Opinion

Felix Salmon

The unintended consequences of cheaper remittances

Felix Salmon
Mar 5, 2014 02:02 UTC

Once upon a time, remittances, especially to Mexico, were the next big thing. In 2002, for instance, Bank of America bought 24.9% of one of Mexico’s big three banks, Serfín, mainly for the remittance business:

Bank of America says it will compete with Citigroup for Mexican and Mexican-American customers in the United States. It particularly hopes to win a larger share of fees from the $10 billion in remittances they send to Mexico each year…

Kenneth D. Lewis, Bank of America’s chairman and chief executive, made it clear today that a primary goal of the deal was to gain more Mexican-American customers in the United States and ”dramatically increase our market share” of their remittances.

BofA’s purchase was in large part a defensive move — a reaction to the 2001 acquisition of Mexico’s largest bank, Banamex, by Citigroup. That deal, too, had a significant remittances component to it, and by 2004 Citi and Banamex had launched their Access Account, a product allowing Mexicans to easily send money from any Citibank branch in the US to any Banamex branch in Mexico.

The Access Account competed against a consortium of Mexican savings banks, who had teamed up with US Bank to create a similar product in 2003. But that wasn’t the end of the dealmaking: later in 2004, the third big Mexican bank, BBVA Bancomer, bought Texas bank Laredo National Bancshares for $850 million, with the aim of increasing Bancomer’s 40% share of the remittance business.

The banks were racing into the remittance market because it held a huge amount of promise: it was growing fast, the incumbents (Western Union and MoneyGram) were easy to undercut, and the potential profits were huge: after all, to a big bank, the marginal cost of moving money from the US to Mexico is essentially zero.

The promise of cheaper, next-generation remittances was so great that the World Bank, in 2009, set what it called a “5X5 Objective”: that it would reduce the cost of remittances by five percentage points in five years. By 2014, remittances would cost only 5%, rather than the 10% prevailing in 2009.

The objective was entirely achievable — and indeed, last year, looking at the depressed MoneyGram share price, I blithely declared that “money transfer is in the process of being disrupted”.

Certainly the growth in remittances, over the past five years, would more than allow for economies of scale. While international capital flows have fluctuated, remittances have been growing steadily, and have remained above all debt and portfolio equity flows every year since the financial crisis. Here’s the flows chart, from the World Bank:

Screen Shot 2014-03-04 at 7.48.07 PM.png

But here’s the chart showing whether the 5X5 objective is going to be met — and it’s not pretty. The reduction to an average cost of 5% isn’t even close to being achieved.

 

Screen Shot 2014-03-04 at 7.50.41 PM.png

In Mexico, remittance flows are falling, up even as the number of migrant workers in the US now comfortably exceeds the levels seen before the financial crisis. And the banks, who were once so excited about this market, are packing up shop:

Banamex USA underwent a downsizing last year. The company had a sizable business in taking money from third-party agents in the United States and then remitting the money back to an extensive network of Banamex bank branches in Mexico, industry experts say.

But now Banamex USA will transfer money from the United States to Mexico only from its own customers, a spokeswoman said. Last year, Banamex USA also reduced the number of its branches in California, Arizona and Texas, three states with large Mexican immigrant communities, to three from 11.

Citigroup said the changes at Banamex USA are part of the bank’s global restructuring of branches and businesses. But industry participants suspect that the moves may have more to do with avoiding the costs and risks of trying to meet anti-money-laundering regulations.

The problem with remittances, it turns out, is that such operations have a habit of getting hit by anti money laundering probes. The current problems at Banamex, for instance, come in the wake of similar issues at Western Union, which stopped using thousands of agents in Mexico who couldn’t meet regulatory-reporting requirements. On top of that, because there’s no shortage of smaller companies trying to compete on price, busy corridors like US-Mexico are now actually pretty cheap: the World Bank’s Dilip Ratha told the NYT last year that the cost of a $300 transfer is now only around 2%.

Indeed, if you look at the World Bank report, a curious phenomenon emerges: remittances seem to be growing fastest where they’re most expensive, and falling where they’re relatively cheap.

What this says to me is that if the World Bank wants to maximize remittance flows, maybe concentrating on bringing the price down is not the best way of doing that. Financial services to the poor are nearly always expensive, and the rich tend to have a very understandable and predictable reaction when they see that: they want to bring the price down, for the sake of the poor people. All too often, when that happens, the supply of that service tends to dry up — or the poor continue to pay more than they strictly need to.

Here’s a theory: when the cost of remittances is high, the providers of those remittances have every incentive to make it as easy as possible for as many people as possible to remit as much money as possible back home. And when the cost of remittances falls, those incentives weaken, and it’s easier to sever ties to merchants and generally discourage the use of services which you formally pushed aggressively. Maybe remittance services are sold, just as much as they are simply purchased. As a result, when they’re cheaper, and not sold as hard, the migrants end up spending more money where it’s earned, and sending less back home.

Most of the new companies competing on price against Western Union are doing so with mobile apps and the like: they try to make it as easy to send money home as possible. Maybe it’s as easy as just pressing a few buttons on your phone. But I suspect that what such services are not doing is adding much in the way of behavioral layers: they’re not giving people an incentive to send as much money home today as they possibly can. After all, if it’s that cheap and easy, why not send less today, and then more tomorrow, if it’s still there?

There are still a lot of areas of the world where the cost of remittances is too high, of course. But when it comes to Mexico flows, I don’t think that’s necessarily the problem. Not any more, anyway. Instead, if anything, the cost of remittances might be too low: it doesn’t give banks an incentive to be active participants, given (a) the headaches involved with respect to money-laundering regulations, and (b) the up-front cost of enticing migrants to use the service in the first place. So the banks will keep the product in place — they just won’t make it particularly easy to use, and they won’t promote it aggressively. And they won’t be too upset if usage declines.

