Misbehavioral Finance

Credit: McMillan

Question:  Why would a captain purposefully capsize her ship?

Answer:  Because the ship she is commanding was floating right-side-up in an upside-down world.


I've been keeping an eye on what is happening to the German Sparkassen to see how they are reacting to the Eurozone's (and particularly Germany's) negative nominal interest rate environment.  I would like to know what we, in the United States, can learn about the street-level structural business impact of the negative nominal interest rate environment on the community banking model.

The German Sparkassen can be viewed as a rough analog to community banks in the United States.  They are a network of 409 local savings banks that offer a full menu of banking services to individual persons and small-to-medium size businesses.  The major difference is the ownership structure, as Sparkassen are public-sector municipal banks and are not privately-owned.  They, however, compete with the retail operations of the large private banks in Germany.

Negative Interest Rate Policy (NIRP)

In the U.S., at the present time, we are fortunate to be only observers of the negative nominal interest rate banking phenomenon.  We have ring-side seats to the most dangerous monetary policy experiment in the history of modern finance.

NIRP is misbehavioral finance in action, plain and simple.  It can be likened to the Rosemary's Baby of monetary policy.  This experiment involves the corrupting, by mainly the European and Japanese central banks, of a core economic concept of what constitutes "money" in our society - money as a fundamental store of value.

When you have to pay someone to accept your money (that exists in the form of bookkeeping entries), then your money (that exists in the form of bookkeeping entries) does not have a stable value, it instead becomes a eroding asset which loses purchasing ability every day.

Money in the form of physical banknotes might seem to escape the corrosive centripetal force of NIRP, but the cost of storing, protecting, and insuring physical banknotes is itself a form of negative interest rate.  So people and companies in NIRP economies need to compare one cost to the other when making decisions about their money.

But all sorts of twisted, counter-intuitive behaviors occur in this NIRP environment.  For example, it has long been a basic tenet of finance that you try to defer paying your taxes for as long as it is allowable.  In the upside-down world of NIRP, it is better to prepay as many expenses as possible, including your taxes.

Governments, have traditionally had to pay interest for the privilege of borrowing when they spend more money than they take in from taxes and fees.  In the doppelgänger world of negative nominal interest rates, the marketplace pays governments to borrow more!  In fact in the first quarter of 2016, the German government made over a billion euro issuing negative rate debt.

Buying bank cashier's checks or bank drafts have been mentioned in the internet chatter as a way to avoid negative rates while avoiding the costs (and dangers) of bulk cash storage.  Is this the kind of unhealthy game-playing behavior we want to encourage?

What other kinds of weird behavioral finance distortions, yet to be appreciated, is NIRP giving birth to?

How NIRP is Affecting the Sparkassen

Nevertheless, my histrionics and prejudices aside, observing and learning how NIRP is affecting the Sparkassen could be instructive should the Federal Reserve ever be dragged toward negative nominal interest rates by the arsonous behavior of the central banks practicing NIRP or, even by the next recession in the United States.

In the United States, the banking system has occasional bouts with dealing with negative real interest rates.  That is, the nominal rate of interest less the rate of inflation.  Negative real interest rates are invisible, however, to retail bank customers because their nominal rates of interest (the interest rates they see printed on their bank statements) have, so far, always been positive interest rates.

Generally, banking is all about the spread, the margin; the difference between what a bank pays and what the bank receives.  In a normal, positive interest rate world, the bank pays for deposits and charges for making loans.  In the upside-down world of pure negative interest rates, the bank pays for loans and charges for deposits.  In the bizarre twilight zone that exists between those two states of being, banks would have negative deposit interest rates and positive loan rates - effectively taking in income from both sides of their balance sheet to make their margin.

The book-trained economists running the central banks that have signed up to NIRP blithely assume that their banks are as flexible as an Indian Yogi and can contort themselves into any form of pretzel to maintain their interest margins.

The Sparkassen are showing us a collision between the economist's academic theory and the customer's reality.  In the impure, real world we live in, the victim in the middle, becomes the bank and that raises further questions about whether NIRP also undermines systemic financial stability.

