Tuesday, June 29, 2010

Will the financial overhaul bill fix what's wrong with banks?

On Friday, congressional conference committee members announced that they had reached agreement on the final contours of the financial overhaul bill. The bill is expected to be put to a final vote in the next week and perhaps be ready to be signed into law by July 4. Knowing the speed with which Congress completes tasks, I will not hold my breath, but it is time to examine what's in the bill and whether it will accomplish its stated objective: to put financial services firms (and especially banks) on a firmer footing and to prevent another banking crisis.

The bill is almost 2000 pages long, which scares the daylights out of me, but it supposedly contains the following ingredients (I will admit that I have not read whole chunks of this bill and what I have read is mind numbingly boring):
Regulatory framework: In addition to allowing regulators to seize and break up troubled financial service firms, the bill allows regulators to recoup the costs of the bailout by making other financial service firms with more than $50 billion in assets pay a fee. In tandem, it reduces the Fed's emergency lending powers and prevents bankers from having a say in who gets to be a Fed president. The Office of Thrift Supervision will cease to exist and the Fed will retain oversight of community banks.
The Volcker Rule: The rule restricts banks from trading with their proprietary capital and from investing more than 3% of the capital in hedge or private equity funds. It also limits banks from bailing out hedge funds that they have invested their capital in.
Derivatives: Standard derivatives (on foreign currency, interest rates etc.) have to be traded on exchanges and backed up by clearing houses, with standardized capital and margin requirements. Banks can still create customized derivatives for clients, but only in restricted circumstances. Banks have to create separate entities for their swap business.
Consumer Agency: There is a new federal agency (Consumer Financial Protection Bureau) that is supposed to protect consumers from fraud/misinformation in financial service company products (including mortgages) by regulating these products and enforcing the regulations.
Investor protection/ power: The SEC can set standards for brokers who give investment advice and hold them to the same fiduciary duty requirements already governing investment advisers. Hedge funds and private equity funds have to register as investment advisers and provide information on trades.
Securitization: Banks that package assets and securitize them are required to hold 5% of the credit risk on their balance sheets.
Credit Rating firms: Allows investors to sue ratings firms for "knowing or reckless" failure in assigning ratings.

The reviews are already coming in. On the one hand, there are some who believe that this reform is too little, too late and that it will do nothing to prevent the next crisis. These critics feel that Congress should have returned Glass-Steagall to the books and broken up big banks. At the other extreme, there are some who believe that the heavy hand of regulation will destroy the competitiveness of US banks, by making them less profitable and valuable, and move the derivatives and swaps businesses to offshore locales. Strange though it may seem, I think that both sides are right on some issues and wrong on others.

Focusing just on the bank-related portion of the bill, there are three questions that I would like to address:
1. Will this bill prevent financial service firms from becoming "too big to fail"?
I don't see how this bill will reduce the likelihood that banks will become "too big to fail". While the bill doles out some punishment to larger banks - the fees on banks with more than $ 50 billion in assets and the exemption of smaller banks from some of the regulations - there is nothing in the bill that will prevent banks from becoming larger. In fact, given that a ton of regulation is going to emerge from this bill, I will predict that the largest banks will have a competitive advantage when it comes to playing the "rules" game and get even larger. I will also predict that the requirement that banks carve out the swap business and other risky businesses will make them more complex and less transparent. From a valuation standpoint, I am not looking forward to valuing either JP Morgan or Bank of America in a couple of years.

2. Will it reduce "bad" risk taking at banks?
The focus of this bill is clearly directed at trying to prevent "bad risk taking" by banks, where "bad risks" are defined as very large risks, which if they pay off, deliver large profits to the bank, but if they fail, become systemic risk that taxpayers are called upon to cover. The separation of the swap businesses at banks, the restrictions on derivatives and the limits on investing proprietary capital in hedge funds seem to be directed at this bad risk taking. On all counts, the lawmakers are reflecting the conventional wisdom of both academics and practitioners on the roots of the 2008 banking crisis and the legislation is written to prevent a re-occurrence. Having watched investment banks operate for 30 years, I believe that they will find new and never-before-seen ways of taking large risks. I will predict that the next crisis will look nothing like the last one, and that this legislation will not only do little to prevent it but will actually contribute to it (by driving risks underground and away from the regulatory eye). Until we deal with the compensation structures at these institutions, where decision makers profit from upside risk and are relatively unaffected by downside risk, we are designed to repeat our mistakes over and over again: "Groundhog Day" in financial markets.


