Checkup for U.S. Banks: Healthy in Appearance — but Weaknesses Remain

At first glance, U.S. banks look like they’re getting healthier. Many of the biggest have repaid government bailout money, some are reporting solid profits and the government is winding down programs that held financial services firms together during the worst of the crisis.

But it’s not yet clear that the banking industry is emerging from the financial meltdown with the kind of fundamental changes its harshest critics — and even some of its staunchest defenders — had hoped for.

Some experts think the banking industry is sufficiently chastened by the horrors of the past year to foreswear the high-risk practices like leveraged investing that nearly destroyed it — at least for now. But others worry there has been little meaningful change, that the banks’ apparent health is largely owed to government help rather than smarter practices and that another crisis is a virtual certainty, even if many years away.

“Having survived the crisis, the banks will cut back on risks for a while,” says Wharton finance professor Richard Marston. “Partly, this is because of their near-death experience. But it is also because the economy is in recession, so caution is in order.” This was “a crisis that’s not going to be forgotten tomorrow,” adds Wharton finance professor Jeremy J. Siegel, arguing that banks and other financial institutions will play it safe for some time. “It’s indelibly printed on, I think, all of the financial institutions.”

But Wharton finance professor Franklin Allen is not as optimistic. “Nothing much has changed. All the potential for problems is still there,” he says. “In fact, in many ways it is worse, because after Lehman we know that the government won’t let the banks go…. Whatever they do, the government is going to come in and bail them out.”

While the financial crisis began early in 2007 with the tumbling values of securities based on subprime mortgages, it was the government’s September 2008 decision not to rescue Lehman Brothers, the investment bank, that pushed the industry to the brink. A wave of panic arose as institutions worried about one another’s financial health, undermined by their holdings in debt-based securities that were plummeting in value. Amid mounting concern that loans would not be repaid, lending dried up.

After receiving enormous infusions of government cash, the banks are clearly in better shape today. On September 11, Treasury Secretary Timothy F. Geithner told Congress that banks were having growing success at raising money from private investors, allowing the government to begin winding down some of its emergency loan and guarantee programs. The Obama administration is no longer talking about possibly needing another $750 billion in bailout funds, feeling the original $700 billion is enough. Of that, about $239 billion was pumped into banks and other financial institutions, and about $70 billion has been repaid. Geithner said he expects another $50 billion to be paid back over the next 12 to 18 months. Programs to prop up money market funds and guarantee bonds sold to financial institutions will wind down this fall.

“The consensus among private forecasters is that our economy is now growing, the financial system is showing signs of repair and the cost of credit has fallen dramatically,” Geithner said. “It is clear we have stepped back from the brink.” Marston, too, sees positive signs. “With the economy coming out of recession soon, if not already, the prospects for banks over the next few years are quite good,” he says. “But in the very near term, they will see loans default, especially in the real-estate sector, including commercial real estate.”

Two of Wall Street’s biggest banks, JP Morgan Chase and Goldman Sachs, announced record earnings for the quarter ended June 30. But two other giants, Citigroup and Bank of America, continue to struggle, although they, too, are getting healthier. An analysis by The New York Times shows that financial institutions’ combined market capitalization is far smaller than it was at the peak two years ago, but that acquisitions have actually made JP Morgan and Wells Fargo bigger than in Oct. 2007. Big firms are even more dominant than they were back then. Four firms — JP Morgan Chase, Wells Fargo, Bank of America and Citigroup — account for just over half of the market capitalization of the largest 29 firms, compared to about one-third two years ago.

Too-Big-to-Fail Banks Now Bigger

Many experts worry that these and other large firms continue to be so big that, if there were another financial crisis, the government would have to rush in to prevent a failure that could again send a tsunami of fear and risk through the financial markets.

Some also worry that the banks reporting surging profits are merely benefiting from unusual conditions rather than finding better and safer ways to do business. JP Morgan and Goldman have flourished on traditional investment banking functions like securities trading, and underwriting new stock and bond issues. JP Morgan benefitted tremendously from government help acquiring two troubled companies, Bear Stearns and Washington Mutual. Some reports say the firm’s dominance allows it to charge more for services to corporate clients.

According to Richard J. Herring, finance professor at Wharton, the Federal Reserve’s policy of keeping short-term interest rates near zero has been a boon to the banks, allowing them to pay next to nothing to borrow money that can be lent at much higher rates. Interest paid to depositors with ordinary savings accounts averages around 0.2%, while banks can collect 5% or 6% on mortgages, for example.

