Whatever one's view of Occupy Wall Street -- and how quickly those on the right and those on the left have gone to their respective corners and hammered out their talking points -- it is a positive step that there might be some thought given to where we are and where we are going. But so far, one group has been fairly quiet, if the point is to address the undue political clout and financial power -- to say nothing of economic risk -- now manifest in our leading banks. It is the voice of the American banker.
Not Jamie Dimon, the CEO of JP Morgan, who continues his reign as the doyen of US banking -- nor Goldman Sachs CEO Lloyd Blankfein, who occupies a very different role in the public imagination -- but rather the leaders of 7,500 other banks across the country. These are the banks that continue to play the critical role of commercial banking in our economy -- they take deposits and make loans.
As a result of two decades of consolidation, the commercial banking industry in the U.S. has become increasing concentrated. Today, the four largest banks, JP Morgan, Citibank, Bank of America and Wells Fargo, comprise just over 40% of the total assets of the U.S. commercial banking system.
Contemporaneous with this consolidation was the integration of investment banking and commercial banking, with the final removal of Depression-era restrictions two decades ago. Legislated changes in 1999 and 2000 paved the way for the new focus on trading within the commercial banking world, and the explosive growth in derivatives.
But the purpose and rationale for a publicly-supported commercial banking system remains its depository and lending functions. Banks take deposits, which are federally guaranteed, and they use a combination of these deposits, equity and debt capital, and loans from the Federal Reserve Bank to make loans -- to judiciously allocate capital across the productive sectors of the economy.
A quick scan of the list of highest loan/deposit ratios among bank holding companies published by American Banker illustrates the richness of the banking sector, with institutions ranging from Bank of America to Big Sandy Holding Company, the owner of Mile High Banks in Colorado that boasts 160 shareholders. The ratio of loans to deposits may not be the most appropriate metric for assessing bank performance in their public mission, but to a lay person it seems to be a reasonable start. Wells Fargo and Bank of America, both commercial banks with deep roots on Main Street, are among the top 200 banks in that ranking, while neither JP Morgan nor Citibank, both banks culturally rooted in Wall Street, appear on the American Banker list.
JP Morgan and Citibank are at the top of another list -- this from the Bank Trading and Derivatives report published by the Office of the Comptroller of the Currency, the lead federal regulator of the commercial banking system. JP Morgan and Citibank are ranked one and two here, with a combined $134.2 trillion of total outstanding derivatives contracts, or 54% of the total $249.3 trillion of derivatives in the commercial banking system. Add the third and fourth ranked banks, Bank of America and Goldman Sachs, and those top four hold $191.1 trillion, or 77% of the total derivatives exposure in the banking system. By comparison, those four banks hold 46% of the total risk-based equity of all banks that participate in the derivatives market.
Without doubt, certain derivative products play a valuable role in commerce, trade and commercial risk management. Commercial, industrial and agricultural clients -- the traditional clientele of the commercial banking sector -- reasonably need to hedge interest rate exposure, foreign currency risk and commodity prices. But the $134.2 trillion of contracts for JP Morgan and Citi alone far exceeds the levels of economic activity that one might imagine being hedged -- the $89.6 trillion of interest rate hedges is six and one-half times our national GDP, the $10.4 trillion of foreign exchange hedges are five times the dollar value of the imported goods and services that domestic firms might conceivably want to hedge in a given year, and JP Morgan's $6.1 trillion book of credit derivatives approximates the total value of corporate debt outstanding in the U.S. economy.
Does this matter? Beyond the shock value, are there valid reasons to reassess the appropriateness of this volume of derivatives business and the potential financial risks that it entails? Does the fact that one-quarter of commercial banks do no derivatives business at all, and only one percent of US banks have enough derivatives exposure to warrant public concern, suggest that the extent of the derivatives exposure of the top banks is not necessary for assuring effective and efficient client service? This is not a question of government meddling in private affairs. Quite the contrary, the commercial banking system has been constructed based on a system of deposit insurance and access to loan capital from the Federal Reserve. Accordingly, these banks are engaged in businesses that are directly supported by public resources and guarantees, and therefore can expect public scrutiny.
The argument JP Morgan would make is that their "derivatives book" is fully balanced, with every positive exposure balanced by a negative exposure. That is to say that for all their long positions in a given currency, or interest rate movement or General Motors bond, they have an offsetting negative position. They are not "net long" or "net short."
Similarly, their derivatives book is balanced with respect to counterparty credit exposure. For every position where they might be taking, for example, Deutsche Bank risk, they have a balanced and opposite position that theoretically keeps them neutral and protected against counterparty credit events.
Thus, in the case of JP Morgan, as reported to the OCC, its total $78.1 trillion derivatives portfolio actually leaves it with total net credit exposure of $361.0 billion, or just 2.71 times their risk-based capital. So, the theory goes, despite the eye-popping numbers, JP Morgan, and by extension other banks active in the derivatives business, are managing their affairs. And, they would submit, the risks are manageable.
But the theory seems to miss two salient points.
