Nearly five years out from the 2008 financial meltdown, many of us have seen our retirement accounts recover, and home values are headed in the right direction. But you know what would really help us relax? The assurance that a catastrophe like that could never happen again.
Unfortunately, despite new regulations and the recent round of bank stress tests, which determine whether banks would have enough capital on hand to withstand financial crisis situations, some critics warn that banks are once again taking on the kind of risks that could endanger the financial system. In fact, a new Senate report on last year's $6.2 billion trading loss by J.P. Morgan Chase found that the company didn’t heed internal controls, manipulated documents and even withheld information from regulators.
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Most surprising, some banks' new risky behavior may be in reaction to government regulations aimed at aiding the recovery. We look at the current pressures on banks and explore whether our newly instated regulations are up to the task of preventing another financial crisis.
Banks' standard method of making money is pretty simple: Borrow cash at one interest rate and lend it out at a higher one. The problem with that right now is that the Federal Reserve has kept interest rates so low—in its efforts to stimulate investment and job growth—that banks aren't earning much on loans. As a recent report from Moody's Investors Service put it, “Low interest rates are supportive to the economy, but undermine banks’ profitability.”
Not only are rates low, but consumers and businesses are borrowing less, which further hampers business for banks. On top of that, complying with new regulations increases banks’ costs. And the new Consumer Financial Protection Bureau is investigating overdraft fees and the way they are charged—and any changes in those practices could limit banks' future revenue.
All this pressures banks to find other ways to make money. Potentially risky bank behaviors that worry experts include:
- Making higher-risk loans: “Banks have already begun to relax loan standards after they were tightened in response to the financial crisis,” Moody’s says.
- Entering unfamiliar businesses for which they may lack appropriate control processes and expertise: A report by the Office of the Comptroller of the Currency, a Treasury Department bureau that regulates banks, says some of these businesses include commercial and industrial real estate, indirect auto loans, and oil and gas lending.
- Investing in riskier securities in hopes of higher yields: Moody's says banks are looking at investments that might be more profitable but also riskier—and that those risks may not become apparent until interest rates begin to rise.
- Making bets on mergers and acquisitions: American Banker editor-in-chief Neil Weinberg, in a recent column calling out an increase in risky activities in the banking industry, said, “Three recent deals involved premiums of 32% to 83% above tangible book value, implying that buyers are willing to bet on the prospect that the targets will be worth more in the future than they are today.” Translation: Some buyers bought companies for more than they were worth, indicating that they were willing to bet that the investments would increase in value in the future—and as with all bets, these may not pan out.
“They're reaching for yield and going out on the risk spectrum” by making loans to customers they wouldn’t normally lend to or charging rates that aren’t commensurate with the risks, said Rebel Cole, a professor of finance at Chicago's DePaul University. Banks are taking investment risks too; the prime example being the J.P. Morgan Chase loss from last year. That kind of speculative trade mimics behavior leading up to the 2007-2008 financial crisis, when banks made investments in securities based on bad mortgages. When the true value of those mortgages were revealed, banks did not have enough money on hand to back up their bad bets. Could banks land in the same hot water now?
What About Those Regulations?
After the crisis, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, a sweeping bill that calls for various government departments to write new rules limiting the risks banks can take, increasing transparency and protecting consumers. Some of the regulations called for in the law are still being written, so it's hard to judge now what the full impact will be, but some critics already think it’s insufficient.
The aspects of Dodd-Frank most visible to the public so far are:
- The creation of the Consumer Financial Protection Bureau, which aims to protect consumers from abuse when dealing with credit card companies and mortgage and payday lenders.
- The Volcker Rule, which requires banks to separate their trading sides from their consumer lending arms. That would then stop banks from doing their normal business of lending to consumers while also making speculative investments with the same money. Passage of the Volcker Rule has been delayed by drawn-out negotiations between banking regulators and the Securities and Exchange Commission.
- The annual stress tests that banks must now take to prove that they have enough assets on hand to survive another financial catastrophe—without needing another taxpayer bail-out.
Moody's said that the new regulations—and others being passed abroad—are “likely to make banks safer in the long term … Once fully implemented, these regulatory changes will likely lead to banks strengthening their capital positions, liquidity buffers and risk-management capabilities,” the Moody's report reads. And, in fact, most big banks passed this year's stress tests, which according to the Federal Reserve means they are stronger and have more money on hand.
But there are still doubts about how much the Dodd-Frank-based regulations will protect consumers and investors. For instance, DePaul's Cole is pessimistic, arguing that the stress tests weren't tough enough. His main criticism is that the banks were allowed to run their own simulations.
“It's kind of like asking a drunk driver to give himself his own sobriety test,” Cole says. Although the Federal Reserve corrected some of the banks' estimates, he feels that even the Fed fell far short of estimating what banks actually could lose in another financial disaster.
And the Senate's report on the $6.2 billion trading loss underscores his point about whether the banks can be trusted to police themselves: The normal practice at banks is to value investments at the midpoint between the amount the bank was bidding and the offer prices in the market. But when J.P. Morgan began to realize that some big trades were going bad in early 2012, it began to change the value of those investments to what New York Times business columnist Gretchen Morgenson calls "well outside the midpoint." This was done to make it look like J.P. Morgan's losses were smaller than they were.
This kind of behavior might explain why a recent survey by Barclays Capital found that more than half of institutional investors did not trust how banks measure the risk in their own investments. And when hedge fund managers were asked how trustworthy they find banks’ estimates of how much money they need on hand in a downturn, 60% gave them a 1 or 2 rating, with 1 being “not trustworthy at all.”
The Missing Pieces?
So if banks didn't learn their lessons in the recent crisis, what measures could get them to stop engaging in the behaviors that put all our finances at risk? Here are three recommendations:
- More transparency: In a recent Atlantic article, Frank Partnoy, a law and finance professor, and Jesse Eisinger, a senior reporter at investigative publication ProPublica, dove into the financial statements of Wells Fargo. They found that even in the post-recession era, the bank described its trading activities—the moves that were culprits in the crisis—in a “cryptic” way. In one of several examples, the company could not quantify the risks with “customer-accommodation trading,” which usually refers to derivatives bets—the very financial instruments that contributed to the financial crisis. Partnoy and Eisinger recommend that banks describe risks in lay terms that an investor can understand. A new standard could judge bank statements by how clear and meaningful they were, thereby making a bank’s activities more transparent.
- Change the standard for prosecuting bank executives: Executives are now prosecuted based on intent, which requires prosecutors to prove bank executives intended to engage in bad behavior. ProPublica recommends that be changed to recklessness, which only requires them to prove that another reasonable person in the same position would not have made the same decision. Pointing to the fact that no executives were punished for the 2008 financial crisis, they say that if more bankers were punished for risky behavior, we might see less of it.
- Break up the big banks: The Times's Morgenson says that J.P. Morgan, the world's biggest bank, did not submit crucial investment data to regulators and that the government did not investigate questionable trading at the bank. She concludes that J.P. Morgan is too big to regulate and asks at what point we acknowledge that having banks as big as J.P. Morgan is simply too big a risk for taxpayers to bear.
This last suggestion has quite bit of support: Senator Sherrod Brown, a Democrat from Ohio, is working on legislation to break up the big banks, and Senator Elizabeth Warren, a longtime consumer advocate against predatory banking practices, seconded the idea. There is also grassroots support, in the form of an online petition at SignOn.org that almost 150,000 people had signed as of earlier this week.
Bottom line: With legislation not even drafted, whether or not this idea gains momentum is anybody's guess, but it's clear that the saga of the financial crisis may not be quite over yet.