Fuchita (ed ) after the crash; the future of finance (2010)

The conference considered the future of the financial services industry after the crisis of 2007–08 and focused on commercial banks, investment banks, and hedge funds in particular.. In

BROOKINGS INSTITUTION PRESS Washington, D.C.

As the global economy continues to weather the effects of the recession brought on by the

fi nancial crisis of 2007–08, perhaps no sector has been more affected and more under

pressure to change than the industry that was the locus of that crisis: fi nancial services

But as policymakers, fi nancial experts, lobbyists, and others seek to rebuild this industry, certain

questions loom large For example, should the pay of fi nancial institution executives be regulated to

control risk taking? That possibility certainly has been raised in offi cial circles, with spirited

reactions from all corners How will stepped-up regulation affect key parts of the fi nancial services

industry? And what lies ahead for some of the key actors in both the United States and Japan?

In After the Crash, noted economists Yasuyuki Fuchita, Richard Herring, and Robert Litan bring

together a distinguished group of experts from academia and the private sector to take a hard look

at how the fi nancial industry and some of its practices are likely to change in the years ahead

Whether or not you agree with their conclusions, the authors of this volume—the most recent

collaboration between Brookings, the Wharton School, and the Nomura Institute of Capital Markets

Research—provide well-grounded insights that will be helpful to fi nancial practitioners, analysts,

and policymakers

Wharton School, University of Pennsylvania ◆ Wayne R Guay, Wharton School, University of Pennsylvania

◆ Tetsuya Kamiyama, Nomura Institute of Capital Markets Research ◆ Kei Kodachi, Nomura Institute of

Capital Markets Research ◆ Alan McIntyre, Oliver Wyman Group ◆ Michael Zeltkevic, Oliver Wyman

Group

YASUYUKI FUCHITA is a senior managing director at the Nomura Institute of Capital Markets

Research in Tokyo He coedited Prudent Lending Restored (Brookings, 2009) with Richard J Herring

and Robert E Litan and Pooling Money (Brookings, 2008) with Litan.RICHARD J HERRING is

the Jacob Safra Professor of International Banking and professor of fi nance at the Wharton School,

University of Pennsylvania, where he is also codirector of the Wharton Financial Institutions Center

ROBERT E LITAN is a senior fellow in Economic Studies at the Brookings Institution and vice

president for research and policy at the Kauffman Foundation His many books include Good

Capitalism, Bad Capitalism, and the Economics of Growth Prosperity (Yale University Press, 2007),

written with William J Baumol and Carl J Schramm

AFTER THE CRASH

nomura institute of capital markets research

Tokyo

brookings institution press

Washington, D.C.

yasuyuki fuchita richard j herring robert e litan

Editors

AFTER THE CRASH

The Future of Finance

the brookings institution

nomura institute of capital markets research

All rights reserved No part of this publication may be reproduced or transmitted in any form or by any means without permission in writing from

the Brookings Institution Press.

After the Crash: The Future of Finance

may be ordered from:

brookings institution press

c/o HFS, P.O Box 50370, Baltimore, MD 21211-4370 Tel.: 800/537-5487; 410/516-6956; Fax: 410/516-6998

Internet: www.brookings.edu

Library of Congress Cataloging-in-Publication data

After the crash : the future of finance / Yasuyuki Fuchita, Richard J Herring, and Robert E

Litan, editors.

p cm.

Includes bibliographical references and index.

Summary: “Examines the ramifications of the 2007–08 financial crisis on the financial

services industry and some of its practices and how these are likely to change in the future”—

Provided by publisher.

ISBN 978-0-8157-0404-1 (pbk : alk paper)

1 Financial institutions 2 Financial institutions—Deregulation 3 Financial services

industry 4 Financial crises—United States—21st century 5 Financial futures I Fuchita,

Yasuyuki, 1958– II Herring, Richard III Litan, Robert E., 1950– IV Title.

HG173.A38 2010

9 8 7 6 5 4 3 2 1 Printed on acid-free paper Typeset in Adobe Garamond Composition by Cynthia Stock Silver Spring, Maryland Printed by R R Donnelley Harrisonburg, Virginia

Yasuyuki Fuchita, Richard J Herring, and Robert E Litan

Alan McIntyre and Michael Zeltkevic

3 Regulatory Changes and Investment Banking:

Kei Kodachi and Tetsuya Kamiyama

Christopher C Geczy

5 Is There a Case for Regulating Executive Pay

John E Core and Wayne R Guay

In 2004 the Brookings Institution joined with Nomura Institute of Capital

Markets Research to showcase research on selected topics in financial market

structure and regulation of interest to policymakers, scholars, and market

prac-titioners in the United States and Japan, as well as elsewhere Initially led by

Brookings senior fellow Robert E Litan and Yasuyuki Fuchita, senior managing

director of Nomura Institute of Capital Markets Research, the collaboration

was joined in 2008 by Richard J Herring of the Financial Institutions Center at

the Wharton School of the University of Pennsylvania A conference has been

convened each year since 2004, leading to four volumes published by Brookings

Institution Press, most recently Prudent Lending Restored: Securitization after the

Mortgage Meltdown (2009).1

The chapters in this fifth volume in the series are based on presentations made

at a conference, After the Credit Crash: The Future of Finance, held on October

16, 2009, at the Wharton School in Philadelphia The conference considered the

future of the financial services industry after the crisis of 2007–08 and focused on

commercial banks, investment banks, and hedge funds in particular All of the

chapters represent the views of the authors and not necessarily those of the staff,

1 The first five of these conferences were sponsored by the Tokyo Club Foundation for Global Studies

(now part of Nomura Foundation) and the Brookings Institution.

officers, or trustees of the Brookings Institution, the Nomura Institute of Capital

Markets Research, or the Wharton Financial Institutions Center

The editors thank Adriane Fresh for research assistance and for checking the

factual accuracy of the manuscript; Diane Hammond for careful editing; and

Lindsey Wilson for organizing the conference and providing administrative

assis-tance Both the conference and this publication were funded in part by Nomura

Foundation

yasuyuki fuchita richard j herring robert e litan

After the Crash:

Will Finance Ever

Be the Same?

The financial crisis of 2007–08, which led to what is now known as the

Great Recession of 2008–09, will go down in history as one of the most

troubling economic events of the postwar era Although some prescient analysts

forecast that the housing bubble in the United States, which triggered the crisis,

eventually would burst, we suspect that few foresaw the crisis bringing the United

States and other global economies nearly to their knees Certainly, no

main-stream forecaster or high-profile policymaker predicted this outcome

Even now, after the dust has settled somewhat and a halting recovery is under

way, many questions about the future of the global financial services industry

remain After receiving massive government infusions of capital and experiencing

large numbers of failures, what will the U.S commercial banking industry look

like in the years ahead? Further, with only one major independent investment

bank left in the United States after the crisis, what impact will new regulations

have on the investment banking business, under whatever corporate structure it

is conducted? The same question can be asked of the hedge fund industry, which

went into the crisis largely unregulated And finally, what is the evidence that

the executive compensation structures of some financial companies contributed

to the crisis (a criticism leveled by regulators and many in the media)? Should

compensation regulation be imposed on the financial services industry? And if

so, what form should it take?