If a community bank levies an interest charge on its depositors (or attempts to cloak its intentions in the form of  "administrative" charges) that bank risks losing its key funding source and lifeblood.

On the other hand, attempt to raise the rates on loans and the bank risks being noncompetitive in the market.  So interest margins collapse and the viability of the traditional community banking business model comes into question.

In August, after finding its interest margin squeeze no longer tolerable, a tipping point may have been reached.  One community bank in Germany began charging retail customers for depositing money in the bank.  It would not, probably could not, shelter its customers from the European Central Bank's dysmorphic monetary policy and still stay in business.

Wolfgang Münchau, in the Financial Times (subscription required), summed up the conundrum:

"Of the German banks, the Sparkassen and the mutual savings banks are most affected. They are classic savings and loans outlets in that they lend locally and fund themselves through savings. Credit demand is more or less fixed. So when savings exceed loans, as they now do in Germany, the banks deposit their surplus with the ECB at negative rates — known as “penalty rates” in Germany. They cannot offset the losses by cutting interest rates on savings accounts because of the zero lower bound. Savers would switch from accounts to cash in safe deposit boxes."

Following on that thought, a related Financial Times article gives an example:

"In Dillingen an der Donau, a small town in rural Bavaria, the local Sparkasse savings bank is providing an unusual service. For customers who live a long way from a branch, it is giving out free bus tickets. And for those who cannot get to the bank at all — the old or sick, for example — it offers to send a member of staff directly to their homes to deliver small sums of cash.

The Sparkasse came up with the idea to compensate for the fact that it was closing several branches as revenues dwindled due to interest rates being at a record low and customers visiting less frequently. “If your revenues are shrinking, then you have to do something about your costs,” says an official at the bank. “You have to economise.”

The pressure on Germany’s army of savings banks is just one example of the increasing strains on the country’s financial system caused by the ultra-loose monetary policy of the Frankfurt-based European Central Bank.

In a bid to jolt the eurozone’s lacklustre economy back to life, the central bank has, over the past five years, slashed interest rates to record lows and even pushed its deposit rate into negative territory. On top of this, it has launched a €1.7tn asset purchase programme, which has driven down bond yields across the continent."

In it's 2015 Annual Report, BaFin, the German Financial Services Regulator said this about the Sparkassen:

"Most banks currently have sufficient capital to survive this period of low interest rates.  But earnings will deteriorate significantly if ­interest rates remain at these low levels – despite the positive economic conditions.  Even a rise in interest rates would not solve the problems immediately.  Banks that have focused heavily on maturity transformation, i.e. accepting short-term cash deposits and turning them into long-term loans, would only feel the effects after a considerable time lag.  A sudden sharp rise in interest rates would even exacerbate their situation.

BaFin looks across the board at what the institutions under its direct supervision are doing to counteract these problems.  Are they cutting costs?  Are they interrogating their business models and thinking of ways to expand their non-interest-bearing business?  Are banks offering their services on adequate terms and conditions?  It is also important to find out whether they strengthen their capital in a timely manner.  There are no one-size-fits-all solutions.

One thing is certain, however: it would be irresponsible to wait and do nothing, because there can be no reliable predictions as to how long the low interest rates will persist."

Accelerated Financial Darwinism

Add the post-financial crisis layering-on of increasing regulatory compliance costs, and the community bank model in Germany is under immediate existential threat.  For the Sparkassen, evolution must become revolution.

NIRP, new compliance requirements, as well as growing customer preferences for distance-banking services for routine transactions, are forcing the Sparkassen (like the captain at the beginning of this blog post) to have to flip their existing community banking model upside-down.

Instead of overlaying distance-banking technology services over an existing brick-and-mortar network (as is also the present community banking structure paradigm in the U.S.), the German community banks need to immediately consider a lower-overhead and smaller brick and mortar network that is sits on top of more cost-efficient technology-driven distribution channels.

These necessary strategic structural changes in the model of community banking in Germany should be a wake-up call for community banks in the U.S.  We, in the United States, have had the luxury of moving in an evolutionary fashion, with most community banks surfing the slow changes in their customer demographics at the pace of a leisurely stroll.

