View from the Top: A Prime Solution to the US Banking Crisis

The past several months have been a blur of activity. On the eve of Veteran’s Day, when Americans remember those who have served and have died to protect our freedom and our way of life, let’s take stock of where we are.

Following the takeover of Pasadena, CA-based IndyMac Bank in July, IRA launched our IRA Bank Cart (“How’s My Bank?”) product to help provide consumers with descriptive analytics on bank safety and soundness. We actually credit CBS’s Bill Whitaker for planting the seed. He interviewed us about four months ago and asked IRA CEO Dennis Santiago what to tell Mr. and Mrs. America about what’s actually happening inside their banks. We had to admit that around the time of that interview, the Do-It-Yourself solution was for individuals to learn to become better analysts at interpreting raw FDIC Call Reports, a skill even professionals on Wall Street were struggling with. With the failure of IndyMac, we got the message loud and clear that the non-analyst world needed better.

So our team in Torrance set to work assembling an affordable online report, via The IRA Bank Cart, that provides all customers of banks as much if not better information on the fundamental stresses affecting U.S. banking institutions than most financial professionals possess. Because most people can and do deposit money in all types of banks, we chose not to limit our coverage to just the largest publicly traded banks that the media and Wall Street follow. Instead we created a comprehensive analytical product covering the entire federally-insured bank population.

As part of the IRA Bank Cart tool, IRA also introduced our Bank Stress Index that measures five life critical aspects of the business of banking – earnings, capital, efficiency, losses and lending commitments. To build this index, we created an explicit census of US banks by calculating actual measures for every FDIC-insured unit for every quarter going back every year to December 31, 1995. Americans deserve no lesser diligence.

We combine these individual measures into an overall measure of stress – a ratings system in effect — for the entire US banking industry. The Bank Stress Index represents yet another distillation of the FDIC data by IRA and let’s all bank customers compare the relative safety and soundness of every active FDIC Unit Certificate Holder and the bank-only portions of all the Bank Holding Companies submitting periodic reports to U.S. banking regulators.

Corporations Get into the Act

In the two months since the Bank Stress Index product was introduced, a new need emerged, namely serving the cash management activities of corporate CFO’s and Treasurers. It actually first began when the IRA Bank Cart product was launched. Worried representatives of church groups and 501(c3) non-profit organizations actually came to call our offices in CA. These risk-averse investors were looking to reduce the deposit risk exposures for their treasury funds in the $1MM to $2MM range and were of a mind to spread deposits from 100% in a single institution to typically 20% to 34% per institution.

Remember, we did not have any retail customers prior to May of this year. Now we have thousands.

About a month later, we were working with reporter David Evans from Bloomberg Magazine on a story of about the banking industry. We also started to see evidence of increased activity in the use of brokered deposits to improve cash assets protection by persons and entities seeking to safeguard larger amounts. We featured just one of several such stories in the last issue of The IRA (“Brokered Deposit Risk Screening: A Case Study; Halloween in Washington”).

The enemy in all this is the systemic risk manifesting in the markets as all of finance moves down in unison in terms of effective leverage. By now it’s no secret that portfolio strategies are seeing growth assumption going down the no matter how noisy and volatile the roller coaster ride may seem. So we see people turning their attention to asset preservation. In many ways it’s not unlike looking for really big mattresses and mayonnaise jars.

Presently people seem to be migrating cash management towards mixtures of large deposit relationships to garner preferential treatment for business purposes combined with instruments with explicit full faith and credit guarantees namely positions in U.S. Treasuries and brokered deposits in FDIC-Insured deposit amounts. A cottage industry seems to be emerging for the latter.

The initial phenomenon was to take X million and split it into $100K chunks to chase the magical government insurance guarantee. As noted previously, these are corporate entities looking to set up stable long term strategies. Unlike worried consumers, the so-called temporary guarantees don’t seem to impress the corporate treasurer group as much. True to form money learns fast. A month later we are beginning to see people becoming even more sophisticated assessing the process.

The first pitfall people now want to avoid is “false spreading”. This is a condition where one starts with all your money in a bank that sports a bank stress index of say, for the sake of argument, 5.2 versus the 2Q2008 industry wide average of 1.4. Let’s say it’s a big name institution with credit crisis driven stresses such as Citigroup (NYSE:C). C is not a bank that’s going to fail per se, but the on and off-baance sheet stresses are enough – an overall Bank Stress Rating of 2.6 vs. 1.4 for the industry at June 30, 2008 — that it’s also probably not going to be as attentive and supportive of customer needs as it was in the past. And C may end up controlled by the Treasury by the end of next year. More on this next week.

