The massive $16 billion (Dh58.8 billion) mortgage fraud settlement agreement reached by Bank of America and federal authorities — only the latest in a string of such settlements — makes it easy to lose sight of what good shape banks are in.
Banks are now far better capitalised, with tighter credit processes and better risk accounting. The bigger Wall Street houses have also jettisoned many of their most volatile trading operations. Yet most have still managed to turn in decent earnings. That is a tribute to the steady and generally thoughtful imposition of the new Dodd-Frank and Basel III regulations, the rules on “stress-testing” balance-sheets and the controversial Volcker Rule that limits speculative proprietary trading operations.
And the fees are keeping on the pressure, as demonstrated by their rejection of almost all the “living will” plans submitted by the major banks, which are supposed to prevent the kind of disorderly collapse that Lehman Brothers went through in 2008. These living will impositions are designed either to reduce the riskiness of bank holdings or to make the financial institutions post more capital and reserves to cushion against reverses.
While these reforms were badly needed after the virtual wholesale deregulation of the 1990s, they almost all raise costs and limit flexibility. But that is far from the worst problem facing the banks. The regulatory impact on revenues and profits is likely to be dwarfed by the pain banks will experience after the inevitable removal of their current federal life-support systems.
The Federal Reserve has taken extraordinary measures to entice banks to lend money. It has used two main tools. The first, called quantitative easing has entailed the Fed buying massive quantities of securities normally held by private financial institutions. The second has been to keep the fed funds rate, or the rate at which major banks lend their short-term funds to each other, at unusually low levels.
The Fed’s use of these tools has been extremely aggressive. Take quantitative easing. The Fed is a bank and has a balance sheet. At the end of 2007, the value of its securities portfolio totalled about $925 billion; because of QE, the Fed’s balance sheet has ballooned to $4.4 trillion. It’s safe stuff, mostly Treasuries and mortgage securities, but in normal markets, those volumes would be on the books of private institutions, not the Fed.
In effect since 2008, the Fed has freed up about $3.5 trillion of new cash, nearly a fifth of annual US gross domestic product, that the financial sector can recycle into the economy.
The Fed funds policy has been just as aggressive. For context, during the high-growth years of the 1990s, the fed funds rate hovered at about 5.5 per cent. After the 9/11 disaster and the 2001-2002 recession, then-Federal Reserve Chairman Alan Greenspan reduced the fed funds rate to 1 per cent — the lowest since the 1950s. He kept it there well after the economy had begun to recover.
Then, together with his successor Ben Bernanke, Greenspan gradually moved it back to 5.25 per cent by mid-2006. When the crash hit, Bernanke quickly pushed it back to 1 per cent. In recent months, it’s been hovering at only a fraction of 1 per cent.
How do such measures help the banks? Consider JPMorgan Chase. Last year, it had interest income of $53 billion against interest expense of only $9.7 billion, for a gross margin of 81 per cent on its lending activities. In 2006, when fed funds were creeping back to 1990s levels, its gross interest margin was only 36 per cent. If that same margin had applied in 2013, it would have cost JPMorgan $24 billion.
To put that number into perspective, that’s about a quarter of its annual gross revenues, and not much lower than the bank’s total compensation in 2013. So it’s fair to assume that without the Fed’s extraordinary measures, JPMorgan would be a far smaller bank.
Banks with more traditional business models, however, won’t be as exposed as a JPMorgan when the Fed’s abnormal assistance dries up. Wells Fargo, for example, is a big bank but without the investment banking and trading pretensions of a JPMorgan. A greater share of Wells Fargo’s lending is funded from customer deposits, whereas JPMorgan is more reliant on the global money markets. That’s a big advantage for Wells Fargo, because when rates start rising, retail depositors react more slowly than the money markets do.
Wells Fargo’s 2013 gross interest margin was 91 per cent, even better than JPMorgan’s. In the tighter environment of 2006, its gross interest margin was substantially better — 62 per cent to JPMorgan’s 36 per cent.
The Fed began to ratchet down its quantitative easing programme earlier this year, and its chairman, Janet Yellen, recently announced it will accelerate the phase-down. The stated intention, however, is to keep the fed funds rate at its current level for an unspecified period.
The extreme easy-money policy has been successful. It prevented a wholesale banking collapse in the wake of the crash and, to a somewhat lesser extent, managed to deliver measurable stimulus to the economy. Bernanke’s brave innovations deserve to be celebrated.
But as with any subsidy regime, the distortions being created may soon outweigh the good that’s been done. Since the Fed has been the major driver of the stimulus programme, it has naturally used the financial sector as its primary tool, so much of the largesse has been diverted into financial-sector pockets.
Disgracefully, in 2009, when the real economy was staggering, earnings and bonuses at most of the biggest banks broke records. Cheap money also feeds asset bubbles — stock markets soar when margin rates are historically low. Keeping rates artificially low also punishes the diligent small savers with conservative retirement portfolios.
There will undoubtedly be hiccups as the stimuli are wound down. Indeed, some further stimulus may be needed. But the right course will be to put it directly into the real economy — including badly needed infrastructure repairs — where it will do more good rather than continuing to subsidise the financial sector shareholders and executives.