These are important questions not just for those who own shares in or work

for financial services companies but also for the policymakers designing a

regula-tory framework and for concerned citizens, who fear another disruption of their

lives, destruction of their wealth, and the fiscal consequences of government

spending on cleaning up after such crises

It is appropriate, then, that these questions were also the subjects of a research

conference jointly organized by the Nomura Institute of Capital Markets

Research, the Brookings Institution, and the Wharton Financial Institutions

Center in October 2009 This volume contains the revised presentations made

at the conference, which came just one year after the worst of the crisis unfolded

During the third week in September 2008—after Lehman Brothers declared

bankruptcy, after Merrill Lynch fled to safety in the arms of Bank of America,

after the Federal Reserve improvised an unprecedented bailout of the creditors of

AIG, and after the U.S Treasury rushed to guarantee the more than $3 trillion

held in U.S money market funds—many observers believed the future of the

financial services industry was utterly bleak

We provide in this introductory chapter a summary of the chapters that

fol-low A broad theme that runs through these chapters is that each of the segments

of the financial services industry we review has been significantly affected by the

crisis and is likely never to be the same again

Alan McIntyre and Michael Zeltkevic, of Oliver Wyman Group, focus in chapter

2 on the industry in which many of the problems first surfaced, the U.S

com-mercial banking industry, and examine its future But first the authors briefly

revisit the industry’s recent past, specifically what they call its golden era, the

decade between 1993 and 2003 Cognizant of the savings and loan and banking

crises of the previous decade, banks during the golden era recapitalized (at the

direction of new legislation) and earned returns on equity of roughly 14 percent,

the highest of any decade since the 1920s

The industry’s performance began to deteriorate in 2004, however, as the

Federal Reserve reversed the loose money policy it had pursued in the wake of

the 2000–01 recession With a flatter yield curve, the spread between bank

lend-ing and deposit rates (upon which banks traditionally relied to earn most of their

profits) narrowed To cover their fixed costs, banks turned to asset growth,

espe-cially subprime and alt-A mortgage lending to make up the difference.1 Larger

1 Alt-A mortgages (alternative-A paper) are considered riskier than prime mortgages (A paper),

because borrowers have less than full documentation, lower credit scores, higher loan-to-value ratios, or

more investment properties than prime borrowers Alt-A mortgages, however, are considered safer than

subprime mortgages.

banks seemingly hedged the risks of such lending in one of two ways: one, by

packaging the loans into securities and then selling them to third-party investors,

who might mix them with other securitized assets and resecuritize the pool as

col-lateralized debt obligations; or two, by holding them in theoretically

off-balance-sheet affiliates, the so-called structured investment vehicles

As we all know now, when the residential real estate market began to sour in 2007,

those less-than-prime loans, and the securities that used them for collateral, turned

toxic Banks that had such “assets” on their balance sheets suffered, as did the large

institutions that were forced by reputation—and arguably by contractual liquidity

arrangements—to provide liquidity or take the structured investment vehicles and

their newly troubled assets back onto their balance sheets As a result, by 2008 the

industry’s overall return on equity had turned negative and a number of institutions,

large and small, either failed or had to be rescued through arranged mergers

What lies ahead? McIntyre and Zeltkevic projected in October 2009 that

banks and insurers around the world still had substantial credit losses to come

and not just in securities backed by mortgage loans but also in commercial real

estate loans held directly or in the form of securities But the authors’ focus

here is on the period after these losses have been absorbed; they spell out three

future scenarios for bank performance Each scenario reflects different

assump-tions about the key drivers of performance, including macroeconomic factors,

the regulatory environment, and intensity of competition between banks and

between banks and nonbanks, including capital markets

In the authors’ baseline scenario, which is the one they believe the most likely,

the industry’s return on equity will average 10 percent, or roughly the

histori-cal norm over the past seven or eight decades Their benign scenario sees the

industry returning to golden era profitability, with credit losses returning to

pre-crisis levels and the global economy recovering reasonably smartly In the third

scenario banks barely break even, the macroeconomic environment is poor, and

U.S unemployment remains in the 9 percent range

The scenarios depict industry averages, but within any average, some

institu-tions will outperform, others will underperform What factors are likely to make

the difference? The authors suggest that the keys to superior performance include

positioning in rapidly growing markets and the ability to manage risks and to

take advantage of disruptive change (perhaps through targeted acquisitions) The

authors also expect wider dispersion in performance among banks in what they

call the new normal (less-buoyant) business environment

The investment banking business was a major casualty of the financial

cri-sis and the Great Recession Two leading institutions—Bear Stearns and

Lehman—disappeared (one by forced merger, the other by failure) A third,

Merrill Lynch, merged with Bank of America, pushed by the Treasury and the

Federal Resrve And the two remaining bulge-bracket investment

banks—Gold-man Sachs and Morgan Stanley—hastily converted to bank holding company

status to ensure access to the Fed’s discount window and to forestall liquidity

pressures At the time of the October conference, Nomura Securities was the only

major independent international investment bank standing

In chapter 3 Kei Kodachi and Tetsuya Kamiyama of the Nomura Institute

examine the future of the investment banking business through the lens of eight

major regulatory changes that, at the time of the conference, were contemplated

by the G-20: strengthening the risk-weighted bank capital standards, raising

cap-ital charges for banks’ (commercial and investment) trading books, adopting and

enforcing leverage ratios, extending certain banking rules to nonbanks,

tighten-ing the rules governtighten-ing securitization, increastighten-ing regulation of over-the-counter

derivatives, regulating short selling, and regulating hedge funds The chapter

describes each of these initiatives and argues that, in general, these changes

indi-vidually and collectively would harm investment banking Accordingly, they

offer alternatives that address the perceived problems but in ways the authors

believe to be less harmful and more cost effective

For example, higher capital standards in general carry the danger of giving

investment and commercial banks incentives to engage in “regulatory arbitrage,”

thereby moving such activity to unregulated markets or affiliates Instead, the

authors suggest improvements in risk control by the institutions and the

regula-tors that oversee them Similarly, higher capital charges for trading activities

could be counterproductive by reducing trading activity and therefore liquidity,

which could lead to increased price volatility An alternative approach is to limit

the kinds of assets in trading books A simple leverage ratio ignores the quality

of assets on the balance sheet (the reason regulators have adopted risk-based

standards) and would have a disproportionately negative impact on countries,

such as those in Asia, where banks are more important than markets as providers

of credit The authors suggest instead that country-specific leverage or capital

requirements be adopted

Because the crisis has revealed that large nonbanks (such as investment banks)

may pose just as much systemic risk as large commercial banks, there is much

interest within the G-20 in extending banklike regulation to large nonbanks

But this could lead to the same difficulties as with stringent bank regulation

Accordingly, the authors urge regulators to look for alternatives to the Basel II

