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Banking 2012: Maneuvering to Survive the Desert Landscape of Zero Interest Rates

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Maybe that Mayan calendar is right and the world will be ending shortly after the presidential election. You'd certainly think so by the furor of deck chair arranging going on in the banking industry. I'm told the buzz of the 2012 season of meetings is all about "Who's buying whom?" and "Who's for sale?" The stage seems set for a round of consolidations that will take America's 7,500 plus FDIC insured institutions down to a much smaller number. The big will get bigger and consumer choices -- and their ability to get decent financial terms -- will get fewer.

The root problem I hear about over and over is Zero Interest Rate Policy (ZIRP). Simply put, with zero interest rates pushing operating margins down to nothing, the only thing starving bankers have left to do to survive the drought is cannibalize the industry. It's another sign of the handcuffed wealth of the U.S. economy. And it's not for lack of money. As I pointed out previously in the article "Investors Stuff Mattresses and Wait for U.S. Economy to Find Direction", there's a glut of idled deposits distributed throughout the banking system. But the economics of lending are lacking in vigor. Bankers cope with this in two ways.

Some have just abandoned lending and have given in to taking deposits and putting it into low yield government securities. They've effectively become conservative mutual funds. Yes that does mean we have a situation where consumers stuff their money into a bank mattress and then the banks in turn stuff another government bonds mattress. Talk about draining Main Street of energy... times two. For all you people who "Moved Your Money," you might want to ask you banker or credit union if they are playing the "double stuffed mattress" game with your cash. If they are, maybe you need to make noise about moving again. Nothing says that grass-roots activism has to be static.

The above "money parking lot" game can buy you time but it's not an operational business proposition bankers like. Clearly they should not. Other more proactive bankers tenuously attempt to find productive uses for these deposits despite the difficulties of selling services under a cloud of doubt about the future direction of the economy. The "lending engine that could" conversations I hear from these large and small bankers have three distinct themes.

Theme One: If there's a good deal out there, we're all going to bid on it and compete with as many incentives as we can pile in there to outmaneuver the competition. It is cut throat and it means thinner margins on fewer successful asset deployments.

Theme Two: If it's not a quality deal, we're not touching it with a 10-foot pole. We just can't do it. Not with the uncertainty about this economy. This is most true for banks fighting to regain solid footing for the asset quality portion of their CAMELS* ratings. It's also, by the way, an area where I'm told the old sub-prime mortgage crowd is coming around trying to sell loans to sub-quality commercial and industrial borrowers. The people who laid waste to our mortgage market haven't gone away. They're morphing. Well at least they're no longer unemployed. Is that a good thing?

Theme Three: If it's a big company, forget it. They complain the Fed's ZIRP -- there it is again -- means it's an invitation only game for the 1% club. The implication is that large C&I companies are being driven like sheep into the waiting arms of the cabal on Wall Street by U.S. fiscal policy. When I talk to corporate treasurers about the issue, they pretty much concur.

The smaller bankers who live well off the radar screens of Wall Street also complain about one other insult to injury. They complain about role of "ratings" in impeding business. The big Nationally Recognized Statistical Ratings Organizations (NRSRO's) aka the big ratings agencies -- who are viewed as members in good standing of the Wall Street insider's club -- only cover the biggest banks who can afford their services for doing ratings on multi-billion dollar debentures. It simply costs too much for the smaller banks to go "buy" a rating from these companies. It hurts community banks two ways.

  • First, they are sometimes forced to go through a TBTF to issue a standby line of credit (LOC) using their money to pledge to one of their direct clients. So when it comes time to issue an LOC to a corporate borrower, they too often have to send that money over to a big bank that acts as a credit facility manager -- with service fees of course -- to funnel the money to the bank's own customer. It raises the cost of the transaction somewhere around 75 to 150 basis points. That's actually a lot. To make the deal work, the smaller bank eats the cost which, of course, cuts in to operating margin and causes yet more systemic malnutrition. For these smaller banks it can happen for as few as 1 out of 20 deals to as many as all of them.
  • Second, many corporations and funds now have risk management controls that specify that all deposits in financial institutions be insured. This includes super large deposits. The way that works is that the depositor buys a private insurance for the amount beyond the FDIC insured amount. The insurance companies in turn ask for a rating from an NRSRO which the smaller bank won't have because the deposit size is nowhere near big enough to justify paying for such a rating so they lose the deal to one of the TBTF's. That effect is very much in evidence when you look at how much deposit accumulation has happened at the big banks versus the smaller ones in the past two years.

This is particularly macabre when you consider that in many cases, the smaller institution actually has better safety and soundness properties than the bigger one acting as a conduit or "NRSRO rated" recipient of the large deposit. We know this because other more specialized bank analytics companies that do analysis on the safety and soundness of the bank industry indicate so. IRA is one of those analysis providers. The company delivers ratings indicators on 100% of the active banking industry in a timely fashion for compliance, monitoring and counterparty evaluation purposes. IRA isn't the only company doing so. There are others. Among IRA's business niche cohorts, the analysis not only aligns well, the various services have nuances that when taken as a set provide users with far better illustration of the bank's condition. The banks don't hire these firms to make ratings. They assess all of them because that's how you're actually supposed to analyze an industry channel. It begs the question, if you can make more direct measurements and you don't, who's being the fool? Banks do argue that these alternative ratings are very valid because they know the numbers align with their regulatory examination CAMELS ratings.

The bank regulators have had their own trouble with relying on NRSRO data by the way. The FDIC mandated that ratings agency data would no longer be used to computing bank insurance assessments last year and rules about stress testing under the Dodd-Frank Act say banks are not to rely on these external ratings going forward either. This, of course, asks the second question, "If bank regulators are in fact shifting to better objective standards to manage down future systemic risk, why are capital markets lagging behind?"

So here's the "think outside the box" finance policy question of the day. What if all those line of credit and large deposit deals relied on direct measurement analytics sources instead, bypassing the need to process LOC's though an NRSRO rated manager or parking hard-earned deposits in a TBTF. How many basis points could this shave out of the economy's systemic cost of capital? What would it mean in terms of creating vigor in the 7,000+ smaller banks in this country to be a greater part of America's economic recovery? Will this help change the direction of discussions when bankers get together from starvation and consolidation towards competition and growth? I think these are questions worthy of the banking and the insurance industry exploring. Not a bad thing for policy makers and candidates to be pondering as well.

Clearing the decks for Main Street of unneeded furniture is what I'm trying to explore here. Ultimately this is a search to find a way to bring our industrial system back into sustainable balance. I wrote about this last October in "Economic Recovery Means Learning to Export Unemployment" where I floated the notion that repatriating as little as five-percent (5%) of the U.S. industrial base would go a long way towards getting our corner of the world back to the good side of the systemic tipping point. I mention this in closing because President Obama also made this very point in his State of the Union address. He left it at encouraging business to "think about what you can do."

So I am.

*CAMELS ratings are how bank regulators assign safety and soundness ratings to banks. The acronym stands for Capital Adequacy, Asset Quality, Management, Earnings, Liquidity and Sensitivity to Market Risk.

Around the Web

BBC News - UK bank lending to shrink in 2012, says Item Club

Bank lending to shrink in 2012 - Ernst & Young | Reuters

Look Out, Bank Lending Is Slowing - Deal Journal - WSJ