Has the Banking Industry Really Been Fixed?

The banking sector still faces big challenges, but greater transparency will boost investor confidence and also encourage banks to manage risk better internally.

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Eric Thayer / REUTERS

Traders stand outside the New York Stock Exchange on March 27, 2009.

The biggest economic puzzle of the past few years is why the recovery has remained so weak. The underlying cause of the 2007-2009 recession was the bursting of the real estate bubble. But it was the banking crisis resulting from the drop in home prices that actually sent the U.S. tumbling into the worst economic downturn since the Great Depression. Continuing problems in the banking industry have been among the chief factors holding back the recovery. The key question now is whether the banks have finally tackled their problems, so that the economy can start to grow more robustly.

It certainly seems as though the banking sector should be on the mend. Home prices have turned up after hitting bottom early last year. And other borrowers are in better shape, too. Corporate profits have rebounded powerfully, and consumers have got their household debt under control. So you might think that banks would be in a stronger position to finance economic growth. The reality, however, is more complicated. The losses banks suffered because of falling home prices exposed a host of fundamental problems in the industry. Here’s a look at what needs to be addressed to get the financial system back to full strength:

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Regulation. There are two key types of regulation. The first limits the amount of risk a bank can take. Only trouble is, it’s hard for regulators – or anyone else – to monitor the riskiness of bank portfolios. Indeed, the major credit-rating agencies have come under sharp criticism for failing to recognize the risk of some sophisticated investments. The second type of regulation separates aggressive forms of banking from more mundane lending for mortgages, businesses, and consumer finance. That prevents speculative losses from leading to a cutback in credit available for ordinary business activities. A provision known as the Volcker Rule restricts banks from making risky investments with the same capital that they use to make loans to clients. But the rule does not require the nearly complete separation of commercial and investment banking that the old Glass-Steagall act did. Moreover, financial firms already seem to be finding ways to get around the complex provisions of the Volcker Rule.

Credit quality. Looser regulation wasn’t the only thing that led to risky investing before the recession. Federal Reserve Chairman Alan Greenspan pursued an easy-money policy that encouraged banks to lend as much as possible. And since the number of high-quality borrowers is always limited, expansive lending led to a decline in creditworthiness and an increase in so-called subprime real estate lending. Today banks are more cautious. But the Fed is still very expansive, so the potential for speculation remains.

Sophisticated investments. What sent risk levels into overdrive prior to the recession was the growth of sophisticated investments – sometimes known as derivatives – that repackaged mortgages and other loans so that they could easily be bought and sold. These vehicles increased the scale of potential losses if loans went bad. They also made it difficult for outsiders – and sometimes even for banks themselves – to gauge how risky their portfolios were. Although the volume of derivatives outstanding has declined a bit recently, it still remains very high by historical standards.

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Transparency. The difficulties outsiders face in trying to figure out the true risks in bank portfolios is analyzed in a recent Atlantic cover story. According to the article, the biggest cause of panic during the financial crisis was that “it was impossible to tell, from looking at a particular bank’s disclosures, whether it might suddenly implode.” The article goes on to conclude that the situation is not much different today.

Some top banking analysts say that the worst has passed, that the banking industry has reformed, and that the outlook can only improve from here. Prices for bank stocks are still far below their pre-recession highs, and if the industry really has fixed its problems the shares look like terrific bargains.

I’m not so sure. Even at banks with the best reputation, internal risk management seems insufficient. J.P. Morgan Chase’s own investigation into its $5.8 billion dollar trading loss last year concluded that management didn’t fully understand the trading strategies, didn’t provide effective oversight, and basically had no idea how much money was at risk. As a conservative investor, I’ve steered clear of financial stocks. At today’s prices, they may be good buys for aggressive investors, but I’ve been able to find plenty of high-yielding retirement investments among oils, pharmaceuticals, telecoms, utilities, and some other industrials.

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As for the bigger question, the banking sector won’t be able to boost the economic recovery as long as key challenges remain unresolved. It’s necessary to regulate the industry without stifling it, to encourage lending without risking a deterioration of credit quality, and to keep up with global financial innovation without creating additional uncertainy. One thing does seem clear, though. Banks need to be a lot more forthcoming with analysts and investors. Striving for transparency will not only increase confidence in the industry, it will also encourage banks to recognize the risks they’re taking and manage them better internally.