(risk-based) capital framework for reducing the systemic risks associated with

large nonbanks

As for the lack of incentives for prudence in securities origination, the authors

argue that there is no need for a mandated “skin-in-the-game” requirement for

mortgage originators, because the market, they assert, already imposes such

requirements There are clear systemic risks in over-the-counter derivatives

mar-kets, but these can be handled with greater standardization of the instruments

traded and greater reliance on central clearinghouses With respect to naked short

selling, the authors see some regulation as inevitable And with respect to the

sys-temic risk posed by hedge funds, the authors urge greater regulatory supervision

of prime brokers and reporting by the funds of their leverage

More broadly, independent of the specific regulatory changes that may be

coming, the authors outline a future of the U.S financial service industry in

particular, which contains a mix of financial conglomerates (some services

domi-nated by commercial banks, others by investment banks), megaregional banks,

and perhaps a few “pure play” investment banks

Although much concern had been expressed in the years before the financial crisis

about the systemic risks posed by hedge funds, these financial institutions in fact

played little or no role in the crisis That does not mean, however, that they will

be immune from forward-looking reporting and perhaps regulatory requirements

(for those few large funds that regulators deem to be systemically important)

At the same time, however, the crisis has had a major impact on the hedge

fund industry Although some funds earned record profits, many incurred

sub-stantial losses during the decline in equity markets And although some of the

bleeding stopped when equity prices picked up in the spring of 2009, many

hedge funds have closed their doors (or have been obliged to shrink their asset

base by their prime brokers, who withdrew much of their leverage)

What does the future hold now for hedge funds? In chapter 4, Christopher

Geczy of the Wharton School seeks to answer that question, among others: what

the consultants who advise institutional investors have been saying about the

future; the past and likely future performance of the hedge fund industry; efforts

to develop new products aimed at replicating the performance of hedge funds;

how hedge fund exposures have changed over time; and the likely changes in

regulation and enforcement in the post-Madoff era

The consultants who advise institutional investors, according to a survey

con-ducted by the author in late 2009 and the first quarter of 2010, report significant

postcrisis changes in the advice they give their clients There is much more focus

now on transparency of hedge fund activities and risk exposures, greater attention

to liquidity, more emphasis on lowering the fees the funds charge, an

expecta-tion that hedge funds will be subject to more regulaexpecta-tion, and the likelihood that

many investors will want to invest in “hedge fund replicators” rather than in the

funds directly

Gezcy’s survey of consultants also reveals that most institutional investors are

believed to have limited knowledge of hedge funds Of those pension funds that

allocate some investments to hedge funds, the allocation tends to range between

2 percent and 10 percent A majority of consultants recommend (and expect to

observe) a modest increase in hedge fund investment Gezcy’s chapter reports

more specific results on various provisions in hedge fund arrangements,

includ-ing the typical length of “lockups” (six to twelve months), risk measures, fees,

application of fair value principles to the valuation of hedge fund investments,

and concerns about fraud and the quality of due diligence

Gezcy next turns to the performance of hedge funds, beginning by offering

a typology of four types of fund, each with different investment strategies The

central conclusion is that one should not measure aggregate performance of all

hedge funds because of the differences in risk factors to which they are exposed

The only meaningful comparison is to examine the performance over time of

funds in a particular category, adjusted for the risk factors in that category

A recent phenomenon is the development of a new class of funds that seek

to replicate the performance of hedge funds of a given type without actually

making the investments and following the precise strategies of those funds A

key advantage of replicators is that they can be constructed as mutual funds or

exchange-traded funds and thus are open to a much broader class of investors

than typical hedge funds, which are open only to sophisticated individuals of

means or institutional investors There are pros and cons to these tracker, or

replicator, investment vehicles Some argue that they are more transparent than

the hedge funds they track Critics argue that replicators generally track only the

average or aggregate performance of funds in a category and thus miss out on any

superior returns offered by star funds

A key claim of hedge funds is that they in fact offer their investors superior

returns, adjusted for risk, to other investment vehicles: alpha, for short Gezcy

evaluates this claim, noting that measures of alpha obviously depend heavily on

the measure of risk used His overall assessment is mixed, with only about half of

the funds he studied reporting statistically significant alpha

Gezcy also evaluates through standard statistical techniques the impact of

Statement of Financial Accounting Standards 157 on fair value measurements

(FAS 157) on hedge funds, which became fully effective in November 2008—or

right in the middle of the financial crisis FAS 157outlines the conditions under

which certain assets, such as the kinds of mortgage-backed securities making up

many hedge funds, have to be marked to market Gezcy finds that FAS 157 did,

in fact, have a noticeable impact on returns reported by some hedge funds

Gezcy ends his chapter with several tentative conclusions about the future of

the hedge fund industry He shows that private equity strategies and hedge fund

strategies have been converging and thinks it likely that the trend will continue

He believes that one of the key lessons hedge fund managers learned from the

crisis is the need to place much tighter controls on the mismatch between the

duration of their assets and liabilities Gezcy expresses some skepticism that the

interest of consultants in separately managed accounts (as a means of making

hedge funds more transparent) will change the structure of the industry, given

its passion for secrecy

Although it is tempting to forecast the demise of the traditional compensation

standard (2 percent of assets under management and 20 percent of profits above

a high-water mark) because of the advent of replication approaches and other

more liquid, transparent, and cheaper ways of gaining access to some hedge fund

strategies, he concludes that, instead of a compression of fees, we are likely to see

a bimodal distribution, in which the hedge fund managers with the best track

records will continue to command stratospheric fees while other fund managers

will be forced to reduce fees to meet the competition from the cheaper

replica-tion techniques

Policymakers around the world and many in the media and among the public

in fact blame the compensation structures of financial institutions for creating

the crisis or, at the very least, for making it worse The main purported villain:

salaries or bonus arrangements tied in some fundamental way to the volume of

business generated (such as mortgage origination), regardless of the downstream

or longer-term consequences Is this criticism correct? And if so, what kinds of

compensation regulation might be appropriate? John Core and Wayne Guay of

the Wharton School at the University of Pennsylvania take up these questions in

chapter 5 and provide some unconventional answers

The authors begin by placing their topic in the larger context of mounting

concerns over CEO compensation generally, concerns related in their view to

even broader concerns about growing income inequality There is no doubt that

CEO compensation, especially for those heading the largest corporations, is high

But is it too high?

By one standard, the answer is—not really: the authors point out that

eco-nomic theory would suggest that compensation of managers, and CEOs

espe-cially, should rise as the size of their entities increases, since larger organizations

tend to be more complex and more difficult to manage And it turns out that,

empirically, CEO compensation is correlated with firm size Corporate CEO

compensation is also not high when compared to compensation of hedge funds

and private equity funds (which, in some ways, may be less difficult to manage

than the typical large corporation) The authors note that U.S corporate CEOs

do make more than their counterparts in the United Kingdom but that U.S

executives also bear greater equity risks

If, then, there is a plausible defense of the level of CEO pay among U.S

corporations, can the same be said about CEO compensation in the financial

services industry? Based on their empirical analysis of the 1992–2006 period,

the authors find that both the levels and the composition of the pay packages of

financial services CEOs are comparable to those of CEOs at nonfinancial firms

The authors also cite evidence rebutting the common view that financial

execu-tives’ compensation is too short-term oriented; to the contrary, the bulk of their

compensation consists of stock and options, which the authors argue give the

executives a long-term outlook This finding is consistent with recent evidence

that financial executives took heavy losses during the financial crisis and did not

cash out in advance

Nonetheless, it is not surprising that, in the wake of the crisis, financial

compensation has become an explosive political issue U.S Treasury Secretary

Timothy Geithner suggested in June 2009 that, going forward, financial

institu-tions should pay their top executives in a manner consistent with a number of

