Over the past year or so, several activist investors have poured millions into a campaign to wrest Fannie Mae and Freddie Mac from their Treasury-constructed conservatorships. Enveloped in a cloud of taxpayer-protection rhetoric, this campaign is of course about realizing a huge win on a highly-speculative bet. It’s unlikely to succeed, but that doesn’t mean it isn’t a very loud, very important bell ringing to alert the largest U.S. banks to what a similar attempt could do to their own franchise value. Already under siege by break-em-up forces on the Street and up Capitol Hill’s way, individual banks and the industry more generally will take direct fire if a coalition of like-minded investors akin to that challenging the GSEs decides there’s money to be made in breaking up big banks.
Sometimes, the break-em-up bunch talks, as Chair Yellen does, in academic, hands-off terms about requiring the largest U.S. banks to “internalize their negative externalities” – translation, turn them inside out to empty out their pockets. Sometimes, the rhetoric harkens back to the financial crisis and the trillions it of course cost our collective public good – the shareholder resolution seeking to restructure BofA is a case in point here. And, with particularly devastating impact, the break-up rationale sometimes comes in dozens of complex charts and tables prepared by activist analysts looking at the very biggest banks in hopes of greater investor return. Some of these arguments are, I think, right; others, quite wrong-headed. But, together, they constitute the greatest challenge to the business of banking since the 1930s.
Of course, U.S. big banks aren’t Fannie and Freddie. Even though no one much likes them, they aren’t the political lightning rods the GSEs have become nor are they as much under the political thumbs of both the White House and Congress. Further, the huge (or still sort-of huge) market cap of the biggest banks gives them considerably more insulation from activist investors than the GSEs, where common shares trade for pennies. However, the largest U.S. banks are nonetheless at grave strategic risk because of the gathering perfect storm of punishing regulations that change key business fundamentals, activist investors and analysts who see short-term gains from these stress factors, and continued embarrassments and operational failures resulting in part from still-complex corporate empires.
Banks south of the G-SIB thresholds might take comfort in the fact that, so far, activist investors and opinion leaders are largely targeting the very biggest U.S. banks. However, I caution all of them not to rest easy. The smaller the bank, the easier it is for one or more investors to go after the franchise either to gain de facto control or force a divestiture that rewards their bet regardless of its long-term impact on real shareholder value. A lot of banks in the $100-500 billion are the artifacts of years of M&A that still doesn’t really work all that well when considered holistically. With new deals harder to find or get approved, determining which sources of organic growth have future value and which don’t is vital. Banks that don’t take this on for themselves can, I think, count on investors to do it for them.
Banks are of course mounting a formidable policy and political defense against not only the regulatory storm, but also the political wind-shear that fuels it. This will insulate the industry to some extent, but the new capital, liquidity, resolution, and broader prudential framework is largely in place and immune from near-term rewrite. The market forces pummelling the industry also aren’t likely to ease and, indeed, some could grow dangerously worse given recent near-death experiences with market illiquidity. And, of course, non-bank competitors aren’t going anywhere anytime soon but further into the core activities that once defined the fundamental business of banking.
The strategic franchise-value challenge has a two-part solution. First is of course to continue the policy discussion so that unintended consequences of new rules are identified as quickly as possible and corrected before they spark another systemic crisis for which big banks are almost surely to be the scapegoats and, thus, be broken up for sure and by statute.
Second, and at the same time, banks need clearly and carefully to lay out for themselves where their current structures have value and where they don’t under the new rules in the new, empowered financial marketplace. Where the franchise is credible as is, a stout defense of it needs quickly to be mobilized – policy-makers can be put off, but activist investors smell blood and have quick reflexes. Where key business lines are not, in fact, long-term keepers under the new framework in light of the evolving marketplace, best to move fast before investors make the bank do so on their terms, not its own. This is an unforgiving arena in which banks that wait for all the rules to be finalized before sizing up their franchises will find themselves under simultaneous assault from regulators, policy-makers, investors, and competitors.