3. Will it make banks less profitable?
Interesting question. At first sight, the answer seems to be yes, since there are restrictions on banks investing in hedge funds and limitations on their derivatives and swaps businesses. On a pure return on equity basis, these are some of the highest return businesses for banks but they are also the highest risk businesses. As an investor in banks, I have always looked at these businesses with a jaundiced eye: they earned high returns but I am unconvinced that they earned high excess returns (over and above the risk-adjusted cost of equity). My prediction is that, if this legislation is passed and put into effect, the returns on equity at banks will decrease, as they return to safer businesses, but their excess returns may very well increase, as the regulations scare away new entrants. Bottom line: Banks may become less profitable (if you define it in terms of return on equity) but in the process become more valuable.

Like all legislation, this one is written with the best of intentions. I hope it succeeds but I don't think it will.

19 comments:

donlsan04 said...

Thanks a lot for the great insight of this new bill. This post is really helpful understanding the complexities and arcane stuffs involved in the policy. Your valuation expectations of financial firms are very interesting. I highly agree that these firms' ROE will get lower as they can no longer load themselves up with debt to the eyeballs anymore. But I am a bit unsure about your valuation perspective. Your argument seems to be based on the assumption that these banks will earn reasonable amount of return with lower risks than before, and the high returns earned in the past were accompanied with high risk, not making them necessarily more valuable. But, I believe that these firms derived lots of value from consistent innovation. It is true that some of them, i.e., credit default swaps, contributed a great deal to the mess we are facing right now, but numerous things created great amount of businesses as well. That being said, I think this bill will change the long-term incentives of professionals working in this field, discouraging them to engage in new areas where it can enhance Main Street's chance to obtain capitals in a new/better way and manage risks/returns in a creative way; and I think this portion of value is underestimated in your thoughts. In other words, there might be a greater chance that these firms' value will plunge than expected.

perpetual wonderer said...

Thanks Prof for this post. As I was reading the highlights of the bill, I kept wondering how most of what it says required a crisis this big to bring it into consideration. I mean, it is really astonishing that it took us as late as 2010 to decide that banks who have invested in a hedge fund should not be allowed to bail it out!

I think the key to avoiding financial crises is to really drive home the fact that crazy returns will almost always have a crazier risk associated with them. And if we keep at it for long enough, the risk is going to come true. The pressure on the financial houses to abstain from such risks needs to come from the consumer side rather than (or in addition to) the regulatory side. Once people realize that it is simply too risky to park their money with someone who, although promising them the sky, is taking on uncomfortable amounts of risk that will bite them sooner or later, there will be pressure on the financial business to either look for more innovative products that offer good returns at a saner risk or offer less risky products that the consumers will be actually looking to buy.

Easier said than done.

perpetual wonderer said...

Prof, I am wondering about the last sentence of this post: "I hope it succeeds, but I don't think it will."

Like you I too can't imagine a law preventing a meltdown. But I can't help but feel that sometimes we are too cynical (not without reason mind you). Is there a way you can think that we can get the law to succeed? I mean, you do agree that its been written in the right spirit. So then what is missing? What do you think this law needs to make it successful? Or are we kidding ourselves by even believing that a law can help in averting (or at least reducing the damage caused by) a crisis?

Is there anything at all, that the legal system can do to prevent such a disaster from happening again? Or is all effort going to prove in vain eventually?

MJS said...

Thanks for the commentary. I agree that it will not prevent the next crisis. The problem is its reactive to some of the causes, while it needs to be not just reactive but proactive to be preventative. Since we don't know the next generation of complex financial engineering that will generate risky profits, regulation should address the incentive structure, which it does not necessarily do.

If they actually spin-off derivatives trading into completely separate companies with separate shareholders/investors, I would think they may move toward becoming less complex during a valuation. But a lot depends on what they define as proprietary trading, another area the bill failed to address, eliminating some of the vagueness in classifying certain activity.

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Joseph Greiner said...

Does anyone have any insight into whether or not this bill is going to improve the transparency of off-balance sheet activities and structured investment vehicles (SIV)?

perpetual wonderer said...

@Joseph:

Although I don't know about that, I do think we are going to need a little more than just a bill to get us transparency on off-balance sheet activities in general. :)

Joseph Greiner said...

I certainly agree. I am bit concerned that this bill will drive a majority of "risky" banking operations into off balance sheet entities instead of increasing transparency and reducing risk. Also, there seems to be an implicit moral hazard in enabling the banking holding companies to 1. operate as a participant in the market and 2. simultaneously act as a market maker.

As a rule of thumb, I simply avoid investing in banks and financial institutions because I find them nearly impossible to value with any reasonable level of comfort.

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