In the end, the pressures of a "Big Flip" in Germany means either extinction of a treasured form of banking, making the Sparkassen a quaint footnote in the history of banking in Germany or, alternatively, we will see its rebirth and revival.

I'm hoping for the latter.   As we are finding out in the financial press this week, relying on the German banking giants, Deutsche Bank and Commerzbank, is not a wonderful alternative.

The Nuns With Guns

Credit: Zerohero

Recently the Wall Street Journal ran a series of articles on the present state and potential future of banking.  One of the most intriguing articles in the series was one entitled: Nuns With Guns: The Strange Day-to-Day Struggles Between Bankers and Regulators. 

"The sobering reality of banking in 2016 is that lenders are awash in new regulations; and growing armies of rule-interpreters and enforcers -- for good or ill -- are bringing striking changes to banks' internal cultures."

The article goes on to note the significant hiring of new staff on the part of both banks and bank regulators to deal with the flurry of new regulations.  It also explores some of the psycho-dynamics that occur between front-line bankers and their own bank's internal compliance staff; and further, between both of those groups and the examiners from the multiple government regulators that may have jurisdiction over the bank or some segment of the bank's operations.  

Reportedly, in an exercise conducted during one Barclays PLC employee town hall, front-line bankers and bank compliance executives shared images of how each group thinks of the other.  Front-line bankers were viewed as "cowboys on horses with guns", while compliance executives were viewed as "nuns carrying guns".

The article was a public airing of an often unspoken and usually cloaked aura of tension that suffuses many of the relationships between these three groups today.  The Journal gave us all a quick peek at several internal banking business cultures that are characterized by anxiety, wariness, guarded comments, and over-cautiousness.  Business cultures which, in turn, exhibit a lamentable (and costly) hypersensitivity to both formal and informal communications with government regulators and internal bank compliance staff.

One particular sentence from the article speaks volumes about the situation: "Bank executives largely avoid publicly voicing frustrations with the regulatory regime, and most wouldn't comment on the record for this article."

This backdrop of hypersensitive preoccupation goes well beyond the set of bank operating deficiencies that rise to the level of being cited as Matters Requiring Attention (MRAs) by examiners.  MRAs are "must-do" priorities that obviously must be rectified in a timely manner by the bank.

No, that hypersensitivity even kicks in when there are informal recommendations and off-the cuff observations made by bank examiners.  Chalk it up to free-floating anxiety alluded to in the Journal article.  That anxiety results in resigned acquiescence by front-line bank staff which then prompts "abundance of caution" remedial actions on the part of the bank (with their associated financial expenditures).  These "nice-to-do" remedial actions, in turn, drive up industry-wide compliance costs much further than is really necessary.

And if that, by itself, was not enough; fanning the flames even more are my colleagues in the bank consulting tribe:

"You think compliance costs are high?  Well, they pale in comparison to the civil fines and costs to your reputation of non-compliance!"

This aura of tension and banker hypersensitivity seems, to me at least, to be the inevitable fallout from the fervid bank regulatory agency enforcement postures spawned by the 2008 financial crisis.  

The Evolution of Enforcement Postures

I lived through the financial crisis as a regulator and as part of the team that set up the initial operations of the U.S. Treasury Department's Troubled Asset Relief Program (TARP).  And I fully appreciate that the public's vocal demands for accountability, for both regulators and bankers, forced a re-evaluation of historical banking agency enforcement practices.  Agency enforcement activities moved from a policy of patient, calibrated escalation (beginning with moral suasion), toward a less tolerant, incident-driven policy of  "you've got one bite of the apple".

At the same time, the banking agency enforcement action decision-making process was being moved further from field offices and progressively centralized in geographically-remote district, regional, or headquarters locations in a trend that conflated the industrial concept of uniformity with the more custom-tailored concept of consistency.

Remote decision-makers, who have not had direct connection with the banks (and bankers) involved, tended to avoid the risk of giving bankers the benefit of the doubt on the close calls.  That's just a natural distance bias.  Plus, at the end of the day, regulators rarely get criticized for being too tough or conservative in their decision-making.

