We are pleased to provide a copy of the keynote address from the Third Annual Program for Financial Studies Conference. This edited transcript will be published in the Journal of Applied Corporate Finance, Vol. 25 Number 4 (Fall 2013), pp. 8-13.
Good morning, everybody. Thank you, Professor Hodrick, for your very kind welcome. And let me also wish you all a happy post-Halloween. I hope you dressed appropriately as you went about the streets of Manhattan last night. When I said to my wife, “I think I’ll go out as a Wall Street CEO,” she said, “I’m not so sure I would do that if I were you.”
We have a big, wide-ranging topic to cover here, and I’m not sure I can do it justice in my remarks of about thirty minutes. The financial industry has just been through its greatest change, both in this country and around the world, in the 70 or so years since the Great Depression. In fact, Morgan Stanley was founded 78 years ago, in the midst of the Depression. Its founding was a result of the Glass Steagall Act’s splitting off of investment banking from commercial banking. And that period really was the last crisis that compares with what we have just experienced.
As Rahm Emanuel, President Obama’s former Chief of Staff, has many times been quoted as saying, “You never want to let a crisis go to waste.” So let me commend Columbia Business School’s Dean, Glenn Hubbard, for conceiving this program and showing this kind of initiative and leadership. It’s very important that institutions like Columbia Business School inside this great university help us all try to understand what happened, and what we can do about it. Are banks really bad, the main source of all the trouble we have gone through? Or were there some more fundamental and wide- ranging problems that need to be addressed?
This is a discussion that we expect to play out over several years—and my goal is to make a small contribution this morning. To do that I’m going to begin by taking a very quick look back at what I think happened five years ago. And I’m going to try and identify a culprit—after all, there’s no good story without a culprit. Then I’m going to talk a little about the regulatory, political, and legislative response to the crisis, which is obviously ongoing—and about the response of the banking sector and globally important financial institutions to the Dodd-Frank legislation in particular, and to the prospect of further regulatory change. And then I want to comment on Morgan Stanley’s response—about whether it’s been enough, and, if not, what more needs to be done. Finally, at the end of my remarks, I will announce a new initiative at Morgan Stanley that we’re doing in collaboration with Columbia Business School.
So let’s start by looking back and trying to understand what happened. My simplistic explanation—and I know I’m leaving out some important historical information here—is that bank balance sheets became over-levered with more and more illiquid risky assets. As time went by and it became apparent that some of those assets were problematic as well as risky and illiquid—and therefore difficult to sell at anything close to fair value—banks started taking losses to their capital. And their capital bases were already pretty thin to begin with, since in most cases they were operating with leverage of about 30 times. That kind of leverage means that if you write off just over three percent of your balance sheet, you also write off a hundred percent of your capital. So it didn’t take investors and creditors very long to figure out that banks’ over-levered balance sheets—in combination with assets that were illiquid and far from robust”—had exposed them to the risk of running out of capital and going out of business.
For financial institutions, of course, maintaining the confidence of investors and depositors is critical. Even the most conservatively capitalized institutions are levered at least ten times, which means they can afford to lose only ten percent before they become insolvent.
And it was that concentration of losses to capital in already overleveraged institutions that created a crisis of confidence. The essence of the financial crisis was a crisis of confidence.
You’ve all seen the Jimmy Stewart film, “It’s a Wonderful Life.” When Mrs. Jones wants her money, the teller tries to explain that it’s been lent out to Mr. Brown, who in turn used it to buy a house—and so we don’t actually have the money here.
Banks are conduits. They don’t keep most of the cash their depositors give them. So when there’s a crisis of confidence and everybody wants their money, you have a liquidity problem. And if the crisis of confidence becomes deep enough, you get a good old-fashioned run on the bank. Once you’ve had a run on one bank, people start to look around and say, “Well, how good are the other banks?”
It’s a bit like the pattern of planes landing at Newark airport I used to see when working on the west side of our building on 48th and Broadway. You could see all of the planes coming from upstate New York through to Newark. There was one about to land at 1000 feet off the ground. There was another one at about five thousand feet, probably five miles away—and yet another at fifteen thousand feet, maybe ten miles away. The first plane, I thought to myself, was Bear Stearns; they sort of hit the tarmac, the rescue crews were there and scraped them up pretty quickly and shuttled them off to a very wealthy hanger over in the corner and cleaned them up. The next one to come in was Lehman and things didn’t go so well. Then came Merrill Lynch, which worked out okay. But, of course, they got a good deal of help landing—but then they got moved off the scene and had their wings clipped.
