Simpler Banks Favor Shareholders

Published by clickbroker.blogspot.com.

The New York Times’ “Ailing Banks Favor Salaries Over Shareholders” reports that while Goldman Sachs (GS) is paying out only 45% of profits in compensation, less fortunate institutions are paying out close to or up to more than their profits to keep up. JP Morgan (JPM) is paying out 63%, Bank of America (BAC) 88%, Morgan Stanley (MS) 94% and Citigroup (C) a whopping 145%.

Do shareholders really benefit from hiring the smartest men in the room? Obviously, when Goldman mixes high compensation with political connectedness the results are indisputable. But the imitators have all fallen short. None of Goldman’s competitors have been as astute at managing risk. Greed and jealousy had succumbed caution. But even to this day, I don’t see any signs of banks paying heed to the black swans and long tails.

Can Goldman be agile forever? I have no idea. It’s a little like believing that Warren Buffett’s brand is immune from being tarnished. Buffett has been working hard on CNBC to polish his brand and Goldman is trying to figure out how to match its behind the scenes political prowess with better populous appeal. While Buffettt readily admitted benefits from the Government bailouts; Goldman, like Federal Reserve Chairman Bernanke claimed they did no wrong.

It’s hard for me to believe that Goldman was not on the brink at the time of the AIG bailout, whether or not the pass through capital alone was a make it or break it. The short sellers were closing in when Goldman and Morgan Stanley finally called former alumni and Treasury Secretary Paulson for help. Goldman’s stock has since more than recovered on stellar earnings and the belief that the smartest guys are once again infallible.

Now we have President Obama and former Federal Reserve Chairman Paul Volcker calling for a return to basic banking for firms that either take FDIC insured deposits or have access to the Fed window. The 10% ceiling on the nation’s deposit base is proposed to include wholesale funding. Along with 0.15% tax on wholesale funding, this will make deposit taking far more attractive. So, whether through FDIC insurance fees or the tax on wholesale funding the government will now be compensated for “too big to fail” on the entire asset base.

Contrary to popular rhetoric, Goldman and Morgan Stanley will not escape by simply jettisoning their deposits or from their previous TARP repayments. They are both banks with Fed privileges. And Congress will counteract any manipulations to get a “too big to fail” credit enhancement for free.

It can be argued that banks that stop competing for the smartest or best connected guys will become utilities with little chance for explosive earnings. Volcker said the greatest financial innovation was the ATM, so let’s leave innovation to Silicon Valley. Instead, we’ll look at the investor benefits to large banks functioning as utilities.

Interest margin and transaction fees provide more predictable earnings than trading (with the exception of the golden one). New accounting and capital rules reduce benefits of off-balance sheet entities, forcing banks to keep more of the loans they originate. This should encourage more prudence. Earning linearity and lending prudence should lead to both higher stock multiples and dividends. Life as bank utilities could be very good for investors.

Implementing the Volcker doctrine appears to be problem prone after the government promoted megabank extremes during the forced mergers of the bailout panic. And separating trading for client service from trading only for the benefit of the house is nearly impossible. But I believe a line can be drawn between new issues and other broker/dealer operations.

I look forward to a Citigroup and JP Morgan without investment banking, and Goldman and Morgan Stanley not supporting deals with their own capital. Commercial banking capital should support commercial and consumer loans, not buyouts and hedge fund leverage. Investment banking capital should support client trading, not loans and “investments.”

A key reason why Citigroup was saved was to keep its worldwide payment processing system alive. This shows the relative value of the Citigroup commercial bank to the Citigroup investment bank.

Disclosures: Author long AIG, BAC, and C.

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