Like Agatha Christie's Murder on the Orient Express, where no one person committed the murder in question; no one or two items are expressly responsible for the evolution of the internal bank cultures explored in the Journal article... but the two I mentioned above are strong contributors.

But I will say this, unequivocally.   The enforcement environment has succeeded in frightening community bank boards of directors.   More often than not, community banks choose the costlier path of least resistance: "just do what the examiner suggests."

It is difficult to broad-brush this issue as many talented individuals, in both bank compliance departments and in the bank regulatory agencies, use their exceptional people skills to successfully manage through this issue and promote positive and productive relationships.  These people really mean that a "recommendation" is truly a recommendation, and a voluntary action... not a stealth requirement.


The Dangers of Regulator-focused Banking

I've explored the dangers of regulator-focused banking a few years ago:

" Historically, as a bank regulator and bank examiner, your job was to calmly officiate in the marketplace for banking services.   As a member of a rule-making body, subject to statutory guidance and notice-and-comment rule-making, you helped establish the dimensions of the ball field and rules for player behavior.

 In your day-to-day job as a bank examiner, you were also an umpire or referee on the field who monitored player behavior, called out-of-bounds play, and penalized some for personal fouls.  And as a corollary part of the job of officiating, you sometimes had to sideline someone from the field of play or, in grave situations, ask the Federal Deposit Insurance Corporation (FDIC) to carry an ailing player off the field on a stretcher.  

The game itself, though, was played by teams of bankers, doing what bankers do well --- making a visible contribution to a safe, sound, and prosperous banking system that is earnestly attending to the legitimate credit needs and healthy growth of the most powerful economy on Earth.

Like any sports competition, the fans show up to the game to applaud the performance of the players on the field and appreciate the quality of the game play.  Every fan knows that when the game's center of attention becomes the officiating, there is something grossly wrong with the game." 

Banking Industry Responses

Owing to the increased regulatory overhead and this notable hypersensitivity to communications from bank regulators, we are seeing at least a couple of reactions.

First, all across the United States, bank boards of directors are being stocked with former regulators to help boards navigate the psychology of the regulatory and bank supervisory process.  The practice is becoming more and more common.

Second, banks are steering their consulting needs toward consulting firms whose staff roster contains a healthy number of former regulators, particularly those higher-profile ex-regulators, who walked the beat in their respective agency's Washington, D.C. headquarters.

We have seen a similar phenomenon in the defense-industrial complex, where former executives of the Department of Defense join the upper echelons of large defense contractors in order to help them understand the "process" and to leverage previous personal relationships so as to better compete for lucrative government contracts.

But the big difference between this phenomenon as it is manifest in the defense industry, versus the banking industry today, is that in the defense industry, it is in the pursuit of financial gain, not the avoidance of pain.

An Added Option for
 CRA Investment Test Credit

March 1995 - Used with permission

It was 1989 when the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) amended the Community Reinvestment Act of 1977 (CRA) and required the federal bank regulatory agencies to publicly issue CRA ratings (using a new 4-tiered rating system) and disclose written performance evaluations that outlined facts and data to support the agencies' ratings conclusions.  It was a very controversial statutory provision, as it was the first time in history that Congress "opened the kimono" on one facet of the otherwise confidential bank examination process and mandated that CRA examination ratings and CRA performance evaluations be made public as a matter of routine.  

In 1990-91, I was Deputy Comptroller for Compliance Management at the Office of the Comptroller of the Currency (OCC).  All of the federal banking agencies at the time were tasked with making the FIRREA statutory mandate operational by updating the CRA regulations; designing the form and content of these new CRA performance evaluations; testing the revised process with sample CRA examinations; and then training bank examiners nationwide on how to prepare the new CRA public disclosures.  We worked very hard to get it right under some very tight deadlines.

It was during that challenging process that I first met Dr. Ken Thomas.  He was (and still is)  America's foremost expert on the formal requirements and the important nuances of the Community Reinvestment Act.  Over the years, Ken has consulted with numerous banks and thrifts on CRA matters.  That's him standing to the left of former Senator William Proxmire.  Senator Proxmire was widely-credited with being the Father of the Community Reinvestment Act of 1977.  

