FTI Consulting recently gathered six of the world’s top financial leaders to discuss the financial crisis, the new reforms, and whether they can truly protect global markets from another meltdown. Discussion leaders were former Federal Deposit Insurance Corporation Chairman William M. Isaac, who is now Senior Managing Director and Global Head of Financial Institutions at FTI Consulting, and Stephen Kingsley, Senior Managing Director in FTI Consulting’s London office. The panel comprised Mark Carawan, Chief Internal Auditor at Citigroup; John C. Dugan, former Comptroller of the Currency and now a partner at Covington & Burling; Cornelius K. Hurley, Director of Boston University’s Center for Finance, Law & Policy and Senior Provost Fellow Professor of the Practice of Banking Law; and Simon Samuels, Managing Director, European Banks Equity Research at Barclays Capital.

WILLIAM M. ISAAC: We have four topics to cover, and we will lead off with John Dugan. The first question: Will the global financial reforms prevent the next crisis?

JOHN C. DUGAN: I don’t think we’ll ever fully prevent the next crisis, whatever it will be. I do think it was very important to increase the amount of common equity capital in the banking system. Once we did that, the crisis began to ease. But there has been too little work done on developing liquidity standards for the banking system, and I don’t think what is being put in place now is right yet — it needs a lot of work.

ISAAC: Was Dodd-Frank necessary? Regulators have always had the authority to deal with capital and liquidity issues.

DUGAN: I think the most important thing was to raise capital across the board, not just in the United States but also in other countries. You need an agreement among regulators, but you didn’t need Dodd-Frank for that or for setting new liquidity standards. Dodd-Frank addresses those subjects, but they’re not really at the heart of what Dodd-Frank gets at. I do think some of the Dodd-Frank reforms were necessary, especially the regulation of systemically significant nonbanks — but some reforms went too far.

CORNELIUS HURLEY: We are not better off with Dodd-Frank, mainly because there’s no structural reform. We’ve just nibbled around the edges. The Vickers Report proposes real structural and competitive reform.
I would have recognized the too-big-to-fail genie for what it is: a loose, destructive spirit in the land. Dodd-Frank called every financial institution over $50 billion systemically important, and that’s just not credible. The Vickers Report suggests a much more reasoned approach. It would confine the retail bank and allow the separate investment bank to do proprietary trading.

SIMON SAMUELS: I personally think the crisis was fundamentally about credit underwriting standards and liquidity. And ultimately the reason why Lehman fell was not from its starting position of capital, which was fine. It was due to a liquidity failure because people didn’t trust the underwriting.

DUGAN: I also believe that if we’d had some bare minimum mortgage underwriting standards, real documentation of income and even modest down payments, the whole crisis would have been much smaller. I would say, though, that a lot of people thought Lehman was very undercapitalized.

ISAAC: When I was running the FDIC my highest priority was increasing tangible equity in the largest banks. Going into the recent crisis, many of the largest firms simply did not have enough tangible equity capital, and the regulators allowed them to get away with it. The liquidity crisis occurred in significant part because the markets perceived that the banks had insufficient capital in relationship to the risks in their portfolios.

HURLEY: I think the lawyers were to blame too. Entire legal careers are spent looking for ways around regulation. I don’t see anything in the culture of the legal profession that says lawyers won’t do the same thing with Dodd-Frank or the Vickers Report — “We’ll guide our clients around regulations rather than helping them to comply with the spirit of the law.” That’s the gorilla in the room that no one dares to talk about.

MARK CARAWAN: One of the areas that we’ve not focused on is the role of management. While we are looking at enhancing capital and liquidity regulation, we should also ensure that management is ultimately responsible and held accountable for ensuring adequacy. Do we need more rules or is there scope to better enforce the ones we have?

ISAAC: It seems to me that we in this country didn’t make the structural reforms to prevent this crisis from happening again. Dodd-Frank slapped the regulators on the wrist and said, “Start worrying more about capital and liquidity. Do your job right.” But regulators already had the authority to get out in front of this crisis and take action if they had recognized the problems and had the political will to deal with them.

DUGAN: As comptroller, one of the problems that I saw was that there were a lot of practices that were okay, not great, inside the banks. But they were much worse outside the banks. There was no way to have a common set of rules that applied to both banks and nonbanks. I think odd-Frank has addressed that, although at times in a very cumbersome way. We will now have common mortgage underwriting and risk retention standards for all mortgage providers, although a lot of regulators have to agree on the rules. The CFPB [Consumer Financial Protection Bureau, the new consumer protection agency] will set common consumer protection standards for all providers too. Also, while the SEC [Securities and Exchange Commission] did not do a good job of regulating some of the investment houses that had increasingly become like banks, these companies are now deemed bank holding companies and can be regulated as such.

ISAAC: Okay, that will have to be the last word, as we need to move to the second topic: “too big to fail.”

STEPHEN KINGSLEY: How you think about too big to fail depends on where you are in the world. The United States has been used to banks failing regularly. In the United Kingdom, until Northern Rock, the last time we had a run on a bank was when Queen Victoria was on the throne. The cost of rescuing the banking system in some countries, including my own, has been very substantial. In some places, like Ireland and Iceland, the impact is going to be felt for decades. And taxpayers may not have the appetite for repeating what they did in 2008 and 2009.
One question is whether larger financial institutions will be allowed to fail next time or whether the politicians will rush back in. And can one large firm fail without precipitating a wider market collapse?

CARAWAN: We should be figuring out how to put in place the appropriate frameworks to ensure that government agencies focus on a robust commercial solution and not a politically driven one. They should be ready to make the tough decisions and close down banks that are insolvent so that there are market consequences for those that don’t manage or restructure properly.

DUGAN: Does anyone think that the existence of too big to fail caused the crisis?

ISAAC: I think it played an important role. The perception that some firms are too big to fail diminishes discipline that would otherwise be present in the marketplace. The suppliers of wholesale funds and capital need to believe that they are truly at risk. If they do believe that, behaviors will change in banks. I do not believe things could have gotten so far out of hand precrisis had suppliers of capital and liquidity believed they were at risk. Once thecrisis hit, the government going back and forth — bailing out one large firm and then letting the next one fail — utterly confused the markets and created panic.

HURLEY: Too-big-to-fail banks get a subsidy because they can buy funds at a cheaper rate, just like Fannie [Federal National Mortgage Association] and Freddie [Federal Home Loan Mortgage Association] did, knowing the sovereign will come to their rescue. We should quantify that subsidy and require those banks to segregate it on their books as a reserve account. That reserve account would be capital in the event of a bankruptcy.

