The hidden costs of bailoutby James Frischling, President, and Ron D’Vari, CEO, NewOak
JP Morgan currently has the high watermark of $13 billion in terms of settlements with the government over its mortgage operations, but Bank of America may be on the verge of taking over that position. While the two sides are at an impasse, negotiations between the bank and the Justice Department are at a $12 billion offer and a $17 billion ask.
One of the commonalities between these two banking institutions is the acquisitions both made at the height of the financial crisis. While some of the acquisitions were encouraged by the Federal Reserve (and “encouraged” may not be a strong enough word to capture the pressure these institutions felt to take on these troubled firms), others were done of their own accord.
JP Morgan unsuccessfully tried to argue in its negotiations with the government that the penalties on the mortgage activities associated with Washington Mutual and Bear Stearns should not be levied as harshly on the bank as its own mortgage securities business. Bank of America is also trying to have the government distinguish between its activities and the ones that were undertaken by Merrill Lynch and Countrywide. Based on how JP Morgan faired with the Justice Department—and because its acquisitions were essentially engineered by regulators—Bank of America finds itself in a tough spot. While the acquisitions of both Merrill and Countrywide were meaningful in containing the financial crisis, neither were seen as taking place at the urging of the government.
The immediate issue is for the bank to put this chapter behind it, so expect Bank of America to try to reach a deal close to its current offer price of $12 billion. The forward-looking issue is how financially strong institutions will respond when asked to step in to help quell a financial storm. The message that must be taken from the current wave of investigations and settlements is that if you help now, you still will need to pay later. Picking up the pieces of some of these failed institutions may have proven to be the far more cost-effective strategy, assuming there was still a system to save.
SME Lending: Where Are the Banks?
Despite all the talk about focusing on small-to-medium enterprises (SMEs), banks’ ability and willingness to lend to SMEs is at its lowest point in recent history. Yet SMEs employ many more people in aggregate than larger companies and significantly outnumber them. Further, SMEs are driving innovation and competition in many economic sectors.
There are several reasons for lower lending to SMEs. One is that their deposits dominate the total profitability of a bank’s SME book and not the SME loan portfolio. This is partly due to the risk capital charges and lower rating of the SMEs and partly due to the higher cost of due diligence and lack of underwriting skills of such entities. Additionally, the lack of ability to syndicate, trade and securitize SME loans has limited the additional fees earned in these activities in large company leverage loans.
The new regulatory rules have had an unintended consequence. Given the stricter capital requirements of Basel III, banks have been optimizing their risk-weighted capital allocation and cutting back on their SME lending. Instead, banks are allocating capital to other higher-margin activities like commercial and residential real estate lending.
While the Federal Reserve has recognized that economic recovery and job creation will be propelled mostly by SMEs and has tried to encourage it, at the same time it has cautioned banks to adopt tighter lending guidelines. Lack of SME originating, underwriting and servicing skills and capacity have turned into a major stumbling block preventing banks from replenishing their SME portfolios, let alone growing them.
The banks’ curtailment of SME lending activity has created a unique opportunity for non-bank finance firms that can underwrite working capital as well as asset-based lending and manage the covenants. Non-bank finance firms are developing more and more capabilities for underwriting SME loans and are using new technology and big data infrastructures to manage the work process flow and make it transparent to the stakeholders.
NewOak is an independent financial services advisory firm built for today’s global markets. Led by a team of experienced market and legal practitioners, NewOak provides a broad range of services across multiple asset classes, complex securities and structured products for banks, insurers, asset managers, law firms and regulators, including financial advisory and dispute resolution, valuation, credit and compliance, risk management, stress testing, model validation and financial technology solutions. We have analyzed or advised on more than $4.5 trillion in assets to date.
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