. New kinds of institutional investors, like mutual funds, were growing fast and gaining market power to force reductions in trading commissions. In 1975, the New York Stock Exchange abolished fixed commissions. In essence the bottom fell out for pricing stock trades. Securities firms started looking for new ways of making money. Merrill Lynch invented the cash management account, which was a way of taking advantage of high interest rates to dis-intermediate bank deposits. The banks' regulators responded by relaxing Reg Q restrictions on deposit rates and allowing the banks to expand geographically and to broaden their product lines. So you began to see institutions in formerly separate sectors of the financial industry colliding and competing to generate profit margins.

 

All of that was accompanied by major innovations in finance, such as modern portfolio theory, the capital asset pricing model and the Black-Scholes options pricing model, which opened up opportunities to create new kinds of products and services that could offset the declines in profit from traditional cash products like stock and bond trading, deposit taking and corporate lending. So it was fortunate for the industry that these new financial innovations coincided with a period of deregulation, as did the advances in computing that enabled financial firms to offer a far wider range of products and to expand globally and increase size dramatically through acquisitions. In recent decades we've seen increasing experimentation with unproven products and much greater leveraging of balance sheets in the quest for profits, leading to greater vulnerability to banking crises and greater stress on business models.

 

That's a long answer. In short, the industry was completely transformed over the last 40 years from a highly segmented, highly regulated, relatively uncompetitive environment, to one today, and over the last 15, 20 years, of intense competition, of rapid innovation, with many of these innovations producing less and less real value added. The later innovations have been increasingly extreme product extensions like derivatives of derivatives, securitizations of securitizations and funds of funds, accompanied by much higher leverage in order to generate greater return on equity.

 

Q: You were president and COO of Merrill Lynch when Long-Term Capital Management collapsed in 1998. You've been credited as coming up with the framework for the private-sector bailout that averted a catastrophe at that time. Did that experience inform your thinking over the years about the too-big-to-fail problem?

 

Allison: Yes. That was one of a series of banking crises you can trace back to at least the early '80s with the first of the Latin America debt crises. Then there was the stock market crash in 1987 followed by another Latin American debt crisis, this time in Mexico in the early '90s. Then came the Asian currency crisis, the LTCM crisis and a few years later the dot-com crash and the failures of Enron, Tyco, Arthur Anderson and others.

 

All those put pressure on the banks and each time the Fed had to inject large amounts of cash into the financial system to bolster the largest banks. Long-Term Capital Management was a private-sector bailout, as you know. And what you saw in that crisis was that the banks had taken massive risk on a counterparty that they didn't fully understand. To me, all those crises are parts of a pattern where banks are driven to take excessive risk and often to abuse their own clients and shareholders, all for the sake of maximizing profit.

 

Q: In the book you talk about the industry changing from client-focused businesses to product-focused businesses.

 

Allison: That's right. The rise of institutional investors, who themselves were competing to outdo each other's portfolio returns, Milton Friedman's dictum that the primary social purpose of business is to increase profits, and the advent of takeover firms and private equity firms put great pressure on these companies to grow profits so they wouldn't be taken over by private-equity investors or by banks searching for additional profit.

 

So as margins on traditional products were collapsing, one way banks could grow profit was to acquire other financial institutions and slash their combined expenses, which would increase their stock multiples and the value of their stock as currency for still more acquisitions. So we saw an accelerating race, dependent on increasing profits. The bigger, more aggressive banks gradually, almost imperceptibly, shifted their focus from meeting clients' needs and maintaining their loyalty to looking inward at how financial engineering might generate and sustain profits.

 

Q: Your e-book is titled "The Megabanks Mess." How would you define a megabank? Are we talking about essentially six banks in the United States — JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs, and Morgan Stanley?

 

Allison: In effect, yes. And if you look at the structure of the industry today, you'll see that those six institutions handle about half of banking and investment banking activity. So these are mammoth, highly diversified, extremely complex financial institutions. They dominate the industry and they're very powerful.

 

Here's an important point. A lot of the recent books on the financial crisis are dramatic accounts of individuals' greed or managerial failures. I think it's much more constructive to try to understand better what are the underlying forces that have caused this extraordinary consolidation in the financial industry and have put intense pressure on the banks to relentlessly increase profitability by whatever means possible, including extreme leverage, introducing and pushing unproven products, and masking the full prices of their services - putting their own interests above the interests of their clients. Obviously, some people in the industry broke the law or otherwise cheated their customers. Others were negligent or irresponsible.