SAMUELS: I’ve never understood the idea that you’d somehow act recklessly if you get bailed out, because you would long ago have been fired. And from a shareholder’s perspective, you get wiped out. So this is purely about the debt market.
This is the kind of debate that you have years down the line but not months down the line. The funding markets are so extraordinarily fragile. There’s a lot of uncertainty in the wholesale funding markets in the United Kingdom because of the Vickers Report. The presumption is that if you’re outside the ring fence, your wholesale funding costs will be higher. You’ve seen senior bondholders suffer haircuts [absorbing losses] in Denmark, and now large Danish banks are struggling with funding.

KINGSLEY: The liquidators of Lehman faced problems on both sides of the Atlantic because Lehman was very complex. Lots of institutions continue to live in that complex global environment. And it strikes me that those organizations are going to find it very hard to do a proper living will.
ISAAC: The Vickers Report is essentially a living will. You take the part of the institution that the people on the street worry most about in a crisis — checking accounts, mortgages, small business lending — set that aside and then put the more complex parts in another part of the organization.

CARAWAN: Both retail and commercial customers want global capability, low cost and instant information about their accounts. To compete in the marketplace means that you offshore, outsource and have service centers around the world in many jurisdictions. In a crisis, each regulator will ring fence activities in its own jurisdiction and follow its own course to stabilize its marketplace and resolve insolvent institutions. To structure readily resolvable global institutions is very complex and will involve huge organizational coordination, a web of service-level agreements and ample time to make things happen. One must not underestimate the challenge.

ISAAC: Let’s turn to question three: Are we focused too much on regulation and too little on improving prudential supervision of financial institutions?

SAMUELS: I think ultimately credit bubbles will damage financial institutions when the bubbles burst, regardless of what supervisors do. And arguably banks in some of the bestsupervised systems in the world, like Spain, have suffered terribly as the credit and housing market bubbles collapsed. I also think the complexity of some of the new rules that they’re being asked to apply represents a huge impediment to economic recovery.
The macro prudential angle is very important. Fixing things like the structure of the U.S. housing market, the nonrecourse lending in many states and loan-to-value caps would help the industry tremendously to withstand subsequent cycles and avoid bubbles.
Also, the Basel III capital framework includes a buffer to deal with market bubbles. The idea is that capital requirements will increase as a cycle reaches a crescendo, essentially to choke off that last piece of the bubble. In theory that could help enormously. But somebody has to decide, “We’re in a bubble and it’s now time for that buffer to kick in.”

KINGSLEY: A highly empowered, rightminded person at the center of the financial system in each country could say, “That’s enough, guys. We’re now going to stop the party, and we’ll raise capital requirements for particular kinds of loans. We will actually outlaw particularly unsound loan-to-value ratios,” or whatever it happens to be. And the fascination for me is: In a democracy, how do you actually empower somebody who can face off against the elected politicians?

ISAAC: I’m old enough to recall when the Federal Reserve, back in the 1970s, got concerned about the economy, and it told expansion-minded financial companies, “No. Your capital is too low, considering how overheated the economy is getting. Increase your capital and then we’ll think about your application.” We need to get back to the days when regulators actually had to think and use judgment.
The system needs firm underwriting standards, and firm capital and liquidity standards. And we need to allow the examiners to go in and actually look at assets and off-balancesheet exposures. That’s the job of management and the board of directors first, and regulators are a check on that system. But they should all
be using some judgment rather than just blindly relying on flawed models they don’t really understand — models that told us that residential real estate loans and sovereign debt were relatively riskless assets.

DUGAN: I think you do need some firm rules; it can’t be all about discretion and judgment. I just don’t know how much of this you can legislate — how much you can tell someone to be a better supervisor. When the system goes wrong, it’s hard to sort out how much failed supervision or failed regulation was at fault. The only way policymakers can react is with increased regulation. They can’t mandate better supervision.

KINGSLEY: That is a perfect segue to the last discussion topic: the impact — unintended or intended — of these regulatory and other changes on the banks and the economic recovery.

SAMUELS: I see a very slow economic recovery happening. I expect credit shrinkage or very anemic credit growth and I see banks being required to hold more capital. But I am just not sure that there is a clear linkage between all three. I think it is realistic to expect that when a recession was created by too much debt, then its recovery process will likely result in lower levels of debt. Whether or not banks need more capital now, it’s entirely reasonable to expect the economic recovery to be very sluggish because that is what usually happens after a financial crisis. I should also point out that the banking industry in Europe spent the whole of the 1980s and 1990s generating a return on tangible equity below its cost of equity. Today the bankers cry, “If you do this and this, our return on equity will go down too much and it will be unacceptable to our stakeholders and eventually we won’t be able to provide credit for the economy.” But throughout the ’80s and ’90s, economic growth across Europe was fine.

ISAAC: I’m chairman of Fifth Third Bancorp, and it has increased its capital rather dramatically. The bank is eager to make loans, but it can’t find enough decent ones to grow the loan book after you net out the paydowns of existing loans. A lot of people are deleveraging voluntarily or they’re bypassing the banking system and going right into the markets to lock in long-term debt at low rates. Having said that, if we keep increasing capital and liquidity requirements and imposing other significant regulatory burdens on banks, credit will continue to be less available and more expensive, which will impede economic recovery.

HURLEY: In each of our countries, the largest five or six banks occupy about 80% of the banking system, so they dominate the field. Their too-bigto- fail subsidy, depending on whose study you read, is between 25 and 75 basis points. In this kind of economy, there’s little incentive for the mega banks to do anything that is going to stimulate the economy when they can sit back and enjoy the bounty of that subsidy. So I think this question of the subsidy is linked inextricably with the capital issue and the timing of when we emerge from this crisis. Until there’s a sense of urgency, we will not get out of it.

DUGAN: I’m not sure I agree with that, for the reason Bill said. I think bankers make money through loans and want to put that capital to work — especially in a low interest rate environment where they can’t earn much spread by investing in Treasury securities or Fed funds. So I think they have every
incentive to try to make loans right now; it’s just hard to find them.

HURLEY: And the No. 1 problem facing bank management these days is “What do we do with all this money?” Banks in New York have started charging large depositors to put deposits in the bank!

SAMUELS: I think one of the enduring features, post–financial crisis, is that the idea of a level playing field goes out the window. Take capital: If you’re a regulator of a very large banking system that collapsed, your view toward how that should be regulated would differ from the view of a regulator of a smaller banking system that didn’t collapse. And so the United Kingdom’s starting point is a banking system that is, depending on how you measure it, between five and six times the gross domestic product of the United Kingdom. The starting position of the United States is a banking position that is a tenth that size relative to the U.S. economy. And so the chances of those two regulators agreeing on the same magic capital ratio number, I’d say, is zero.

