Will COVID Finally Give Big Banks Their Direction?

By Shreya Jain

If the recently finished 2020 has taught us anything, it is that we’d do well to re-evaluate the way things usually work. And in a world, that is still struggling to its feet after a tumultuous year, one can look around and notice that some pieces of reality have played musical chairs: social activities once regarded as keystones of public life are now greeted with deep suspicion, even fear; previously stable industries are on life support; and minimum wage employees suddenly bear the mantle of “essential workers” despite few immediate benefits of this increased responsibility.

Life, in other words, is not behaving as usual. And neither are the banks.

According to FDIC data, a record $2 trillion[1] has been deposited in U.S. banks since the coronavirus first struck the U.S. in January. More than 5.2 million[2] loans were issued by banks participating in the Paycheck Protection Program (PPP) to keep several businesses afloat during the COVID-19 induced pandemic. This is the primary role of banks – to accept deposits and to grant loans.

In a direct juxtaposition to this primary role, if we look at the sources of revenue for banks to determine its role, especially during crisis, it however tells a story of banking institutions deviating from their primary role.

Consider the revenue distribution for a few top banks (Fig. 1):

Fig. 1: Composition of total revenue in 2019 H1 and 2020 H1

For all three of these banks, an increasing percentage of total revenues has been coming from the Investment Banking division, primarily driven by the Fixed Income Market.

In fact, in the most recent Dodd-Frank Stress Tests (DFAST), Goldman Sachs and Morgan Stanley are ordered to hold the most capital of all the 34 firms tested- 13.6% and 13.2%[3] respectively. Goldman Sachs and Morgan Stanley have particularly high stress buffers because of the nature of the Fed’s exams, which put extra pressure on banks that rely heavily on capital markets; Goldman Sachs also has their decision to maintain dividends.

There is an intriguing question in all this – one made easier by recent developments.

“Should Banks be in a Growth Business?”

There are a number of sources to draw from for a possible answer. We have a number of lessons from the past. The Glass-Steagall Act is a 1933 law that separated investment banking from retail banking. By separating the two, retail banks were prohibited from using depositors’ funds for risky investments. Only 10% of their income could come from selling securities. They could underwrite government bonds. [4]

However, the banking industry soon objected that the act was too restrictive. They believed they could not compete with foreign financial firms offering higher returns as the U.S. banks could only invest in low-risk securities. They wanted to increase returns while lowering overall risk for their customers by diversifying their business.

The most audacious move was when Citicorp and Travelers Group — a commercial bank and financial services company, respectively – merged to create Citigroup Inc. It was an unforeseen event that took the financial world aback for a number of reasons – not least of which was that such a move was technically illegal. But Glass-Steagall had a number of exploitable loopholes. This was just one possible outcome.

On November 12, 1999, President Clinton signed the Financial Services Modernization Act that repealed Glass-Steagall. This consolidated investment and retail banks through financial holding companies.[5] , creating new entities supervised by the Federal Reserve. For that reason, only a few banks took advantage of the Glass-Steagall repeal. Most Wall Street banks did not want the additional supervision and capital requirements.

Those that did take advantage became “too big to fail”.

The Bigger They Are…

The focus today on “Growth” above and beyond what would otherwise be allowed under Glass Stegall Act has been worrisome. The…