Raise More Capital and Innovate

I am no fan of needless regulation. The industry has enough to deal with right now with Dodd-Frank, a new (and leaderless) Consumer Financial Protection Bureau, derivative regulations and the like. But I question the wisdom of the well-heeled lobbyists in Washington, allegedly representing the interests of the banking industry (read: top 20 banks), aggressively pushing against any talk of meaningful capital reform.

At its most basic level, capital allows an institution to absorb losses from bad loans or other investment activities. Banks and other financial institutions  (read: Bear Stearns, AIG, Merrill Lynch, et al.) want to hold as little capital as possible, so they have more leverage to lend, securitize, purchase collateralized debt obligations (CDOs), or whatever. You and I as taxpayers, and allegedly our government, which is there to look out for the interests of taxpayers, want those banks and other financial institutions to hold as much capital as possible. Why? So we don’t have to bail them out when the going gets rough.

Before Bear Stearns got the knock on the door, its capital was at less than 3%. Similarly, low capital ratios were seen at AIG and Lehman Brothers before they fell. Some of the big bailout banks were also skating on the edge of their Tier 1 capital requirements back in 2008. Basel III, the international banking accord addressing myriad banking issues in our interconnected financial world, wants to put minimum capital requirements at 7%, although the accord is not yet finalized. For the largest “too-big-to-fail” institutions in the world, the great Basel minds are still debating adding a sliding scale requirement increasing that capital from 7% to 10%. Seems reasonable, in light of recent events. So, why are our taxpayer-protected banks pushing back so hard? Depends who you ask.

The banks claim it’s because their competitiveness in the global market will be stifled if the U.S. adopts its own, arguably reasonable, capital requirements. This line of reckoning stems from the sorry state of the European banking market, with the Basel committee indicating it will likely hold off implementing the new capital requirements until 2019 while Congress is looking for action a bit sooner. I guess we should all keep our fingers crossed that nothing too terrible happens in the global market in the next eight years.

I think it’s because the larger banks realize they may have to roll up their sleeves and get back to work earning an honorable buck. When the system has evolved to the point where a bank makes more money securitizing mortgage loans than actually making mortgage loans, then something is probably amiss. When the system rewards a bank for taking assets off its books and selling them as far downstream as possible to second and third purchasers so the institution is insulated from liability, rather than carefully assessing risk and keeping a loan on its books, then something is probably amiss.

If banks, especially the larger ones, had to maintain higher levels of risk-based capital, I think three good things would happen. First, with less access to debt to finance risky “voodoo” transactions (as opposed to relationship banking), banks would naturally be more conservative in the types of activities they engage in. Second, the probability of systemic default and the resulting bailout at any given bank goes down dramatically. And candidly, I can think of a host of things I would rather see my hard-paid tax dollars going toward – education, infrastructure, jobs, or alternative energy, for example – than another AIG-type bailout. Third, and most importantly, banks should see higher capital requirements not as an impediment to growth but as a call to action.

Banks need to develop an innovation capability as a core competency, one that involves a relentless focus on customers – commercial and retail alike. Instead of dreaming up the next exotic financial instrument or hiring quants to figure out how to slice a package of mortgages into endless risk tranches, banks should be focusing on innovating “meat and potatoes” financial services. Too many banks still can’t tell at the front line all of the products and services a retail customer has with them. Too many banks still can’t tell if the principal of one of their important commercial clients also has a retail/wealth management relationship with the bank. Too many banks send a commercial “lender” out on a sales call who is often neither interested nor trained to knowledgably discuss a commercial customer’s cash management needs and pain points.

Come on banks. Let’s wake up; let’s get back to basics; and let’s add a heavy dose of innovation and creativity. A higher capital requirement isn’t the bogeyman – the inability to innovate and know your customers in an increasingly competitive and commoditized marketplace is.

Mr. Sommer is chief executive officer of Cornerstone Advisors, a Scottsdale, Ariz., based consulting firm specializing in bank management, strategy and technology advisory services. He can be reached at [email protected].