HURLEY: When we use the term regulation, it means different things to Republicans and Democrats [in the United States]. Just the word regulation has become an attack these days. Regulation comes in many forms — I have a list of about 35 different types. And some of those regulations are really designed to promote market discipline, especially in the area of disclosure. So often the debate about regulation or overregulation or underregulation ends up being just a political diatribe where the parties never really have a discussion. They never start from the point, “What are we trying to accomplish, and what is the least burdensome way of getting there?” If we could just have that discussion, we might get to a place that yields a stronger, more resilient financial system that fosters sustainable economic growth.

ISAAC: That is a perfect thought to end on, Con. I wish we could continue all day, as this has been a fascinating discussion. Thanks to each of our panelists for taking the time to share your thoughts and wisdom.

The Push and the Pull

Today, European corporations find themselves at a crossroads. Governments and commissions are pushing organizations to diversify the gender composition of their boards by adding more female directors. This regulatory push has created some momentum toward diversification.

Corporations in Europe and elsewhere also have access to studies showing that companies with gender diversity on their boards typically outperform their competitors in terms of profitability and good-governance performance. This knowledge constitutes a pull that adds to the diversification movement.

And yet, despite the combined force of these powerful push and pull motivators, gender diversification still is moving far too slowly in many countries. Consider the situation in the United Kingdom. The annual Cranfield University Female FTSE Board Report for 2010 noted an incremental increase of just three additional women on FTSE 100 Index boards over the prior year, a change it called “barely perceptible.”

The Nordic Way

Thus far, authorities in the United Kingdom have chosen persuasion over regulation in their efforts to encourage board diversity, but regulators and political leaders in other parts of Europe have not trodden so lightly.

Norway led the pack with its 2002 mandate stating that at least 40% of the seats on public boards be held by women. State-owned enterprises had four years to comply, while other companies were given until 2008. The mandate has been met. Today, women constitute just over 40% of Norwegian board directors, according to 2010 data from Corporate Women Directors International (CWDI). Norway is the clear frontrunner when it comes to gender diversification at the board level, but other Scandinavian countries also have made impressive strides in this direction. The same CWDI report shows that Sweden (21.9%) and
Finland (16.8%) both are ahead of the United Kingdom in terms of female representation on corporate boards.

These changes are only the tip of the iceberg. Several other European nations, including Spain and France, have passed laws that mandate 40% female board composition for large, public companies within the next four to six years. Additional countries, such as Iceland, Denmark and Ireland, have also passed quotas, with the Netherlands and Italy considering doing the same.

Is the United Kingdom also headed toward a quota system? For now it appears that U.K. regulators prefer to rely on more gentle pressure. As a case in point, the Consultation Document: Gender Diversity on Boards was introduced in May by the Financial Reporting Council (FRC). For the first time, the FRC included a principle recognizing the value of diversity in the corporate boardroom.

The principle states that “the search for board candidates should be conducted, and appointments made, on merit, against objective criteria and with due regard for the benefits of diversity on the board, including gender.”

Outside observers might view such pronouncements skeptically since they do not have the force of actual law, but the United Kingdom has a strongly ingrained corporate culture of “Comply or Explain.” The FRC notes that both U.K. companies and their shareholders have broadly accepted the notion that corporations should comply with FRC codes or explain transparently and convincingly how the alternate path they have chosen constitutes good governance.

More Women, Better Governance

Of course, the assertion that having more women on a board really does represent good governance lies at the crux of the push for greater female board representation. Policy-makers certainly believe that having more women on a board is good for a company’s bottom line. “The business case for increasing the number of women on corporate boards is clear,” wrote Lord Davies in his Women on Boards report, commissioned by the British government and published this past February. “When women are so under-represented on corporate boards, companies are missing out, as they are unable to draw from the widest range of possible talent. Evidence suggests that companies with a strong female representation at board and top management level perform better than those without and that gender-diverse boards have a positive impact on performance.”

In making these claims, Davies cited a 2010 McKinsey & Company report called Women Matter that shows companies with the most women on their executive boards outperformed their sector competitors with all-male boards by sizable margins. Looking at data from 2007 to 2009, McKinsey found that the most gender-diverse boards surpassed their competitors by 41% in terms of average return on equity while achieving 56% higher EBIT margins.

The McKinsey study is not an outlier. Other research findings support the notion that women can make a strong, positive contribution in leadership positions. In 2001, a researcher from Pepperdine University in California analyzed 19 years of data (1980 to 1998) and concluded that the 25 Fortune 500 firms with the best record of promoting women to the executive suite were 18% to 69% more profitable than the median Fortune 500 firms in their industries (Adler, Roy D. “Women in the Executive Suite Correlate to High Profits” [European Project on Equal Pay]).

How can we explain the performance gaps in favor of companies with greater gender diversity on the board? Perhaps diversity has some inherent benefits at the board level. Naturally there are many criteria that make someone a good board candidate. Intelligence, accomplishments, capabilities, skills, credentials — these all go into the assessment of a board candidate, but we should not ignore the attributes a candidate brings to the boardroom by virtue of his or her background and personal experience.

When you have 10 men in a room who all have similar backgrounds, experiences and formative influences, their viewpoints and opinions often will be less varied than when people from a range of backgrounds with different experiences and ways of thinking are thrown into the mix.

A case in point: One of the U.K. boards on which I serve has an Italian director, a French director, two American women, a German director and a British chairman. As we look at vital strategic issues, we all come at the problem from slightly different ways, which frequently provokes a healthy and productive debate.

Having women on the board is in some ways a proxy for saying that we want people with different experiences on the board. It is an indisputable fact that most women in the United Kingdom who have achieved corporate success have done so by taking a path somewhat different from that of their male counterparts.

When the Financial Services Authority (FSA) conducts its ARROW governance reviews, it checks diligently to make sure there is an appropriate amount of challenge occurring at that board level. If we look at the big governance failures from the last decade — for example, the Royal Bank of Scotland — we see governance nightmares and homogenous boards dominated by the CEO. Board diversity might have led to more challenge and risk evaluation.

Having a diverse board prone to lively and spirited debate is not an ironclad guarantee against fraud and mismanagement, but it certainly can help from a risk-management standpoint. The Conference Board of Canada recognized this fact nine years ago with a report drawing a link between female board membership and good-governance credentials. The report found that boards with higher female representation tended to pay more attention to audits and risk oversight. Boards with three or more women turned out to be far more likely (94%) to insist on conflict-of-interest guidelines than all-male boards (58%). And nearly three-quarters of boards with two or more women directors conducted formal board performance evaluations, compared with less than half of their all-male counterparts.

Quotas: Necessary or Not?

At the moment, a majority of both political and business leaders in the United Kingdom seem to favor the current approach of using recommendations and exhortations to build the momentum toward greater female participation on executive boards. The Davies report urged FTSE 100 companies to strive for
at least 25% female board member representation by 2015.