 

But broadly attributing the failings of financial industry to evildoers or to greed on Wall Street is a misreading of what was really going on. I think that the great majority of people in the financial industry, including those in the largest banks, embody traits like honesty, hard work and reliability that most Americans admire. But they were - and still are - under tremendous pressure. If they didn't meet or exceed their goals, their jobs were in jeopardy. So they took greater and greater risks that ultimately put themselves and their institutions in jeopardy and vulnerable to failure. And repeatedly the institutions had to be bailed out by the Federal Reserve through massive injections of cash into the system, and through positive yield curves that allowed them to be recapitalized over a period of time.

 

Q: You describe the megabanks as rife with conflicts of interest, and you call for them to be broken up into smaller independent companies, each of which is focused on serving a set of clients with distinctive needs. Explain why this is necessary.

 

Allison: I think it's in the interests of the institutions' own shareholders, not to mention their customers and the general public, that they disaggregate themselves into fully independent new companies, each focused on a particular client segment. If you look at the performance of these banks, leaving aside the fact that they all would have been destroyed without bailouts because of excessive risk-taking, you see that their price/earning and price/book multiples, even after government-assisted improvement in their earnings, stock values and equity capital, are no better than those of regional banks, and worse than broader market multiples.

 

And you're now seeing increasing comment in the press, among analysts and within the industry that market volumes, trading spreads and securitization may not return to pre-crash levels in the foreseeable future, and that the megabanks' business models may no longer be able to deliver the results that investors demand. Already they've had to reduce leverage substantially, and new regulations may force them to increase capital ratios further. And you see a number of them announcing headcount reductions and reducing bonus accruals. I think there's plenty of evidence that their business model — the diversified financial services company — has become obsolete.

 

Of course, the big banks will disagree with that conclusion. They'll say something like this: "Look, how can we compete globally against the megabanks elsewhere if we aren't a megabank ourselves? Our broad capital base, diversification of businesses and scale are critical to our leadership in the markets." But that argument doesn't hold up. First of all, it assumes that the capital and earnings of the banks' more stable businesses, like retail brokerage and banking, can reduce the overall impact of losses in their capital markets activities in a crisis. But that assumption proved false during the crash, when all of their businesses subsided simultaneously. The capital markets businesses had been woefully undercapitalized, and the businesses that had been considered more stable needed all their capital to support their own activities.

 

The crash showed that each business of the conglomerate needs to be fully capitalized to withstand its own stress scenario. If a more stable business is expected to cushion losses in a megabanks' other businesses during a crises, then that business must have more capital, and be charged a higher cost of equity, in order to provide that cushion. In other words, there's no truth to the assumption that the diverse businesses of a financial conglomerate reduce overall risk and require less capital than those businesses would need if they were separate from each other. They don't benefit financially from being combined. So in effect what they were doing was under-charging for capital on the retail side, let's say, as they were using that business to backstop the other businesses. If you really deconstruct the capital needs of the various activities, you will find that each needs to be fully capitalized for the risk that it's taking, and if you do that, and you no longer have these implicit subsidies, they would need more capital. They don't benefit financially from being combined within megabanks.

 

And if you looked at the groupings of the megabanks' subsidiaries that serve individuals or corporations or investment companies, you'd see they could be just as competitive, if not more competitive, by operating independently from the other groups. For instance, the capital markets businesses of most megabanks are world leaders. They could be appropriately capitalized and funded if they were stand-alone businesses, and they would have to reduce their systemic risk in order to assure that they could fund themselves in the wholesale markets.

 

The capital markets businesses of the megabanks could compete just as well without the retail side, and retail could compete just as well and probably better without the capital markets side. Today, one of the mantras of the megabanks is cross-selling - distributing products of each subsidiary through the others. But if, say, their retail businesses really put the interests of their customers first, they'd be totally objective about where they sourced their products and might select products from other companies rather than from their affiliates. Cross-selling is the epitome of a corporate-centered, self-centered approach to doing the business, not a client-centered approach. The banks shouldn't be setting goals for increasing the number of their own products they sell to their own clients. The target ought to be providing their clients with the best possible products from whatever source. And if they did that, they would also be charging lower prices, and becoming more competitive and more trusted.

