A couple of years ago—well, getting on 25—Ed Crutchfield, then CEO of First Union Bank, lashed out in frustration at “that little red-haired kid” Tom Brown after reading yet another of his analyst reports on the bank that, in typical fashion, was bluntly critical.
Undeterred, Brown has never changed his stripes in calling it as he sees it. Initially, his work appeared as investment notes as a sell-side analyst for Donaldson, Lufkin & Jenrette, and other firms, then as a manager at the Tiger Management hedge fund.
In 2000, he established his own successful financial services hedge fund called Second Curve Capital, named after a book called The Second Curve, by Ian Morrison. He continues to write regularly on bankstocks.com, the news and commentary site he and his staff have run for many years.
Brown may run a hedge fund, but he never hedges his opinions. You know where he stands. If you take him to task over some view—in person or on his blog—he’s always up for the challenge. But unlike some pundits, he will admit it when he’s wrong.
Agree with him or not, Brown is a keen observer of the banking scene. His commentary is skewed more toward large institutions, but his fund invests in banks down to a “couple of billion” in assets, and, as you will read here, he is not a believer that size alone is better.
The dialogue that follows won’t disappoint Tom Brown aficionados—and will probably annoy the heck out of others. If you find yourself in the latter camp, just keep reading, because you’re bound to find someone else’s ox being gored that will have you nodding in agreement.
Q1. There is still a great deal of anger in the industry toward the largest banks. What would you say to those bankers who view the largest banks as detrimental to the industry’s reputation?
I would say, first, I’ve never been a banker, but I think the big banks have taken a bad rap for many years that they caused the Great Recession. I have written blog after blog trying to explain why I don’t think that was anywhere close to being accurate, and it generates an incredible [counter] reaction every time I do. I don’t think it’s ever going to change.
Of the bankers under $5 billion, maybe half of them agree with me that the Independent Community Bankers Association should not be fighting the big banks as much as they are. But the other half says they should.
My view is that banking industry leaders ought to be fighting together to ease some of the regulatory burden on them. Not fighting against each other, which then doesn’t enable anything to get through Congress.
Q2. A couple of months ago, you took BB&T to task for the bonus that the board voted to give top management for the acquisition of Susquehanna Bancorp, if it works out. Why is it that managements and boards of banks—large or small—sometimes appear tone deaf to the impression such
BB&T has a record of being an extremely well-managed organization. But as I wrote, it absolutely makes no sense to me [to pay management a bonus for doing what is, essentially, its job]. With some institutions, you might say the management was just greedy. But that would not be what I would suspect is the motivation here.
I think if I had to look at one factor, it would be, frankly, an incestuous board. I’m a fan of—let’s call them—soft term limits. So after somebody is CEO for ten years or after somebody is a board member for ten years, I think the burden should be on them as to why they should stay in that position. We need more turnover. We need more dissent.
Q3. Two-part question. First: In your time in the business, can you think of any improvement in the regulatory regime? Or has it only progressively grown more complex and burdensome? Second: If you were in charge for a day, what would you change?
You know, we’ve seen a couple of major real estate cycles, and, certainly, the rapid growth in outstandings, and the concentration in outstandings wasn’t something the regulators caught in the second cycle [leading up to 2008], but maybe the necessary changes are in place now so that it won’t be as painful in the next cycle.
But what I worry about the most is that we have now pushed so much business outside the banking industry that the credit problems in the next economic down-cycle will take place in the shadow banking system. The best example of that would be leveraged lending. The regulators have been all over the banks to cut back on their leveraged lending, and they have. If you look at where the non-performing assets are in the leveraged lending portfolios today—in a healthy economy—they’re eight times higher in the shadow banking system than they are in the banking system. Nobody is looking at those lending activities.
Some of the individuals in the regulatory bodies are so scared to death that they’ll be called in front of Congress again that they are coming out with rules and regulations and supervisory actions that are overly restrictive, making it easier for the nonbanks to pick up business.
If I were in charge for a day, the overall goal would be to simplify regulation. There are too many people inside a bank today that do nothing but try to focus on compliance.
Take a $5 billion bank. They’re getting pressure now to not only have a chief credit officer, but to also have a chief risk officer. That’s not even a requirement for a bank that size, but the examiners come in and they say, “Well, that’s a best practice for a bank over $10 billion and that seems to be where you’re headed, so . . . .”
Also, we’ve got too many conflicting regulations today. For example, large banks have new liquidity requirements, and they have higher capital requirements. But the liquidity requirements and the capital requirements are in conflict, because to increase your liquidity means you increase the level of [liquid] assets, which then means you have to increase your capital position.
As for rolling back Dodd-Frank, I think with any major legislation like healthcare or Dodd-Frank, there are certain elements that even a guy like me would say, “Okay, that’s a constructive change.” For instance, it eliminated the OTS, so that’s a positive that I wouldn’t change. But I think there’s probably about 90% of that law I would change.
Q4. Given his focus on supervision, is Federal Reserve Board Governor Daniel Tarullo the most powerful person
in the banking industry?
If there’s a populist sentiment against big banks that is very strong and very deep, that’s exactly how I feel about Dan Tarullo. He is the most powerful person. He’s never worked in the private sector. He’s big government—knows all the answers—but, unfortunately, all major [supervision] decisions go through him. He is out to get big banks and big bankers. And I don’t think that’s his job. I wish more of the Federal Reserve Governors would get involved in bank supervision, but they all love monetary policy so much they don’t.
One of the results of this is the conflict between having higher capital standards and having a stress test. We don’t need both. If you can pass a stress test and have the minimal level of capital based on the assumptions that our regulators are requiring, then I don’t think holding institutions to a separate capital standard is necessary. We’re wasting a lot of effort by having both of them.