But is this goal realistic? Even Davies had to acknowledge that 18% of the FTSE 100 companies and nearly half of the FTSE 250 companies do not have a single woman in the boardroom. Given the apparently glacial pace of progress toward diversification of FTSE 100 boards, can top U.K. companies possibly double the number of female board members in just five years? Would not hard quotas such as those employed in Norway be a more reliable way of achieving the desired goal of more equitable, diverse and effective boards?

I believe the current path is the right one and that quotas are not necessary. Even without quotas, the Fortune 500 companies in the United States have achieved a higher rate of female board member representation (15.2%) than many of their European counterparts (CDWI 2010 Report: Accelerating Board Diversity).

British business leaders already have shown their capacity and willingness to rise to the occasion and take the necessary bold actions. For example, Sir Win Bischoff of Lloyds Banking Group and Sir Roger Carr of Centrica have led the creation of the 30% Club, a group of chairmen from some of the leading British corporations who have promised to use cross-company mentoring programs, industry forums and political debate to keep the topic of board diversification front and center.

As the name of the group boldly proclaims, the 30% Club hopes to surpass the 25% standard set by the Davies report and rally FTSE 100 businesses to achieve 30% female representation on executive boards.

There are indications that this approach is starting to gain traction. A recent article in The Independent newspaper noted that just the threat of quotas implied in the Davies report had caused a major jump in the number of women hired as nonexecutive directors to FTSE 100 companies (“Boards Double Number of Women Members,” The Independent, May 29, 2011). The paper found that 23% of all new nonexecutive board appointments in the previous six months had been filled by women, a staggering increase from 2010, when less than 10% of such appointments went to female candidates.

The article also notes that French companies are on a similar path, with a 38% rise in the number of nonexecutive board appointments between 2008 and 2010. Surely that trend will only accelerate, since France passed a bill in January that calls for 40% female board membership by 2016 for listed companies, companies that have more than 500 employees or companies with a turnover of more than €500 million.

Take the Carrot or Get the Stick

Guidelines may be preferable to quotas, but if businesses in the United Kingdom and the rest of Europe do not move in the direction of diversifying their boards, these countries soon may find themselves facing them. Lord Davies has said, “I won’t be recommending quotas to the government, as the best solution is one of natural evolution. But if companies don’t take a radical change in attitude and hire more women at the top, then we will have to introduce quotas.”

This sentiment was amplified by EU Justice Commissioner Viviane Reding. In March, Reding challenged publicly listed European companies to sign a pledge representing their commitment to increasing the percentage of women leaders on their boards to 30% by 2015 and 40% by 2020.

Reding warned companies that her committee would be evaluating their progress toward the inclusion of women in executive decision making. “If this has happened by March 2012, I will congratulate the European business world,” she said. “If it has not happened, you can count on my regulatory creativity.”

Whether by carrot or by stick, it seems as though Europe is destined to move toward gender parity on corporate boards. The question for U.K. firms is whether they want to reap the advantages of being in the vanguard of this movement. I believe they should join the wave now rather than get caught later in an ugly
undertow of mandates and quotas.

The eurozone’s weaknesses have sat in plain sight from the start. The group of countries that constituted the eurozone did not meet the preconditions for a single currency to operate sustainably. Productivity and prosperity vary widely from country to country, and there are no financial transfers between them on a scale that would correct for those differences. And linguistic, cultural and economic barriers to migration hinder the labor mobility that would alleviate persistent unemployment.

The consequences have been felt most keenly in the country of my birth: Greece. In 2001, Greece was allowed to join the eurozone, ostensibly having met the economic preconditions. In reality, Greece had manipulated and falsified its economic data.

Entry into the eurozone gave Greece’s consumers, businesses and government access to credit at much lower interest rates than they otherwise would have had. The risk of Greece’s taking a haircut through devaluation disappeared, and the financial markets assumed that the eurozone would stand behind any of its member countries’ debts.

The result was unsurprising: Greece went on a spending spree. In the meantime, it failed to press ahead with the difficult reforms that might have improved its productivity and competitiveness relative to other members of the eurozone, such as Germany. In fact, taking real unit labor costs as a measure of industrial competitiveness, the gap between Germany, the eurozone’s largest economy, and the peripheral economies (those of Portugal, Ireland, Spain and Italy, as well as Greece) widened rather than narrowed.

This could not go on forever. In 2010 the markets decided that Greece’s debt was unsustainable. The risk premium on government debt soared, and Greece faced insolvency. The International Monetary Fund, the European Central Bank and the European Commission financed a bailout. Greece now is implementing major fiscal consolidation and structural reforms, such as improving public sector efficiency, opening up the professions and liberalizing markets.

But austerity programs themselves reduce demand in the economy and slow economic growth. The latest forecasts for Greece are that 2012 will see the fourth consecutive year of falling gross domestic product, with a cumulative fall in output of some 12%. A second bailout package has been agreed to that will involve a significant element of debt forgiveness. Although the risk of Greece defaulting on its debts has been reduced somewhat, the markets still think there is a high chance of it happening within the next two years. Portugal and Ireland also have been forced to take bailout packages because they could not finance their debts at sustainable rates.

A default by any one of these countries would deepen the financial crisis among banks in France, Germany and elsewhere that hold those countries’ debt. Economic and political tensions are high. Certainly Greek politicians of all parties are responsible for the country’s crisis. But the European Commission and the other member states are not blameless. They did not effectively scrutinize Greece’s economic data. They watered down the Stability and Growth Pact, the eurozone’s rulebook, when it became clear that France and Germany might fail the budget deficit test. And the technical assistance the EC provided Greece was inadequate given the scale of structural reform it needed.

Can the eurozone hold together? I believe its long-term viability will require stronger economic and fiscal governance, including:

• Limits — backed by the risk of sanctions — on member states’ ability to run up budget deficits
• Greater consistency between the economic and social policies that underpin productivity and competitiveness in each country — including traditionally sovereign decisions such as retirement ages, pension financing and healthcare systems
• Much larger fiscal transfers between “rich” and “poor” members of the eurozone, either through making direct transfers (such as the current Structural Funds but on a larger scale) or by allowing members to issue debt backed by the eurozone collectively
• Radical reform of the governance structure in Europe to cope with the emergence of a lender of last resort: the ECB, with enhanced powers and the European Financial Stability Facility, currently at €440 billion, but the intention is to expand it to €1 trillion
• Closer monitoring of individual governments’ fiscal policies and greater involvement of the European Commission

These are controversial ideas that, if implemented, would profoundly strengthen political integration while affecting national sovereignty. Many policies that currently are the choice of member states and their electorates in effect would become collective choices determined in some way by eurozone members. But already, alongside the negotiation of bailout packages for troubled member states and an ongoing debate about the size of the facility available for such rescues, we see the emergence of stronger economic governance mechanisms within the eurozone.