Update: Timothy Ogen replies.

COMMENT

I wonder if banks are going to find themselves bypassed when remitters use bitcoin (et al).

Posted by markhahn | Report as abusive

Incompetent Banamex

Felix Salmon
Feb 28, 2014 22:28 UTC

A couple of weeks ago, I was at a lunch discussion of immigration policy, of all things, in which I defended Citigroup’s decision to move various risk-management operations from New York to Mexico. I was talking to a woman who was complaining about the move and about the amount of time that the Mexico office would sometimes take before arriving at a decision. But my view was that moving such operations to Mexico was probably a good thing, on net. After all, Citi’s Mexican bank — Banamex — is one of the most efficient banks in the Americas, and makes a lot of money while taking very little in the way of risk. And on the other side of the trade, the New York office was precisely the place where Citi’s risk management was worst. After all, it was New York which missed the entire subprime problem, along with many other incidents in which Citi managed to blow itself up.

Now, however, it seems that Banamex has a level of risk management which is bad even by Citi standards. Earlier this week a Reuters report showed how Banamex managed to lose some $85 million making bad loans to homebuilders, despite opposition from the head office:

The $300 million in loans were made starting in 2009. Bank executives at Citigroup in New York turned down at least some of the business because it seemed too risky, two sources involved with the lending process said…

New York balked, but the bank’s Mexican subsidiary, Banco Nacional de Mexico, better known as “Banamex,” went ahead and lent to the homebuilders. Banamex, which is the second biggest bank in Mexico with 1,700 branches, has room to make some loans that do not get vetted by New York, as long as its overall portfolio is safe enough, the sources said.

“New York turned them down because they made no sense,” said one of the sources, referring to loan applications by Mexican homebuilders at the time.

Today, things got much worse: it turns out that Citigroup has had to write off some $400 million of what were previously thought to be perfectly safe loans to an oil services company called Oceanografia.

The Oceanografia loans, which totaled $585 million at the end of last year, were ostensibly simple advances against Pemex receivables. The state-owned Mexican oil giant can be slow, so if you’re owed money by Pemex, and need a bit of liquidity, you can essentially sell your receivables to Banamex. The problem is that Banamex seems to have bought a large number of fake pieces of paper:

Citi estimates that it is able to support the validity of approximately $185 million of the $585 million of accounts receivables owed to Banamex by Pemex as of December 31, 2013. This $185 million consists of approximately $75 million supported by documentation in Pemex records and approximately $110 million of documented work performed that was still going through the Pemex approval process.

There are two huge failures here. The first was in the accounts receivable department, where Citi employees, through incompetence or venality, failed to ensure that the assets they were lending against were real. The second is higher up, in the bigger Banamex and Citigroup risk-management departments, where no one seems to have stopped to ask how on earth a simple accounts-receivable credit line could have grown to more than half a billion dollars in size. After all, Pemex might be slow, and it might be big, but it’s not so slow and so big that it’s likely to owe a single vendor $585 million just in simple unpaid invoices which are wending their way through its bureaucracy. As Matt Levine says:

This went on for years? That to me is the oddest part. Oceanografia is — somewhat obviously — not a public company, but a random assortment of pseudo-comps suggest that typical accounts receivable turnover in the oil-services industry averages around three months. One imagines that Pemex gets more breathing room than the average customer, but still, at some point, wouldn’t Banamex call Oceanografia after not getting paid for a year or two? Did Oceanografia just say “yeah, I know, what jerks, they’re really slow, keep trying”? And Banamex kept extending more credit on more fake receivables, to a total amount of $585 million? And never called Pemex?

This explains why Citi CEO Mike Corbat is saying that “all will be held equally responsible” in this affair: the risk managers who let this one through the cracks just as much as outright criminals who (maybe) accepted kickbacks to look the other way. In a bank the size of Citi, you can’t just assume that all your employees are excellent, law-abiding folk who will catch any attempt to get around the rules: you need protocols that ensure massive frauds simply can’t happen, even in the face of employee misconduct or idiocy.

One big question raised by this loss — and the mortgage problems, too — is what they mean for legendary Banamex chief Manuel Medina-Mora, a man who almost became Citi’s CEO. Medina-Mora is in charge not only of Banamex, these days, but also the entire global consumer bank — Citibank, as it’s known everywhere except for Mexico. There are two possibilities: either, on the one hand, Medina-Mora has simply been stretched too thin, and was forced to take his eye off the Mexican ball. Or, on the other hand, Medina-Mora made his name and his reputation by loaning enormous amounts of money to large Mexican companies, be they homebuilders or oil-services vendors, and that was a strategy which was bound to blow up in his face eventually.

Citibank has a deserved reputation for consistently making bad loans — few banks have failed more often, or more spectacularly. The latest problems in Mexico are manageable even by Mexico’s own standards, let alone by the standards of the parent company. But they do show that Citi still hasn’t managed to get its risk controls nailed down. Probably, it never will: it’s just too big. Which means that this kind of thing is going to continue to happen, not only at Citi, but also at every other commercial lender of its size.

COMMENT

Felix

“Which means that this kind of thing is going to continue to happen, not only at Citi, but also at every other commercial lender of its size”

Including HSBC? http://www.financialtransparency.org/201 2/12/13/why-the-u-s-absolutely-should-ha ve-prosecuted-people-at-hsbc/

Posted by crocodilechuck | Report as abusive

The bank tax rises from the dead

Felix Salmon
Feb 26, 2014 06:05 UTC

Back in January 2010, Barack Obama — flanked by Tim Geithner, Larry Summers, and Peter Orszag — unveiled a new tax on big banks, or a “financial crisis responsibility fee”, as he liked to call it. Of course, this being Washington, the initiative never got off the ground, and was largely forgotten — until now:

The biggest U.S. banks and insurance companies would have to pay a quarterly 3.5 basis-point tax on assets exceeding $500 billion under a plan to be unveiled this week by the top Republican tax writer in Congress.