 

If you look at satisfaction surveys of financial firms, you see that the megabanks score very low in trust among their own retail clients and the general public. Other, more focused, client-centered financial firms have much higher trust levels. Look at where the growth has been in the retail services businesses. It's been with major institutional investors like Vanguard, Capital Group and Fidelity that focus more on delivering returns, and are more transparent about their total fees and performance for clients than are the major banks. So to sum it all up, I think that the megabanks' shareholders, employees and clients, would be much better off if those banks were broken up, and the resulting independent firms each focused on a particular client base, and were more open about their pricing and actual performance for clients. I think we'd have a much healthier financial system because there'd be a lot less systemic risk as well, since each business would be more transparent and funded according to its risk profile.

 

And then, if the banks were to adjust their internal measures of profitability for the particular risk of each activity, and gear employee compensation to risk-adjusted profitability even using imperfect risk models, they would create real incentives internally to control risk, to moderate leverage. The megabanks got no lasting benefits from the illusory profits coming from higher leverage before the crash, because those profits entailed much higher risk and were reversed after the crash. If those profits had been adjusted for risk, they would have been far lower than actually reported. So compensation would have been lower as well. There'd be a whole lot less public anger about compensation. Executives and employees would have still been very well compensated, but not for those illusory profits that later were written off.

 

Q: There's a paradox in what you're saying. You're saying that if the banks were to move from a more profit-focused business model to a client-focused one, they would actually produce higher, more reliable returns to their shareholders. Why should that be the case?

 

Allison: You're absolutely right. That looks like a paradox. And in fact that's the irony of all this. What has their current approach, focused solely on profits on them, gotten them? With a sole focus on profits, the level of profits is never enough. It always has to be more, next quarter and next year. And so they grew faster than the economy in their pursuit of profits. To keep the game going, they had to increase risk in all kinds of ways. And so they ended up facing collapse.

 

They all would have failed were it not for massive federal intervention to save the financial system. Even with all that assistance, they inflicted huge losses on their shareholders. We should keep this in mind: their shareholders would have lost their entire investment if the megabanks had been allowed to collapse. AEven with the bailout, Citi's shareholders lost over 90 percent of their value, and other megabank shares fell 50 to 80 percent. So the shareholders are eventually badly damaged by this almost blind, obsessive pursuit of profit. If a bank's overriding objective is to grow profit, it inevitably loosens constrains on its conduct. It loses sight of the main purpose of its business, its social purposes, which are to help clients improve their financial situations and to finance the economy efficiently and reliably over time. We now have a financial system that, even after the bailouts, is more concentrated than before, so the system is even more vulnerable to problems in those banks down the road.

 

If the megabanks were truly concerned about producing long-term returns to shareholders and customers, they'd adopt a more balanced set of objectives. They'd include, in addition to profit, improvements in efficiency that lower prices and improve competitiveness, and careful control over risk. Their compensation plans would reward balanced achievement of those objectives, so there would be strong incentives to benefit clients and to control risk. Employees would have to generate true economic profits, risk adjusted, and greater benefits for clients in order to be rewarded. So I think you'd more prudent long-term decision-making. The client-focused businesses would have higher, steadier returns over time and would be better able to avoid what I call the megabanks mess of massive bailouts.

 

 

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Q: Given that the Dodd-Frank Act falls far short of your prescription for reform, how would you assess the law, one year after its enactment?

 

Allison: We hear the big banks complain loudly about overregulation and the impact of Dodd-Frank. But they brought on Dodd-Frank through their own irresponsible conduct, and this is not the first time that we've seen a crisis followed by the imposition of additional regulation. Look at Sarbanes-Oxley early last decade. Many banks were complaining that it was going to raise costs and stifle innovation and competition. Nobody complains about it now. But Sarbanes-Oxley didn't prevent the latest crisis. I think it's totally understandable why the government had to enact Dodd-Frank. There was tremendous outrage, and justifiable outrage among the public, among shareholders and customers of the banks, and among people in government, and something needed to be done.

 

Although I think that Dodd-Frank was an understandable outcome of the crisis and that the banks' own actions brought on Dodd-Frank, I believe it's time to take a deeper look at how we regulate the financial industry. In the past, additional laws and regulations have almost always been enacted as a reaction to a crisis. That was true, for example, with Glass-Steagall and Sarbanes-Oxley. So the crafting of regulations is usually backward-looking - aiming to prevent the failures and misdeeds blamed for the last crisis. By focusing on the obvious manifestations, the symptoms, of the last crisis, new regulation hasn't addressed the underlying forces that repeatedly drive these banks to the brink of failure by taking excessive risks, and also cause them to lose sight of their clients' interests in their headlong pursuit of profits.

