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U.S. Banking Reform

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The devil is in the regulatory details

After G7 finance leaders resurfaced from their Arctic meeting last month, reaffirming their commitment to banking regulation to stabilize the world economy, the spotlight is now on the failing American banking system. When the housing market tanked and banks claimed bankruptcy because too many people couldn’t make their mortgage payments, the feds stepped in to save those banks “too big to fail” with a massive bailout package. With President Barack Obama’s firm push for a banking bill to pass and a filibuster looming up in Capitol Hill, ABJ’s  Antonia McGuire breaks it down to recalculate the root of the problem, what that the media has failed to acknowledge, and how the end result will impact the banks’ bottom line and, ultimately, their customer: the American consumer.

Many people lost their jobs, their homes, and their overall sense of security during the GFC. In mid-2007 and through 2008, the American Dream vanished into thin air, marking a devastating period known as the Great Recession. During this time, every Friday, the feds would announce yet another seven bank closures in the United States. This occurrence became so regular it was like clockwork, in fact.

It was no surprise that, when the superpower saw its own economy crumble before the world’s eyes, observers were quick to draw a comparison to the Great Depression, according to Joseph Stiglitz, a Nobel laureate economist and author of Freefall (Norton, 2010). Critical of President Barack Obama’s economic advisors, including Ben Bernanke (head of the Federal Reserve), Stiglitz refers to Obama’s choice as one of the “mistakes of the past.” Back in the spring of 2008, people like Bernanke advised the worst was over, when, in reality, that couldn’t have been further from the truth. “Regulators didn’t want to admit that they had made really bad regulatory decisions. They didn’t want to admit that they had allowed a housing bubble to grown,” tells Stiglitz in an interview with the New York Times Magazine.

Although both the banking industry and regulators agree there is a need for change to the U.S. financial system, there are still some discrepancies that are worrisome. Despite the fact that a banking bill is now before the Senate, Stiglitz is adamant that the U.S. government has not pushed hard enough for a reform and has yet to address deeper problems. Small bankers couldn’t agree more, pointing out the crux of the economic crisis, which has yet to be addressed. “We’ve gone through the meltdown of larger banks—which weren’t really “banks,” but rather investment banks, and they weren’t regulated by the feds as we, the banks, are,” tells Mike St. Onge, president of Alerus Financial. They have now become regulated banks in order to qualify for TARP (Trouble Assets Relief Program).

The devil is in the regulatory details

Looking back at the economic meltdown, there were a variety of securities in home mortgages that had really strange terms—no interest, small payments at the beginning with large sums later on—which, regular banks generally do not follow. “What ended up happening is these securities were bundled together, by institutions or investments banks, selling them as securities, these bundled securities were then bought as investments by a variety institutions such as retirement plans,” says St. Onge in a phone interview from his North Dakota office.

The price was right and more people were buying houses, but (predictably) not many could keep them for the long-term. “These securities consisting of numbers of mortgages in a bundle suddenly began to default; this investment started to look pretty questionable.  Institutions holding these securities were left to figure out how to act on the delinquent mortgages to get out of them. How do you collect when half of the mortgages are in default and the other half aren’t?” St. Onge asks rhetorically.

At that time, the federal government had to decide very quickly whether these ‘banks’ were too big to fail. “They had to be propped up by the U.S. government but what this meant was that these institutions had to become proper banks, regulated by the OCC and FDIC. In order to get the TARP money, the idea was the government would buy these troubled assets from large institutes after they become part of the banking community and that would shore them up,” explains St. Onge, whose small regional bank has over $1.1 billion in loans and deposits, $350 million in securities and $6 billion in assets under management.

But perhaps the most troubling fact was that many of the homebuyers probably never should have even had access to such credit to purchase a mortgage for a new home. Yet, these ‘investment banks’ were allowed to do so, making many people’s American Dream come true—for a while. St. Onge argues the media’s lack of attention to the lessening of mortgage lending standards has contributed to a general misunderstanding of the problem. “And that distinction [between banks and investment institutions] really hasn’t been made in the media. The public has difficulty distinguishing between these bank types and tends to lump all banks together. It is a difficult public relations problem when people ask if we are the same as Bank of America, JP Morgan, CITI, AIG or other investment banks,” says St. Onge.

Salvaging some credit while it lasts

Loose regulations for credit lenders and American consumers’ greed left bankers with a PR disaster on their hands. In an attempt to salvage some of their reputation, or at least what’s left of it, the U.S. banks are just now trying to regain the public’s trust. After the meltdown, the public’s trust in the financial sector took a hit. In fact, many organizations struggled to regain that sense of security with their own customers. “One of the things we first did is to talk about our soundness and safety. Because at the end of the day, it comes down to how safe your money is in the organization,” tells St. Onge.

