There’s a lot of talk in global-regulatory circles about doing something sometime about “shadow banks” – essentially unregulated wolves in regulated-bank clothing. But, an unusual ad in the Wall Street Journal took us to an entity that, while a regulated U.S. banking organization, howls at the moon. For all the excoriation of big banks now the rage, small fry can still pose big, real risk. Why? For risky small banks – as with big ones tempted to go astray — leverage rules miss the point and compliance with all the legal activity restrictions of a banking charter does nothing to constrain high-flying financial fun and games.
We came upon this shadow bank within a bank when a full-page Journal ad in a striking deep blue captured our attention on Wednesday. In it, a company distinguished only by its initials – CXA Corporation – asked all comers to call it for rep and warrant violations on subprime MBS listed in the ad. At first, we thought the nondescript moniker for the MBS older was a new disguise for a tort lawyer. But, pressing on, we found it’s actually a subsidiary of a banking organization, Beal Bank. This isn’t a tiny little insured depository looking for some quick cash in a wholly non-traditional way. Instead, it’s a BHC that owns two banks – one perhaps conveniently in Las Vegas and the other in Big D, little A, double L, AS (Dallas). Together, the state-regulated banks come in neatly below $10 billion in assets, a ceiling its parent is sure to keep them under to avoid the added scrutiny that comes with size.
Do these two insured depositories make the kind of loans that built Bedford Falls? Not exactly. From what we can tell from perusal of the bank’s public releases, the two institutions promise “aggressive, competitive” prices for purchasing loans and other investments from anyone who wants to sell. They also promise depositors across the country higher-than-market rates, conveniently providing a place for you to give them your zip code to learn how much the banks will pay for your insured funds. The parent and/or the banks are also affiliated with several not-so-traditional affiliates, including one involved in commercial real-estate purchases that describes itself as a “hedge fund.” Yoohoo, Mr. Volcker.
Perhaps because this business plan raises an eyebrow, the website backs its offer to take your money with a promise that the banks are highly-capitalized. On a nominal basis, this may well be true. On a risk-based one, I doubt it. What’s the right amount of regulatory capital for holding the tranches in junk MBS the bank, through its affiliate, wants to buy? The four percent leverage rule now applicable, backed by the only slightly higher regulatory capital for these tranches? The Brown-Vitter fifteen percent leverage rule? Or, perhaps, the dollar-for-dollar capital Basel III would impose – a risk-based rule abhorred by advocates of simple banking even though, as this case suggests, leverage lets loose a whole lot of risk even in small banks.
Not only are these banks seemingly well-capitalized despite all their risk, but they’re also well within the borders of their banking charters, doing nothing beyond the “hedge fund” that would be banned were Glass-Steagall resurrected. Dallas’ Richard Fisher and many others have tried to reform banking by walling off banks from their high-flying friends, but a look inside banks like the ones noted above makes clear that barring inter-affiliate transactions or pulling back the safety net from a non-bank does little to reduce real risk in loads of banks.
For years, state and federal agencies have competed with each other by allowing all sorts of products within the scope of the “business of banking.” One of my favorite examples here is the OCC’s decision before the crisis to deem real-estate development permissible – despite an express statutory prohibition on this business line for national banks – because the property in question (the Charlotte Ritz Carlton) was close to a national bank and, thus, handy for putting up the staff and, perhaps, visiting examiners. But, there are lots of other examples of non-bank securities, insurance and investment activities safely ensconced in insured depositories, many of them grandfathered in 1999 when the Gramm-Leach-Bliley Act sought going forward to segregate traditional banking from the hot stuff.
So, simply separating banking subsidiaries from the rest of what goes on in their holding company won’t in fact pull the safety net back under those who gather deposits and make loans, as advocates anticipate. Instead, because of the propensity of banks like Beal to take permissible activities and ramp them into speculative ventures immune from leverage-capital standards, banking – even if seemingly confined to ordinary activities – can be anything but traditional. Even less flighty folk have all sorts of stuff grandfathered into their insured depositories that would take years to unwind even if Congress told them to.
That bank regulators allow institutions to take brokered deposits and hold high-risk assets under cover of being “well-capitalized” is a repeat of all the errors that preceded the financial crisis, with the only comfort here being that this high-risk bank is likely small enough to pose risk only to itself, its creditors and the FDIC, not the rest of us. Its relatively small size should ensure it isn’t systemic, although size is a notably poor predictor of market consequence under catastrophic stress. But the fact that activities like
this can proceed seemingly without constraint after all the hard lessons of the 2008 crisis is a reminder that looking for villains to come in the big-bank trees or the shadow-banking bushes may miss the culprits now a whole lot closer to home.