But eventually the crisis hit every financial institution. Anyone who says that this crisis didn’t affect them has a fundamental lack of understanding of what a liquidity crisis is. It affects the whole system and, ultimately, it undermined confidence in the U.S. financial system and everything that we stand for. Which is why the U.S. government acted as it did. We can all argue whether it was done right, whether we should have done it with Bear or with Lehman, and whether they could have taken different steps than they did. But what they did with the various interventions, most notably the Troubled Asset Relief Program (TARP), ended up working; it succeeded in restoring confidence. And we have to give them credit. As I’ve said publicly many times, what Treasury Secretary Paulson, Chairman Bernanke, and head of the New York Fed Geithner did was very courageous.
So, that’s what happened: We had a run on the banks, it escalated, and the government stepped in and stopped it. In the meantime, there were failures, and forced mergers. There were restructurings and recapitalizations. All of that has taken place in the past five years, in Europe and in the U.K. as well as the U.S. Interestingly, such failures and restructurings did not happen in certain other heavily banked markets with very large banks, notably Canada and Australia. Although I won’t go into the whys and wherefores, the success of these other banking systems in weathering the crisis raises a fundamental question: Did our system nearly fail because our banks are too big?
My sense is that the crisis had almost nothing to with the size of U.S. banks. It was actually the smallest of the large U.S. financial institutions that got into the most trouble. Among the biggest U.S. banks, it was in fact the largest— JPMorgan Chase—that saw the least destruction of value during the crisis. And as someone pointed out to me, Chase’s balance sheet is by no means the world’s largest; in fact, it ranks eighth—and it’s the only U.S. institution in the world’s top ten.
So, again, I don’t see the size of our banks as the culprit. For historical reasons, the U.S has the most fragmented banking system in the world. In the mid-1980s, we had over 15,000 banks; and though their numbers keep coming down, we still have 7,000 banks—the vast majority of them are quite small.
By contrast, in Australia, where I grew up, essentially four banks have some 85 or 90% of the total deposits. And much the same is true of most of the world’s other countries, including France, Japan, and Canada—and the Swiss banking system is even more concentrated. In the U.S., by contrast, no single bank has more than 10% of total deposits. And despite all of the rhetoric in the press, our 7,000 banks suggest that the U.S. has by far the most dispersed and diverse financial system in the world.
So, again, it’s hard to blame the crisis on the size of our banks, especially given the success of countries like Canada and Australia with much greater banking concentration in avoiding the crisis. As I said earlier, it was the smallest of the large U.S. institutions that got into the greatest trouble. And the U.S. government was eventually forced to rely heavily on the largest U.S. banks when bailing out these troubled institutions—with the net result that the biggest banks got only bigger.
But what about the complexity of the institutions? Was that a major part of the problem? There I think the answer is “yes and no.” Being a large complex institution does not in itself make it unmanageable, as evidenced by many great banks in this country that did not get into trouble during the financial crisis. JPMorgan Chase and Wells Fargo are good examples. There were large complex institutions that did just fine. And, as I just suggested, they were eventually seen by regulators as saviors, as a major part of the solution.
On the other hand, I think there were a lot of institutions that had not properly grown up from their days as Wall Street partnerships, when their capital was their own money. When these partnerships suddenly became public companies—and I think DLJ was the first to go public, and then Merrill Lynch—they didn’t necessarily put in place all the gates that you would if you were a true public company. They continued to rely on aspects of the partnership model, but in a public company spectrum with much larger balance sheets and little if any of their own capital at risk; it was now somebody else’s capital. In some important ways, the Wall Street fraternity had not grown up quickly enough with the size of their institutions, particularly in terms of developing risk management processes and controls.
Another possible culprit is bad strategic decisions by management. If you want to understand why some institutions failed and not others, I think you will find that management was part of the problem in most of these instances. In some cases, institutions loaded up on and levered a particular type of asset—or they decided to expand aggressively by buying institutions they failed to do enough due diligence on. A good example of the latter was Wachovia’s acquisition of Golden State. Golden State had about $120 billion of option-ARM, or “pick a pay,” mortgages. They were so highly leveraged that, if you took a twenty-point mark on them, you had a $24 billion dollar capital hit. Wachovia did the acquisition mainly because they wanted to be a national bank—and to be national in this country, you have to be in California. And not too long after the deal closed, Wachovia found itself marking down these option-ARM mortgage portfolios and wiping out their capital base. That was a management decision; they didn’t have to do that.