This doesn’t mean the tax is likely to actually see the light of day, of course — but the fact that it has some kind of Republican support has surely breathed new life into a proposal that most of us thought was long dead. After all, the initial proposal was designed around the idea that the tax would allow the government to be repaid for the cost of the TARP program — a goal which has now pretty much been met.

There are some interesting differences between the Obama tax of 2010 and the Dave Camp plan of 2014. The Obama tax was on liabilities; it specifically excluded deposits (which already have a sort-of tax associated with them, in the form of FDIC insurance); and it would have been levied on all financial institutions with more than $50 billion in assets. It was set at 0.15%, and was designed to raise $90 billion over ten years.

The Camp tax, by contrast, is on assets, which means that deposits sort-of get taxed twice; but that means it can also be set much lower, and the size cap be raised much higher, while still raising the same amount of money. Camp’s tax is a mere 0.035%, and is applied only to assets over half a trillion dollars. It’s designed to raise $86 billion over ten years — although, confusingly, the Bloomberg article also says that “it would raise $27 billion more over a decade than the president’s plan would”.

I like the simplicity of the Camp plan, although I would have preferred to tax liabilities rather than assets. After all, it’s not size that’s the real problem, it’s leverage, and it’s always good to give banks an incentive to raise more capital and less debt.

I like the way that it’s targeted: just ten US institutions would account for 100% of the revenues from the tax. The list in full: JPMorgan; Bank of America; Citigroup; Wells Fargo; Goldman Sachs; Morgan Stanley; GE Capital; MetLife; AIG; and Prudential. None of them need to be as big as they are, and between them they’re more than capable of coming up with $9 billion a year to help make up for the fact that they each pose a huge systemic risk to the US economy.

At heart, this is a Pigovian tax on something (too-big-to-fail financial institutions) we don’t want, and often Pigovian taxes are more effective than regulation when it comes to minimizing such things. What’s more, it’s sharp enough to hurt: JPMorgan, for instance, would have ended up paying about 15% of its 2013 net income in this one tax alone.

For exactly that reason, however, I’m still skeptical that the tax will ever actually arrive. Those ten institutions are extremely powerful, and are more than capable of persuading politicians on both sides of the aisle to vote against a tax which singles them out for pecuniary punishment. The tax was a good idea in 2010, and it’s a good idea today. But it has very little chance of ever becoming a reality.

COMMENT

Isn’t 3.5bp/quarter pretty much the same rate as 15bp/year?

Posted by niveditas | Report as abusive

Why BBVA is good for Simple

Felix Salmon
Feb 20, 2014 17:42 UTC

Simple began in July 2009, but it took three years before it was ready to actually start sending its debit cards out to members of the public. And now, after just 18 months as a scrappy independent financial-services provider, it’s being bought, for $117 million, by Spanish banking giant BBVA.

This is not the billion-dollar exit that Simple’s VC backers dreamed of; one source told Ellis Hamburger that “they had kind of run out of steam” of late. But that might actually be a good thing, in the long term, for Simple: I suspect that Simple is actually going to be much better off within BBVA than it was up until now.

The first and most obvious reason is that Simple is now, finally, what it always wanted to be: a bank. When CEO Josh Reich first started talking to me about his retail-banking dreams, in September 2009, he didn’t want to be a pretty app sitting on top of someone else’s bank: he wanted to be a bank. And now, finally, that’s what he is.

BBVA is also, in many ways, the ideal parent for Simple. It’s technologically forward-thinking, which means it’s going to be more receptive than Simple’s current partner, Bancorp, in terms of providing the technical ability to do lots of clever, real-time things. It also gives its subsidiaries a huge amount of autonomy and freedom: it has a holdco structure, rather than the kind of command-and-control structure you might see at, say, Citibank. It is a very long-term investor: it’s buying Simple for ever, not so that it can flip it for a profit in a few years’ time. And finally, it is one of the most international banks in the world, which is going to make Simple’s global expansion a lot easier.

Simple’s business is highly capital-intensive, and BBVA has capital: the purchase price is already more than the $100 million that BBVA promised last year to invest in innovative companies, and you can be sure that BBVA is going to invest a very large chunk of money in Simple after having acquired it. That money isn’t going to require VC-level returns; BBVA will, rather, ask only that it creates an innovative new bank which can expand globally and which the rest of the BBVA network can learn from. (Certainly the Simple card is leaps and bounds ahead of BBVA’s rival SafeSpend card.) To date, Simple has raised a total of $15.3 million in capital; BBVA’s total future investment in the company is likely to dwarf that sum, and allow Simple to create products — like its long-promised joint account — much more quickly.

One criticism of this deal is that it reduces consumer choice, but I don’t buy it. For one thing, very few people are choosing between Simple and Compass, BBVA’s US arm. And for another, insofar as there are such people, the choice still exists: Simple will remain a standalone entity, and will compete with Compass as much as it does with any other bank.

That said, there are always downsides to any deal. For one thing, Simple will lose a very large chunk of its current revenues: as part of a big bank, it will now be subject to Dodd-Frank limits on debit interchange fees. It will also, as a bank, have much more regulatory oversight than it’s had up until now — and regulators always slow down the pace of innovation. (Rightly so.) Will Simple’s friendly customer service and full-of-personality Twitter feed be able to manage the onslaught of compliance officers that this change is going to bring? I hope so, and Simple certainly wants that to be the case, but it’s far from certain.

