Before I start writing todays post, I am glad to announce that I have successfully mastered a milestone in the CFA program, and passed the Level I exam. Due to future career prospects I may get with having passed this exam, I have decided to enroll in the second leg of the curriculum.
The former chairman and CEO of Citigroup appeared on CNBC to share his views on the ailing economy and about prospects for future reform concerning the banking industry. Since I am unable to embed the video file in this blog post, I will write out the main tenants of his monologue.
Sandy Weill said:
- break up investment and commercial banking
- manage a system that will not allow excessive leverage, somewhere in the 15 to 18x debt to risk adjusted capital
- force banks to book derivatives on their balance sheets and not manage risks off balance sheet
- protect taxpayer funds from having to bailout TBTF banks
Now, with all due respect to Mr. Weill, who also stated that the biggest banks were also the main providers of capital and growth in the global economy in the past two decades, he is putting the cart before the horse on some of these issues.
To be fair, he did state that investment and deposit banking should be broken up. I put commercial because in the mainstream, the two coincide with one another. But the problem with this reasoning is that somehow deposit taking and making commercial loans will make the investment banking business much to tied up with the former and the latter will be in a constant conflict of interest which will force the government through regulatory measures to force financial institutions to construct “Chinese” walls between departments so no kickbacks may occur and no hefty commissions be generated. To Mr. Weill’s point, it is not the commingling between these activities that cause the problems, but the fraudulent nature of loan origination that occurs in todays economy through secondary deposit creation.
His second point deals with leverage. Leverage as an instrument of magnification, may boost returns that may not be generated without the debt standing behind it. But capping this somewhat arbitrary number will again not solve the problem. Especially when banks, in response to a low yield environment must be forced to generate returns sufficient enough to satisfy customer needs, as well as not losing their revenue base to alternative investment vehicles or pools of funds. Also, on this point, different industries operate on different degrees of leverage. (To make a point, there is a difference between operating leverage, which shows the effect of fixed assets and gross profits on revenue, as well as financial leverage, which shows the difference that operating profits have on net income).
Now, in respect to derivatives, I do agree that these instruments, as like any other that abide to commercial law, must be placed on the balance sheet as a source (asset) and flow (income) to the company. The problem with derivatives, is that, any change in price stemming from the contract (variation of the instruments fair value), and especially if the instrument is booked as AFS under IFRS, doesn’t show as an unrealized gain or loss in the income statement, but rather as a change in the OCI component at shareholder’s equity. That is point one, and point two, if companies, wish not to keep it on their books, in the form of a SPE, they can do whatever they want; but if there are guarantees and contingencies, they ought to be represented as a liability when calculating financial ratios.
And finally, to protect taxpayer funds, why bailout anybody? Why the need for this made up TBTF notion? They are a drag to the economy and should be allowed to reorganize and selloff unsound units and business ventures.
But all in all, someone that sat at a ranking position should have had the courage to speak out regarding these problems in foresight, and not in hindsight.
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