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The Resilient Bank of the Future

Martin Pfinsgraff, of the OCC, outlines the vital function banks play in supporting the economy and discusses how lessons learned from the 1984 bank failure of Continental Illinois National Bank & Trust Co. can be applied today.

By Martin Pfinsgraff

I believe banks provide a vital function in supporting economic and community growth, and so I felt fortunate to get a job in banking shortly after I graduated from college. Not long after I began work, Continental Illinois National Bank & Trust Co. failed in 1984, the largest such failure up to that point. It was a poignant moment for senior managers in the banking industry because they held Continental in high regard. In fact, many regional banks aspired to be like Continental, which appeared to have a winning formula. 

After the failure, many asset-liability managers studied what happened at Continental, including my team at Mellon Bank. We found that there were many contributing factors behind Continental’s demise. But the bank’s extraordinarily rapid asset growth in the preceding five years – which indicated a lowering of credit underwriting standards – combined with its very high reliance on hot money proved a volatile mix. That was striking for us, because Mellon also relied heavily on wholesale funding and had recently installed a more aggressive senior management seeking to enhance the bank’s position as a “super regional.” The fact that Continental had been viewed as the model super-regional bank was not lost on our team. 

Mellon was not alone in depending on wholesale funding. The same was true for other regional and money-center banks at that time. Reliance on wholesale funding was most acute for banks operating in states that did not allow intrastate branch banking. Subsequently, there was a concerted effort to alter statutes and regulations to permit intrastate and eventually interstate branch banking on the premise that it would broaden the ability of financial institutions to secure more stable funding and reduce the likelihood of another Continental. For asset-liability managers of that era, this relatively simple ratio was developed, which became the Holy Grail:

Asset-liability management (ALM) ratio: 
Core deposits + long-term debt + equity + liquid assets = 80% to 90% of total assets

The gist of the ratio was that to the extent that a bank’s long-term funding sources were insufficient to cover its long-term or non-marketable assets, there needed to be readily liquid assets to meet the shortfall during a time of stress. Those liquid assets included the securities portfolio, usually comprising of Treasury, agency, and municipal securities, and short-term interbank placements that could easily be run off. Some amount of funding risk was acceptable, but if you had a combined asset-liability management ratio of less than 80% to 90%, there were increasing degrees of funding risk – that is, “run risk.” If a bank had a ratio above those levels, it was thought that management would have sufficient time to sell assets, raise capital, or avoid forced liquidation of assets at distressed pricing during an idiosyncratic or systemwide stress event. Since most banks were operating at less than half that target, achieving the minimum threshold was challenging and elusive.

The ALM Ratio and the Last Crisis
How does this relate to the more recent financial crisis that resulted in a steep, global economic slowdown and the failure of Lehman Brothers, IndyMac, and other domestic and foreign financial institutions? Unfortunately, the lessons learned from the failure of Continental did not persist, particularly with respect to rapid asset growth and in the context of the ALM ratio. 

Credit risk in the banking system experienced robust growth in the years prior to 2008, and large banks acquired a number of distressed firms during the financial crisis. While those acquisitions prevented failures that would have been hard for the system to absorb, the acquiring banks took on liabilities and operating risks that proved to be extraordinarily costly to remediate. 

The ability of the banking system to absorb a shock on its own is the strongest it has been in my career.

Just how costly has it been? Banks regulated by the Office of the Comptroller of the Currency (OCC) incurred nearly $120 billion in cumulative fines, settlements, and penalties from 2010 to 2014, with approximately 90% of that amount attributable to mortgage foreclosure, servicing, and underwriting issues. These numbers do not include the billions in asset write-downs, operations, systems, and human capital costs to fix root causes. 

Unfortunately, as stresses in the subprime and high-yield markets became more severe, turning previously liquid assets into illiquid assets, banks and non-banks alike were vulnerable to deposit outflows, similar to those that beset Continental in 1984. Wachovia – an OCC-supervised bank, which had acquired Golden West, one of the largest subprime mortgage lenders – was a victim of an old-fashioned liquidity crisis, as uninsured deposits – the hot money – quickly fled the bank. Wells Fargo subsequently acquired Wachovia and absorbed those losses, avoiding a potentially costly resolution.

