Friday, February 05, 2010

On Risk & Capital Allocation In Commercial Banking

Most people have little notion of how capital is treated inside a commercial bank. While regulators and those concerned with systemic risk want banks to hold as much capital as possible, those inside the bank want to operate on as little capital, especially equity, as possible.

Like every other business, banks are sensitive to the costs of capital, and, following basic economics, which is about rationing scarce resources, their managements want to use the absolute minimum to do their business.

Back in the late 1980s, RAROC (Risk Adjusted Return On Capital) was developed at Bankers Trust's. It is, or was, the original risk management tool for bank capital allocation. From it, and its design team, flowed many of the modern variants of VAR-style risk metric systems in financial services firms.

While working on resource allocation and productivity at Chase Manhattan, it was necessary to address risk capital. Thus, I retained the developer of Bankers Trust's famous RAROC model, Philippe Geneste, as a consultant to assist us in introducing the concepts into resource allocation at Chase, as well as to better understand its likely ramifications on business unit operating decisions and overall bank profitability.

There were, and are, fundamentally two methods to internally adjust for risk. One is to raise required rates of return for businesses, on notionally-allocated capital. The other is to use some variance-based approach to allocate more capital to riskier businesses, where risk is defined by greater variances in returns, or losses, of the business.

When dealing with risk, internal capital and allocation, one rapidly runs into a conundrum. It was on display yesterday morning on CNBC, where a guest, no less than Bill Gross of PIMCO, was opining on the need to make banks carry as much capital as possible to mitigate risk.

Here's the problem.

Internally, business units decline to accept capital allocations. They will claim to not need as much as is allocated. But, from a corporate viewpoint, the regulatory-mandated capital has to be allocated. Otherwise, one is in the position of having unallocated, in effect fallow capital. Capital that has been raised and is being paid for, whether through interest or implied total return to shareholders.

In the normal course of business, probably 95% of the time, that added regulatory capital buffer is unnecessary. It constitutes a drag on bank earnings and returns to shareholders.

Of course, in rare circumstances, like those of late 2008, losses in various units of a bank can skyrocket. But, when those so-called black swans appear, even the excess regulatorily-mandated capital levels are unlikely to be sufficient to absorb the losses.

If you look closely at a commercial bank, such as Chase, you'll see that even today, it's common equity/total assets ratio is only about 8%. An incredibly thin wedge of pure equity is in that ratio, as preferred equity outweighs common by about 10:1.

It doesn't take a genius to see how fast a commercial bank can lose substantial equity and become insolvent from a particularly big valuation hit in one or two businesses.

Yet, if regulators force a commercial bank to carry more equity, they inevitably depress profitability and returns. Bank CEOs want to believe their institutions can offer total returns which are competitive with industrial firms. But, if regulators have their way, this can't and won't be true.

Like it or not, fractional reserve banking systems and commercial banks' participation in modern capital markets as publicly-owned entities virtually guarantees that big risk mistakes on their part will quickly lead to insolvency. The banks won't carry more capital than they are forced to, yet, given the risks they take, they are occasionally going to burn through that thin wedge of equity.

Debating about a few percentage points of capital won't really change that.

Thursday, February 04, 2010

The False Hope of a New Financial Resolution Authority

As I listened to Paul Volcker's testimony before a Senate committee earlier this week, I found myself rather incredulous that he believed some special, additional 'resolution authority' would be able to prevent sudden failures of financial service companies.

I saw this again yesterday morning, as Senator Bob Corker, R-Tenn, reiterated Volcker's belief that, no matter what else the Senate does, they'll create some new entity to put 'banks which are near failing' into some sort of regulatory limbo, to avoid systemic repercussions.

As I discussed this topic yesterday with a colleague, I asked whether he saw things as I did.

To wit, consider Bear Stearns. When Bear went out of business, its financial condition deteriorated in a matter of only days. And the worse the rumors became, the more counterparties began pulling their business. Add to this the fact that modern investment banks are primarily funded with short-term borrowed money from broker dealer desks at commercial banks, and you have situations in which a company can become insolvent literally overnight.

Forget, for a moment, for argument's sake, the fact that Morgan Stanley and Goldman Sachs are now, technically, commercial banks with access to the Fed window.

In markets as far back as 1998, when Long Term Capital Management failed, here is how non-commercial banks become insolvent.

A broker or investment bank takes positions in securities. The positions may be on a trading desk, or they may be, as was the case with First Boston some 20 years ago, underwritten debt from a funding transaction on behalf of a client, e.g., Ohio Mattress.