Meanwhile, Silicon Valley has moved on, with payments companies, rather than banks, getting the bonkers valuations. (Stripe: $1.75 billion; Square: $5 billion.) Simple has a payments capability of its own, but it’s still nascent, and it does seem that banking doesn’t scale quite as quickly as the VC world would like it to. After all, it’s very rare that people change their bank: doing so is much harder than, say, switching your credit card.

Building a huge new bank takes more time, and more money, than Silicon Valley likely has. BBVA, on the other hand, has both the patience and the capital to make Simple’s dreams come true. That doesn’t mean that Simple is going to achieve all of its ambitions, of course. But it’s probably better-placed to do so today than it was yesterday.

Why the Post Office needs to compete with banks

Felix Salmon
Feb 3, 2014 23:32 UTC

Back in 2011, I said that “the only way to save the Post Office will be to allow it to move into financial services”, seeing as how “banks in the US are mistrusted and disliked and many people would love to be able to just bank at the Post Office instead”.

That’s still true, and has been given a lot more salience since the Post’s Office inspector general released a 33-page white paper, last week, saying that the Post Office should move into what it calls, in its headline, “Non-Bank Financial Services for the Underserved”.

The report has been warmly greeted by Elizabeth Warren, on its own terms:

If the Postal Service offered basic banking services — nothing fancy, just basic bill paying, check cashing and small dollar loans — then it could provide affordable financial services for underserved families, and, at the same time, shore up its own financial footing.

Warren also, however, praises David Dayen’s article about the white paper, which has an unambiguous headline: “The Post Office Should Just Become a Bank”. And Adam Levitin, who used to be Warren’s co-blogger at Credit Slips, also uses the paper to push the idea of postal banking.

So let’s be clear: there’s a very important difference between postal banking, on the one hand, and what the inspector general is proposing, on the other. And while postal banking is a good idea, the non-bank proposal from the inspector general is simply not going to fly.

Indeed, it’s rather worrying and disconcerting — not to mention disingenuous — that the inspector general goes out of its way to say that the Post Office should be a non-bank, rather than a bank:

The Postal Service is well positioned to provide non-bank financial services to those whose needs are not being met by the traditional financial sector. It could accomplish this largely by partnering with banks, who also could lend expertise as the Postal Service structures new offerings. The Office of Inspector General is not suggesting that the Postal Service become a bank or openly compete with banks. To the contrary, we are suggesting that the Postal Service could greatly complement banks’ offerings.

This is a bit weird, since the centerpiece of the inspector general’s proposal, the Postal Card, seems to do nearly all of the things that a bank account does:

 

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The inspector general, it seems, wants the Post Office to partner with a real bank, which would ensure that the funds on the Postal Card were FDIC insured: such a setup would be similar to the way in which Simple (which is technically a non-bank) partners with Bancorp for such things. But this is nit-picking, really: Simple explicitly sells itself as a bank replacement, and the Postal Card does pretty much everything that Simple does, plus — crucially — loans. (Which are the one big banking service Simple doesn’t offer right now.)

The inspector general — along with Elizabeth Warren — is at great pains to point out how useful the Postal Card would be to the “underserved” — that is, the millions of Americans without bank accounts. And they’re absolutely right about that: 38% of post offices are in ZIP codes with zero bank branches, and so such a card would bring banking services to lots of people who have no easy access to them right now.

But if the Postal Card is as attractive as the inspector general paints it, then why shouldn’t it also appeal to people who do have bank accounts? After all, the white paper explicitly says that the Post Office should offer “a diverse suite of financial services”: this is a much broader proposal than the basic savings account, capped at $2,500, which the Post Office offered between 1911 and 1967. And while it might well make sense to farm out back-end services to a bank rather than making the Post Office a bank itself, the fact remains that the Post Office would still be competing with banks. (Which explains why the banks are so opposed to the idea.)

If the Post Office was hobbled so that it would compete only with payday lenders and not with banks, then the whole Inspector General plan is, I’m sad to say, a non-starter — for exactly the same reasons why the Church of England can’t play a similar role in the UK. Non-banks compete on convenience, not on cost, and tend to be open very long hours; while the Post Office has the advantage that a lot of the underserved go there anyway, it’s still going to have real difficulty competing with Western Union, check-cashing stores, and all the other high-cost non-bank financial-services shops which do exist in the ZIP codes without banks.

In order to make a postal bank work, it needs to be a postal bank: it has to be able to take market share away from existing banks. That in turn means that the existing banks will fight tooth and nail to prevent such a thing from ever seeing the light of day.

The charitable view of the Inspector General’s report is that it’s essentially pushing a Trojan horse: that it will try to set the Post Office as a “non-bank”, on the grounds that doing so will help the underserved and not really compete with banks. That’s the only way Congress would ever allow such a thing to happen. But once the Postal Card is up and running, nothing’s going to stop the Post Office from competing directly with every bank in the country.

But if the Post Office is hobbled from day one in such a way as to prevent it from competing with banks, then the Inspector General’s idea is never going to work.

COMMENT

By the same token, the Postal Service should have been at the vanguard of email (specifically), but in providing Internet services as a ‘common good’.

Who wouldn’t have paid…say…$5/month for Internet access back in the mid-90s? And every post office could have been a digital hub.

C’est la vie.

Posted by josfrick71 | Report as abusive

Why Zions needs to bite the bullet and sell its CDOs

Felix Salmon
Jan 9, 2014 15:15 UTC

It’s hardly news that in the run-up to the financial crisis, some banks created highly-toxic collateralized debt obligations, and other banks bought those highly toxic CDOs and put them on their balance sheets. The result was that when the crisis hit, and the CDOs plunged in value, a lot of banks needed to take a lot of write-downs.