Such a system of governance will not emerge overnight. The politics are extremely difficult. We see that in Germany’s strong negative reaction to the idea of euro bonds (debt issued by member states that is backed by the European Central Bank and thus by member states collectively). German voters do not wish to subsidize the more profligate peripheral states. The Germans might be persuaded to change their position if reforms included much stronger controls over the policies and actions of member states that receive aid, but those states, of course, might see that as an unacceptable intrusion into their internal business. We have seen in Greece that popular resistance to austerity can derail measures agreed upon by elected governments.

There also is the question of how stronger links within the eurozone might affect the relationship with those members of the European Union that remain outside the eurozone, including the United Kingdom, Sweden and Poland.
One should not doubt the determination of the eurozone’s political leaders — especially those in France and Germany — to keep the union together and make the single currency work. But at this stage, the eurozone’s future is uncertain. If it is to survive, it needs much greater economic and political convergence. It is questionable whether the voters of Europe are ready for that.

And regulation has spawned not only its own industry of advisers and lobbyists, to help comply or change the regulation, it also has shaped the competitive environment of today’s business. The modern playing field is not so much tilted as turned into a maze where the winner is not the fastest or the cheapest but the one who knows how to navigate through.

There appear to be three reasons for this plague of regulation. The first is that, as officials have been forced to vacate large areas of their national economies through privatizations, and as private service providers have risen, authorities have not been able to resist leaving land mines behind them. Often viewing the private sector as the enemy, those booby traps are constructed in the name of maintaining the “standards” of service provision.

Such policies also are an expression, though, of the growing irrelevance of national government in many areas of global life. The local matters — building codes or tax arrangements in Shanghai or Buenos Aires; and the global matters — Basel III agreements on banks’ capital ratios, or standby arrangements in the case of a breakout of a global communicable disease such as a flu epidemic; but the national often doesn’t.

Now, of course, national government is not ready for its funeral rites quite yet: tax rates, personal and corporate; the quality of the macroeconomic environment; or trade and investment liberalization remain critical factors of national competitiveness that are determined by national politicians. Nevertheless, in many areas of economic life the writing is on the wall. The rules are going to be set elsewhere, hence the blizzard of national regulation set off by the self-important snowmakers of national government — officials and their political masters. They want to prove they still matter.

As a former member of a British cabinet, I was rarely presented with a problem that my domestic political colleagues did not want to legislate against. And legislation is of course the tree from which most national regulation falls and takes root. I remember a cabinet divided over whether a colleague’s complaint of school bullying was best addressed by a law or by a program of, say, £100 million, suggested by the Prime Minister, or both. I was almost alone in gingerly proposing that the problem was best left to good headmasters and responsible families and that outlawing it was beside the point. But the cabinet wanted to do something, reflecting the politician’s most primal need: to be seen to act. That politician’s itch is the mother of nearly all national regulation.

There is, however, a second root to the regulatory upsurge: the rise of the global. As we have globalized our economy, fashioning as close to a single market as the world has ever seen, we finally are grappling with regulating that economy. And excuse my bias, for while I consider much national regulation a mountain of red tape that should be set fire to, I am rather a fan of global regulation.

Without regulation, I do not see how we can build a global economy that can enjoy long-term political support. Yet while this mild statement in support of global regulation may seem commonsensical to some, it is to others anathema. Global markets have been seen by some people as a chance to escape national rules, not exchange one yoke for another. These advocates have defended their regulation-“lite” vision by claiming that markets discern the good from the bad, and reward the former. Yet this market fundamentalism, as some have dubbed it, often fails to produce what those involved would consider fair results, for pretty self-evident reasons.

For globalization to work, the markets must be seen as fair, transparent, noncorrupt. Further — and here is the nub of regulation — all players must be seen as subject to the same rules. Global capital, like global health or global security, needs uniform rules of the road.
Another, third reason universal regulation will spread is that countries and industries alike will want to end the free rider problem: countries that will not accept environmental standards on emissions, thereby perhaps winning a comparative cost

advantage; or jurisdictions that go easy on international financial services located in their territories. Finally, as businesses come to operate globally, they will seek common standards that offer predictability.

Such universal regulatory regimes will not deal national authorities out of the process, but instead task them with implementing globally agreed-upon rules and standards at the national level. So Basel III, negotiated as it has been by national officials fulfilling a political framework set in forums such as the G-20, is translated into national regulation by the national financial authorities. The global oak tree that spawns national saplings will not be a global legislative body. Rather, it will consist of international coalitions of interested parties — governments and also industry representatives and often not-for-profit advocates — arriving at common global standards that are likely to be endorsed and adopted by a universal body such as the United Nations. These policies will then be returned to countries for national legislation and regulation to implement the agreed-upon global standards.

So, contrary to what many readers might instinctively believe, global regulation is often broadly a good thing, and a lot of national regulation is basically a bad, redundant thing when it does not conform to global standards.

The difficulty is that governments seem incapable of tearing up the old national rulebook and replacing it with the national version of a global one. Rather, they just pile on the extra regulation, thereby making the maze
I described at the start.

Our battle cry needs to be “The old king is dead (national regulation), long live the new king (global regulation, made local).

Challenging Sacred Cows

Wells Fargo famously navigated the financial crisis better than most of its peers. Now the man who led the bank through the crisis to the high ground, former Wells Fargo chairman and CEO Richard Kovacevich, challenges what is becoming conventional wisdom about what drove the financial crisis.

Kovacevich argues that a bank’s risk has nothing to do with its size — banks fail because their risk is too concentrated. He firmly believes that TARP, stress tests and mark-to-market accounting did not stem the crisis; they made it worse by creating panic. Legally combining commercial and investing banking didn’t fuel the crisis — this particular crisis would not have occurred had the Glass-Steagall Act not separated the two industries in 1934. And the Dodd-Frank Act absolutely does not end “too big to fail.” Kovacevich also brings his experience to bear on the vexing challenge of emerging from the crisis and spurring U.S. economic growth.

The following are excerpts from the interview conducted by William M. Isaac, Senior Managing Director and Global Head of Financial Institutions at FTI Consulting. He is the former chairman of the Federal Deposit Insurance Corp. Isaac also serves as chairman of Fifth Third Bancorp.

The complete interview is available at fticonsulting.com/critical-thinking. It further illuminates the dangers still inherent in the financial system and is a must-read for all who work in, regulate and analyze the banking industry — or, like most, simply rely on its health.

William M. Isaac: What event or events do you think turned the recent crisis into a panic?

Richard Kovacevich: One of the most critical was the process of bailing out Bear Stearns and then days later not bailing out Lehman. The biggest mistake was not, as most people think, failing to bail out Lehman. The mistake was bailing out Bear Stearns and then not bailing out Lehman. The investors just said: “We have no idea what’s going on. We don’t know what’s happening next. We are getting out of the market.”