“Keeping short-term rates at about zero is a direct subsidy” from the government to the banks, Herring notes. Moreover, bank business is not growing as much as rising profits suggest. “For most of the banks, most of the increases in profitability have been in cost reduction rather than increased revenue.” Banks that trade securities with their own funds have profited from unusually volatile securities markets, he adds, and some investment banks are making money helping out other banks that are still in trouble. Gains from low rates, cost cutting, volatile markets and helping institutions in temporary trouble are “not sustainable” in the long run.

Other experts worry that banks, though chastened by bad bets, leverage and other risky practices of a few years ago, have not learned their lesson for good. At Goldman, risk has been reduced by cutting leverage, so there is only $14 in investments and loans for every dollar of capital, compared to $24 a year ago, according to The New York Times. But how long will a more conservative approach last if there is lots of money to be made taking big risks?

On Wall Street, pay is returning to levels that seem astronomical to outsiders. The 30,000 Goldman Sachs employees earn an average of $700,000 each. At such rates many earn enough in just a few years to be set for life. Critics say that encourages short-term risk taking that can pump up bonuses while undermining the long-term view that is safer for the economy.

While much attention has focused on the improving results among large banks, there are still plenty of problems among the smaller ones, says Herring. “I’m kind of waiting for another shoe to drop.” Large banks that engage in activities like trading their own funds and underwriting new securities generally have to carry assets on their “trading” books at current market prices, he says, while many smaller banks have more accounting leeway.

“If you’re a simpler bank that doesn’t deal in much trading or capital-market activity, then everything is in your banking book, and it gets marked down when you or your regulator makes the judgment that it’s no longer worth what you are carrying it for on your books, and that’s a long process.” This makes it harder to tell if smaller banks are carrying ticking time bombs in the form of assets, like debt-backed securities, that may not be worth as much as the banks think they are, Herring adds.

Putting accurate prices on such assets is difficult because values depend on whether future cash flows come in as expected. If the economy does not recover quickly, many homeowners will default on mortgages, undermining the value of mortgage-backed securities that pass mortgage payments on to investors. Securities based on credit card debt, commercial loans and other debts would also be undermined by a sluggish recovery, hurting financial institutions that own them.

“Basically, the solvency of a bank depends on its cash flows,” says Wharton finance professor Marshall E. Blume, adding that prices of some “toxic assets” may have recovered a bit over the past year, but so long as they remain on banks’ books they can cause serious damage. “The problem’s not over.”

‘Lots of Trouble Ahead’

Herring notes that the Federal Deposit Insurance Corp. had 416 banks on its “problem list” on June 30, up from 305 March 31. “That list is going to grow, it’s not going to shrink,” he says. While the FDIC has a proven process for shutting failed banks, it is only capable of closing four or five a week, he says. “So that’s a lot of trouble ahead.”

Herring is skeptical there will be a robust enough economic recovery to avert this problem. “I don’t see consumers resuming their former spendthrift ways for some time,” he says. Millions have lost their jobs or worry they will, most have seen their savings and investment shrink, and falling home values leave homeowners with less equity, if any, to tap for spending. “The other thing to worry about is commercial real estate,” Herring says. “It’s on a downward trajectory, and [reversing] that is going to be highly dependent on economic recovery.” This is a big concern for smaller banks, which have made large commercial real estate loans.

Obama has proposed regulatory reforms that would give the government power to step in and shut down large troubled firms in an orderly way. He also wants tougher regulation of exotic derivatives like the credit-default swaps that swamped American International Group, the giant insurer. And he wants to create a Consumer Financial Protection Agency to regulate lending and other transactions affecting ordinary consumers.

But his proposals have not gained much traction in Congress, which is preoccupied with health care reform and sees the financial crisis abating. “In a sense, the best time to get reform through Congress was probably right after Lehman collapsed [in September 2008],” Herring said. “But no one knew what to do then…. By the time we do, there might not be much pressure for reform.”

Siegel argues there is no need to rush reform, noting that key elements of the administration’s proposals would limit financial institutions’ use of leverage, which they are doing on their own out of fear of repeating past mistakes. “We do not need to go forward [with reform] tomorrow,” says Siegel, who supports higher capital requirements and a system for shutting down all kinds of failing financial institutions similar to the FDIC procedure for closing deposit-taking banks. “We are not going to have to start bailing them out next year, and the year after, and the year after that.”

Marston notes there already is opposition to significant regulatory change. “Now that the worst is over, the banking lobby will work hard against meaningful reform,” he says. “So we will have a banking crisis again — many years later. And next time banks will be more confident that they will be saved. Banks and a lot of other financial firms are too big to fail, but also big enough to prevent meaningful reform.”

“I don’t think much will happen until we get to the next crisis,” Allen said of regulatory reform. “Maybe it’s five years from now, maybe it’s 10 years from now, but maybe it’s just a couple of years from now. We will see.”

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