key principles Perhaps the most important of these are that financial executives

should be rewarded in relation to the performance of their institutions over the

long run, not the short run and, further, that pay practices be aligned with sound

risk management of the institutions The authors find these principles

noncon-troversial and argue that compensation practices have been largely consistent

with them

Still, since mid-2009 the Treasury Department has strictly limited financial

executive compensation at institutions that received government money under

the Troubled Asset Relief Program (TARP) The authors are critical of a number

of aspects of Treasury’s rules in this regard and the ways they have been

imple-mented by the department’s pay czar, Ken Feinberg For example, the

require-ment that independent directors approve compensation plans is already required

by stock exchange listing standards The push to have financial executives’ pay

consist partially or primarily of restricted stock is puzzling to the authors in light

of their evidence that executive compensation already conforms largely to this

model The authors level substantive critiques of other aspects of the pay rules,

including the attacks on severance payments, tax gross-ups, and nonbinding

say-on-pay votes by shareholders While not all of the participants at the

confer-ence shared the authors’ resistance to greater regulation of financial executive

compensation, their chapter marshals the best evidence available supporting the

notion that further regulation is unwarranted

The financial crisis of 2007–08 clearly was a watershed event in the financial and

economic history not only of the United States but also of the rest of the world

The financial institutions and industries at the heart of that crisis—commercial

and investment banking—as well as the hedge fund industry, which some believe

could be at the heart of a future crisis, clearly have changed and will undergo

more change in the future We hope that the chapters in this volume shed light

on what these changes are likely to be and how, in some cases, current and future

policy might affect them

alan mcintyre michael zeltkevic

The Uncertain Future of U.S

Commercial Banking

Commercial banking in the United States since about 1930 has for the

most part been a simple business, with adequate but not particularly tive returns to shareholders Then for a golden decade, between the early 1990s

attrac-and the first half of the 2000s, it outperformed, offering high attrac-and stable returns

to shareholders and accounting for an increasing share of corporate profits

At the time, few sought to identify the confluence of factors that led to such

a positive environment for banking or to ask whether that environment was

sus-tainable With a decline that began somewhat slowly in the middle of the 2000s

and then accelerated with the giddy fall of 2008 and 2009, commercial banking

underwent a reverse alchemy, turning gold into lead With eleven straight

quar-ters of declining profitability, enormous industry dislocation, and unprecedented

financial support from the government, some may now be tempted to declare

commercial banking a bad business, and there are certainly reasons to do so.1

A combination of investor fear, increased market discipline, more intrusive

supervision, and stricter regulations is likely to raise both regulatory and de facto

capital levels, reduce balance-sheet leverage, and generally limit risk taking and

its returns The financial crisis also sensitized consumers and regulators to certain

bank fees, considered excessive and opaque, resulting in quick action on credit

1 FDIC (various years b).

card fees and legislation focused on deposit fees, debit interchange, and consumer

financial protection

In addition to the threat from both prudent and more politically motivated

regulation, the industry faces an uncertain macroeconomic environment The

next few years could see either the spectre of inflation reemerge—and with it

higher interest rates and corresponding challenges for profits—or a tepid

recov-ery with persistently high unemployment and low interest rates, which would

also challenge the banking industry (as the Japanese discovered in the 1990s)

Given these developments, commercial banking could face an extended period

of low returns, even after the current credit losses have worked their way through

the system

Yet despite these not immaterial challenges, it is too early to declare

com-mercial banking to be a poor, or even a mediocre, business Banking services

remain a basic need for the vast majority of the population, and only 10 percent

of U.S households lack a checking account.2 Financial services are an essential

lubricant in the gears of the broader economy, offering not only transaction

ser-vices but also the stores of value through which the results of all other economic

activities are ultimately measured Nor will increased government involvement

in the industry necessarily erode profits On the contrary, increased regulation

may create barriers to entry that prevent profits from being competed away and

may permanently eradicate the shadow banking sector that thrived during the

1990s and the first half of the 2000s The government’s implicit promise to bail

out any large failing commercial bank also amounts to an economic subsidy, as

it massively reduces banks’ cost of debt capital and strengthens their competitive

position vis-à-vis institutions without that government backing

As we show in our historical analysis of the profitability of the industry, the

fortunes of commercial banks depend primarily on such structural factors as the

rate of economic growth, the shape of the yield curve, and the regulatory regime

under which they operate How the commercial banking industry emerges from

its currently fragile state, and which are the best business strategies to maximize

returns, depend on the direction taken by these structural factors Nobody can

anticipate such developments with certainty, but some possible and quite plausible

scenarios—and their likely effects on the industry—can be considered The three

scenarios we envision are benign, malign, and a base that lies between these two

In our three scenarios we attempt to look beyond 2010 and 2011 to a point

at which current credit losses have worked their way through the system and

new domestic and international regulation is in place We also look at current

2 Federal Reserve (2007).

markets (and in particular bond markets) to tell us what macroeconomic

envi-ronment we might expect two years out and how that envienvi-ronment will affect

bank economics

In our base scenario we posit a combination of macroeconomic, regulatory,

and competitive conditions that we think is plausible for the industry by 2012–

13 In this scenario, the industry’s post-tax return on tangible equity returns

to its long-run average of around 10–11 percent In this scenario, commercial

banking as an industry may struggle to exceed its cost of capital, is certainly not

the high-returns industry of the golden decade, and is more closely coupled with

the overall performance of the economy than in other scenarios However, there

is a wide error band around this estimate The three key

drivers—macroeco-nomic conditions, regulatory change, and the competitive environment—need

not move in sync: it is this lack of correlation that creates a plausible wide range

of industry profitability We estimate that industry return on equity could range

between 1 percent in our malign scenario and 17 percent in our benign scenario

Whatever scenario unfolds for the industry as a whole, there will be a

distribu-tion of returns; and we expect that distribudistribu-tion to be wider than it has been in

the past While the industry may return to its long-run average profitability, it is

unlikely to return to being a homogeneous sector There will be opportunities for

individual institutions, through a combination of good positioning and

execu-tion, to outperform and emerge as industry leaders (Later we address the factors

that will drive the variation in performance of individual banks and suggest some

common characteristics of institutions that will not only survive but may actually

thrive over the medium term.)

The Historical Performance of U.S Commercial Banking

Commercial banking revenues are derived from four activities:

—Treasury: Matching the duration and convexity of assets and liabilities or

generating earnings from taking imperfectly matched positions

—Lending: The origination, servicing, and investment in or distribution of

credit risk

—Deposits: Gathering and investing deposit liabilities

—Fee income: The provision for fees of non-balance-sheet services, ranging

from payments to investment management

The profitability of these activities depends to a large extent on a number of

structural factors beyond banks’ direct control: the regulatory regime, the level of

competition, and the macroeconomic environment For the treasury, or

balance-sheet, elements of the business, the most important factors are the shape of the

yield curve, the interest rate trend, and the rate of GDP growth The history of

the industry is to a large extent the history of these structural factors

In this look back, we focus on the extraordinary confluence of favorable

con-ditions during the golden decade and on their undoing before and during the

financial crisis (figure 2-1)

The First Three Eras, 1945–92

The last trauma of similar magnitude to the current crisis to affect the banking

industry was the banking crisis of the early 1930s, which led to the creation

of the Federal Deposit Insurance Corporation (FDIC), the Glass-Steagall Act

separating commercial and investment banking, and the government-sponsored

mortgage enterprises

Following this period the industry settled down to nearly forty years of relative

stability Its business model was simple: conservative underwriting and low losses

(an average of ten basis points of total assets), low interest rate spreads (on average

Figure 2-1 Rate of Return, U.S Commercial Banking Industry, 1936–2008

Source: FDIC (various years b).

