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Bank regulators are actually increasing risk in the system

Richard X. Bove, equity research analyst at Rafferty Capital Markets
Thursday, 13 Feb 2014 | 12:03 PM ET

Virtually every major country in the world has a highly concentrated banking industry populated by multi-product banks. The United States banking system, surprisingly, is much less concentrated than the banking systems in the biggest industrialized nations. There are sound financial reasons as to why the global banking system has evolved in this manner. Simply stated, despite periodic flare-ups, these systems work best.


Jin Lee | Bloomberg | Getty Images

Where are they now?

What do not seem to work are financial systems that are heavily populated with monoline companies, which focus on one financial area. Think about it and ask yourself the following questions: How many big publicly held mortgage banking companies are there in this country? How many large public credit-card companies are there? How many big commercial lenders are public? What about auto-financing companies, consumer-finance companies, leasing companies, factoring businesses; how many big companies exist in these industries?

The answers are surprising. There are no big public mortgage companies left in this country. Countrywide Financial is gone and so is Lomas & Nettleton. Discover is the only big credit-card lender left in the public domain. Visa and MasterCard are data-processing companies and American Express is one of the big multiline financial companies that do so well; they do not count.

(Read more: Bove: Why America needs big banks)

CIT has come out of bankruptcy to be the only big public commercial lender. There are no big public auto-financing companies, or leasing companies or factoring companies. Beneficial Finance, the Money Store, and Household Finance are artifacts of financial history. They are long gone. Plus, Citigroup is unable to sell the remnants of Commercial Credit and the Associates. No one wants them.

Small monoline-like banks are following the same path. They have the same protections as the big multiline banks but these small banks keep going away. In fact, over the past 27 years, the nation has lost a small bank through merger or failure every 21 hours. This is 11,200 banks — all of which have supposedly FDIC and Federal Reserve protection against dissolution.

In fact, the situation has become so bad for small banks that for the first time in recorded history, no one has opened a new bank in the United States for three years. This has never happened before for as little as one year – even in the Depression entrepreneurs were opening small banks. They do not do this anymore.

Need for cash flow

The reason for the disappearance of large monoline companies in this country, and elsewhere globally, is not hard to explain. These companies have two major flaws. First, they only have one major revenue source and when this business hits a cyclical setback, monoline companies cannot recover. Second, and actually more important, these companies cannot obtain funding in high interest-rate environments and/or periods of depressed economic activity.

These companies cannot function at either end of the cycle. They do well only when the economy is growing at a moderate pace and relatively low cost financing is available.

(Read more: Bove: Regulators are driving banks out of New York)

The big multiline financial companies have antidotes for both problems. They have multiple revenue sources so that at least some business is always functioning well in bad times. They always have access to funds irrespective of cyclical swings. Therefore, very few of these companies fail in bad times. Those that do seem to have focused their businesses on limited product offerings ignoring the whole company.

NY driving banks out: Bove
Richard Bove, Rafferty Capital, and Andrew Stoltmann of Stoltmann Law Offices, discuss how bank regulations and lawsuits in New York are driving big names elsewhere. Bove says there aren't many banks and brokerage firms left headquartered in NY.

The lessons of history are very clear here. What works in financial systems are big multiline companies with access to continuous flows of funds. What does not work are one product companies with limited access to the financial markets.

Eliminating strength

If this is what history teaches, not just in this country, but worldwide, what type of system are the banking regulators in the United States attempting to put in place? Well, they reducing the size of and attempting to eliminate the biggest multiline banks and they are bringing back the small unregulated monoline financial companies.

How are they doing this? Through a series of new laws, literarily hundreds of new rules and regulations, lawsuits, fines, and what might be called administrative actions, the regulators are forcing the biggest banks to contract. Reacting to what has been demanded the biggest banks have sold insurance operations, brokerage and asset management businesses, sold trading businesses, stopped proprietary trading, eliminated student lending, stopped providing mortgage loans to low income households, reduced credit availability to small businesses, stopped providing funds to grey market finance companies, sold mezzanine finance businesses, stopped leveraged lending, eliminated bank investments in joint ventures, pulled out of overseas operations, and shrunk their positions relative to banks in countries as diverse as Canada and China. And, this is only a small part of what has being done. Plus, there are hundreds more rules and regulations coming.

The regulators are pursuing a theory that ignores the growth of profits and the need for positive cash flows. They care little if they force banks to divest businesses that generate profit. They actually believe that smaller less profitable banks are better structured to withstand financial reverses. Therefore, they push for the elimination of profitable businesses.

Rather than focusing on cash flows, the regulators drive their regulations to emphasize asset values. They create fictitious accounting entries showing that banks have reserves when no bank in the United States actually has a pool of money set aside as reserves.

(Read more: Dick Bove's warning on JPMorgan Chase)

They create rules that "make believe" banks buy back all of their outstanding debt on the last day of every quarter and then issue that self-same debt on the first day of the next quarter even though no bank in the world ever does this. Then they force banks to take losses from this imaginary event even though the event has never taken place. They demand the creation of fictitious balance sheets in banking that are not based on actual values but "what if" values instead.

Rebuilding weakness

They regulators are pushing so hard on the regulated banking industry that they are stimulating the rebirth of the unregulated financial system. Business Development Corporations, Master Limited Partnerships, Mortgage REITs, Payday Loan companies along with hedge funds that only buy loans are thriving. The monoline financial companies are back in the hundreds. They are taking market share away from the regulated banks which is what the regulators want.

Think about this: History shows that the multiline companies being crippled by the regulators are best able to withstand financial shocks. The companies being fostered to grow by the actions of the regulators are ones that history tells us cannot withstand financial shocks very well at all.

So what are they doing? They are driving risk through the system. They are insuring that the next financial crisis whenever it develops will result in a massive Depression. These people are totally out of control and have no requirements to listen to what Congress and/or the American people want. Congress set them up in positions where they can ignore any request or demand by any legislative body, the president or the people of the United States. They are driving us to tragedy.

— By Richard X. Bove

Richard X. Bove is an equity research analyst at Rafferty Capital Markets and author of the book, "Guardians of Prosperity: Why America Needs Big Banks" (2013).

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