And for the Fed and [former Treasury Secretary Henry] Paulson to say, as they have, that they had no authority to bail out Lehman is simply not true. How can they say they had the authority to bail out AIG but they had no authority to bail out Lehman?

In my opinion, we should not have bailed out Bear Stearns, which was much smaller and much less risky than Lehman. It could have been handled more easily.

If that had happened, there was no question in my mind that Dick Fuld [CEO of Lehman] would have said “Uh-oh, game’s up. I’d better sell this thing right away at whatever price I can get.” He may have been able to sell it. I’m told it was close many times. And if Lehman could have been sold, then you may not have had the run on the other investment banks.

Isaac: You’re arguing that they should have let Bear Stearns go and then Lehman would have taken care of itself.

Kovacevich: Because if they bailed out Bear Stearns and also Lehman, everyone would know that every financial institution was going to be bailed out. Then you’re back to too big to fail, squared. I think the reason Lehman was allowed to go bankrupt, and I know Hank [Paulson] pretty well, I think he said to himself, “Well, if we rescue Lehman, then we have to do it for everybody. And we don’t have enough money or political will to bail out everyone.”

When they let Lehman go down, and the markets all crashed and liquidity dried up, they then realized the world was coming to an end. They ran to Congress to get the $700 billion to purchase toxic assets under the TARP program. Then they realized that the $700 billion for assets would not even put a dent in the problem, so they ended up bailing out everybody by supplying capital.

To cover their mistakes, they claimed they had no authority to bail out Lehman and, with a straight face, bailed out AIG a few days later. Chaos occurs when people don’t think in terms of what’s the next step if we do such and such now.

Isaac: You and I are probably the two people in the world who hate mark-to-market [MTM] accounting the most. What role did it play in the crisis?

Kovacevich: A huge role. People thought the world was coming to an end because everyone was reporting huge book but not actual losses because of MTM accounting.

We had to write off $900 million on a prime mortgage portfolio that we thought had a maximum loss exposure of $100 million. Our current loss estimate for that portfolio is now just $35 million. But we had to report nearly a billion-dollar loss that never came to fruition. And that was just one relatively small portfolio. I could give you many more examples.

Also, we wanted to purchase some assets because we knew they were undervalued. We were very reluctant to be a purchaser, however, because we would have to take an MTM loss if the asset went down further, even though we knew over the cycle it would be profitable.

This caused the markets to cease functioning. It destroyed a lot of companies and ultimately forced the Fed to intervene with trillions of dollars and be the buyer of last resort. Mark-to-market accounting was a huge culprit in the financial crisis and caused unnecessarily massive damage to the economy, and to housing in particular.

Kovacevich: I quickly learned that the riskiest part of the banking business is lending. If your loan risks become concentrated, whether geographically, by borrower or by industry, a bank’s total risk becomes excessive, even if you’ve underwritten those loans well. Banks fail due to concentrated risk. Risk has little to do with the size of the bank…. In fact, more small banks fail than big banks because they are generally more concentrated geographically, by product and by industry. Now if a big bank is concentrated, then obviously it is a higher risk.

Even if you underwrite well, when real estate goes to hell or the economy slows significantly, you’re going to get hammered. So you must underwrite well. But then to mitigate the macro factors you can’t control, you have to spread the risk. Risk management in banking should be more like it is in an insurance company. There you spread and diversify the risk.

I believe that the chance of Wells Fargo’s failing today at $1.2 trillion in assets is less likely than when I joined Norwest. It was a $20 billion company with a narrow product line concentrated in the upper Midwest and in agriculture-related lending.

Isaac: I’ve noted that the five largest institutions control more than 50% of the financial system and that is an undue concentration. Do you agree with that?

Kovacevich: I don’t. Five or fewer companies control more than 50% in every industry, from cereal to automobiles. Five banks control more than 50% of their industry in about every country in the world.

Isaac: You don’t believe banking is different or special compared with, say, the beer or cereal industry?

Kovacevich: No. In any given product line or geography the largest bank has, on average, 15% of the business. Some banks are big only because they have product and geographic diversity. That reduces the concentration of risk. If U.S. banks had been allowed to bank nationally from the get-go, as was the case in most other countries, few would even question their market share today. Texas banks in the 1990s were small by today’s standards. But they all failed because they were not allowed to bank outside of Texas. Savings and loans in the 1980s, individually, were not big. But they were excessively concentrated and required hundreds of billions of dollars of taxpayer money to be resolved. In the recent crisis, the taxpayer is unlikely to pay a dime for bank failures.

When we acquired Wachovia, it doubled our size but reduced our risk because it doubled the geography in which we operate. I believe that deal reduced risk for the system — as it increased our ability to serve more customers, with more products and in more geographies — and is absolutely positive for the economy.

Isaac: Do you believe that we have, through the Dodd-Frank Act, ended too big to fail?

Kovacevich: Absolutely not. But too big to fail must be stopped. No bank, none whatsoever, should be too big to fail. I worked on this issue with the Minneapolis Fed 20 years ago. Gary Stern [former president of the Federal Reserve Bank of Minneapolis] has been writing books and papers about this for two decades. It’s very simple — the only way we can solve too big to fail is when it’s clear that everybody that supplies capital to a failed bank, except insured depositors, is going to take a haircut [absorb losses] in a failure. That includes the failure of a $300 million bank or a $1 trillion bank. Until we force haircuts on all suppliers of capital to failed banks, we will be living with too big to fail.

Administering haircuts requires a huge liquidity fund from the Fed or from the FDIC because it could take months to fully wind down the bank, and there’s not going to be enough liquidity to do that without the government supplying the temporary funding. But banks should be able to be wound down at no cost to the insurance fund or taxpayers. The cost will be borne by the debt holders, the uninsured depositors, and the common and preferred stockholders. I believe that haircuts will cause those who provide capital to banks to be more disciplined about determining to whom and how much will be provided. Capital suppliers will monitor a bank’s risk appetite more closely, and will restrict additional capital when the risk grows too large and banks become too concentrated. In fact, I believe self-interested vigilance on the part of capital suppliers will be more effective in reducing bank failures than our regulators have been.

Kovacevich: The Fed called us after they completed our stress test and said we needed to raise something like $15 billion in additional capital. I was shocked. I said: “How did you get $15 billion?” They had reduced our earnings forecast. There was very little difference in projected credit losses. In fact, the Fed actually had our credit losses a few million less than ours really were. Where you would expect there might be differences, such as operating expenses, there were no differences. Instead the Fed had reduced our revenue forecast by more than 30%, which was the sole reason they had reduced our earnings forecast. I said: “What?” Just making sure I understood.

Isaac: Something tells me you didn’t just say “What?”

Kovacevich: “So you are saying that between May and November, our revenue is going to decline by 30%?” The answer: “Yes, that’s what our model shows.” I said: “That’s mathematically impossible. I couldn’t do it even if I tried. Let me see your model.” And they said: “We’re not going to show it to you.” How’s that for transparency in prudential regulation?

