In the final hours of the 2012 Presidential campaign, Obama backers have been trumpeting the case for their candidate, and like most electioneering, some of the claims don’t stand up well to scrutiny, particularly regarding the impact of regulations on big financial firm profits.
The normally astute Gillian Tett leads the way by looking at the dramatic headcount cuts and restructuring at UBS, which is largely exiting fixed income, a core business for global banks (note she is not doing this out of fealty to Obama, but some Democratic party stalwarts, such as Paul Krugman and Mike Konczal, have made strong claims regarding the impact of Dodd Frank. So we’ll deal with Tett’s argument first). She sees it as a harbinger for the City, and by extension, Wall Street, and bizarrely blames UBS’s action on “those half-formed Basel, Dodd-Frank and Volcker rules.”
The fact is UBS has been in the crosshairs of its primary regulator, the Swiss National Bank, for some time. Its actions indeed appear to have been major contributors to UBS’s downsizing, but were separate and apart from, and more important for this discussion, more draconian, than any of the other pending rules she cites. Separately, investment banking businesses (securities trading and businesses that have long been aligned, such as mergers & acquisition) are very cyclical. Past downturns that were less severe than the global financial crisis have bitten major Wall Street firms badly. Now that these former stand-alone businesses are mingled in with the broader “banking” industry, which includes the more stable retail banking and asset management businesses, the extreme cyclicality of the trading engine has been missed in the analysis of industry dynamics by casual observers. That’s particularly unfortunate, since it allows banking industry incumbents to peddle their self-serving narrative, that the fall in their profits is due to nasty government interference, as opposed to blowing up their customers en masse and having fewer parties left to fleece.
Back to UBS. The Swiss have good reason to be deadly serious about getting their too big to fail banks under control. The banking sector in Switzerland is so outsized relative to the real economy that the failure of one of its two big banks (Credit Suisse is the other) would send a huge economic shock. When UBS needed to be rescued, the Swiss government set up a vehicle which bought bad UBS assets and funded the vehicle with $25.8 billion of loans. Even though the rescue resulted in billions of dollars of losses, it is widely regarded as a success. The SNB was also alone of all bank regulators in requiring its bailout recipient to hire an outside firm to probe how it had gotten in this fix and publish the results in a report to shareholders.
As a result of this wake-up call, the Swiss decided to impose capital requirements on their biggest banks well above the to-be-implemented (and still being thrashed out) Basel III standards. From a 2011 summary (emphasis ours):
Large Swiss banks are currently required to provide for a capital adequacy target in a range between 50% and 100% above the international minimum requirement (pillar 1) of Basel II. In good times, these banks must increase their capital up to a target level of 200% (100% pillar 1 and 100% pillar 2). These buffers will then be available to the banks during crises up to an intervention level of 150%.
To reduce the likelihood of a systemically important bank becoming insolvent, the TBTF Banking Act Reform Bill proposes that capital adequacy requirements become more stringent. Systemically important banks will need to hold equity of at least 19% of the risk-weighted assets. This equity capital must be divided into three different components (see box, TBTF capital adequacy requirements):
Basic requirement. This consists of an equity ratio of 4.5% of the risk-weighted assets (Common Equity).
Capital buffer. This consists of a minimum of another 5.5% of Common Equity and a maximum of 3% contingent convertible bonds (CoCo Bonds). These CoCo Bonds will be converted into equity if the Common Equity falls below 7% of the bank’s risk-weighted assets (debt equity swap).
Progressive component. This consists of a minimum of 6% of the risk-weighted assets. It is made up entirely of CoCo Bonds, which will be converted into equity if the Common Equity falls below 5% of the bank’s risk-weighted assets.
This means that 10% of the risk-weighted assets must be issued by Common Equity and the remaining 9% may consist of CoCo Bonds. These proposals are considerably more stringent than the international standard provided under Basel III. Basel III will implement a capital requirement of 10.5% only, with an additional requirement for systemically important banks of about 1% to 3% of the risk-weighted assets (the latter figures have not yet been agreed).