C, like many other big name institutions, is seeing most earning being diverted into provisions for future loan losses instead of new lending, so don’t even ask the Citibanker for a loan. The larger banks like C see ROI possibilities on the deposit liabilities you lend them, but growing loan exposure on the asset side is not on the agenda for 2009.

So eventually you divide your money and place parts of it in other large name brand institutions – JPMorgan Chase Bank (NYSE: JPM) or Bank of America (NYSE:BAC). Both have lower Bank Street ratings than does C – 1.4 and 1.5, respectively, as of June 30, 2008. But the problem is that they all have above-normal stresses in areas such as loan losses for the same reasons as C. So while you have spread the “risk” among more accounts your cash still carries the same exposure to systemic stress.

Moving to higher quality but still large names like US Bancorp (NYSE:USB) or Wells Fargo (NYSE:WFC) gets you below the industry average Bank Stress benchmark of 1.4, but not by much. For many of our retail customers being below 1.0, the 1995 base year of the Bank Stress Index, is where they want to be.

The second pitfall people are concerned with is “blind spreading”. This has to do primarily with brokered deposits. Roughly 3,400 bank units in the United States accept brokered deposits. Pretty much all of them meet the regulatory “Well Capitalized” test needed to do so. The test is one of the five areas of examined in the IRA Bank Stress Index, but not the only one.

Perfectly spreading cash among these 3,400 entities should result in money having an industry average indexed net risk profile. However no single program has access to all placement options. Some programs have relatively few deposit placement options and the risk profiles of their participants may be skewed. IRA’s assessment of the FDIC-insured banks accepting brokered deposits indicates half of them have exceptionally good risk stress profiles and the other half not so good.

The third pitfall is “over spreading”. Asset protection has opportunity costs just like any other activity. The more you spread the more you pay in costs both internally and in fees. Do too little and you’re over exposed to systemic risk. So finding a balance that fits one’s COSO “risk appetite” is going to be part of the “Next World Order” landscape in money management.

Targeting “net stress exposure” seems to be the next evolutionary step of the process. IRA’s Bank Stress Index, being a catalog of apples-to-apples comparable profiles of US depository institutions, allows such targeting to occur. We expect to see other fundamentals-based stress screening methodologies evolving in coming years, both for use by investors and regulators.

For certain risk adverse strategies, rules based “Lock Out” filters may make sense. These filters allow companies to declare what bank profiles are acceptable and which are not using a variety of criteria. These lists are then used to select which banks eligible for large placements and acceptable within brokered programs. The criteria can be broad or nuanced as required. But it’s documentable for COSO and Sarbanes-Oxley purposes and the continued monitoring and auditing of stress levels can be done to ensure each bank used remains within acceptable criteria.

Other strategies may be to actively manage and target net risk exposure to a benchmark. An example benchmark might be the previous quarter banking industry average stress level. A target point might be an X% cushion factor below it with an additional requirement that Y% of the assets be below a hard limit stress maximum of Z. The criteria can be further refined based on tailoring the contributing factors behind the overall IRA Bank Stress Index to suit specific scenario needs. Just as in the “lock out” approach the choice of position is based on COSO “risk appetite” and can be monitored.

Are Counterparties Next?

As we observe the learning curve of individual and corporate depositors develop, it strikes us that hedge funds and insurers need to assess and tailor their systemic risk exposure along much the same lines. They also need objective ways to determine their exposure to the risk roller coaster with regards to their banking counterparties. For that matter, so do banks with respect to each other, particularly so when it comes to the presently stagnant counterparty business of bank-to-bank lending beyond over night terms.

We believe it is critical to the National Interest to explore pathways to take the U.S. financial engine out of reactive mode and into a more proactive, transparent regime for measuring risk, from the retail consumer to the institutional fund manager or treasurer. We know that it takes top down solutions that enable change. We also know that this must be balanced by grassroots migrations of capital that leverage and accomplish that change.

And we repeat: the object of better analytics is to drive good money to good banks. If we want a stronger financial system that can support lending to the US economy, then we must see money go from bad banks to good. A diffuse migration of deposit assets from high stress bank placements to low stress placements repositions aggregate economic capital so that on the margin it can better support new lending as opposed to mitigating good money after bad situational stresses. That is what we at IRA call a “Prime Solution.”

Originally published on November 10, 2008 at The Institutional Analyst and reproduced here with the author’s permission.