The first point reflects the corruption of the culture of commercial lending as banks embrace the trading culture that is central to the derivatives world. The mission and purpose of the commercial banking system is the efficient allocation of capital across society. Commercial banking has been seen as a sleepy world of bankers with green eyeshades, pouring over financial statements, even as Jimmy Stewart, playing George Bailey in Frank Capra's 1946 movie It's a Wonderful Life, portrayed the iconic Main Street banker, who made America work.
And that remains the mission of America's commercial banks. They invest in Main Street businesses, small businesses that grow from the dreams of their founders, businesses too small to issue stock or access the bond market, and they partner with them from one decade to the next.
Commercial banking is a slow business that takes time. This is a sharp contrast with the world of derivatives trading. Derivatives trading is a form of securities trading with magnified, and in certain cases unlimited, leverage. As noted above, derivatives contracts have two primary risk attributes, event risk -- did interest rates move against your bet, or did GM go belly up--and counterparty risk -- this was the AIG problem, where AIG could not perform on its end of the derivative contracts and there was a scramble among counterparties to get what they could.
As in the AIG episode, the collateralization provisions of the standard derivatives contracts now constitute the largest area of risk exposure. With the downgrades of Bank of America and Wells Fargo this month, and the turmoil in the European banking system, it is easy to imagine an AIG-type event on the horizon. Many have forgotten that AIG did not collapse because of housing bond defaults. It collapsed because it was downgraded from double-A to single-A, and that downgrade triggered a collateralization event that required AIG to post $180 billion of collateral.
Unlike a hypothetical loan to a local restaurant that is collateralized by their real estate and equipment, AIG did not pledge specific collateral to its counterparties. Like every financial institution, AIG was highly leveraged and its outstanding obligations were many times its available capital resources. Accordingly, as -- Goldman Sachs demonstrated when it pulled $7 billion out of AIG in advance of other creditors -- in a derivatives credit event, time is not your friend and counterparties have to move quickly to protect your interests.
This stands in stark contrast to the commercial lending world. If that restaurant were to have a cashflow problem, the bankers from Mechanics Bank would not come crashing in -- You, grab the pans, I got the Fryolator -- to get a jump on Mission National Bank or Union Bank. Rather, the rules governing commercial lending, foreclosure and lender liability result in the need for a senior lender to exercise prudence and carefully consider the impact of its actions on the borrower -- as well as dealing with competing interests of other creditors, equity holders and management -- even as it seeks to protect its financial interests. This results in a slower process that is more deliberative and enables the workout of complex situations. In contrast, in a derivatives event everything has to be done over a weekend, to avoid spooking the markets. To put it simply, in the derivatives world, you grab the Fryolator first, and ask questions later.
The second point builds on the first. If commercial banking is an operational business that takes time and attention, investment banking and trading are transactional worlds of urgency and short attention spans. Profits and bonuses are the immediate imperative, and relationships and character -- the core of commercial banking -- are relatively unimportant. In the past two decades, the culture of investment banking -- the culture of Wall Street -- imposed itself on the world of commercial banking. Dating back to Salomon Brothers merger with Philipp Brothers and culminating in Sandy Weill's assault on Citicorp, Wall Street's pursuit of capital created the world today, where a handful of leading commercial banks are imbued with the culture of Wall Street and increasingly largely diverted from the traditional, slow function of commercial lending.
Which leads to the question that should be addressed: Why?
Why should American banking be captive of the political clout and financial interests of four or six or eight firms? It simply is not in the interest of the overwhelming majority of commercial banks to let federal policy be driven by the political power of or risks related to that handful of firms. Two of those firms, Goldman and Morgan Stanley, only became commercial banks in the wake of the financial collapse in 2008 in order to gain access to the resources of the Federal Reserve Bank, and have no business remaining bank holding companies now that the crisis has ebbed. Whatever one believes about the fairness of public dollars and protection being used to support those two large investment banks, that time is past and the linkages with the public purse should be firmly severed.
This is a question that is not being asked, but that must be asked. As our political parties fight for access to Wall Street money, the ability to make sound policy that serves the larger interest of assuring a sound and effective commercial banking system has been undermined. Nor is Occupy Wall Street raising the questions that must be asked in a way that will reach the wide range of legislators the need to take notice.
What is missing from the new focus on Wall Street is the voices of the American banking community. Through consolidation and crisis we have gone down a path that has undermined the effectiveness and stability of our commercial banking system. Derivatives trading -- now central to the profitability of those largest banks -- entails uncharted and unknowable risks to the financial system, and it is part of a cultural shift that has impaired the effectiveness of those banks in serving their primary function of commercial lending. The Dodd-Frank and Sarbanes-Oxley laws were created at moments of crisis in response to the egregious practices of a small number of market participants, but now constitute enormously expensive regulatory regimes that constrain and impair the effectiveness of thousands of banks that simply have not heretofore been part of the problem.
Occupy Wall Street might make good media, but if we are to address the serious challenges that confront us about the structure and direction of our commercial banking system, the voices that must be heard above the din are those of Main Street bankers across the country whose future success is critical to our long-term economic recovery.