“As a banker, I believe that the higher FDIC insurance amount will remain in place because it makes sense. The consumer has a higher amount of confidence and will put more dollars into banks like ours,” explains St. Onge. He adds all staff at Alerus Financial receive regular training tohow educate customers on the banks’ safety and soundness, as well as discuss how they can structure their customers’ accounts so they receive maximum protection, as outlined by the FDIC. Even still, one has to wonder why that kind of banker-customer conversation should even have to take place.

Many business leaders agree that, at this stage in the banking reform, the role of the U.S. government should be a catalyst for change. In fact, Jeffrey Immelt, CEO and chairman of General Electric described the reform talks as “a fundamental shift in capitalism.” When asked if the economic crisis was a reset or just a pause, Immelt told Maclean’s in an interview: “When you look at capital markets and financial services especially, there needs to be things put in place so people can trust the system…the industry is a vibrant, important industry, so there’s a way to have financial reform on one side, without completely trashing bankers and lending.”

Taking note from the Canadian banking system

In the past year, there have been comparisons drawn between the U.S. and Canadian banking systems, to which Canadian Prime Minister Stephen Harper has touted as “a model for the world.” But as Canadian news magazine Maclean’s columnist Andrew Coyne is quick to point out: “If Obama really wanted to copy the Canadian model—and there are many reasons he should—the first thing he’d have to do is consolidate financial regulation under a single, national regulator, in place of the hodgepodge of state and federal agencies that now make the rules.”
 
Within the current financial system, a U.S. banking conglomerate might find itself or its subsidiaries regulated by some or all of the Federal Reserve, the Securities and Exchange Commission, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Office of Thrift Supervision, the National Credit Union Administration—just to name a few, at the federal level. Canada, on the other hand, has OSFI: the federal Office of the Superintendent of Financial Institutions, which has the power to regulate the whole entity, subsidiaries and all.
 
The influential columnist Paul Krugman has wrote in praise of Canada’s “boring” banks. Even the former chairman of the Federal Reserve, Paul Volcker, on whose recommendations the President’s reforms are based, has spoken highly of the Canadian system, with its focus on the traditional business of banks: taking deposits, making loans and operating a fee-based system. Canadian banks charge customers monthly fees that are directly withdrawn from their account. Although widely unpopular, they are commonplace as the monthly fees cover almost everything from money transfers and customer service to overdraft protection.

Some analysts say a pay-for service or fee system is something U.S. banks may soon have to consider. “Every time we accept and pay for customers when they overdraw, we’ve just extended unsecured credit for which we have no collateral. We approve a lot of them, but should we be paid for that risk?” St. Onge asks rhetorically. “If U.S. bankers suddenly opted out of the automatic overdraft option, their consumers would have their checks returned and could suffer damage to their credit rating,” St. Onge argues, adding it is an example of ‘unintended consequences’ of regulatory changes.

Finding consensus to change a broken system

Many small bankers say both the U.S. and Canadian banking industries can learn a thing or two from each other. In particular, American bankers are taking note of the conservative approach Canadian bankers take when it comes to its credit lending practices. More specifically, Canadian bankers do not take the gamble on extending unsecured credit because it’s believed to be too big of a risk, so they charge the customer up front. “That’s one of the things we’ve looked at because it has to work,” says St. Onge, adding the rest of the changes to the system he leaves up to regulators in Capital Hill.

President Barack Obama has since admitted that 96 percent of all sub-prime lending, or high-priced loans occurred outside of traditional FDIC insured institutions, and yet the majority of the pressures occurring on U.S. banks are focused right at traditional institutions. With the ongoing debate in the Senate on the banking bill, however, President Obama’s firm stance on consumer protectionism and crackdown on loose credit financing practices is supported by those in banking industry.

For the most part, that is.

Crackdown puts pressures on smaller banks

The flipside of the coin, however, is that the crackdown has put an insurmountable pressure on the “smaller guys”, and that has some worried that the U.S. government is taking aim at the wrong target. “I am very concerned about the direction bank reform is taking in this country. Again, looking at the banks’ point of view and, nationally speaking, many of the problems Congress is debagging about are sub-prime lending, and the debacles that brought down the U.S. economy,” argues Rick Clayburgh, President and CEO of the North Dakota Bankers’ Association.
 
A law graduate and former politician, Clayburgh is no stranger to the regulation.

Clayburgh believes that even prior to the meltdown, the traditional commercial banking industry is still one of the most heavily regulated industries in the U.S. “Now, they want to add more rules and regulations to an already existing structure of high-end regulated institutions, when they aren’t addressing the problems that led to the meltdown,” points out Clayburgh, who served as North Dakota’s Tax Commissioner prior to his career in the finance industry.