Suddenly, the securities begin to lose value. A lot of value. Marked-to-market values plummet, destroying the firm's equity deployed to the desk at breakneck speed. Since the firm is highly-leveraged, its counterparties react by either requiring more collateral on losing positions funded with their money, or, if a general lender, perhaps cutting credit lines.

As word begins to circulate, within hours, of the firms' losses and emerging credit pressures, counterparties shun the firm, and clients remove money from accounts with them, so as to not risk its being tied up in a bankruptcy.

Perhaps only a day later, as assets drain from the firm's balance sheet, and trading volumes shrink, the firm's positions, after the 4PM market close, show that it cannot settle all of its trades, because it has lost credit lines, has too little cash to honor its commitments, and cannot quickly borrow enough to fund them.

For any 'resolution authority' to be credible and effective, it would have to have a representative on site, at the firm, observing the insolvency as of the 4PM markets close.

Seeing the inability of the firm to settle its trades and, with resulting trading and other asset values, post a positive equity value by the market open on the following morning, the authority would have to call a halt to all financial flows from the firm, and declare it failed.

That's effectively what happened to Bear, and Lehman. When the end comes, it can be a matter of hours. But notice that only 24 hours earlier, the firm wasn't insolvent. So shutting it would have probably been an illegal government taking of private property.

If what is being suggested is having regulators on site at each major, and perhaps even minor/boutique financial service firm, that can already be done with Fed, FDIC and OTC regulators. It's not a matter of requiring a new resolution authority, but, rather, acknowledging the context in which such closures would have to occur.

Regulators would have to be viewing the firm's books, current financial and trading positions in near-real time.

As I listened to Volcker and Corker, I heard, instead, a sort of semi-languid tone suggesting that someone from Washington would board a plane to visit the troubled firm and see what was going on.

In the real world, there's just not that much time. The unremarked upon reactions of trading counterparties to ailing and failing institutions is what seems to be unacknowledged by legislators and regulators.

There's a fine line between government seizure, without basis, of an about-to-fail institution, and the closure of an insolvent one. But if the government sends clear signals that no financial institutions that fails will, beyond deposit insurance, be assisted in any way, you can rest assured that counterparties will look after their own risks.

The Constitution specifies bankruptcy for failed firms. For some reason, regulators no longer wish to use that option.

As my colleague and I discussed this topic, we wondered why so many people believe that Lehman's failure could have destroyed the US and, possibly, global financial system.

What if, instead of everyone's worst fears, Lehman's regulator simply stepped in and declared it bankrupt, froze its assets, appointed a trustee, and, like Drexel Burnham Lambert years ago, went about the long and complex task of sorting it all out under court protection?

Or Bear Stearns? Rather than let Chase steal the firm, first for about $2/share, then, grudgingly, about $11/share, how about simply letting a bankruptcy trustee and court freeze the firm's assets and begin to settle its liabilities? If there were value remaining at the end, it could be auctioned to the highest bidder.

Not some large bank which extracted a government loss-protection guarantee as it paid a lowest-possible bid to 'rescue' the firm.

It all boils down to expectations. If market participants believe that a failing financial services firm will be allowed to do so, and enter bankruptcy proceedings, then they will take appropriate steps to limit their exposure.

If, however, government officials run around wringing their hands and declaring each possible failure to put the nation's financial system at risk, then market participants will behave differently.

The most effective, disciplined, and efficient method of removing systemic risk from individual financial service firm failures, regardless of their size and nature, is for government to warn market participants that conventional bankruptcy will be the only option, and action, for failed companies.

No government intervention prior to that event. No quick sweetheart sales to large competitors. No stripping off and selling of choice business units. No emergency loans from the Fed.


Do that, and watch how the system's players move to protect themselves from any systemic catastrophes in the future.

Wednesday, February 03, 2010

James Lockhart's Disingenuous Claims

James Lockhart, former regulator of Fannie Mae and Freddie Mac, appeared on CNBC yesterday to respond to questions raised by passages from former Bush Treasury Secretary Hank Paulsen's newly-released book.

Lockhart's comments provided an ideal example of how federal regulators, Congressmen and administration officials, both former and current, twist and misrepresent history in their quest to appear blameless, heroic and successful.

In Lockhart's case, he contrasted his office's takeover of Fannie and Freddie, whose oversight he bungled in the first place, with Lehman's demise.

Crowing proudly, Lockhart claimed that there was no systemic shock from his handling of the two GSEs as his regulatory office placed them into "conservatorship," while Lehman's poorly-handled bankruptcy had a catastrophic impact on financial markets.