12 comments
Scottchilds88
Scottchilds88

I think that there is a lot of media coverage that would lead us to believe that the banks are on their way to being fixed but that a lot of the raw numbers are shielded from the public. According to this report we could be about to go into the worst financial crisis in UK history http://bit.ly/13Q8uuA

DonBartenstein
DonBartenstein

You mean "fixed" the way boxing matches are "fixed"?

thecrud
thecrud

The fact is it is up to them if they want to stay in business. We bailed them out so actual risk reward is still unknown. This gives them all the cover they need to fail again. Or do business as usual as to them they are still here so there was no fail.

Just manipulating a very stupid government and they are pretty sure they can rip everyone off over time and survive again.

I mean hay it worked once and near as any of them can tell it is working again.

bryanfred1
bryanfred1

As usual, no mention that Congress mandated an ever-expanding portion of Fannie and Freddie-backed mortgages that come from subprime borrowers (more than half of all new originations by the time of the bust), or that banks bought these "risky" investments (nevermind that they were buying only the investment grade tranches) at Federal Reserve encouragement to hold as bank capital because the natural market for those securities was oversaturated.  Banks and other originators eventually discovered that Fan and Fred would buy or secure literally any mortgage that could be originated because the "real" subprime market was nowhere big enough to support such volumes, pushing the bubble into its final phase.  All this in the name of helping people own homes who otherwise wouldn't qualify.  Word of advice to future politicians:  creating a mandatory financially non-viable scheme in the interest of "doing good" will not end well.  The question is just when and how big the reconing will be.

HikaruSulu
HikaruSulu

Banks lost money? They own the house and land, jumbo loans only paid interest, so people where renting their McMansions from the bank. People get kicked out, bank still owns land and house and is no renting to some other buyer. Where is the loss? The real losser are those people that lost equity. Banks still own everything.

frankwall1965
frankwall1965

It really is a very complex topic. While it seemed like banks in Europe were stabilising, Commerzbank and Deutsche Bank, Germany's two biggest banks have just announced substantial losses.However, I think the world is in a much better position now than it was three years ago, though the situation is quite delicate - look at statistics regarding Bank of America's performance over that period and you'll see that a corner has been turned, though things are far from ideal - there's still a lot of work to be done: http://www.statista.com/statistics/249556/bank-of-america-quarterly-net-earnings/

antonmarq
antonmarq

Yep, they're back to normal. Profits are up, jobs are down, lending is stagnant, foreclosures are up, stress is up on borrowers, new feeds on almost everything, etc. Yep, things are back to normal for them.

bryanfred1
bryanfred1

Buyer pays $500k for a home, puts down $50k. Bank loans $450k.  Buyer pays no principal and defaults.  In the current market house is worth $350k.  Bank has therefore lost $100k.

???

bryanfred1
bryanfred1

What this article and so many like it get wrong is the primarly causation behind reduced lending.  Banks are earning next to nothing putting money in Treasuries - trust me, they'd much rather be lending to businesses and making a nice interest margin.  The problem is borrower demand.  Just like household debt has come down (a good thing) so has corporate leverage.  Management teams have become more conservative and most will not borrow money to fund expansion unless the opportunity is iron-clad and staring them in the face.  Such opportunities are not exactly plentiful right now.  Otherwise with GDP expanding at approximately the rate of inflation - i.e. no real growth - there is no incentive to borrow.  If low interest rates could cure this then companies would be borrowing like crazy right now.  The suggestion by commenters that banks aren't lending because they're EEEEEVIL is just silly.

Littleatay
Littleatay

It is amazing how misinformed the author and the commentators are about the banking industry.  The issue confronting the banking industry today is the low interest rate environment.  The Fed has pursued a policy of record low interest rates for over 4 years because the Government can't afford to pay the interest on the massive debt we have.  The spread is so thin that there is no incentive for banks to lend.  Maybe the commentators on this article could benefit from a college course in Financial Markets and Institutions.  The Government was responsible for the housing bubble and subsequent collapse and the Government is responsible for the current stagnation.  But blame it on the banks if that makes you feel better.

notLostInSpace
notLostInSpace

@antonmarq Please add big paychecks for top bankers are back to normal too, while interest rates on credit cards are still high, in other words, it is the same old same old.   Is the industry fixed?   "no and hell no".  My vote, if these banks ever need rescuing again they must be nationalized and the managers be held responsible (that means jail for some of them, which should have happened last time).