The roots of modern banking can be traced, in some ways, back to 1960, when Charles Sanford joined Bankers Trust. He rose up the ranks to become chairman and chief executive in the late 1980s. During his tenure, which lasted until 1996, the bank pioneered a number of practices that would later become common in the industry, including the development of new ways to measure risk.
However, the most important innovation that Sanford is most often credited for is the originate-to-distribute model of lending. By writing and then repackaging loans for sale to other market participants, Bankers Trust established a secondary market for loans. This freed up capital from loan originators’ balance sheets, which could then be used to generate even greater volumes of finance. It also placed loans with owners whose funding profiles were a better match for the long-term nature of the credits.
Ten years before the collapse of Lehman Brothers kicked off a global financial crisis in 2008, Bankers Trust was sold to Deutsche Bank as rumors swirled of large losses in its trading book. A few years earlier, derivatives deals for some of its corporate clients went sour, bringing several lawsuits and damaging the bank’s reputation. After agreeing to sell itself, Bankers Trust reported losses of more than $2 billion in late 1998 and early 1999.
The bank’s somewhat ignominious end as an independent institution is “one of the great ironies of modern financial history,” according to Gene D. Guill, a Bankers Trust employee and now a managing director at Deutsche Bank. In “Bankers Trust and the Birth of Modern Risk Management,” a paper written for Wharton’s Financial Institutions Center, Guill describes how a “well-capitalized, highly profitable wholesale financial institution fell victim to the very forces it had sought to manage.”
This observation could also apply to Bear Stearns, Lehman Brothers and other financial firms that suffered when the subprime bubble burst. Now, as financial regulators rewrite rules and customers rethink their relationships with banks, the jury is out on whether a “new normal” will emerge or whether history is destined to repeat itself.
For Richard J. Herring, a Wharton finance professor, a new normal is emerging, although the precise details remain uncertain. But one thing is for sure, he says: “Users of finance are inevitably going to have to pay more.” When demand from borrowers returns to pre-crisis levels, however, “it remains to be seen what kind of innovation will enable banks to generate the same kind of credit,” he adds.
Herring worries about the “clumsy” way in which financial reform efforts, such as the U.S.’s Dodd-Frank Act passed last year, address the shadow banking system. In some ways, pushing for more simplicity and transparency encourages those who prefer their services to remain opaque and complex — not an insignificant part of the financial services sector — to continue to operate in the shadows. Imposing higher capital and liquidity requirements on risky products may also prompt banks to redouble their efforts to shift certain securities off their balance sheets.
It’s not surprising that bankers and bank supervisors don’t see eye to eye on the best way forward. Last year, the Institute of International Finance (IIF), an association of financial firms, openly criticized many aspects of the new capital and liquidity requirements developed by the Basel Committee on Banking Supervision, a forum for the world’s central bankers and financial regulators. “There is a price for making the banking system safer and more stable, and that price will inevitably be borne by the real economy,” said Peter Sands, CEO of Standard Chartered Bank and chairman of the IIF’s Special Committee on Effective Regulation. The “headwinds” resulting from the Basel Committee’s proposals — which have since been adopted, with some softening of certain requirements — will result in slower economic growth and more sluggish job creation, Sands argued.
Whatever the arguments to the contrary, banks will stress that the extra funds they are forced to set aside is capital that they could otherwise lend. By extension, the credit that remains will be more scarce and expensive than before.
As economies recover and interest rates begin to rise in the U.S. and Europe, banks are likely to reassert themselves, even if some of their customers permanently shift to other sources of funding. For all the anger over the banks’ role in the financial crisis, customers are notoriously reluctant to sever banking relationships. Thus, although customer satisfaction scores for smaller lenders and credit unions consistently outperform the biggest banks, meaningful competition for business remains confined to a select club of large institutions.
Other aspects of the emerging landscape for banks (and their customers) will be familiar. Governments are browbeating lenders over extending more credit to small businesses, homeowners and other important constituencies. The size and nature of bankers’ bonuses also remain a source of tension. But the ultimate measure to promote more competition and diversity in the sector — forcibly breaking up the biggest banks — does not seem palatable to officials. “When push comes to shove, legislators and lobbyists for the banking industry make a good case that banks, by and large, do a pretty good job of allocating capital,” says Herring. He wrote papers in the 1980s and 1990s that explored the concept of “narrow banks” — institutions with limited functions in specific business lines — but Herring is “much less optimistic than I was that it will ever be a solution.”
Of course, whether a truly new banking order emerges that encourages a safer yet productive industry depends on “the extent that you believe that the regulations that have been imposed will actually be enforced,” notes Herring. Left to their own devices, “the financial markets have remarkably short memories.”