And there were some other kinds of bad management decisions. For example, some failed institutions passed up opportunities to act preemptively by selling off assets at maybe not the optimal prices, or the prices they wanted, but at prices that would have saved them. So, don’t underestimate the ability of management to really screw things up. Especially when you are talking about financial institutions, management can really make a difference.
But, again, there was no single culprit in this crisis; there were a lot of contributing factors. But at the core of the problem was what I said earlier: When you use very high leverage on very thin capital bases to acquire risky and illiquid assets, then if any shock hits the system you’ve got a problem. The smaller and more concentrated you are, the bigger the problem that you have got. And that’s pretty much what happened, though with varying degrees of damage, to virtually every large financial institution in the U.S., and many if not most in Europe as well.
What has been the regulatory and political response to the crisis? A lot of people have complained that no one has gone to jail for these particular activities. But to go to jail you have to commit a crime. And the last time I checked—and for good or ill, I started my career in Australia as a lawyer—to have been proven wrong or incompetent, or to have taken on too much risk, are not criminal activities. So, there’s a reason why people convicted of insider trading are going to jail, and why executives who oversaw institutions that failed or needed help aren’t going to jail. Of course, I can’t speak for the entire industry. But I think that, on the whole, the finance industry in this country “works”—and it works in part because we have an effective legal system. The possibility of regulatory fines, penalties, and class action lawsuits is one important way of keeping business honest, of deterring fraud and other kinds of inappropriate activity that are bound to show up from time to time. And it’s important that financial institutions—and their top executives—that are convicted of such activity are made to pay back to society for their wrongdoing.
On the regulatory side, I think of the U.S. system as a pair of bookends with a continuum in the middle. Bookend number one consists of the changes on the front end, the preventive measures that can be illustrated by changes in capital and liquidity requirements. The regulators have effectively said to the banks, “We know that capital and liquidity were too small, and leverages positions too large, so let’s set some rules to stop that from happening again. If your capital ratios were five percent, they are now ten percent. If your leverage was 30 times, it’s now 15 times. If your liquidity was five percent of your balance sheet, it’s going to be 20 percent.” The regulators of U.S. banks have been aggressive in proposing and implementing these kinds of changes. And although this has clearly improved the safety of the financial system, it has created some challenges for the banks themselves. If you double your capital but earn the same amount of money, your ROE has just dropped by fifty percent. The stock analysts who follow the banks say that the banks’ ROEs aren’t high enough. But the ROEs are low today not necessarily because the banks’ operations are not profitable, but in many cases because they are now carrying massive amounts of capital.
So the regulators have put in place a new set of protectors, or preventive measures, at the front end. At the same time, they have put in a back end that is meant to deal with the possibility of financial trouble. They have said to the banks, “Let’s assume our new capital and liquidity requirements aren’t completely effective, and we have to unwind an institution or put it in a bankruptcy or resolve it by selling off pieces. Do we have a process for doing that? Do we know what all the legal entities are globally? How do we run that very complicated set of legal entities through a machine that helps us sell them off, unwind them, and effectively put them into bankruptcy? These are important questions because, as we saw in the case of Lehman Brothers, there was a major problem, particularly in the U.K., in releasing capital that was “trapped” on its balance sheet.
So that regulatory response at the back end has taken the form of a resolution plan for banks. The plan has been put together by the FDIC in collaboration with the Bank of England and our Federal Reserve. The regulators have told the banks, “We will walk into your institutions and if those gates that you put up at the front don’t work, and the bad stuff is happening, here’s how those problems will get resolved. Here’s how any problems at Morgan Stanley will get worked out.”
So the government and the regulators have put in place new front-end requirements that are designed to keep banks from getting into financial trouble. And they have developed a plan to deal with any cases where the new requirements fail to keep institutions out of trouble. And in the meantime—in between these front and back bookends, if you will—all large banks also get a report card once a year from the Federal Reserve known as a “CCAR” (Comprehensive Capital Analysis and Review) that requires the banks to put their businesses and balance sheets through stress tests that are worse than the financial crisis we just went through. The point of these tests is to see if banks would survive a theoretical set of scenarios, with survival defined as a capital ratio that never falls below five percent.