Economic turmoil:

stagflation

Golden decade

Financial crisis

11.1 10.1

S&L crisis

Average ROE

2.1 percent of assets), and limited fee income (0.6 percent of assets).3 While this

model led to low income levels, revenue was aligned with a simple low-cost

busi-ness model (net interest expense was 1.6 percent of assets) to generate return on

assets in the 0.6 percent range Apart from the bump in returns that came from

the drop in equity levels (from 13 to 8 percent of assets during the late 1930s and

early 1940s), it was also a period of stable if not spectacular shareholder returns

(8–10 percent) This stability reflects to a large extent the stable regulatory and

competitive macroeconomic environment in which the industry was operating

While the 1970s were challenging economic times for much of the U.S

econ-omy, the economic turmoil actually benefited the commercial banking industry

With spiking inflation and rising interest rates, banks had far more scope to

man-age interest rate margins than they had in a more stable macroeconomic

environ-ment As a result, net interest margin expanded to an average of 3.2 percent of

total assets during this period Although fee income remained low (0.7 percent

of assets) and operating costs grew (to 2.5 percent of assets), this higher margin

combined with continued low losses (twenty basis points) to deliver an industry

average return on equity of 12 percent

At the end of September 1981 banks faced an unusual and, at the time,

challenging macroeconomic environment Ten-year U.S Treasury bond yields

peaked at 15.8 percent Struggling to quell the inflation of the 1970s, Paul

Volcker’s Federal Reserve inverted the yield curve with three-year Treasury

bonds yielding 16.5 percent and a Federal Reserve funds rate peaking (in May

1981) at 20 percent, generating a negative interest rate gap for commercial banks

with short liabilities and long assets The general economic outlook was bleak,

and the ensuing recession saw double-digit unemployment and a sharp and

sig-nificant contraction in the economy These were difficult times for banks and

nonfinancial corporations alike

While the aggressive action of the Federal Reserve Bank may have helped bring

on the recession of the early 1980s, it also set the stage for a long-term boom in

commercial banking The taming of inflation stabilized and then strengthened

the value of the dollar and set in motion a long-run fall in interest rates, which

bottomed out (temporarily) with a ten-year Treasury yield of 3.1 percent in June

2003 During the period 1980–92 the underlying profitability of commercial

banking improved Declining short-term interest rates created an environment

in which banks could easily profit from their natural maturity mismatch of assets

3 We calculate net interest margin on the basis of total industry assets rather than on earnings assets,

which are commonly used when individual bank margins are reported All performance ratios are derived

from FDIC historical profit and loss and balance-sheet data.

and liabilities: that is, funding long-term assets with short-term liabilities Banks

also began to change the way they priced their services, adding a wider range

of fees to their traditional balance-sheet-related interest rate spread However,

industry performance was undermined by the losses of the S&L crisis In 1987

provisions peaked at 1.3 percent of assets, a level not to be visited again until

2009–10 It was only after the savings and loan crisis and the recession of 1991–

92 had passed that the golden decade of commercial banking truly arrived

The Golden Decade, 1993–2003

For financial firms, and especially banks, 1993–2003 was a period of

unprec-edented returns Average return on equity over the decade was 14 percent, with

spikes closer to 16 percent (compare this to the long-run industry average of

10–11 percent) This was also a period in which commercial banking profits

decoupled from the rest of the economy For sixty years commercial banking had

accounted for around 6 percent of total corporate profits In contrast,

commer-cial banks now accounted for more than 12 percent of profits, spiking closer to

18 percent in the early part of the decade

Figure 2-2 Pretax Net Operating Income, Commercial Banking,

as Share of All U.S Corporations, 1934–2006

Source: FDIC (various years a); Thomson Reuters.

This performance was the result of improved profitability (return on assets of

1.2 percent and total revenue of 5.8 percent of assets), not the result of increased

leverage The notorious high leverage of the pre-crisis period was characteristic of

investment banks, not commercial banks On the contrary, commercial banks’

equity ratios actually increased from the lows reached during the S&L crisis The

composition over the decade shifted somewhat from tangible common equity

toward other types of capital, but these levels were not out of line with the

long-run history of the industry A case can be made that if some of the larger

com-mercial banks such as Bank of America and Citigroup had been forced to bring

onto their balance sheet all of their structured investment vehicles and other

off-balance-sheet vehicles—which they ultimately had to stand behind—then

the effective leverage of commercial banking would have been much higher

However, for the typical regional bank, returns during the golden decade were a

result of increased profitability, not simply of increased leverage

Figure 2-3 Bank Profit Drivers in the Golden Decade, 1993–2003

Source: Oliver Wyman.

High banking profits

Net long

Treasury

positions

Steep yield curve Falling rates

Strong home price appreciation

Sustained high employment

Increased second market liquidity

Strong deposit growth

High barriers

to entry into deposit business

High Treasury profits and operating leverageHigh lending profits

High profits and operating leverage in branch-based deposit gathering

Very low credit losses Very high asset

origination volumes and balance growth

Rapidly increasing capacity to borrow (demand)

Rapidly increasing capacity to lend (supply)

Depressed competitive intensity sustains market share and pricing power

of incumbent banks

This increased profitability was caused by an extraordinary confluence of

positive structural factors Deregulation, innovation (especially the rise of asset

securitization, which decoupled origination volumes from the need for

balance-sheet growth), and persistently high barriers to entry in the extremely

profit-able business of retail deposit gathering were among the most important These

industry-specific factors combined with a generally positive economic

environ-ment to drive banking profits ever higher In addition the golden decade also saw

sustained growth in the fee income associated with deposit products

Between 1982 and 2003 the yield curve changed shape many times; although

the overall trend was falling interest rates, the typical curve remained upward

sloping (figure 2-4) Long-term rates (ten-year) were consistently around 200

basis points higher than short-term rates (overnight or thirty-day money) Banks

took advantage of this difference to generate “gap” earnings, funding long-term

lending with short-term borrowing This strategy generated significant

addi-tional margin for banks from the early 1980s until about 2003, when the Federal

Reserve funds rate hit 1 percent

Interest rates fell dramatically and more or less continuously from the early

1980s until 2003, a trend with a positive effect on asset growth Even as

house-hold debt increased by almost 300 percent, the cost of servicing that debt (as a

fraction of income) barely moved because of falling interest rates (figure 2-5)

Figure 2-4 Treasury Rates, Six-Month Moving Average, 1982–2009

Source: Thomson Reuters.