Of course, Lockhart conveniently glossed over the fact that his and Paulsen's actions meant that the Federal government guaranteed Fannie's and Freddie's obligations, thus removing any need for financial markets to panic.

But there was Lockhart, grinning and taking credit for what was actually caused by your and my role as taxpayers.

Lockhart also failed to mention the continuing losses stemming from the GSEs' operations, and the recent action by Geithner to uncap taxpayer exposure to their losses going forward.

That's success, Jim? I'd hate to see the cost of a failure in handling Fannie and Freddie.

Following Lockhart's dissembling on the matter of Fannie and Freddie, a CNBC anchor asked him if, in his new capacity as Vice-Chairman of one of Wilbur Ross' companies, his advocacy of principal forgiveness for mortgage loans wasn't convenient for his new employer, who happens to own substantial mortgage servicing companies that will benefit from being allowed to charge for implementing these revisions to the mortgages?

Lockhart again danced around the question, claiming to have been in favor of this tactic last year, and assuring the questioner that his and Ross' stances were beyond reproach.

Throughout the interview, Lockhart exhibited a nervous, anxious visage and manner which contradicted his words.

So much for truth about the past, or present, from our regulators. Especially when they are in that revolving door between their government posts and new, related private sector positions.

Volcker vs. Dodd Yesterday On Capitol Hill

If you happened to watch former Fed Chairman Paul Volcker's testimony on Capitol Hill yesterday, you were treated to some subtle comedy and tactful snubbing.

Volcker was testifying before retiring Senator Dodd's committee on his so-called "Volcker Rule."

After reading a lengthy, clear and comprehensive prepared statement, Volcker entertained questions.

The first one was from the witless Connecticut Senator, himself. Dodd began by presumptuously asking "Paul" to elaborate on how the matter of detecting proprietary trading would be handled. Dodd continued by pontificating on the subject of how difficult this would be, and generally exposed, despite years on the committee, his near-total lack of understanding of modern commercial and investment banking activities.

Volcker responded in an icy tone, fairly dripping with disdain, beginning with a pointedly formal, non-personal "Mr. Chairman."

He then went on to implicitly spank Dodd by casually noting that the answers to Dodd's questions were contained in the text which Volcker had just finished reading.

It was a priceless moment. I think Dodd was probably the only person either in the room or watching via cable coverage who didn't grasp how he'd been humiliated by Volcker in a single sentence.

There's a reason Paul Volcker is iconic, and it was clearly on display yesterday.

Tuesday, February 02, 2010

Gerald Weiss, SVP Corporate Planning & Development, Chase Manhattan Bank, N.A., RIP

It was with great sadness that I learned over the weekend of the death of Gerald Weiss, retired SVP of Corporate Planning & Development, and Chief Planning Officer at Chase Manhattan Bank, NA, for some twenty years, and prior to that, senior strategist at the General Electric Corporation, where he had worked for over twenty years prior to joining Chase Manhattan.

Gerry was 83 when he passed away last Friday from pneumonia in Cincinnati, Ohio.

It's a challenge to convey succinctly the unique talents of someone who, over time, was my boss, mentor, informal business adviser, career guide, co-consultant and close friend.
I believe the best way to provide some measure of Gerry Weiss' brilliance, importance and impact is to provide some anecdotes representing, during the years I knew him, those qualities.

When I joined Gerry's Strategic Planning group in 1983, I was one of five VPs in a group that had two other smallish units, comprising no more than perhaps 20 professionals. Gerry had originally been recruited to Chase by David Rockefeller, where he inherited a much larger staff, including a bevy of individuals responsible for business unit strategy development. These latter he rapidly transferred back to their respective businesses, preferring, instead, to run a smaller, more objective and creative group focused on advising the Chairman and CEO on how to manage the bank to increase shareholder value. Few SVPs would willingly give up staff and budget, but Gerry knew what he wanted, and didn't care to be an empire builder.

For the next decade, while larger, more cumbersome and less-focused corporate planning and strategy units vanished from America's large corporations amidst leveraged buyouts, layoffs, restructurings and corporate raids, Gerry maintained his small but influential group of strategists, management scientists and M&A specialists.

Over the next few years, by working closely with Gerry and two of his former GE colleagues, Jack Grossman and Don Heany, I learned that Gerry had reconstituted the vaunted GE Corporate Planning unit, in design and style, of his own mentor, Jack McKittrick. McKittrick, for whom a Google search will return this reference, was the strategic mind behind Fred Borch's management at GE. Gerry explained to me on several occasions how McKittrick, due to his personal wealth, enjoyed an objectivity at GE that few others could have managed. In his own way, Gerry duplicated McKittrick's philosophy, style and aggressive attitude.