So, the new regulatory regime consists of three main phases and sets of requirements. At the front end, you have some blunt instruments that say that banks have got to have more capital, more liquidity, and less leverage. The back end says that, if God forbid, this thing doesn’t work for some banks, there’s a way to unwind them. And in the middle, we have annual report cards that give each bank a “score.” That score dictates whether the bank can do buybacks, acquisitions, or pay dividends—or whether it has to raise more capital instead. And that three-part regulatory model is now starting to be rolled out globally.
And let me stop here and say that I don’t think it’s well understood just how effective and important this response by our regulators has been. In my opinion—and I obviously have some reservations about parts of the new regulation—a robust response by our regulators was clearly necessary. We can’t afford another financial crisis of the magnitude that we just had. It caused the country to go into a recession, it caused a lot of people to lose their jobs, and it caused a lot of people to lose their homes. It caused a lot of pain and hardship.
And when evaluating the government’s overall response to the crisis, let’s not forget the effect of its actions on U.S. taxpayers. By that I mean TARP, the money that was given partly to banks to recapitalize them to the point where they could go out and raise their own capital. First of all, most people seem to have forgotten that most of the $700 billion did not go to banks. The amount that went to the banks was about $245 billion; the rest went to GSEs like Fannie and Freddie, insurance companies, auto manufacturers, and so on. And the big banks all paid back TARP, as they should have; that was their responsibility. And the banks ended up providing taxpayers with a high return on investment in the form of interest payments and warrants. In the case of Morgan Stanley, the return to taxpayers was 21%. And that was completely appropriate; taxpayers deserved a sporting return for underwriting a big risk. The smallest hundred or so banks still owe about $2.7 billion. But I think it’s important for people to recognize that the capital provided to the big banks was all paid back—and to commend the foresight and persistence of the government officials whose work helped make it possible for the recovery of the banks to be strong enough that the money would get paid back—and, as I said, with a high rate of return built into the payback. It proved to be a wise investment of taxpayer funds; and if it had not been done, the damage to our economy—and the global economy—would almost certainly have been much greater than it turned out to be.
But what about Morgan Stanley, how did we respond to the crisis? We responded, frankly, in a way that was very much in the spirit of, and which anticipated many of, the regulatory changes. We like to think we did some of these things before our regulators told us to do them because we were sufficiently introspective or self-aware to know that we had to make the changes. For example, we didn’t need someone to tell us that we were undercapitalized, and so we went out and raised a lot of capital. And as a result, we now have two very large investors: China Investment Corporation (CIC), which is the sovereign wealth fund of China; and Mitsubishi UFJ Financial Group, the largest Japanese bank that now owns 22% of Morgan Stanley in a unique global partnership.
So we’ve created strength and stability at the front end. Our liquidity at the time of the crisis was about $80 billion on a balance sheet of $1.25 trillion. It’s now about $180 billion on a balance sheet of about $800 billion. Our leverage at the time was about 35 times; it’s now about 12 times. Our capital was $30 billion; it’s now $62 billion.
So, we have put up a lot of strong barriers at the front because I can assure you that we don’t want to go through this again. And we have also just completed our resolution plan for the regulators. I’m sure we’ll get some feedback as to whether it’s sufficiently robust or not. It’s thousands of pages, and we’ve had a lot of folks working on it, so I feel pretty confident that we will get it done in a way that proves acceptable. And also encouraging, we’ve gotten high enough marks on our annual “CCAR” that we have been given permission by the regulators to do two things: One is to commence a stock buyback program, which we’ve done very modestly. Second, we completed our acquisition of a wealth management business that we’ve been working to buy in a complicated deal with Citigroup over the last four or five years.
As a result of this acquisition, we are now one of the world’s largest wealth managers, which gives us balance and stability. We have shut down all of our proprietary trading positions, and so our Institutional Securities business now just serves clients rather than taking principal risks. And it’s that combination of new safeguards and a contingency plan to deal with trouble that has made us a much stronger and more stable financial institution. So, we have a lot more capital and liquidity to keep us from getting into financial trouble, annual check-ups to ensure that we stay on track, and a solid resolution plan if, God forbid, the economy does an abrupt U-turn and we suddenly need to recapitalize again.