Consequently, consumers and businesses could increase debt levels much

more quickly than their incomes grew Fee and spread revenues associated with

originating and holding lending assets boomed, with total fee income rising to

2.2 percent of assets during the golden decade Funding options also expanded as

credit “liquefied” and securitization markets grew And after peaking in the early

1990s, credit losses declined (to nearly zero in some asset classes) This decline

inflated margins for holders of risk and abetted the growth of securitization

In addition to falling interest rates, at least three major innovations in lending

helped to reduce the cost and extend the reach of consumer finance during the

golden decade:

—The proliferation of risk-based pricing, which increased the range of

con-sumer credit that a bank was willing to take on

—The rise of asset-backed securities and the disaggregation of parts of the

lending activity chain (originating, servicing, and holding), which allowed the

industry to focus on asset origination relatively unconstrained by balance-sheet

capacity

—The introduction of home equity lending, which allowed consumers to tap

into real estate equity to fund current expenditure

The exceptional interest rate environment, combined with these product and

funding innovations, resulted in two significant trends First, banks were

moti-vated to push growth in real estate lending by tapping increasingly risky borrower

segments Second, lenders enjoyed a healthy demand for loans Even as monoline

Figure 2-5 Consumer and Real Estate Debt, 1987–2005

Source: Federal Reserve (2010); Thomson Reuters; Federal Reserve (various years); Mortgage Bankers’

Association (various years).

1987 1990 1993 1996 1999 2002 2005

Home price index

Mortgage outstandings

30-year fixed mortgage

U.S consumer debt growth U.S residential real estate growth

0 1 2 3 4

credit card and real estate lenders dominated, there was still plenty of volume in

the market to support the growth of commercial banks’ balance sheets

Deposits

Deposit gathering was a major source of bank profits during the golden

decade, benefiting from limited competition and strong deposit growth Deposit

return on equity across the industry was consistently above 30 percent, although

the true value of deposit products is often obscured by poor internal transfer

pric-ing.4 Deposit businesses benefited first and foremost from strong volume growth

during this period (figure 2-6)

Deposit growth also outpaced growth in the number of bank branches

dur-ing much of this period This resulted in a relatively fixed-cost base supportdur-ing

ever increasing deposit volumes and revenues Several trends contributed to this

growth of balances:

4 Line-of-business profitability for deposits is reported by only a handful of banks, including Bank

of America However, confidential Oliver Wyman line-of-business profitability studies across the industry

support this more general conclusion.

Figure 2-6 Commercial Banks, Savings Deposit Growth and Overall

3.5% 1.9% –0.1% 5.8% Deposit

growth rate

Recession:

–1.6% real growth

Recession:

–2.9% real growth

Recession:

–7.0% real growth

Exception:

mild recession

Time and savings deposits Real GDP change

—Aging of the population.

—Economic strength (high income growth and low unemployment)

—Concentration of wealth leading to more high-balance accounts

The economics of the deposits business was also supported by limited

com-petition, largely due to high switching costs, price opacity, and regulation Until

relatively recently, banks viewed their deposit accounts not as a profitable

busi-ness but as a cost of doing busibusi-ness They did not compete aggressively on rates

(price), because unsophisticated transfer pricing regimes limited their ability to

understand the effect of pricing change on the economics of the business

Like-wise, consumers were limited in their ability to compare pricing Hence branch

proximity to the customer and local branch density remained a key driver of

customer acquisition

From a regulatory standpoint, interstate banking laws made it difficult for

scale players to emerge and penetrate new markets before the early 1990s Rather

than a national market for deposits and national competitors, many local, highly

concentrated markets dominated the industry In theory, the regulatory

barri-ers should have come crashing down with the dismantling of intbarri-erstate banking

regulations.5 In fact, deregulation was the impetus for few shifts in local market

dynamics Instead of focusing on de novo market entry, large banks relied on

mergers and acquisitions (figure 2-7) The result was an increase in local market

concentration, as the footprints of newly conjoined entities overlapped

Fee Income

It is ironic that after “free checking” was introduced in 1994 deposit fees rose

from $16 billion a year to close to $40 billion a year in 2007, with $29 billion

related to overdraft and nonsufficient fund (NSF) fees.6 Before the mid-1990s

noninterest income on deposit accounts was earned through monthly

mainte-nance fees and minimum-balance fees, which were standard on most checking

accounts However, starting with Washington Mutual, the mid- to late 1990s

saw a competitive shift toward checking accounts with no minimum balances

or monthly fees These accounts quickly became part of the standard offering of

most commercial banks This move coincided with a dramatic rise in debit card

transactions, as consumers shifted to using cards rather than cash for small-ticket

items (figure 2-8)

5 The Riegle-Neal Interstate Banking and Branching Act of 1984 eliminated interstate banking

regu-lations over a number of years, concluding with the allowance of interstate mergers in 1997.

6 FDIC (2008).

Figure 2-7 Commercial Banks, Herfindahl-Hirschman Index and Mergers,

1994–2006

Source: FDIC (various years b).

a The Herfindahl-Hirschman index (HHI) is defined as the sum of the square of market shares times

100 The index is calculated at the level of the core-based statistical area (CBSA) for all “retail” branches

Resultant HHIs are weighted by amount of deposits in each CBSA to create a deposit-weighted “national”

HHI Mergers include commercial banks and savings banks.

Depost-weighted “national” HHI Bank mergers per year

to early rise

in HHI

M&A at lower levels added de novo activity, contributing to lower HHI

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Figure 2-8 Debit Card Transactions, 1998–2008

Source: Nilson Report (2009).

The growth in debit transactions generated a new source of income for banks

through debit interchange fees, but the lack of real-time balance information also

increased the frequency with which customers incurred overdraft and insufficient

funds fees These fees, which can be as much as $40 per incident, have come to

account for close to 75 percent of all deposit fees, which has allowed banks to

cover the cost of servicing low-balance checking accounts without resorting to

monthly maintenance fees.7

The rise of deposit fee income was also associated with a change in banks’

philosophy toward NSF incidents Historically, the NSF fee was meant to

dis-courage writing checks without sufficient funds in the account But as deposit

fee income grew in importance, banks began to frame penalty fees as fees for

service to allow customers to avoid the embarrassment of being unable to pay

at the point of sale or being late with bill payments The result was that, during

the golden decade, service charges on deposit accounts grew more quickly than

noninterest-bearing deposit balances (figure 2-9) These charges boosted overall

bank profitability

7 Ibid.; Bretton Woods (2008).

Figure 2-9 Commercial Banks, Deposit Service Charges and Non-Interest-Bearing

Deposit Insurance, 1994–2006

Source: FDIC (various years b).

a Indexed to 100.

b Compound annual growth rate, 7.3 percent.

c Compound annual growth rate, 5.7 percent.