 

So I think the question is: how can we come up with a regulatory regime that actually harnesses the forces of competition, innovation and profit-seeking in ways that actually work to the long-term advantage of customers, shareholders, and the general public? I think it's possible to do that in ways that don't inhibit competition, innovation and efficiency, and actually improve the industry's performance by shifting the focus of competition to risk-performance for clients and shareholders.

 

We should also take a broader look at the organizational framework for regulating the financial industry. Although there's going to be greater coordination among regulators thanks to Dodd-Frank, the configuration of regulators still reflects the old product-oriented structure of the financial industry 40 years ago. And that's true of Congressional oversight bodies as well. Just as the big banks should reconstitute themselves into client-centered, independent businesses, the regulatory and oversight frameworks should also move from product centered to client centered. For instance, we should consolidate regulation and oversight of financial businesses serving individuals and have a separate structure for comprehensive regulation and oversight of capital markets businesses serving corporations and institutions.

 

We've painfully learned that there were major segments of the financial industry that were not regulated at all, others that were inadequately regulated, and some that were under multiple regulators competing with each other, which led to a race to the bottom in relaxing regulations and oversight. If we step back from the pressures of responding to the last crisis and take a look at how and why the industry has evolved over the last 40 years, we'll see the need for more completely revamping regulations and the regulatory framework in ways that will reshape the industry to better meet the needs of clients, shareholders and the public, and to provide more effective, efficient and comprehensive oversight. Dodd-Frank makes progress in that direction, but it could be improved in time.

 

Q: You spent several years as president and CEO of TIAA-CREF, and you write about how mutual fund fees are taking a big bite out of middle class savings. Do you think this is an important reason why so much of the economic growth over the last several decades has ended up in the hands of the wealthy?

 

Allison: I think that most people at all levels of income and wealth are being overcharged for financial services from the megabanks. I'm sure that even the very wealthy are not aware of how much they're paying for financial services, because the full prices are composed of transactions fees, activity fees, management fees, bundling fees, etc. that aren't presented comprehensively to clients.

 

But I do think that there is a collective intelligence about pricing and performance of the big banks out there in the marketplace, and that could be one of several reasons why savings rates in the U.S. have been low for many years. It is surely one reason why retail assets are growing more rapidly in mutual fund companies than in big retail brokerage firms, most of which are owned by megabanks. I think the public needs to be much better informed about how much they're paying for financial services from the big banks and about the real returns on their assets, net of fees. That information would probably reduce further the flows of savings into the mega-banks.

 

Q: Your public persona is not that of a rabble-rouser or a flame-thrower. Have people been surprised that you're calling for breaking up the mega-banks?

 

Allison: Well, I think the people who know me well probably aren't terribly surprised. Even though I had a great career at Merrill and am very proud of what my colleagues and I accomplished there, my views of what needed to be done were often out of the mainstream. I was frequently advocating for improving ways we did business and strengthening corporate governance, and we did make progress and, I think, lead the industry in those areas for some time. Unfortunately, Merrill became a much different company during the last decade. Like some other major financial firms, it abandoned constrains on risk-taking as it obsessively pursued profit.

 

There's a tendency is to frame stories of the financial crisis around personalities and colorful conflicts. So I can see why it's kind of interesting that I was a leader in the industry and now am criticizing the structure and business models of the industry that I was part of building years ago. But the real story isn't about me or leaders who later ran the megabanks during the boom and crash. It's about what's in the interests of the American public, what's needed to help stabilize and make more efficient the financial system in the United States. To focus on personalities is to miss the point, to distract from understanding the underlying forces pressuring the industry and the flawed responses to those pressures that have diminished potential benefits to the public at large, to the customers and the shareholders. That's what we ought to be focusing on. And that's why I think that my e-book doesn't go into personalities. It is novel, I think, in probing more deeply the underlying reasons why the megabanks keep getting themselves into trouble and falling short of meeting their responsibilities to help clients optimize their financial situations and promoting efficient, stable markets.

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That is super - thanks for posting it.

 

One thing -- a breakup of the megabanks is not a negative for current shareholders, it is a positive.  They end up with their proportionate interests in each of the spinout enterprises.  Most of those will do better, being more focused, and produce higher earnings and P/E multiples.  The breakup of Canadian Pacific several years ago is an example.  As another example, consider Microsoft -- had they chosen to voluntarily go along with the govt pressure a decade ago, and be broken up into two firms, shareholders would have gained a lot.  Who knows, perhaps even one of the MSFT spinoffs would have been in the innovative position of Apple today?  A successful species crowds out its competitors, and then the successful will itself differentiate.

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