Ken was in the OCC's public documents room, making copies of all of the CRA Performance Evaluations from the first round of CRA examinations done by the OCC under the new mandate.  He was checking to see how the examiners' final work product comported with the new FIRREA requirements and how consistent the CRA ratings and performance evaluations were among examiners (and among agencies).  I found him to be both a knowledgeable professional and an amiable fellow.  We have stayed in touch over the 26 years that have passed since that time.

He called me last year to ask if I would be willing to serve as one of the independent trustees of a new CRA mutual fund whose investment objectives are to invest in debt securities deemed to be qualified under the Community Reinvestment Act so that financial institutions subject to the CRA could receive Investment Test or similar credit with respect to their shares in the fund.  The new mutual fund is called The Community Development Fund.  I won't talk about the fund itself as legally all of the talking needs to take place through the Fund's prospectus.  I have no financial interest in the Fund beyond the Fund's established trustee fees and reimbursement of any travel expenses to attend Board of Trustee meetings.

I knew that there are already a couple of  CRA mutual funds in this space, so I asked what distinguishes The Community Development Fund from the others.  There was an awkward silence as if I had asked a stupid question (which I immediately realized I did).  You see, as the fund advisor, fund investors have direct access to Ken's consulting support (and the benefit of his CRA credentials) regarding earmarked CRA investments in the fund.  As an additional plus, Ken is a director of a community bank and has been for many years... so that means he has experienced the real-life challenges of CRA compliance for banks and thrifts.

Over my 37-year career as a federal bank regulator,  I had met many accomplished and outstanding bank consultants, like Ken, and I had also seen my share of consultants who were, like Texans are fond of saying, "all hat and no cattle".   Knowing him for 26 of those years, I could confidently say "yes" to his offer.

Thank you for bearing with me during this long period of radio silence on this blog.  A wonderful family Thanksgiving weekend in Miami was marred when I took a spill while walking with my wife and shattered the bones in my right forearm and wrist... rendering me unable to write or type until recently.  A thousand thanks go to a superb hand surgeon, Dr. Benjamin J. Cousins, and the excellent staff at the Mt. Sinai Hospital in Miami Beach... and of course, to my wife Tara, who is living the vow "for better or worse", and doesn't like it one bit!

Playing the Island Green

I always liked the concept of the "island green" in golf. It encapsulates, in one picture, the psychic dynamics of risk management in banking these days. A narrowly-defined field of play, with a pin (flag) in a cup, surrounded only by hazards. The objective? Put(t) a 1.68-inch golf ball into a 4.25-inch golf hole cup from a long ways away.

There is no neatly-clipped grass fairway to ease your forward progress, only the faint ovoid shape of the island putting green in the watery distance.  In some of those surrounding hazards, you lose your ball (in the water), and in others, your job is made harder (rough grass, sand bunkers, and obstructions, like trees).  Even a clear line to the pin requires the marshaling of absolute concentration, total situational awareness, and the precise muscle memory that comes from long periods dedicated practice and experience.

Today's risk management environment for banks stands in stark contrast to the "golden years" for the banking industry from the 1950's to the early 1980's when the old 3-6-3 rule prevailed.  Pay 3% on deposits, loan those deposits out at 6%, and then get to the golf course by 3 p.m.  That banking industry Elysium was besieged in 1980, when the Depository Institutions Deregulation and Monetary Control Act was enacted into law.  One piece of which was the phasing-out of government-administered price controls on deposit accounts.  Then, in 1982, another deregulation initiative, the Garn-St. Germain Depository Institutions Act, roughly leveled the competitive playing field between banks, savings and loans, and (by introducing money market accounts) money market mutual funds.

Given our collective experience since then, whether you judge the financial services deregulation of the early 1980's a net societal benefit (which I still do), you can surely agree that financial services deregulation significantly changed the existing landscape of the industry at the time.  We can also probably agree, that we created a bright-line tipping point or pivot point for the banking industry that defined a critical epoch in the industry's evolution.