While North Dakota remains one of the few states to not be hit hard by the recession, even maintaining a surplus, the banking industry did see its fair share of closures across the state, sparking mergers and acquisitions as means for survival. By the end of last year, there were roughly 140 banks closed in the U.S. But so far in 2010, there have been eight to 10 closures. “There have been great opportunities for many community-run banks and Alerus Financial is a great example. They have participated in purchasing one to two institutions in the Minneapolis St. Martin location. Alerus has a great presence in southeastern Minnesota,” tells Clayburgh.
 
Despite the mergers, however, more pressures are being placed on small community and family-run banks. This, too, will have its repercussions on the bottom line, and the end result will hinder customer service—because the wait for mortgages, for instance, will take longer due to new rules.

When asked about his thoughts on the banking reform, Clayburgh uses the analogy of a family on a road trip. “Think of our traditional banks as the little brother sitting at the bank of the car on a family vacation. The two older brothers are acting up on both sides meanwhile, Dad is trying to drive and reaching back to straighten things out—only to grab the little brother who didn’t have anything to do with it,” describes Clayburgh.
 
In other words, the regulators are missing the mark and not addressing the real problem.
 
Political repressions

Last month, President Obama proposed new rules to rein in large financial institutions, starting with limiting their market share and barring them from some risky business activities like proprietary trading or owning a hedge fund. “Never again will the American taxpayer be held hostage by a bank that is too big to fail,” vowed President Obama. The plan appeared to catch bank executives off guard in a week when major financial firms were reporting 2009 results and investors pushed bank stocks down.
 
Interestingly, that same week, the Supreme Court overturned two precedents, giving lobbyists a new leverage for revenge. The high court ruling removed any limitations on corporate donations for political campaigns. President Obama condemned the decision saying it was a major victory for banks and health insurance companies, not the American people. The decision is considered by observers to be a potent weapon for corporations, labor unions or interest groups who can spend unlimited sums explicitly advertising against politicians’ re-election, if they vote the wrong way for piece of legislation—like the banking bill, for instance. President Obama responded by saying the court “has given a green light to a new stampede of special-interest money.”

Looming filibuster remains an obstacle

There is some hope for a consensus on the issue of financial regulation. Politicians on both sides tout optimistic statements in the press, saying together they could craft a bipartisan financial reform bill.  And while the top Republican on the Senate Budget Committee has said there is common ground with Democrats on financial regulation legislation, many analysts are questioning the White House stance on consumer protection.

And for the most part, small bankers agree. “It’s the creation of Consumers’ Financial Protection Agency, which was lumped into the House bill that passed that has little support from both Republicans and Democrats…it doesn’t make sense to start a whole new government agency to have some oversight,” says Clayburgh. “That is slowing the process down but I know for a fact that our Senator in North Dakota believes we must address the whole issues of derivatives, because there is that pressure to take action; we must continue to address some of the larger, systemic issues,” he says.

St. Onge agrees the creation of the agency is questionable but adds there are other political pressures. “With what has happened here politically in the States with Mr. Brown winning in Massassachutts and the prospects of filibuster looming, a bank reform will be slow, unless everyone decides they are angry at the banks,” says St. Onge.

In his book, Stiglitz criticizes President Obama’s strategy to keep discussions ongoing, based on the argument that this stalls progress. Meanwhile, by the time the bill has passed, the economic crisis will be over and the momentum for a reform will disappear. Although discussions at the high level are still ongoing, Senate Banking Committee Chairman Christopher Dodd, a Democrat, and Senator Bob Corker, a first-term Republican member of the panel, both hit a deadlock with Senator Richard Shelby, the committee’s top Republican, in talks that had dragged on for more than a year over tightening oversight of banks and capital markets.

Dodd, the chief architect on financial regulation in the Senate, first introduced a draft reform bill but it was met with stiff opposition from Republicans. Bipartisan groups were formed to work on the most controversial parts of the bill, such as the oversight of the $450 trillion over-the-counter derivatives market, corporate governance and banking regulation. Both Republican and Democrat Senators on the committee worked together to draft new banking rules and a way to resolve large troubled financial firms. “There has also been political bantering about between the two parties and it might be more procedural than anything, but for the most part, I think Republicans and Democrats have been trying to address the 'too big to fail' and systemic risk,” says Clayburgh, adding the President’s tenacity to find a solution is a make or break.

Looking ahead, experts say 2010 will continue to be a difficult year for many institutions across the country. As American reporter Barrie McKenna pointed out in his Globe and Mail article: “the legacies of the meltdown is a constant reminder of these challenges in the current U.S. financial system...and now, we have Obama administration trying to push for a banking reform, all of which triggers a new wave of consolidation among regional and smaller community banks.” In fact, small bankers are predicting more mergers and acquisitions this year, just as a means of survival. “And it will be a detriment because our banks are the mainstay on main street; a healthy community needs a healthy bank and a healthy bank needs a healthy community,” argues Clayburgh.

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