Few others at Chase Manhattan realized how much of GE's legendary strategic planning function, attitude and skill had been grafted into Chase with Gerry's arrival.

To those of us fortunate to have worked for and with him, Gerry provided a very rare ability, constantly on display through example, to remain objective and honest on matters of corporate strategy, amidst heavy pressure to simply go along with what was either popular or desired by the Chairman or CEO.

To wit, when I informed a close friend, contemporary and one-time colleague in Gerry's shop over 20 years ago, he replied,

"I will always fondly remember Gerry as the smartest corporate strategy guy I ever came across and as one who had the confidence and principles to say no even when his bosses wanted to hear yes (Ohio thrift acquisitions for instance). He set a great example for all of us."

I can't really express that aspect of Gerry better than my friend and his onetime staffer did.

Another former Chase Manhattan colleague, with whom I spoke on Sunday about Gerry's passing, mused,

'You just never imagine some with Gerry's brilliance and intellect ever not being there anymore.'

During the era in which Chase Manhattan foolishly rushed into acquisitions of failed S&Ls in Ohio, Maryland and Florida, and unwisely overpaid in a bidding war for a real estate development financier, masquerading as a bank, in Arizona, Gerry steadfastly warned against such expensive squandering of bank capital. Only a few years later, one of the expansion's staff, a friend of mine, calculated the deadweight loss of capital invested and losses incurred in the various purchases throughout these states at a then-staggering amount nearing $100MM, at a time when that kind of money was material to Chase's bottom line.

Most Chase employees never knew of the creative initiatives developed by Gerry Weiss, which would have vaulted the bank into the forefront of US finance. Among his ideas were a combination with Norwest Bank, then a leading regional power, to allow Chase shareholders the benefits of Norwest's younger, better management team's prowess with our larger bank's asset base and business mix. Others included moving the regulatory charter to the UK, in order to have the freedom to buy or start businesses in areas prohibited in the US.

Yet, at the same time, over a quarter-century ahead of his time, Gerry prophesied catastrophe from a removal of Glass-Steagall. To paraphrase him back in the mid-1980s on the topic,

'All that will happen is the addition of too much underwriting capacity, managed by mediocre commercial bankers, driving down profits for everyone. This will require ever-riskier behavior from all the investment banks, brokers, and commercial banks, leading to bigger systemic losses, as new, poorly-understood, risky asset classes are invented to drive higher profit margins.'

That's exactly what we saw in the last few years, as Wall Street responded to Congressionally-mandated expansion of marginal quality residential finance lending.

Gerry had the unique ability to both pragmatically understand when a project or idea had hit a brick wall, while also retaining a tireless optimism that, eventually, good strategic ideas and common sense would triumph.

He never shirked from giving his blunt, honest opinions to the chairmen he served, David Rockefeller, Bill Butcher, and Tom Labrecque. The first two valued Gerry's objectivity and wisdom, so that they were never so threatened by his candor that they resorted to asking him to leave.

Having worked closely with Gerry and my then-partner in Corporate Planning, Debbie Smith, in his latter years with Chase, I saw how the bank began to lose momentum and languish, as the CEO ignored Gerry's recommendations on resource allocation and prioritization among businesses, to regain growth and improve income.

The unfortunate result of ignoring Gerry's advice came home to roost after Gerry's retirement, when mutual fund manager Michael Price forced then-Chairman Labrecque to seek a merger with Chemical bank.

Even in so-called retirement, Gerry Weiss had influence well beyond what would normally be expected of a Chief Planning Officer. He continued to guide the Boston-based Strategic Planning Institute, a long-ago spinoff of GE's own planning group from the 1960s.

When Chase EVP Marshall Carter was recruited by competitor State Street Bank to become its next CEO, Carter, upon arrival, retained Gerry as his personal strategy consultant. That relationship continued for roughly a decade, until Carter's own retirement from the well-regarded trust bank.

During the years after Gerry's formal retirement from Chase Manhattan, I saw measures of his continuing influence and the high regard in which well-known business leaders held him. Gerry introduced my own corporate performance work to Carter, whom I also knew from Chase, at State Street Bank.

When Gerry found some related work on productivity and economics which I had developed to be of interest, he contacted David Rockefeller. Within a few months, we had a meeting with the former Chase Manhattan chairman discussing my work.

Similarly, my evolving work on corporate performance, productivity and resource allocation found its way to a meeting between Gerry, Jack Welch, then CEO of GE, and me.