But by removing price controls and increasing marketplace competition, we introduced "wobble" and uncertainty into the inertia of the industry; forcing changes in its momentum and trajectory.  Wobble which may likely have eventually reached some sort stable-state adaptation (as bankers got their new sea legs) if not for the destabilizing influences of economic events such as the Fed's inflation-fighting policy of stratospheric interest rates (and the resulting Recession of 1981-1982), the pesky Texas oil-patch crash, or the unwelcome real estate crisis in the New England states.

Instead of things getting less "wobbly" over time, things got even "wobblier", the big wake-up call coming with the declared insolvency of the Federal Savings and Loan Insurance Corporation (FSLIC) in 1987.

The legislative remedy to the industry's instability came in the form of  the systemic risk reduction and accountability measures in the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) and the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA).  Then came the Financial Services Modernization Act of 1999 (also known as the Gramm-Leach-Bliley Act [GLBA]).  Though rolling back the provisions of the Depression-era Glass-Steagall Act for a small group of megabanks and securities houses, GLBA imposed significant new regulatory requirements on all banks (regardless of size) related to customer financial privacy, information security, and anti-pretexting.  Later, after America was attacked, came the USA PATRIOT Act of 2001, strengthening Bank Secrecy Act anti-money laundering and anti-terrorist financing requirements.

All these pieces of legislation, and their implementing regulations, created new legal obligations for banks and bankers.  These new, and stricter, rules of player behavior were overlayed onto an already challenging game.  The game's fairways, now made narrower by these new rules, also became minefields, subjecting banks and their officers and directors to escalating levels of legal liability.

Fast forward to today.  From the smoldering ruins of the financial markets meltdown and the Great Recession, the Dodd-Frank Act rolls out a foundation-shaking increase in financial services regulation.   The control of industry "wobble" is now called macroprudential banking supervision and new regulatory policy goals are "financial stability and resilience".   Larger capital buffers, the Volcker Rule, the too-big-to fail fixes... all remedies targeted to the problems we experienced during the Great Recession.

In addition, there is a new Sheriff in town, called the Consumer Financial Protection Bureau (CFPB), aggressively policing both old and new consumer compliance rules and establishing evolving standards of fair play.

Dodd-Frank, like the deregulatory legislation of the 1980's, may also have brought us another new, epoch-defining, bright-line regulatory tipping-point for the industry... but a flip-side version of it... with all the uncertainty and unintended consequences to financial services market structure and competition that accompanied the earlier tipping point.

This epoch may be seen by banking historians as the time when, with good intentions and reacting to our legitimate and painful experiences, the American republic began a period of over-engineering banking regulation.  Even senior financial services regulators have admitted to not being sure how the interconnectedness of the 390 required Dodd-Frank Act rulemakings will play out in terms of impacts, implications, market distortions, unintended consequences, and undesired results.  So much also depends on how bank examiners, while in the banks, interpret and apply the rules (and whether they are applied consistently).  Those bridges, we all assume, will be crossed when we get to them.

But the danger is:  Is it being over-engineered in a manner similar to what we see with ponderous Pentagon weapons systems?  Having to accommodate so many desirable specifications, that the final product is prohibitively expensive and does few of its mission-critical functions well.  The Pentagon's Zumwalt-class Destroyer program is instructive in this respect.

Dodd-Frank is accelerating a trend that was already slowly, but steadily, gaining traction and momentum.  While chartered banks are dutifully trying to integrate these new regulations and with most being squeezed by suboptimal profitability, heirloom system platforms, and legacy thinking; the players in the shadow banking arena are attracting capital, gaining yardage, and spreading their wings (at least relatively speaking) in less restrictive airspace.

The robust growth in fintech and shadow banking is a dashboard warning indicator for regulatory over-engineering.  Anyone who has been a parent of teenagers knows that the excessive restriction of a natural inclination breeds circumvention.  It's an immutable Law of Nature.

A near-zero tolerance, over-engineered banking regulatory environment that ties the hands of the "business entities presently legally defined as banks" threatens to pretty much take away the banking game's metaphoric golf fairways altogether.  So that, at every hole, bankers, when they tee-up, are playing to an island green.

I have no doubt that the banking industry will rise to this occasion, as it always has.  You see, there is an additional aspect to the game of golf that provides a virtuous lesson for everyone who plays it.  The game is always played forward, never backward.