The big mistake made by big banks

Following the banking collapse in 2008, the banking industry, with the exception of JPMorgan Chase, worked behind the scenes to influence new regulations but didn't seem to be interested in bringing the bankers' point-of-view on these issues to the attention of the public.

The idea was likely that public dislike of banks, which had reached sizable proportions at the time, would only be exacerbated if the banks made any attempt to explain themselves and their businesses.

In hindsight, this was a massive mistake.

The end result of the banks' silence is that the industry has been effectively nationalized. Managements are no longer allowed to make decisions about the growth of their companies; the allocation of assets; the types of loans that will be made; and how they will fund their operations.

Literally tens of thousands of government associated workers were placed in the banks or hired by the banks to ensure that the banks followed the government's edicts.

A new book written by Adair Turner, once Britain's top bank regulator, entitled "Debt and the Devil," spells out regulatory thinking. It is Lord Turner's view that governments make better credit decisions than the private sector. Therefore, governments should take control of the whole credit process. This is not a theory in the United States — it is fact.

Evidence of this fact was made apparent in two fashions in the past 10 days.

The first instance was the introduction of a new government regulation called Total Loss Absorbing Capacity (TLAC). Under this rule, banks will be forced to borrow up to 20 percent of their funding in long-term debt markets in the United States. By my estimate, the cost of this money to the industry will be close to 6 percent. The reason for the high cost of money is because hundreds of billions of dollars will be obtained in the short term. Plus, the purchasers of this debt will be told that if the bank is troubled, the debt will be replaced with equity.

The banks do not need or want this money. The reason is that they will not be able to lend the funds at a reasonable return. There is another rule called the Liquidity Coverage Ratio (LCR) which basically forces bank to lend about 20 percent of their assets to the Federal Reserve or the Treasury at 0.25 percentage points. In sum, the banks are being driven to borrow long at high cost and lend short at low returns causing losses.

The second event was a statement made by the chief bank regulator in the United States, Daniel Tarullo that the annual stress tests that banks must take will be made tougher. Plus, the banks will be forced to generate more capital as a percent of assets.

Fed Governor Tarullo can make statements like this without justifying his remarks by explaining: a) Why the stress tests must be made stronger or b) Why the banks need more capital because he and his organization do not have to justify anything that they do to the American people. Mr. Tarullo and a small numbers of cronies control all aspects of American banking.

Of course, by forcing more capital and tougher rules on the banks leads to two events:

  • Dividend payouts and stock buybacks must be reduced, and
  • The return on equity in the business falls, preventing bank stocks from rising in line with other commercial investments that are not regulated

Bank boards and management made a massive error by not educating the public as to what has happened to this industry. This has allowed the government free rein to impose whatever rules and penalties it chooses. There are no checks and balances; there are no restraints on the use of unlimited power.

As a result, banks have isolated themselves from the owners of the banking companies – i.e., the shareholders. The boards and managements of these companies have suffered no harm from their policies. They have simply refused to protect shareholder wealth by hiding behind closed doors and not trying to educate the public.

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