As deposit fee income shifted toward insufficient-fund transactions, it also

became more concentrated among a small group of customers with exceptionally

high NSF transactions By 2007 only 5 percent of transaction accounts generated

68 percent of this income, with 74 percent of checking accounts having no NSF

fees at all.8 By the end of the golden decade this skew in fee income essentially

created two models of transaction account profitability for the industry For the

~15 percent of customers with more than five NSF fees a year, the fees associated

with these incidents were enough to make the accounts profitable At the other

end of the spectrum, accounts with average balances of more than ~$3,000 were

profitable based on net interest margin alone However, more than 50 percent of

accounts fell outside these two groups and were unprofitable, leading to material

cross-subsidization between high-balance/high-NSF customers and low-balance/

low-NSF customers.9

As commercial banks came to rely more and more on rising deposit fees from

a small minority of their customers, their profitability rose, but they found

them-selves in a situation in which their net interest income was highly concentrated

and therefore vulnerable to changes in either customer behavior or the regulation

of their deposits

The Financial Crisis, 2004–09

When discussing the 2007–09 banking crisis, the popular press largely focuses

on events that took place after the collapse of the two Bear Sterns hedge funds in

August 2007 Attention also focuses on credit losses and the severe contraction

of both retail and wholesale lending markets However, the problems faced by

commercial banks are not confined to the asset businesses, and signs of trouble

arguably appeared many years earlier Well before the current crisis came to full

fruition, multiple forces were already depressing the returns of the commercial

banking industry In the discussion that follows we review significant changes in

the Treasury and in the lending and deposit businesses between 2004 and 2007

Treasury

After a period of sustained monetary stimulation following the bursting of the

dot.com bubble, in the summer of 2004 the Federal Reserve began to tighten

interest rates, leading to a rise in short-term rates and, briefly, an inverted yield

curve (figure 2-10) This had two immediate effects First, because of the

flatten-ing curve, banks were prevented from makflatten-ing new “gap” investments Second,

8 FDIC (2009).

9 Oliver Wyman analysis based on FDIC data.

because of the rise in rates, banks had to pay more for short-term liabilities

with-out being able to reprice their assets The result was that, for only the second

time in twenty years, the cumulative return of funding long-term assets with

short-term liabilities turned negative The lucrative Treasury “carry trade” was

eliminated

Lending

Changes in the interest rate environment also had a significant impact on

lending businesses When rates started to tick up, loan originators were no longer

able to sell lower payments to borrowers based on interest rate declines Since

credit balances were no longer becoming cheaper for consumers, lenders were

forced into expanding the definition of acceptable credit in order to maintain

origination volume By 2005 originators had significantly grown their appetite

for lending to less creditworthy borrowers and had also expanded their suite of

“innovative” mortgage products, such as adjustable-rate mortgages with their

subprime rates, pay options, and negative amortizations

Lax credit underwriting was enabled and encouraged by large securitization

shops on Wall Street, which had built businesses based on moving credit off

originators’ balance sheets and into the capital markets The result was that

Figure 2-10 Commercial Banks, Three-Year Swap Rate, Three-Month LIBOR,

credit quality became secondary to sustaining the fees associated with

origina-tion, servicing, and securities manufacturing The industry continued to

sup-port growth in consumer credit during this period of rising rates, but over

a third of the mortgage originations were in the subprime and alternative-A

sectors, which together accounted for over $1 trillion of originations in 2005

and 2006 (figure 2-11)

Deposits

The lack of competition that had protected the banks’ deposit businesses

started to come under threat in the early part of the 2000s In particular, pricing

transparency improved as consumers, previously content to simply bank at the

closest branch, became savvy about finding the best value The rise of the

Inter-net and sites such as Bankrate.com enabled consumers’ price comparisons As a

result, the relationship between bank branches’ local market share and deposit

share began to break down

As consumers became better able to evaluate the trade-offs among

conve-nience, service, and price, they considered a broader array of competitors for their

deposit banking Nonbanks such as GMAC, de novo banks such as Commerce,

and foreign banks such as ING Direct began to gain ground The top thirty

non-banks and foreign non-banks achieved compound annual growth rates on deposits

of 96 percent and 21 percent, respectively, between 2001 and 2007 These rates

compare favorably to the 8 percent rates achieved by the top thirty U.S banks

Figure 2-11 Credit Liabilities and Mortgage Originations, Select Years, 2000s

Source: Federal Reserve (various years); Inside Mortgage Finance, various publications; FDIC (various

0

during the same period.10 In addition, since about 2007 (although more than a

decade after the regulations changed), de novo (or “buy and build”) market entry

strategies at long last arrived

The Financial Crisis after 2007

The crisis of 2008–09 has been much written about For this discussion the

most important conclusion to be drawn from the events of those years is that

commercial banking, despite its problems and the need for government support,

has turned out to be the most robust business model in financial services, as

evi-denced by the fact that:

—All large thrifts, with their mortgage focus, have disappeared, including

Washington Mutual and IndyMac

—Asset monolines have either chosen to become commercial banks (COF)

or were forced to become bank holding companies (GMAC, AXP, DFS, CIT)

—Independent broker/dealers have either disappeared (BS, LEH), sold

them-selves (ML), or acquired bank holding company charters (GS, MS)

In many ways, the crisis demonstrates not the weakness of the traditional

commercial banking business model but the extreme fragility of the shadow,

off-balance-sheet, system funded with short-term liabilities that thrived and grew

after the 1990s Once again, during times of severe distress only models with

strong government support were viable, and the commercial banking model,

with its deposit funding and FDIC backing, has proven to be more robust than

the alternatives

Even though the crisis may ultimately result in the failure of up to a thousand

FDIC-insured institutions, the commercial banking sector as a whole will have

survived The injection of government capital via the Troubled Asset Relief

Pro-gram (TARP) proPro-gram, the provision of multiple liquidity guarantees to ensure

access to funding, and the confidence-building exercise of the Supervisory

Capi-tal Assessment Program’s stress test in the spring of 2008 all helped shepherd the

industry through the period without the systemic collapses that characterized

the banking crisis of the early 1930s Significant losses still must work their way

through the banking system—the second quarter of 2009, for instance, was a

low point in bank profitability.11 However, the questions have now shifted from

whether the industry will survive in its current form to what the prospects are for

the recovery of profitability and shareholder returns

10 Oliver Wyman analysis of FDIC and Federal Reserve deposit statistics.

11 SNL Financial; FDIC data analysis.

The Uncertain Future of Commercial Banking

The financial crisis and its aftermath could see up to a thousand FDIC-insured

banks fail Although this would be a severe blow to the industry, it does not

rep-resent a fundamental industry restructuring, and the failure levels are likely to be

below what was seen during the height of the S&L crisis in the early 1990s.12 The

banks that will survive are now asking, What comes next? Will the industry again

see the attractive returns of the golden decade? Or will it be condemned to

util-ity returns and a reversion to the simpler, less risky, and less profitable business

model that characterized it for forty years after the Great Depression?

As mentioned, the fortunes of the commercial banking industry depend on a

number of structural factors How the industry fares over the next several years

will largely depend on how these factors evolve In this section we consider the

environment in which commercial banks will likely operate once the worst of

the current credit crisis has passed through the banks’ balance sheets and profit

and loss statements Our intent is not to assess the short-term prospects for the

industry, which will continue to be dominated by credit losses Rather, our focus

is on the period when, although the sins of the recent past have largely been

recognized, the industry is still subject to the postcrisis pressures on

profitabil-ity; we expect this period to run from late 2011 to 2014–15 We do not try to

predict the future Rather, we consider three plausible scenarios: base, benign,

and malign These scenarios are defined by three environmental drivers: general

macroeconomics, government regulation, and market competition

The scenarios represent a spectrum of likely outcomes, ranging from what a

reasonable optimist might hope for to what a reasonable pessimist might fear

There is also no a priori high correlation among the three environmental drivers It

is plausible for example to posit a future (as we do in the malign scenario) in which

heavy-handed government regulation combines with challenging macroeconomics

to create strong downward pressure on industry profitability For each scenario we

estimate the effect of the environmental factors on a number of input variables and

model their impact on industry performance These input and output variables are:

—Net interest margin (NIM), which affects the pretax return on assets

—Non-interest income (NII), which affects the operating margin

—Non-interest expense (NIE), which affects the efficiency ratio

—Provisions, which affect the pretax return on tangible equity (ROTE)

—Tangible common equity (TCE), which affects post-tax ROTE

12 The S&L crisis saw the narrow failure of 747 thrifts, but between 1986 and 1993 the FDIC

reported 1,453 failures of insured institutions FDIC (2009).