The 19% figure is simply (wonderfully) breathtaking by international standards. UBS threatened to restructure the bank from a capital/regulatory standpoint and domicile its investment banking operations outside Switzerland, only to find that no sensible central bank would take on such a problem child. This is Richard Smith’s helpful tracking down of how this all played out in timeline form (after reminding him of the importance of the SNB action):
I now read it as a combo of the Swiss not folding on the capital regs, plus the Adebolu thing, plus the crap FI markets.
http://www.distressedvolatility.com/2010/10/swiss-finish-sets-new-standard-for.html Swiss cap reg proposed Oct 2010 but not much talk about it for months.
http://www.reuters.com/article/2011/05/01/swiss-regulation-idUSLDE74007M20110501 Empty threats from UBS about looking for a new domicile, minister has called their bluff.
http://www.reuters.com/article/2011/04/28/ubs-idUSLDE73R0K020110428 Snark from Swiss shareholders about the relocation but in fact by April 2011 (see previous link) Gruebel has already given up on that idea. Oddly the stories about UBS moving (mostly May 2011 onwards) only get started properly after it’s given up on the idea. That will be echoes from other lobbyists elsewhere with their own axes to grind (UK US).
http://www.guardian.co.uk/business/2011/sep/18/ubs-shakes-city-again Rogue trader Adebolu blows up
http://www.bloomberg.com/news/2011-09-24/gruebel-quits-as-ubs-chief-ermotti-interim-successor-bank-to-reduce-risk.html Out goes Gruebel. It looks as if he had started to notice that his IB buildup wasn’t going to work but Adebolu nailed him completely.
http://www.ft.com/cms/s/0/5aa094e4-1142-11e1-9d04-00144feabdc0.html#ixzz1e2KcngL4 In comes new bloke with axe to sharpen.
Takes a year to sharpen the axe and here we are.
Now let’s go the other part of the Tett narrative, which as someone who has been in and around the industry since 1980 I find truly peculiar. While the aggregate figures from her article, cited below, are accurate (and Simon Johnson has invoked similar statistics regarding the financialization of the economy), it leaves the reader with the misleading picture that the financial services industry, particularly the highly paid end that has been a magnet to the “best and brightest,” has had a linear march upwards from the the late 1970s-early 1980s to now:
Take a look, for example, at some research conducted by a New York based economist, Thomas Philippon, partly in association with Ariell Reshef of the University of Virginia. They chart the fluctuations of American finance since 1880 and show, firstly, how dramatically finance swelled from the late 1970s to today. Jobs in banking multiplied and the financial sector, adjusted for defence spending, rose from 4 per cent of gross domestic product to just under 9 per cent at the peak. Banker pay swelled too: although average banking salaries relative to non-banking professional salaries were almost at parity in the 1950s, by 2007 they were 1.7 times higher.
This masks serious, wrenching downturns in investment banking businesses, meaning the highly paid debt and equity origination/distribution/trading businesses, which traditional commercial banks, by dint of well over a decade of effort, finally colonized. When I joined Goldman in 1981, the firm was not enjoying great earnings and was still shell-shocked from the one-two punch of the major equity bear market of 1973-1974 and the deregulation of commissions. Wall Street was similarly hard-hit by the combo of the end of the stock bull market and takeover boom of the 1980s. First Boston effectively failed in 1988 and was merged into Credit Suisse, which was a not recognized de facto end of Glass Steagall, since this was the merger of a bulge bracket investment bank with a full fledged commercial bank. Employment in M&A, which had been one of the major profit drivers of the previous decade, fell by 75% in 1990-1991. This was also the time when the S&L crisis was ravaging major banks (Citi received its equity infusion from Prince Al Waleed in 1991). In 1994, an unexpected increase in interest rates sent shock waves across Wall Street (necessitating among other things a back door bailout of firms unduly exposed to Mexico, courtesy Robert Rubin raiding the Treasury’s Exchange Stabilization Fund). The resulting derivative losses destroyed more value than the 1987 crash. One of the casualties was Goldman:
But in 1994, substantial investment and trading losses, along with Friedman’s departure (Rubin had left in 1992),precipitated the loss of about 45 partners and their capital. Jon Corzine was elevated from head of fixed income to senior partner and named the head of investment banking, Henry M. (Hank) Paulson, as president. Corzine and Paulson immediately reduced employee headcount and costs by slashing pay and bonuses, stabilizing the firm by the end of 1995. They also put restrictions on the withdrawal of partners’ capital, and replaced Goldman’s traditional partnership structure of unlimited liability with one that named the firm as general partner and named individual partners and equity holders as limited partners.