Certain banks, however, holding certain CDOs, managed to avoid taking any write-downs, and instead quietly just held on to those instruments, keeping them on their books at 100 cents on the dollar. Essentially, they bought complex financial instruments, and then treated them for accounting purposes as though they were their own loans, being held to maturity, which therefore didn’t need to be marked to market. And regulators allowed them to get away with it — until now.

Nick Dunbar has a very good explainer of what’s been going on with these CDOs — specifically, the ones which include obscure creatures known as trust preferred securities. And Floyd Norris has the best short description of exactly what TruPS are, and how they became CDOs:

Trust-preferred securities became popular with bank holding companies in the 1990s because bank regulators allowed them to be treated as capital by the issuing bank, just like common stock, but they were treated as debt securities by the Internal Revenue Service, allowing the issuing bank to deduct interest payments from income on its tax return. The C.D.O.’s were created to allow many small banks to issue such securities, with the buyers reassured by the apparent diversification.

These gruesome instruments actually helped some banks get through the crisis: if you issued TruPS, then you could (and almost certainly did) suspend interest payments for as long as five years, without penalty. But we’re now getting to the end of that five-year period, and, as Norris says, “it is unclear how many of them will be able to make back payments before the periods end this year and in 2015”. Which means that TruPS CDOs, like many other financial innovations of the 2000s, have notably failed to bounce back to their pre-crisis valuations.

As Dunbar says, these things have no place on banks’ balance sheets. And, gloriously, the Volcker Rule has ensured that they’re being kicked off those balance sheets. (Better late than never.) Under the rule, CDOs of TruPS are categorized as a “covered fund”, which banks aren’t allowed to own.

The problem is that certain banks, most notably Zions Bancorp, still own billions of dollars of these things, and have never written them down. If and when they do so, they’re going to have to take hundreds of millions of dollars in losses. And so out come the lobbyists — and out come the silly pieces of legislation, seeking to create a massive carve-out from the Volcker Rule, which would allow Zions and others to hold on to these TruPS CDOs indefinitely.

Even if your goal is to keep the TruPS CDOs on banks’ balance sheets, this legislation is a dreadful way of doing so — since, as Norris notes, the proposed law goes much further than that, and effectively allows banks not only to hold the old instruments, but even to create brand-new ones. Talk about not learning our lesson. But in any case, Zions and the other banks which bought these instruments should, finally, be forced to rid themselves of them. Zions is never going to be happy about taking a loss, but now’s not a bad time for banks in general to be taking losses. And frankly, all of these gruesome CDOs should have been jettisoned from banks’ balance sheets years ago. Let’s hope this legislation goes nowhere, and that these ugly reminders of pre-crash “financial innovation” finally start being held by buy-siders who mark to market, rather than by banks claiming that they’re worth 100 cents on the dollar.

The invincible JP Morgan

Felix Salmon
Jan 8, 2014 16:11 UTC

When JP Morgan paid its record $13 billion fine for problems with its mortgage securitizations, the bank came out of the experience surprisingly unscathed, in large part because Wall Street reckoned that the real guilt lay mainly in the actions of companies that JP Morgan had bought (Bear Stearns and WaMu) rather than in any actions undertaken on its own watch. There was a feeling that the bank was being unfairly singled out for punishment — a feeling which, at least in part, was justified.

The latest $2 billion fine, however, which also comes with a deferred prosecution agreement, is entirely on JP Morgan’s shoulders — and still, as Peter Eavis reports, it’s being “taken in stride” by the giant bank. It really seems that CNBC is right, and that profits really do cleanse all sins. How is it that a $450 million fine sufficed to defenestrate the CEO of Barclays, but that Jamie Dimon, overseeing some $20 billion of fines plus a deferred prosecution agreement just in the space of one year, seems to be made of teflon?

To answer that question it’s worth looking at the details of what exactly JP Morgan did wrong in this case. The key part of the Deferred Prosecution Packet is Exhibit C, the Statement of Facts, all of which have been “admitted and stipulated” by JP Morgan itself. And it certainly lays out some jaw-dropping behavior on the part of the bank, which oversaw Madoff’s main bank account for more than 20 years: between 1986 and 2008, account #140-081703 received a jaw-dropping $150 billion in total deposits and transfers, and showed a balance of $5.6 billion in August 2008. Even when you’re as big as JP Morgan, that’s a bank account you notice.

Except, maybe, not so much:

With respect to JPMC’s requirement that a client relationship manager certify that the client relationship complied with all “legal and regulatory-based policies, a JPMC banker (“Madoff Banker 1”) signed the periodic certifications beginning in or about the mid-1990s through his retirement in early 2008…

During his tenure at JPMC, Madoff Banker 1 periodically visited Madoff’s offices… Madoff Banker 1 believed that the 703 account was primarily a Madoff Securities broker-dealer operating account, used to pay for rent and other routine expenses. Madoff Banker 1 also believed that the average balance in Madoff Securities’ demand deposit account was “probably [in the] tens of millions.”

This is sheer unmitigated — and, yes, probably criminal — incompetence. It takes a very special kind of banker to not notice that an account has more than a billion dollars in it, for a period of roughly four years, from 2005 through most of 2008. As Matt Levine says, “Madoff Banker 1 is like the one banker on earth who underestimated his client’s business by a factor of 100 or so. ‘Boss, I’ve made the firm thousands of dollars this year,’ he probably said, ‘and I deserve a bonus of at least $200.’”

The incompetence doesn’t stop there. At the beginning of January 2007, the account — which, remember, JP Morgan officially considered to be used “for rent and other routine expenses” — saw inflows of $757.2 million in one day. This tripped all manner of automated red flags, but the investigation into those red flags consisted of — get this — visiting the Madoff website. That’s it.