I pushed back: “How can I accept needing $15 billion in capital when it is based on a revenue assumption that is mathematically impossible?” “That’s it,” they said. “You need $15 billion.” As we stated in our earnings press releases in subsequent quarters, our actual revenue turned out to be even higher than our own forecast. So the Fed’s 30% revenue reduction and $15 billion capital raise as a consequence of that were totally wrong.

Now that’s what happens when you have a strong single regulator.

Isaac: Do you believe that the repeal of the Glass-Steagall Act helped lead to the crisis in 2008 and 2009?

Kovacevich: Not at all. In fact, if we had eliminated Glass-Steagall 40 years ago instead of nearly 15 years ago, this crisis is unlikely to have happened. The biggest problem of this crisis was the nonregulated investment banks that grew to an enormous size and with substantial and concentrated risks under the protection from competition by the Glass-Steagall Act.

One reason why this particular crisis will not happen again is because there aren’t many of these bad guys left. The ones that survived are regulated by the Fed, and therefore there is less chance that they will make these obviously bad decisions of high leverage, liquidity issues and concentrated risk that the SEC totally ignored.

Wells Fargo can now do investment banking, such as underwriting debt and equity and doing customer hedges. We don’t have to originate risky structured products or take proprietary trading risk. We have 95 other businesses from which to make profits. There’s no way investment banks can make attractive returns, in my opinion, with their limited product line and their lack of a deposit base, without taking excessive risks and crossing the line of ethical behavior. That’s why we were never in that business, in a major way, prior to the crises.

the Wells Fargo Way

The benefits of cross-selling in financial services

Kovacevich: If you’re only a lender, the only way you grow is by making more loans. But as you do that, you are increasing your risk and your concentration.

The loan is the hook — that’s what customers want the most. So you have to give them the loan and hopefully some deposits will come in return. But customers buy 14 products from financial institutions — both consumers and businesses — and the majority of those products don’t entail credit risk. They might involve operational risk, but it’s a different type of risk. So you can grow your bank while reducing and diversifying your risk.

Now if you do that, three other things that you haven’t thought of turn out to be true. The cost of selling an incremental product to an existing customer is about 10% of the cost of selling that same product to a new customer. You don’t open up a new account. You don’t advertise. You don’t take other risks.

You can say to the customer, if you bring over your treasury management product, your business or personal insurance, your credit card, your 401(k) or whatever, I’m going to give you a better deal than the competitor who is selling you only one product because of the 10% cost versus that 100% cost. You give a better deal to your customer, and they want to buy more. You benefit because you’re making more profits. You benefit from lower risk, and then finally you have the phenomenon that the more products that customer has with you, the longer they stay with you.

So it’s magic. We reduce cost, increase revenue, make higher profits, have less risk, and the customer gets a better deal. This is a business model for financial services that is far superior to any other one that I am aware of.

Execution

Kovacevich: Let me ask you, is this easy to do or hard to do?

Isaac: Well, I think it’s easier relative to the other approaches because you can sleep better at night.

Kovacevich: No, it’s harder, much harder, because you need to manage hundreds of businesses and products. Systems have to be capable of aggregating products and profitability by customer so you know what more to sell them and what better deals you can give them to incent them to give you more business. You need to be geographically dispersed. We have 100 different businesses out there doing some very complex things that are difficult operationally, and yet they have to work together as if we are one business from the customer standpoint. And that’s why most people don’t do it.

Relevance to management of risk

Kovacevich: Wells Fargo can now do investment banking, such as underwriting debt and equity and doing customer hedges and all the standard investment banking activities. We don’t have to originate risky structured products or take proprietary trading risk and so on because we have 95 other businesses to make profits from. There’s no way that an investment bank can make attractive returns, in my opinion, with their limited product line and their lack of a deposit base, without taking excessive risks and crossing the line of ethical behavior. That’s why we were never in that business, in a major way, prior to the crises.

Isaac: So you’re saying that you believe affirmatively that investment banking and commercial banking need to be mixed together?

Kovacevich: Absolutely, for diversity of risk. And what got us into trouble was they weren’t. I’m telling you that as bad as Citicorp was, if we didn’t have Bear Stearns, Lehman Brothers, Merrill Lynch, Morgan Stanley, and Goldman Sachs, this crisis would never have reached the level it did. Citicorp survived this crisis, despite doing most of the same things as the investment banks that failed, because it was more diversified, including a deposit base.

The Path To The Precipice

When Sheila Bair became chairman of the U.S. Federal Deposit Insurance Corp. in 2006, the housing market was faltering and subprime delinquencies were on the rise. But even so, analysts were predicting only an 8% drop in home prices and a 15% loss rate in subprime mortgages. No one was taking precautionary action. Within two years, regulators were scrambling to avert the collapse of the banking system.

The following are excerpts from an interview of Chairman Bair by William M. Isaac, Bair’s predecessor at the FDIC under Presidents Carter and Reagan, and currently Senior Managing Director and Global Head of Financial Institutions at FTI Consulting. Bair gives a unique behind-the-scenes view of how the FDIC came to terms with the scope of the crisis and how improvements in transparency can prevent one in the future. She also voices a strong concern for the vibrancy of community banks and the regulatory demands that could stifle their role in economic growth.

As a financial crisis silently loomed in 2006, the FDIC was among the first to see the early warning signs.

William M. isaac: How did you come to realize, so early, that the banking system was in grave danger?

Sheila BAIR: To the credit of the FDIC staff, on the day of my arrival they were talking about the deterioration in mortgage lending standards. We were seeing a marked increase in subprime delinquencies, even in 2006. We bought private data on mortgage-backed securities to try to get a better handle on what was going on. As you know, most of this information was not on the bank balance sheets and therefore not reported to us. What we saw was pretty frightening.

There was already an effort under way to tighten standards for nontraditional mortgages, which are basically the negative amortization products like option ARMs [adjustable rate mortgages]. There were clearly some problems there. Subprime mortgages were deteriorating. So we pushed very hard to tighten lending standards for subprime mortgages and to get the states involved because they had the authority over the nonbank mortgage originators.

I was somewhat in tune with these issues from my days at Treasury, but I credit the FDIC staff for identifying the problems early on. Congress had bills pending to deal with subprime lending issues, but those bills weren’t going anywhere. Ironically, the Federal Reserve had authority to set lending standards across the board for bank and nonbank mortgage originators. But it had decided not to use it.

People said we were being alarmist, and the problem was contained. In researching my book, I’ve gone back to look at the financial market commentary during late 2006 and 2007. Analysts were saying, “Oh, it’s going to be maybe an 8% decline in home prices over a couple of years and maybe a 15% loss rate on subprime mortgages.” That was in line with the groupthink back then. Everybody said housing was going to correct a bit, but it would just be ones with subprime mortgages. The losses would be manageable. So I credit the FDIC staff with being on top of that early and understanding it could affect the insured banks as well. However, nobody, including people at the FDIC, thought it was going to get as bad as it did.