There is also a key difference between that past, smaller S&L bubble unwind and aftermath: Alan Greenspan engineered a very steep yield curve, which allowed both commercial and investments to earn easy and comparatively low risk “borrow short-lend long” profits. By contrast, the severity of this financial crisis has led the Fed not only to drop short term rates to unheard of low levels, but to flatten the yield curve (via Operation Twist and the purchase of mortgage bonds). While that flattered financial firm balance short term by supporting asset values, it also undermined a lot of low risk traditional income sources (for commercial banks, also simply using customer “float” or money in transit, which can be deployed profitably on a short term basis when interest rates are not in ZIRP land).
Look at what has happened in areas that have not felt the hand of Basel III or Dodd Frank. M&A again is the poster child. Consider this gallows humor from the FT’s Lex column in late September:
Hooray! So far 2012 has been dismal for mergers and acquisitions. According to Mergermarket, activity in the first nine months is 20 per cent below the same period in 2011.
And 2011 was not at all a good year either.
How about private label mortgage backed securitizations? That was a huge profit engine in the bubble just passed, and it is making zip in the way of profit contribution now. There was all of one deal in 2011. The reason, sports fans, is not reregulation, but the lack thereof. As we’ve recounted at some length in this blog, investors were badly burned by the pre-crisis abuses, and they aren’t getting back into the pool ex serious protections, which simply have not been implemented (or enough newbies finally taking the helm at investment firms that memories will have faded, but that will take at least a few years).
Isn’t the Volcker Rule making a difference? It’s hard to say, since rules are still being duked out, and we are strongly of the suspicion that, as before prop desks were spun out as separate activities, that banks will still be able to do a lot of positioning on customer desks. But the opportunities for prop trading profits parallel those for hedge funds, and hedgies have had a lousy last two years, again strongly indicating that it is hard to blame Wall Street’s fading fortunes largely or even meaningfully on new regulations.
Look, for instance, at this earnings recap from October last year (post Dodd Frank) as an illustration:
Goldman Sachs, weighed down by problems in its private equity portfolio and the broader global economic woes, reported a loss of $428 million, compared with a $1.7 billion profit a year ago.
It’s only the second quarterly loss for Goldman since the investment bank went public in 1999.
The company reported a loss of 84 cents a share, worse than analysts’ predictions of a loss of 16 cents, according to Thomson Reuters.
The troubles, which follow similar weakness in the second quarter, underscore the difficult environment for investment banks. Goldman, widely considered the savviest trading firm on Wall Street, had a significant revenue drop in crucial divisions like fixed income and investment banking amid the market turmoil.
The firm got whacked by negative net revenue of $2.48 billion in the investing and lending group. The results included a $1.05 billion hit on its private equity investment in the Industrial and Commercial Bank of China, a strategic investment made in 2006; I.C.B.C. stock fell roughly 35 percent in the quarter. The firm also booked net losses of roughly $1 billion related to equities, on top of net losses $907 million in debt positions.
“Our results were significantly impacted by the environment, and we were disappointed to record a loss in the quarter,” Lloyd C. Blankfein, Goldman’s chief executive, said in a statement.
None of the causes cited has squat to do with regulations. And we have not even gotten to other factors, such as how the rise of HFT has led retail investors, a good source of bread and butter profits, to withdraw from trading.
The broader picture of the financial services industry similarly does not paint the picture that the Democrats would like you to believe, that the passage of Dodd Frank has been the driver of Wall Street’s fallen fortunes. Via e-mail from Matt Stoller:
TARP (which is really shorthand for the bailouts, it means TARP and HERA, which is the bill that bailed out Fannie and Freddie, which was passed at roughly the same time) is correlated with a spike in financial profits. Dodd-Frank is correlated with… nothing.
Stoller’s second analysis shows the strong correlation of financial services earnings with the housing bubble (click to enlarge):
This chart reveals that financial sector profits are actually still at 2004 bubble levels, and that the profit increases and declines are correlated with the bubble and TARP, not Dodd-Frank.
This is a major topic, and we’ll be returning to it, but there is one big takeaway: in trying to bolster the case for Obama, Democrats are unwittingly carrying the financial services industry’s water in blaming new regulations for their crappy profits, when the direct consequences of the crisis they created is far and away the biggest culprit.