Was there other suspicious activity in this account? Of course there was: lots of it. As far back as December 2001, a client of JP Morgan’s private bank, who also held a huge amount of money with Madoff, moved an astonishing $6.8 billion in and out of that 703 account. In one month. You just can’t do that without generating all manner of suspicious activity reports from JP Morgan to bank regulators. And yet, somehow, impossibly, no such report was generated.

Similarly, in 2007, JP Morgan’s private bank conducted due diligence on Madoff — after all, many of its clients wanted in on Madoff’s amazing funds — and concluded that the numbers “didn’t add up”. And still no hint of running any problems up the chain to either JP Morgan’s regulators or Madoff’s. The same thing happened again in 2008, at an entity called Chase Alternative Asset Management.

And then in late 2008, shortly before the whole Madoff enterprise imploded, JP Morgan bankers in London became so suspicious of the whole enterprise that they sent two different reports to the UK’s Serious Organized Crime Agency. Yet none of this information made it to US regulators.

Levine has a relatively benign explanation for all this: he says that JP Morgan comprises “more or less independent” businesses, which naturally don’t speak to each other, or inform each others’ regulators when they smell something suspicious.

But sometimes the different bits of JP Morgan did talk: for instance, in June 2007 there was a meeting about Madoff in Manhattan, which included the investment bank’s chief risk officer; the Hedge Fund Underwriting Committee (which included “executives from various of JPMC’s lines of business”); the London Equity Exotics Desk (which later examined Madoff in detail and concluded he was probably a fraud); the investment banks’s Global Head of Equities; executives from the broker-dealer; and other people who had direct credit relationships with Madoff. The meeting concluded that JP Morgan wasn’t going to do a big deal with Madoff based simply on Madoff saying “trust me”, and not allowing any direct due diligence. But while JP Morgan was careful with its own investments, and ultimately took out most of the money it had with Madoff before the firm collapsed, once again it saw no reason to tell regulators about its suspicions.

And specifically, there’s one individual within JP Morgan, identified as the “Senior IB Compliance Officer”, who had all of the information from London, who was responsible for passing suspicions on to US regulators, and who ended up doing nothing beyond having “an impromptu conversation in a hallway” with a few colleagues.

The government doesn’t show — it doesn’t need to show — that if JP Morgan had done what it was supposed to do, then US regulators would have cracked down on Madoff before the Ponzi scheme collapsed under its own weight. The point is that regulators can only do their job if they’re given the information they’re required by law to receive — and JP Morgan (not Bear Stearns, not Washington Mutual, but JP Morgan itself) utterly failed, over many years, to provide them with that information.

And yet, to Eavis’s point, JP Morgan is now effectively untouchable by the government. Sure, it can be fined billions of dollars; it can even be slapped with a deferred prosecution agreement. But the fines just come out of the pot of money devoted to paying such things — it’s known as “legal reserves” — and so long as the bank can show that it makes good profits after reserving for fines, Wall Street seems happy for the bank to make few if any major changes. Jamie Dimon remains as CEO, answering to a board chaired by himself; the bank remains one of the biggest in the world; and while prosecutors are winning countless battles against the bank, it’s abundantly clear that the bank is going to win the war.

When did JP Morgan effectively become too big to regulate? How is it that Jamie Dimon and his starry-eyed shareholders have been able to see off forces which toppled many other banks and CEOs? That’s an article I’d love to read — the story of how, with some combination of luck and aggression, Dimon held on to his position as the most powerful bank CEO in the world — even as other banks, and other CEOs, fell steadily by the wayside.

In the face of a determined regulatory onslaught over the past 18 months, from mortgage-related prosecutions to the Volcker Rule, JP Morgan’s share price has gone steadily up and to the right, almost doubling over that period. In the view of Wall Street, that share price is Dimon’s vindication, and his ultimate shield. The lesson of yesterday’s news cycle is that no one can pierce it. Not even the Justice Department.

COMMENT

“The government doesn’t show — it doesn’t need to show — that if JP Morgan had done what it was supposed to do, then US regulators would have cracked down on Madoff before the Ponzi scheme collapsed under its own weight.”

The suspicious activity that JPMorgan failed to file was in fact filed earlier:

“12 Years Before Madoff Was Arrested, A Major JP Morgan Chase Competitor Filed A Suspicious Activity Report”

http://www.forbes.com/sites/robertlenzne r/2014/01/08/12-years-before-madoff-was- arrested-a-major-jp-morgan-chase-competi tor-filed-a-suspicious-activity-report/

“In 1996, some 12 years before Bernie Madoff was arrested for the largest Ponzi scheme in history, a JP Morgan Chase competitor, rumored to be Deutsche Bank DB -3.66%, filed a suspicious activity report on Madoff with regulators, closed its Madoff account and turned over its Madoff deposits to JPMC.”

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Three cheers for small banks

Felix Salmon
Dec 5, 2013 22:55 UTC

Earlier this week, Matt Yglesias wrote a post about what he calls “America’s Microbank Problem”: this country has far too many banks, he says, and they’re far too small. A rebuttal soon came from Rob Blackwell of American Banker, who called Yglesias “dead wrong”. This is an argument which clearly needs to be adjudicated! And in this case, I’m afraid, Blackwell wins.

It’s undeniably true that for various reasons, most of them regulatory, America has way more banks than any other country. Take away that history of regulations, and we’d have the “dozens” of banks Yglesias wants, rather than the thousands we actually have. But, would that be a good thing or a bad thing?

Yglesias says it would be a good thing, on the grounds that America’s existing “microbanks” are poorly managed; can’t be regulated; and can’t compete with the big banks. But Blackwell is absolutely right that none of these arguments really stands up to scrutiny.

Taking them in turn, Yglesias starts — without citing any evidence — by saying that smaller banks are poorly managed:

You know how the best and brightest of Wall Street royally screw up sometimes? This doesn’t get better when you drill down to the less-bright and not-as-good guys. It gets worse. And since small banks finance themselves almost entirely with loans from FDIC-ensured depositors, nobody is watching the store.