A lot of that will be contained in the living wills and resolution plans. The critical exposure reports, if properly implemented, could be a huge boon. A key bit of information that we were missing: If a financial institution goes into an FDIC resolution process, or if a nonbank goes into a bankruptcy, what’s going to be the impact? Who’s going to take the losses? We just didn’t have that information. We didn’t know who the counterparties were. We didn’t know who the bondholders were. It was very, very difficult. And so the credit exposure reports now put the onus on the institution to basically tell the regulators: If they fail, who else could be materially affected? Or, if some other institution fails, will it have a material impact on the bank or its holding company? I think that’s huge.

Isaac: A lot of people are concerned that we’re going to lose a large part of our community banking system.

BAIR: I believe community banks should be strengthened by recent events. People are not angry at them. People want the high-touch banking that they can provide. Though we had a fair number of small bank failures, on a percentage basis the amount of distress in the smaller banks was significantly lower than it was with the large institutions.

Small banks weathered the crisis pretty well. The big issue is regulatory burden. I’m a regulator. But I believe in common sense and efficient regulation. A lot of the reforms are targeted toward practices that you find in larger institutions. If we just layer lots of new regulations on everyone, even though they don’t really have anything to do with what small banks do, we are going to hurt the community banking sector.

So before I left the FDIC, I started a community bank impact analysis of any proposal that we were going to move forward. We did a community bank impact statement once a rule or proposal went out.

I hope the new consumer protection agency in particular will be sensitive to this issue, because many consumer compliance rules can be quite daunting to a smaller bank. A lot of smaller banks would like to do more in the consumer banking space, but they are reluctant because of the expense. There is some valid concern there.

At the same time, we need to simplify the rules because, frankly, one of the reasons consumer regulation has been weak is that it’s so complex. Consumers can’t understand what their rights are, much less the products. So simplification could really help the community banks and consumers.

Restoring A Shaken Citi

When Richard Parsons was named chairman of Citigroup Inc. in January 2009, the bank had just announced an $8 billion quarterly loss. It was on the brink of being nationalized.

Parsons sat down with William M. Isaac, Senior Managing Director and Global Head of Financial Institutions at FTI Consulting, to recount the harrowing experience of preventing one of the world’s largest banks from collapsing. To Parsons, the government played a major role, and he is less critical of its actions than many of his peers. He argues, for example, that TARP [Troubled Asset Relief Program] and its follow-on measures helped restore confidence in the banking system.

Fast-forward to the present: Citi posted profits of $10.6 billion in 2010 and $6.2 billion in the first half of 2011. Having brought Citi back to life, Parsons articulates the bank’s leadership role going forward, including its commitment to housing finance.
The following are excerpts from the interview.

William M. isaac: What was it like being at the top of Citi during that period?

Richard Parsons: Citi was perceived to be the worst of the worst of the big guys. So trying to navigate that was a challenge. In my view, and I’m certain that it was the view of Tim Geithner [then president of the Federal Reserve Bank of New York] and every thoughtful person in Washington, we just couldn’t let Citi go down. The federal regulatory establishment was committed to the general proposition that we had to figure out how to get this big bank through this crisis — and in a way that was defensible given the toxicity of the environment. We had to figure it out and try to avoid making a mistake that could cause the bank to implode.

It was dicey because it’s all about confidence — whether it’s depositor confidence or counterparty confidence. One of Citi’s issues was that a huge part of its balance sheet and operations was funded in the wholesale markets. If those markets were closed to you, or if investors got spooked, your funding might disappear overnight. So we had to make sure we were doing the things needed to keep the markets calm. Then there was the heat of the battle in Washington. Every bank and all the bankers had become pariahs to many of my good friends and colleagues in the Washington establishment. Bank bashing and fat cat bashing were in vogue.

Isaac: How do you view the way the government handled the crisis? How would you grade its effort?

Parsons: B+. I’m talking about how the government handled the crisis once it was on us. I really do think the system could have melted down. I was told by the Treasury Department that there was about an hour on the Tuesday after Lehman collapsed when interbank trading around the world stopped. Nobody would clear anything. It just halted.

The financial world could have been thrown into total chaos. The government’s response, putting TARP in place and the follow-on measures thereafter, salvaged at least some confidence in the system. The bottom line is we worked through the crisis.

Isaac: But Lehman is part of that story in terms of the government’s actions, right?

Parsons: Certainly, it started off badly. But even if Lehman had been bailed out the way Bear Stearns had been, then the next one would pop up. There could have been more forethought to the handling of Lehman. But I’ve heard people argue that Lehman had to happen, so the sooner the better.
From the failure of Lehman forward, the government’s response was pretty good. But neither our government nor the industry did a good job of communicating why the financial system is different from other privately held industries, and the consequence of letting the financial system slip into chaos. So the angst and the anger caused by the crisis and the government’s response to it were higher than they needed to be. The situation was not helped by the handling of AIG — how we dealt with credit-default swaps and who was made whole without participating in any of the pain. In hindsight, I’m sure people would look at that and say we could have done a better job.

Isaac: What is Citi’s future?

Parsons: Here’s the way I think of it. Citi right now thinks of itself as being in three businesses: institutional or wholesale banking, retail banking, and global transaction services. GTS operates in about 96 countries but serves clients in 140 countries around the world. We have by far the biggest global footprint of any U.S. bank. HSBC is a distant second to Citi in terms of its global footprint.

I think of this GTS system as a circulatory system of the corporate body. It doesn’t have the highest amount of reported net income, although it’s highly profitable. But it connects all the other parts, both in country and across borders. We have a new tagline at Citi, which hasn’t actually been publicly promulgated yet: “America’s Global Bank.” Citi is going to continue to provide connectivity for its largest institutional clients and particularly for the top 5,000 corporations in the world.

Isaac: You said that the GTS is not the most profitable part of Citi. What is?

Parsons: It will bounce back and forth between the securities and banking business and the retail business and cards. Credit cards for a long, long time were a quarter of Citi’s earnings.

Isaac: Is there a future for housing finance at Citi?

Parsons: Yes, there has to be. The most stable and therefore valuable source of funding is deposits. If you’re going to be in that business, you’re going to be dealing with retail customers. You have to have a full suite of products and services to keep them there. You can’t just say, “Look, we want to take your deposits, but we don’t do anything else.”

There will continue to be a significant residential and commercial real estate component to Citi here in North America. But the old business of having a whole network of mortgage brokers out there so that you can get the mortgages and run them through the warehouse, package them up and sell them off as securities — that’s gone.