I’m not a big fan of models. Look at the modeled losses on single family residential mortgage loans and what actually happened. So I think we’re better off with just capital standards. What I don’t like about the stress tests is the arbitrary nature that has been put into the process. Essentially, any bank can be failed, because the Fed won’t give the banks enough guidance as to how they’re actually conducting the stress test this particular year. It’s like they purposely try to embarrass the bank managements by failing them.
Q5. Shifting gears, changes in the fintech world are coming fast and furiously. How big an impact do you see for banks?
I give a lot of speeches to bank boards, bank industry groups, and bank management teams, and in my presentations, I’ll often include a picture of an empty [bank] branch. My biggest concern—because I’m an investor—is that I’ve got a bunch of Kodaks in my portfolio. They’re Kodaks because of the fintech competitors that are developing. So we spend a lot of time trying to understand fintech competitors.
But the impact depends on the product. In the remittance business, we’re seeing companies come along and dramatically lower the cost of transferring money, and it’s wreaking havoc on the business models of MoneyGram and Western Union.
With marketplace lenders, however, the bet is that they are going to be a better underwriter, a lower cost originator than companies like Capital One or Bank of America. I don’t think that’s going to happen. One reason is because I don’t think the business model works. And secondly, I think the valuations of the companies are excessively high.
One of the things I’ve learned is that specialists—monolines—can be very successful for a period of time. And then either the lack of diversification or their push for excessive growth in a restricted area causes the specialist to lose.
Also, with some marketplace lenders, such as Lending Club, the question is when they sell these loans, are they securitizations? If the regulators rule that they are, then the lender is going to have to comply with the skin-in-the-game requirements. And that completely changes the business model, because of the capital they’ll need to grow the business. So the cost to originate seems, to me, to be too high. Some argue that that cost will come down as they get bigger. I don’t think it will come down far enough.
One other thing: With a lot of the fintech developments, if the business relates to funds, then they must have a bank partner. That works well as long as you’re not big. But when the nonbank starts driving the results of the bank, then you get the watchful eye of the regulators. We see this in the debit card business, where two banks dominate the nonbank debit card business. One is called Bancorp, and the other is Meta Financial. We are large shareholders of both. Both of them have gotten hammered by the regulators because of concerns that the prepaid card business can be a money laundering tool. And so the systems required of players in that business are incredible. They basically have to have the same BSA software that Citibank uses.
Q6. What leadership traits have you observed over the years that set apart successful banks you have followed?
I have seen many different leadership styles. Take Dick Kovacevich [retired chairman of Wells Fargo]—one of the all-time great CEOs. His leadership style was to inspire, and as the bank grew bigger, he grew less and less hands-on. But he came up with some key principles of how the company was going to operate, and he was able to communicate that throughout the organization, and they executed it well.
Then again, I think Jamie Dimon will go down as one of the greatest CEOs of all time. But, unlike Kovacevich, he needs to understand how every one of his businesses works and how they make money and what the risks are. And so he has a deep understanding of each of the businesses. For Jamie, that style works.
In both cases—and this is true with all great CEOs—you can’t force growth. If you’re a highly leveraged institution like banks are, you have to take what your franchise is giving you at that particular point in time. So you can’t come out and promise 15% earnings per share growth every year, because you don’t know you can deliver that. I’d say a lot of top 100 banks, when they get on a roll, begin to believe that they can’t do anything wrong, as opposed to recognizing that they’re at a very favorable point in the economic cycle. In my business, we’d call that confusing brains with a bull market.
Whereas great CEOs, like both of those two individuals that I mentioned, will pull back on the growth in certain lines of business when they think that they should.
Q7. What’s your take on the community bank sector? Do you buy into the need for a certain scale?
In every one of my presentations, people will ask, “What’s the optimum size?” And I have an answer, but what I point to is that if you look at banks that are $100 million, $500 million, $1 billion, I can show you a very successful bank at any size category.
So it’s not that there’s a size that’s too small. But somewhere between $1 billion and $50 billion is a sweet spot, in my view.
That said, the number of acquisitions in 2015 as a percentage of the banks that existed at the beginning of 2015 is almost back to the peak activity that we saw in the late ’90s. And almost none of that is among banks above $5 billion in assets.
The reasons for that are, number one, the fact that smaller banks now have to add a chief risk officer, among other things, which is expensive. But regulatory burden is not just a cost. These guys are just frustrated they can’t operate their companies like they used to, so it’s the cost of regulations plus increased scrutiny.
The second reason is they’re not earning an adequate rate of return on the capital for their investors. And the investors are tired. I listen to a lot of earnings conference calls, and it is a knee-jerk reaction of management and shareholders to say that, “We’ll all make a ton more money when interest rates rise.” As an investor, that worries me. It’s just not going to be that simple.
In banks of any size, there are two ingredients that we always find lead to success. One is focus. They don’t do everything. They don’t serve every customer in every market. They’re focused on a few things that they do really well. And the second one is the quality of the management.
So community banks can, in some ways, be like a monoline, but not a pure monoline. They have the ability to focus on lending to certain industries or they can be in certain geographies. That can also bring increased risk, but in any metropolitan market, typically what you’ll see is a large national bank losing market share, a large national bank holding market share, and a community banking organization that has been consistently gaining market share. So it bugs me when banks of a certain size say, “We’re not big enough to compete.” Because I can show you banks of any size that are doing very well. And if you don’t know how to run your core business well and grow organically, then you shouldn’t be making acquisitions.
This article originally appeared in Banking Exchange magazine’s September 2015 edition in the “Seven Questions” section.