Actually, you do get less in the way of royal screw-ups as banks get smaller. Small banks are lenders, at heart: they take depositors’ money, and lend it out to their customers. If the customers prove creditworthy, then the bank makes money. Big banks, by contrast, are much more complex institutions, larded up with derivatives and Central Investment Offices and leveraged super-senior tranches of synthetic collateralized debt obligations, and so on and so forth. What’s more, all of those things can generate multi-million-dollar bonuses almost overnight for the wizards dreaming them up: no one waits until maturity. It’s that kind of opacity and complexity which produces the real disasters, not the simple business of lending money to borrowers.

As for the idea that FDIC insurance makes small banks riskier — well, that’s just bizarre. The FDIC crawls all over small banks, precisely because it has so much at risk. And because small banks have simple operations which are easy to understand, the FDIC can and does step in early when they start getting into trouble. Effectively, small banks have the better of two management teams: the in-house one, or the FDIC. And the FDIC knows what it’s doing.

Ygelsias’s second argument is equally weird: that small banks can’t be regulated, since they get carve-outs from lots of bank regulation. Again, this misses the big picture, which is that they are regulated, and regulated well, by the FDIC. What’s more, if the FDIC ever has any difficulty regulating these banks, all it needs to do is raise its dues to make up for the extra risk that it’s facing. Essentially, the US banking system regulates itself: the dues from profitable banks go towards rescuing troubled banks. The rest of us never need to worry. Except, of course, when the bank is so big that the FDIC can’t afford to let it go bust. It’s the too-big-to-fail banks which are the real problem, not the little ones.

What’s more, the carve-outs, such as they are, tend to make perfect sense, for banks which as a rule aren’t even allowed to engage in the relevant activities in the first place. (When I was on the board of a small credit union, for instance, we briefly talked about using interest-rate swaps to hedge our interest-rate exposure, before finding out that our regulator would never allow a credit union of our size to do such a thing.)

Besides, as Blackwell notes, small banks in fact are governed by nearly all the regulations which apply to big banks — including Basel III.

Finally, Yglesias says that small banks can’t just compete with big banks: “Having a large share of America’s banking sector tied up in tiny firms only makes it easier for a handful of big boys to monopolize big-time finance.” Well, yes — the small banks don’t do big-time finance. That, as they say, is a feature, not a bug. The fact is that the second-tier banks that Yglesias has his eyes on — banks like Fifth Third or PNC — would be insane to try to compete with Goldman Sachs in the big-time finance leagues. The international capital markets have seen dozens of second-tier banks attempt that move; they all end up losing billions of dollars and retreating with their tales between their legs. There big-time finance league is actually highly competitive: it includes not only US banks like Goldman and Morgan Stanley and JP Morgan and Citigroup and Bank of America, but also international banks like Deutsche and UBS and Barclays and Credit Suisse. We don’t need more banks in that league: the one thing they all have in common, after all, is that they’re too big to fail. That’s the table stakes.

Blackwell also notes that smaller banks are actually more profitable than the behemoths: if you have assets of between $1 billion and $10 billion, your return on equity is 9.9%, on average. That’s better than the TBTF contingent: there might be economies of scale at the low end, but they completely disappear by the time you get to $100 billion, even as the biggest banks have balance sheets measured in the trillions.

And taking a step back from the original Yglesias blog post, in general it’s always a good thing for banks to be small rather than big. If you’re a small bank, you know your local economy really well. The biggest difference, for me, between talking to a small-town banker and a big international banker is that big international bankers tend to know a lot about banking. Small-town bankers, on the other hand, often know surprisingly little about banking: they don’t need to. Instead, they know about agriculture, or manufacturing, or whatever the local industry might be.

The main role of banks in an economy is to allocate capital to places where it can be most productively used. In international finance, that role is played by the capital markets — which is one reason why big banks aren’t as necessary as small banks. But at the local level, what we really need is bankers who know their neighborhood and can help it grow by funding the best businesses. And small banks are better at that than big banks, where underwriting decisions tend to be automated, with local branch managers having very little discretion.

Smaller banks can pose a systemic risk, as we saw in the S&L crisis. They still need to be assiduously regulated. But give me small banks over big banks, any day. I feel that one of the hidden strengths of America is precisely that it has such a richly diversified banking system. And as web-based banking platforms start becoming available at reasonable cost to banks of all sizes, I suspect that community banks are only going to increase their market share going forwards. Good for them.

COMMENT

It’s amazing how banking has evolved today. Financial services such as interest-free credit finance solutions are now being marketed online. This includes personal loans and business loans as well.

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The $5 trillion dilemma facing banking regulators

Felix Salmon
Dec 3, 2013 17:16 UTC

Last month, I wrote about bond-market illiquidity — the problem that it’s incredibly difficult to buy and sell bonds in any kind of volume, especially if they’re not Treasuries. That’s a big issue — but it turns out there’s an even bigger issue hiding in the same vicinity.

The problem is that there’s only a certain amount of liquidity to go around — and under Dodd-Frank rules, a huge proportion of that liquidity has to be available to exchanges and clearinghouses, the hubs which sit in the middle of the derivatives market and act as an insulating buffer, making sure that the failure of one entity doesn’t cascade through the entire system.

Craig Pirrong has a good overview of what’s going on, and I’m glad to say that Thomson Reuters is leading the charge in terms of reporting about all this: see, for instance, recent pieces by Karen Brettell, Christopher Whittall, and Helen Bartholomew. The problem is that it’s not an easy subject to understand, and most of the coverage of the issue tends to assume a lot of background knowledge. So, let me try to (over)simplify a little.