Likewise, Bank of America acquired Countrywide, the largest originator of subprime mortgages, and subsequently acquired Merrill Lynch, a large integrated originator and securitizer of subprime mortgages. JPMorgan acquired Bear Stearns and Washington Mutual in 2008, both heavily concentrated in subprime lending. But when no white knight appeared to rescue Lehman Brothers, it failed, and confidence in the financial system was fractured. The rest, as they say, is financial history. Government stepped in to stabilize the financial system, which ultimately led to the financial reform legislation included in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. 

Impact of the Dodd-Frank Act on Bank Resilience
There has been much discussion regarding the improved resilience of the industry to sustain another stress event since the passage of reform legislation. Certainly, stress tests such as the Comprehensive Capital Analysis and Review (CCAR) and Dodd-Frank Act stress testing (DFAST) imposed on systemically important financial institutions have become more robust exercises, with banks and regulators expending considerable resources annually to prove that banks can withstand a material stress event of equal severity to the last crisis. Complex rules governing derivatives, securitizations, capital, liquidity, and trading operations have been implemented with full impact not yet tested.

I would offer the simple ALM ratio developed after Continental more than 30 years ago as another credible barometer of industry resilience.

As the table shows, in 2007, nationally chartered organizations supervised by the OCC with assets greater than $50 billion, which included most of the largest banks in the United States, collectively had an ALM ratio of 52%. That represented approximately a $2 trillion to $2.5 trillion shortfall relative to the safe operating levels of 30 years ago. It was a meaningful shortfall that contributed to the perception of run risk at that time. Today, those same institutions have a ratio of 96%, representing negligible funding risk and a $5.8 trillion improvement. That 44-point swing in the ratio is, to be understated, not trivial. It represents a dramatic reshaping of the balance sheets of the banking system, particularly for the largest, most systemically risky banks. The ability of the banking system to absorb a shock on its own is the strongest it has been in my career. 

That is not to say that stress, particularly a severe across-the-board drop in asset values combined with a sustained economic recession, would not cause losses. Banks take risk across the spectrum of financial assets that fuel the economy, and losses could materialize in a severe economic downturn. That is evident in the annual CCAR/DFAST stress test scenarios that the OCC and the Federal Reserve Board oversee. However, the capacity of banks to absorb losses and have sufficient time to implement contingency plans without fear of a run has been strengthened dramatically. 

There is a tendency to focus on individual components of the ratio – equity capital, liquid assets, core deposits – and to lose perspective on the impact that regulatory reform has had in aggregate. I believe that the ALM ratio provides a simple and effective means of capturing the improvement to the banking system’s financial strength following the last crisis. 

Similar Risks and New Constraints 
What about future stress events? We are approximately seven years into an economic recovery, and the OCC’s Semiannual Risk Perspective along with recent speeches by Comptroller of the Currency Thomas J. Curry have highlighted our concerns about deteriorating credit underwriting standards and increasing credit risk. 

The OCC is not alone in voicing concerns. We are witnessing a significant increase in geopolitical risks that may affect global economic growth, and we have seen an increase in market volatility across commodities, currencies, equities, and more vulnerable emerging markets. While U.S. economic growth is projected to remain above 2% near term, risks are growing, which is not unexpected at this point in the credit cycle.
 Where is risk concentrated today? Credit growth over the past 10 years in depository institutions has been relatively modest compared with the run-up to the last crisis. Non-bank financial institution total assets (that is, shadow banking) have grown by $18.3 trillion compared with $5.5 trillion in depository institution growth and $3.6 trillion in central bank growth. 

Recall in the ALM ratio that the banking system has significantly increased its holdings of high-quality liquid assets, tripling them to 27% of total assets during this period. Because of growth in high-quality liquid assets of approximately $2.0 trillion, loan growth in the banking sector has been more muted. Thus, similar to the last crisis, the greatest likelihood is that when stress develops, it will most likely arise in the non-bank or shadow-banking sector, which is estimated to be nearly four times the size of the traditional banking sector. Precisely how or in what asset categories is not known, though we are seeing some indications of what can occur in the high-yield sector today. 
The risk, as always, is that there could be significant declines in asset prices leading to a loss of confidence and a recession. The duration and severity of any recession would, in part, be driven by the duration and severity of declines in asset values. The sooner asset values find bottom and stabilize, the sooner investors and lenders will commit fresh capital and liquidity to support growth.

