If only banking were boring again, as it was from the end of World War II to about 1980, our financial system and economy would be in much better shape, goes the refrain ever since JPMorgan Chase & Co. (JPM) said it had a $2 billion trading loss.
Out with the reckless 20-somethings making millions and back to the safe but dull 3-6-3 business model: Pay depositors 3 percent interest, lend at 6 percent, pocket the difference and hit the golf course by 3 p.m.
Forget about it. The notion that dull-equals-safe springs from a misconception about what banks do. Banking, by its nature, is a risky endeavor. Even the most plain-vanilla banks extend credit and hope to get repaid in the unknowable future. It’s a dicey business and always has been.
What’s more, to re-create the banking industry of the postwar age is a nonstarter. Banks grew along with American corporations as they diversified, spanned the nation, branched out overseas and turned to arcane financial tools to manage their affairs. U.S. banks kept pace, culminating in the lifting in 1999 of the Depression-era restrictions of the Glass-Steagall Act, which had separated commercial banks from their securities businesses.
It is this separation that former Harvard Law School professor and Democratic U.S. Senate candidate Elizabeth Warren, among others, would like to see restored in the belief that it was losses from investment banking that triggered the financial crisis. Banks would then go back to the mundane business of collecting deposits, making loans and providing services to their customers; the roulette players of Wall Street would be on their own and pose less of a threat to the rest of us.
Yet the bulk of the losses for banks during the financial crisis came from lending, much of it tied to residential real estate. The biggest failures — Wachovia, Washington Mutual and IndyMac — were the result of boring banking. They misjudged the housing market, assuming that real estate prices would rise forever. They made too many loans that borrowers couldn’t repay and didn’t charge enough to compensate for the risks.
They went bust the same way banks have since time immemorial. Bankers, like almost everyone else, got caught up in what turned out to be a gigantic credit bubble. When it went bust, losses from bad loans overwhelmed bank capital.
This should be of no surprise to anyone. The other major postwar banking fiascos were also caused by bad loans, whether to Latin America in the 1970s or the Texas oil patch and commercial real estate developers in southern California in the 1980s. Not to mention the savings and loan industry, which was buried by an avalanche of soured loans.
OK, investment banking wasn’t blameless in the financial crisis. Banks’ securities operations helped kick the meltdown into high gear by constructing securities and writing derivatives contracts that no one could understand. Just as indefensible were trades made with money backstopped by the taxpayer-guaranteed federal deposit insurance fund. This practice, the source of JPMorgan’s $2 billion trading loss, would be barred by the Volcker rule provisions of the Dodd-Frank Act of 2010, which has yet to be fully implemented. (A bit of perspective: JPMorgan’s trading loss is dwarfed by the $12 billion in nonperforming assets — mostly uncollectible loans — on its books).
Misjudging risk is what imperils a bank, whether through making bad loans or money-losing trades. Well-crafted rules and vigilant enforcement can help, though regulators are as likely as bankers to miss excessive risk-taking or drop their guard when industry lobbyists whine.
Bankers would surely resist being confined again to the unglamorous side of the business, claiming that they can’t make profits comparable to those in investment banking. This was part of the rationale for ending Glass-Steagall in the first place.
As appealing as it might sound, a measure as draconian as a new Glass-Steagall isn’t in order. A better answer is for investors to demand that banks offer superior performance across all their lines of business, and if they don’t, shed those that fail to measure up.
What’s more, building a business around lending is hardly the road to ruin, provided the right procedures for managing risk are in place. As Bloomberg News reported last week, U.S. Bancorp had the highest risk-adjusted returns among 24 of the nation’s biggest banks in the KBW Bank Index. (BKX) U.S. Bancorp eschews investment banking, unlike JPMorgan and Bank of America Corp., which ranked 16th and last, respectively, in the analysis.
JPMorgan’s dismal ranking raises an intriguing question that in years past was asked of Citigroup Inc.: As an organization, has it become too sprawling and complicated to manage the risks it assumes? If the answer is yes, the bank should either shrink or boost its capital to provide a bulwark against losses.
We think it’s a wise idea for all of the nation’s banks to hold a good deal more capital than now required. The Federal Reserve is leaning in this direction, and has called for banks to hew to the international guidelines known as Basel III. This requires banks to accumulate capital equal to 7 percent of assets by 2019, with the biggest firms holding an additional 2.5 percent.
Even this may not be enough to ensure the safety of the financial system in another crisis. To weather a meltdown comparable to that of 2008, banks might need to have capital of as much as 20 percent. To ensure that they get there, the Fed should be skeptical of demands by banks to use their retained earnings to increase dividends or buy back more of their shares on the open market.
Capital is what stands between a bank and insolvency. It’s what makes a bank safer. Going back to boring doesn’t.