During the financial crisis, everybody became familiar with the idea that a bank could be “too interconnected to fail”. The problem arises from the way that derivatives tend to accumulate: if you have a certain position with a certain counterparty, and you want to unwind that position, then you can try to negotiate with your original counterparty — but they might not be particularly inclined to give you the best price. So instead you enter into an offsetting position with a different counterparty. You now have two derivatives positions, rather than one. The profits on one should offset any losses on the other — but your counterparty risk has doubled. As a result, total counterparty risk only ever goes up, and when a bank like Lehman Brothers fails, the entire financial system gets put at risk.

There are two solutions to this problem. One is bilateral netting — a system whereby banks look at the various contracts they have outstanding with each of their counterparties, and simply tear them up where they offset each other. That can be quite effective, especially in credit derivatives. The second solution is to force banks to move more of their derivatives business to centralized exchanges. If there’s a single central counterparty who faces everyone, then the problem of ever-growing derivatives books goes away naturally.

Of course, if everybody faces a central counterparty, then it’s of paramount importance to ensure that the clearinghouse in question will itself never fail. Naturally, the clearinghouse doesn’t own any positions, but on top of that it has to be able to cope with its own counterparties failing. Typically, the way it does that — and we saw this during MF Global’s collapse — is to demand ever-increasing amounts of collateral whenever there’s a sign of trouble.

Such demands have two effects of their own. The first, and most important, effect is that they really do protect the central clearinghouse from going bust. But the secondary effect is that they increase the amount of stress everywhere else in the system. (MF Global might have ended up going bust anyway, but all those extra collateral demands certainly served to accelerate its downfall.) Pirrong calls this “the levee effect”:

Just as making the levee higher at one point does not reduce flooding risk throughout a river system, but redistributes it, strengthening a central counterparty (CCP) can redistribute shocks elsewhere in the system in a highly destabilizing way. CCP managers focus on CCP survival, not on the survival of the entire system, and this is quite dangerous when as is almost certainly the case, their decisions have external effects. Indeed, greater reliance on CCPs increases the tightness of the coupling of the financial system, which can be highly problematic under stressed conditions.

Essentially, when markets start getting stressed, liquidity and collateral will start flowing in very large quantities from banks to clearinghouses. Indeed, to be on the safe side, central clearinghouses are likely to demand very large amounts of collateral — as much as $5 trillion, according to some estimates — even during relatively benign market conditions. That is good for the clearinghouses, and bad for the banks. And while it’s important that the clearinghouses don’t go bust, it’s equally important that the banks don’t all end up forced into a massive liquidity crunch as a result of the clearinghouses’ attempts at self-preservation.

The banks, of course, will look after themselves first — especially as the new Basel III liquidity requirements start to bite. If they need to retain a lot of liquid assets for themselves, and they also need to ship a lot of liquid assets over to clearinghouses, then there won’t be anything left for their clients. Historically, when clients have needed to post collateral, they’ve been able to get it from the banks. But under Basel III, the banks are likely to be unable or unwilling to provide that collateral.

So where will clients turn? These are truly enormous businesses which might need to be replaced: Barclays has cleared some $26.5 trillion of client trades, while JP Morgan sees an extra half a billion dollars a year in revenue from clearing and collateral management.

Just as in the bond markets, one option is that the clients — the buy-side investors — will turn to each other for collateral, instead of always turning to intermediary banks. That’s already beginning to happen: some 10% to 15% of collateral trades already involve non-banking counterparties. But it’s still very unclear how far this trend can be pushed:

While corporates and buysiders might be comfortable sharing confidential information with their banking counterparties, shifting to a customer-to-customer model is a big step.

“The problem is that buyside firms have to open up their credit credentials to each other to get a credit line in place. I always felt that was an impediment to customer-to-customer business, but the combined impact of new rules changed that,” said Osborne.

Osborne, here, is Newedge’s Angela Osborne; her job is to start replacing banks in the collateral-management business. Once you adjust for Osborne talking her own book, it’s clear that there’s still a very long way to go before the banks will realistically be able to step back from this market.

After all, it’s not as though the banks’ buy-side clients themselves have unlimited amounts of collateral which they can happily post at a moment’s notice. It’s true that they aren’t as leveraged as the banks are. But they themselves have investors, who can generally ask for their money back at any time — normally, when doing so is most inconvenient for the fund in question. If they tie up assets posting collateral for themselves or others, that makes it much harder for them to meet potential redemption requests.

All of which means that as we move to a system of central clearinghouses, a new systemic risk is emerging: “fire sale risk” is the term of art. If a market becomes stressed, and the clearinghouses raise their margin requirements, then the consequences can be huge. In the bond market, the death spiral is all too well known: a sovereign starts looking risky, the margin on its bonds is hiked, which in turn triggers a sell-off in that country’s bonds, which makes them seem even riskier, which triggers another margin hike, and so on. This can happen in any asset class, but derivatives are in many ways the most dangerous, just because they’re inherently leveraged, and the amount of leverage that the clearinghouses allow can be changed at a moment’s notice.

Do the world’s macroprudential regulators have a clear plan to stop this from happening? Do they have any plan to resolve the inherent tension involved in demanding that banks retain large amounts of ready liquidity, even as they also allow clearinghouses to demand unlimited amounts of liquidity from the very same banks? The answers to those questions are — at least for the time being — very unclear. But the risk is very real, and it makes sense that regulators should do something to try to mitigate it.

COMMENT

Maybe I am missing something but this pretty much seems to be a made up risk to me. It would make sense for the banks to push this story so they can keep screwing over their costumers with OTC derivatives.

Is there any example in history of a clearing house causing a financial crisis? Collateral calls add stability to the system by lowering leverage before it gets to levels where systematic default is a danger. If a collateral shortage leads to the credit derivative market shrinking that is a positive in my book.

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