And let me just say that the past four years have been a journey. A lot of very, very complicated and difficult decisions were made during that period. As I like to tell people, I was a strategy consultant at financial institutions for much of my professional life. But at Morgan Stanley, we probably made more fundamental and important strategic changes in the past two years than I saw those institutions as a group accomplish in over two decades. So, thinking and talking about strategic choices is one thing; but actually making a major strategic change at a large financial institution—and dealing with the second-guessing and other consequences that are bound to come with it—is another experience all together. And it’s nice to see when it all plays out.
But the most important part of my message this morning is not about Morgan Stanley. The real story is that the U.S. financial system is now, I believe, safe and sound. It’s a credit to the regulators, and it’s a credit to the institutions themselves—and it is a reality. Of course, this is not something that everyone wants to hear. A lot of folks want to continue to believe that the banking system is in trouble. But it’s no longer true, certainly not in this country. And I’m not talking about profitability; I am talking about the financial strength, stability, and soundness of our financial institutions.
But, let me also concede that if you got most of your information about the financial system from reading newspapers or listening to talk shows, you would conclude pretty quickly that the world doesn’t agree with me on this. And I’d like to spend a minute or so talking about the popular perception of banks. Why is it that the world doesn’t think that today’s banks are sound? And what is the social role of banks? What are the good things they do for us that would justify regulators’ efforts to save them during the crisis?
These are all difficult questions. My rule in advertising is that if the world doesn’t think highly of you, the more you advertise to them, the more you are almost certain to irritate them. If there’s been some problem—say, a run of accidents—with a car or tire manufacturer, running glossy ads about what great cars or tires you make is not likely to persuade people to take your side.
The banking industry has been beleaguered by criticism— some of it justified, but some of it not—and handicapped in its ability to put out a forceful response. When a response has been put out, it has been seen as either defensive, or dismissive of real problems. Or, it has been ignored by regulators who are either under too much pressure from their own critics to listen, or who view their main goal or mandate as protecting consumers against big business.
If the industry is to make an effective response, it seems clear to me that the response has to address the question: Why do banks matter? The answer has to begin with the basic function of the industry, which is to mobilize capital. You can’t take capital out of capitalism. We as a society need banks to match savers and borrowers, investors with money to invest and companies that need capital. Providing hundreds of billions of dollars to today’s large multinationals is just not going to happen with a bunch of small banks. And in terms of meeting global competition, U.S. banks, for all their recent failings, have continued to succeed in—if “dominate” is not the right word—a number of important categories of financial products and services. And why we would want to cede that competitive edge to other nations in the name of smaller banks makes no sense to me. There is no compelling argument—no theory or body of evidence—that says that our financial institutions are too big.
In fact, all my observation and experience suggest that the reverse is true. As I mentioned earlier, the concentration of banks in this country doesn’t come anywhere near the concentration of the industry in almost every other country in the world. That’s an inconvenient truth, as Al Gore would say. The size of our banks doesn’t begin to approach the relative size of the banks around the world. As I mentioned earlier, the four biggest banks in Australia are enormous relative to their home economy. Keep in mind that Australia’s got a population of 20 million people, and an economy as big as New Jersey and half of Pennsylvania. It’s got four very large banks that are very well run. And those banks do a great job of accomplishing the basic functions I cited earlier: matching savers and borrowers, and matching investors and corporations seeking capital.
So, we need to think about how to get the balance back into what the banking system is doing for society. We had representatives from Twitter in our office the other day to talk about the launch of the road show for their initial public offering. Without large and successful banks, we wouldn’t have these kinds of companies being able to access the capital markets. In fact, most of the developing countries around the world are trying to develop what we have—that is, robust capital markets, with a sourcing and trading capability that would enable their companies to source enough international capital to support their growth.
Banks, then, are very important. It’s a good business— one that creates enormous employment in this country. Morgan Stanley itself employs 56,000 people, the vast majority in the U.S.—and we are tiny compared to the largest U.S. banks, some of which are now employing over 200,000 people. The banks throw off a lot of tax dollars, which help to build our communities, and pay for our police forces and other services. And so we have got to find the right balance between our taxpayers’ concern about the safety of our banks—and that is a line that cannot be crossed; we never want to go through that kind of crisis again—and the ability of what has been a highly competitive and successful industry to perform its social function in linking savers and borrowers, investors and enterprises. Banks need to be able to function well, to do what they do, so that the private-sector businesses that are the main source of social wealth—the ultimate source of funding for most of our social programs—can grow the way they have in the past, and will need to do in the future.