Reform Legislation Does Little to Address Systemic Faults in Banking

Congress passed the final version of financial reform legislation this past Friday, July 15, and President Barack Obama will sign the bill into law within days. The effect of the legislation on the industry will be relatively modest, as most agree that the new body of law will do relatively little to reduce systemic risk in our banking industry or cut banking industry profits. Ironically, on the same day, Goldman Sachs, admitting that it made "mistakes," agreed to pay $550 million in a settlement with the SEC over alleged charges that it sold mortgage securities it knew would fail. Are we now to believe that our financial system will never again cause a global meltdown as it did before?

Buckle your seatbelts. The ride will not be any less bumpy because nothing was done to eliminate the present incentive structures that encouraged bad behavior in the first place. The current world of difficult credit, excessive layers of banking transaction fees, and mortgage-backed securities are the ultimate result of years of misplaced incentives and unbridled greed. The general malaise is not specific to just a few banks. The problems developed over the past thirty years, are systemic and run through the entire banking system.

Back in the 80’s, our traditional banking system was struggling with competition on all fronts from insurance, telecom and investment banking companies. The best minds in the nation deduced a major strategic flaw in how banks funded their ongoing operations. Banks take deposits, and then loan the money to businesses and individuals. The practice in those days was to cover the majority of banking costs with margins added to their loans. A better approach would be to create numerous streams of new transaction fees. These would take the pressure off loans and allow margins to be competitive.

All banks were quick to adopt the new revenue strategy. It spread through every department of the bank from credit cards to foreign exchange trading. In order to encourage the new practice, bonuses were also tied to transaction fees collected, a critical mistake. Incentives work. The resulting behavior, however, may not be what was intended. Up to that point, bonuses in banks tended to be discretionary and moderate when compared to other industries. The allure of large bonus payouts catapulted banking to new levels of performance.

Banks had always coveted the exorbitant fees collected by their “cousins” in the investment banking industry, but the Glass-Steagall Act blocked access to this lucrative capital raising business. The Act, passed during the Great Depression, was created to prevent both styles of banking from destroying one another. Merchant banks, as they were called at the time, helped companies raise capital, but took no deposits. Traditional banks took deposits and made loans. In 1999, a Republican Congress removed the prohibitions of the Act altogether.

Greater competition ensued, at first believed to be a good thing. However, investment banks were pressured to invent and sell more complex securitization schemes to generate entirely new revenue streams. Banks became mortgage paper generators, charging high mortgage origination fees and then assigning the paper, much without income verification, to investment pools. Investment banks then marketed shares in the pools to pension funds and governments as “AAA” investment grade securities. Everyone made large bonuses. Everyone was happy, until the real estate “bubble” burst, and “toxic assets” became a new term in daily news headlines.

The debacle that followed is well documented. Many believe Glass-Steagall should have been re-instated, but members of Congress thought otherwise. The new reform bill does place new limits on specific types of revenue, but basically, it is business as usual. These banking trends took years to reach their “tipping point” and will take many more years to reverse. Traditional banks were intended to take risks and make loans, not generate fee income alone. Banks need to be Banks again.