New and existing hedge funds have often been the purchasers of distressed assets, helping to establish a floor upon which new investment can proceed more safely. However, the magnitude of asset deterioration in the last crisis overwhelmed the capacity of that source of purchasing power. The primary source of liquidity to stabilize values in the most recent crisis was the U.S. Treasury and the Federal Reserve, which acted through various programs such as the Troubled Asset Relief Program, the Term Asset-Backed Securities Loan Facility, the Primary Dealer Credit Facility, and the Asset-Backed Commercial Paper Money Market Fund Liquidity Facility. That massive intervention has been the subject of considerable debate. 

 Will the next stress event be triggered by events in China? Europe? Or perhaps North America? Who will stabilize asset prices to restore confidence, new investment, lending, and growth? What if hedge funds and exchange-traded funds, two sectors that have experienced rapid growth, are net sellers of assets? Central banks around the world, including the Federal Reserve, have expended significant resources after the financial crisis in support of economic recovery. As noted above, the Federal Reserve has increased its balance sheet fivefold. Yet, by comparison, Federal Reserve Bank growth looks modest compared with Japanese and Swiss central banks when calculating balance sheet growth as a percentage of gross domestic product, implying some capacity to grow further if necessary. 

An emerging concern in the market today is liquidity, market liquidity, and the potential for severe price discontinuity or an extended period of heightened volatility during a period of stress. These concerns exist for less-liquid markets such as high-yield bonds, as well as for traditionally deep markets such as U.S. Treasuries. 

ALM Ratio and the Next Stress Event
If economic cycles hold true, we will approach another stress event at some point. Timing and magnitude are never certain, and one would hope that actions taken to bolster banking system resilience will mitigate the duration and severity of the next downturn. The ALM ratio developed after the failure of Continental indicates that large banks have significantly greater resources to withstand potential stress today than in 2007. Central banks, including the Federal Reserve, appear to have more constraints, both law- and balance-sheet driven, on their ability to support stressed markets. As in 2007, the non-bank sector is the most likely source of contagion risk. 

What, if any, role can strongly capitalized, highly liquid banks play in the next stress event? It is highly unlikely that banks would consider reprising their role from the last crisis by acquiring troubled entities. Given their most recent experience, the potential liability and damage to their reputations would suggest that is not an option that management or boards would consider seriously. 

I am hopeful that there will be some opportunity for strongly capitalized, highly liquid banks to play a role in accelerating stabilization of asset prices and market function, necessary prerequisites for any subsequent economic recovery. Indeed, the Federal Reserve has built a modest growth assumption for risk-weighted assets into its CCAR stress test for the past two years. The aim is to ensure that there is sufficient capital in place to support growth during periods of stress and when the economy is most in need of stimulus. It is a policy issue for regulators and a risk management issue for banks that deserves more discussion. At the OCC, we would look forward to engaging in that discussion with the industry and our regulatory peers.

About the Author:
Martin Pfinsgraff serves as the Senior Deputy Comptroller for Large Bank Supervision in the Office of the Comptroller of the Currency (OCC). Pfinsgraff is responsible for supervision activities in the largest national banks and federal branches and agencies, and oversees operations of the International Banking Supervision group and the OCC’s London office. He also serves as a member of the OCC’s Executive Committee and the Committee on Bank Supervision. He assumed these duties in July 2013. He served as acting Senior Deputy Comptroller for large bank supervision from February to July of 2013.

Pfinsgraff previously served as Deputy Comptroller for Credit and Market Risk since January 2011 and served as co-chair of the OCC’s National Risk Committee. He has more than 30 years of experience in finance and risk management across the banking, insurance, and securities industry. Before joining the OCC, he was the COO for iJet International, a worldwide risk management company. He also served as President of Prudential Securities Capital Markets, Treasurer of Prudential Insurance Company, and Managing Director of Prudential Investment Corporation. Pfinsgraff holds a master’s degree in finance from Harvard Business School and earned the Chartered Financial Analyst designation. He is a graduate of Allegheny College in Meadville, Pennsylvania.