The inputs and outputs are industry averages There is, of course, variation

around these averages, with some banks doing better than others This variation

is not entirely idiosyncratic The way the environment evolves favors or harms

some banks more than others We consider such disparate impacts below, where

we consider the likely characteristics of the industry’s high performers

The Changing Environment for U.S Commercial Banking

The environment for commercial banking can be changed, as mentioned, by any

of three factors: general macroeconomics, government regulation, and market

competition We analyze these factors below

General Macroeconomics

The macroeconomic environment is a key determinant of banking

profitabil-ity This environment is shaped by three principal drivers:

—The height and shape of the yield curve and its impact on Treasury profits

—Asset performance, which is dependent on economic activity, income,

and unemployment

—Asset and liability growth rates, which are dependent on the aggregate

growth of the economy and level of savings

The most uncertain macroeconomic environment is that in the

immedi-ate future (2010–15) While the economy appears to have officially exited the

recession sometime in the second half of 2009, the character, strength, and

tim-ing of the economic recovery remains a subject of much debate At the core of

this debate is which of two opposing opinions will prove correct On one side

are those who think the United States is heading for a Japanese-style period of

low growth, low inflation, and low interest rates, driven by continued personal

and corporate deleveraging On the other side are those who think that rapidly

increasing and ultimately unsustainable federal deficits and the expansion of the

monetary base to prop up the financial system will lead to faster growth but also

higher inflation, higher interest rates, and possibly an acute dollar crisis, as

for-eign creditors lose faith in the creditworthiness of the U.S government

In our scenarios we try to capture a realistic range of outcomes for these

mac-roeconomic drivers, anchoring our speculations in how the current bond market

is pricing in expectations on inflation and interest rates For example, the spread

between nominal Treasury yields and index-linked TIPS (Treasury

inflation-protected securities), which protect against inflation, indicates muted inflation

in 2010 and beyond The case can be made that traditional inflation-warning

indicators are distorted because, with the Federal Reserve lending money at a

rate close to zero, banks have developed a lucrative carry trade by simply buying

Treasuries, thus keeping their yield artificially low This may be true, but rather

than second-guessing the bond market, we choose to simply interpret what the

market is telling us as the basis for our macroeconomic factors

Government Regulation

The nature of the future regulatory landscape is becoming clearer as the

legis-lation passed in both houses of Congress is reconciled and as the Federal Reserve

and other regulators move from preliminary findings to final rulings on a range

of topics For products such as credit cards, legislation has already passed, and its

impact is now being felt in the industry However, most of the regulations with

the biggest impact on the commercial banking industry are still in the

sausage-making phase of the legislative process From the macroeconomic architecture of

the regulatory agencies to the microeconomic specifics of calculating and

apply-ing overdraft fees, the proposals are many and varied Some of these proposals,

such as the rollback of national regulatory preemption for consumer lending

products, could have significant impacts on the industry, since the issues could be

determined state by state Whatever specifics emerge from the legislative process,

a fair assumption seems to be that the impact on the economics of

commer-cial banking will be negative, and this is what we have built into the scenarios

Among the likely detrimental impacts on profitability are higher capital levels,

lower fee income as a result of both overdraft regulation and debit interchange

restrictions, and a greater cost of compliance However regulation is also likely to

create a level playing field that will be beneficial to commercial banks by

eradicat-ing the shadow bankeradicat-ing sector that thrived dureradicat-ing the golden decade

With higher capital levels, regulatory minimums are likely to increase and the

quality of capital will also likely improve Changing capital levels will be a

big-ger issue for the largest institutions, as they will not only be subject to systemic

risk oversight (the concept of tier 1 financial holding companies) but will also

be hit by narrower changes, such as having to hold more trading book capital

Regulatory minimums will likely increase, and de facto, market-imposed

mini-mum capital levels are also likely to increase as investors take a harder line with

institutions regarding an equity buffer above and beyond regulatory minimums

A variety of measures seem likely to restrict fee income In the cases of

over-drafts and deposit fee income, this is a $25 billion to $40 billion revenue stream,

depending on what is included In 2006, at the peak of bank profitability, deposit

fees accounted for 17 percent of pretax net income.13 Given current changes

being discussed, $10 billion to $15 billion of this revenue stream could be at risk

13 FDIC (2008).

Some fee changes will be adopted voluntarily, as exemplified by those banks

that have already moved to “opt in” overdrafts Other changes, such as the

Fed-eral Reserve’s regulation E and debit interchange fees, are being imposed on

banks Some of these changes, such as regulation E, will undoubtedly lower fee

income for banks However, other contributors to lost fee income are likely to

be at least partially replaced by the introduction of other fees (such as a return to

monthly account fees for accounts with low monthly balances)

The behavior of customers in light of these changes is also uncertain

Cur-rent deposit service fees are highly concentrated among 10–20 percent of banks’

customers.14 These customers certainly pay high fees, but they also benefit from

the service For example, having the confidence that you will be able to pay

by debit card at a Wal-Mart checkout without having your card rejected has

value to many customers, and with debit card payments rising at more than 10

percent a year, the use of this payment protection is likely to increase further.15

While the intent of the current legislation may be to restrict banks’ fee income,

what is unclear (even in an opt-in environment) is whether customers will be

willing to trade the certainty of lower fees for the certainty of payment that the

current system offers Current anecdotal evidence suggests many customers are

choosing payment certainty with opt-in overdraft rates at 70.80 percent at some

institutions

Complying with all the additional regulation, and lobbying authorities for

favorable decisions, will not be cost-free For example, the banking industry has

already spent more than $220 million on legislative lobbying in 2009, and

cur-rent estimates are of 2,000 to 3,000 lobbyists trying to influence the final stages

of the financial reform process.16 The silver lining is that the growing regulatory

burden should benefit incumbents by creating barriers to entry for new

competi-tors; however, the overall impact on the industry will undoubtedly be negative

Given that the compliance burden is a largely fixed cost, its growth should also

encourage further industry consolidation However, the impact of increased

reg-ulation on the industry will not be homogeneous The creation of tier 1 financial

holding companies may create diseconomies of scale for the largest institutions,

as they are forced to comply with a bespoke range of supervisory and regulatory

requests, while smaller institutions may benefit from their exemption from the

Foreign Corrupt Practices Act

14 Ibid.

15 Nilson Report (2009).

16 Stephen Labaton, “Lobbyists Mass to Try to Shape Financial Reform,” New York Times, October

14, 2009.