It only took a letter from Gerry to these business leaders suggesting they take a look at some interesting new business research, for their actions to indicate the credibility they attached to Gerry's opinions.

Throughout my own career, I have never worked for, nor even met, any senior executive who was as intelligent, curious, and secure, as Gerry Weiss. At his own formal Chase Manhattan Bank retirement dinner, he explained his longevity, influence and success as resulting from hiring the best people he could find, then facilitating their efforts, not trying to take credit for their work.

People on Gerry's staff routinely presented to and worked closely with the bank's chairman, CEO, and Vice-Chairmen. Thanks to him, a fortunate group of younger managers gained valuable insights into, experience with, and real understanding of the often messy, inefficient and highly political nature of actual business management and decision-making at senior levels in a modern US corporation.

As I reflect on my relationship with Gerry Weiss over more than 25 years, one anecdote remains with me which I believe depicts his unique mix of talent and style.

My partner, Deb Smith, and I had labored on several drafts of a key presentation that we would be giving to Chase's then-chairman, Bill Butcher. By then, both Debbie and I were in our 30s, and had had years of of working for senior managers who would micro-manage such presentations, then take them to a more senior executive for presentation.

Gerry was different. Sessions spent working on a presentation like this one were highly interactive, with Gerry taking on a role as equal team member, not our boss. Ideas bounced back and forth, with a lot of laughter and sarcastic remarks about the managers and culture through which we typically had to work to effect results.

On a Monday morning, after several iterations of the presentation, he assembled the heavily-marked up pages, stacked them together, and looked at us.

'Well, I think you've done all you two can. I know how I want to tweak some of the points, and there's no point wasting your time making you try to read my mind.'

Where most executives would have had us doing another two or three iterations to precisely machine the presentation to his requirements, Gerry retired to his old IBM Selectric typewriter for the morning. Between his edits and his secretary's finishing touches, he produced the final presentation. Which Deb and I gave, while Gerry observed, largely silently.

Nobody else for whom I ever worked, before or since, possessed such intellectual security and confidence. Nor was so effective.

As my one-time colleague noted in his email, Gerry set a great example for those of us fortunate enough to have worked for and with him.

Monday, February 01, 2010

Yet Another Excuse From Geithner For AIG's Rough Treatment

Thursday's Wall Street Journal's staff editorial reminded us of yet another excuse being offered by then-NY Fed president, now Treasury Secretary, for directing AIG to pay 100% on its credit default swap obligations. Prior posts, here, here and here, have addressed this puzzling aspect of the AIG affair, and earlier Geithner attempts to evade criticism for this action.

First, we were told it was to prevent a systemic meltdown of the US financial sector due to swaps failing to settle.

Then, it was explained that all counterparties had to be treated equally, and some French executives would be imprisoned if forced to accept less than a 100% payout on their swaps. So Geithner blinked and agreed to the full payments.

Somewhere in the confusion since last fall, Geithner suggested that AIG was "too big to fail."

Now, the Journal reports Geithner's latest excuse. He was concerned about AIG's credit rating!

The Treasury Secretary testified that the state-supervised insurance businesses of AIG were, in fact, subject to failure from the effects of the financial products unit's swaps troubles. Further, Geithner said,

"the people responsible" for AIG's insurance unit regulation "had no idea" of the risks the company was facing.

The Journal editorial correctly notes that this is essentially the complete opposite of what state regulators, including Eric Dinallo, former NY state insurance regulator, believed. And that it's a very different story to explain the AIG swap payments as necessary to maintain AIG's credit rating, for the benefit of its many insurance businesses.

This latest excuse rings false. As the editorial observes, when the US government owns 80% of you, nobody will worry about your credit lines.

The real concern arising from Geithner's ever-shifting reasons for the AIG full swaps payments is that each one portends different problems in the US financial services sector, different regulatory issues and potential solutions.

If Geithner can't keep his excuses straight, how can Congress possibly author a responsible, effective reform of regulation for the sector?

It's neither an academic question, nor a funny one. This is serious. We can't even learn what the primary actors in the sad story of AIG's takeover truly thought was the major risk, and why.

The editorial points out the very major question Geithner's latest excuse implies. That is, is our entire state-based regulatory approach to insurance flawed? Or is Geithner simply grasping at excuses in order to evade responsibility for a bone-headed, expensive, unnecessary and ill-advised action?

How can there be productive forward movement for the financial sector from the recent financial crisis if we can't even pin down simple things, like why the Fed behaved toward and with AIG as it did?