Bank of America: Eliminating Non-Core Operations After 2008

Executive Summary

The financial crisis of 2008 was proof of the fallibility of financial models and predictions. The future, by definition, is unknowable. Financial models and prudent foresight are not enough to predict future events. No individual was able to forecast the September 11th terrorist attacks, Pearl Harbor, or the spread of Ebola. These events are uncertain, but each had implications for banks, their shareholders, and society. Although such events cannot be predicted, they should, at the very least, be accounted for. Individuals can do little more than prepare for the inevitable rare event, whenever it should strike.

This proposal is grounded in the framework that the future economic climate of America and the world at large is unknown. Technology changes, personal consumption habits change, and society's priorities change. One thing that cannot change, however, is the need to provide capital to market participants. This is the ultimate function of the banking system throughout the developed world. Bank of America is critical to the proper functioning of the American economy. Therefore, this report proposes that Bank of America rid itself of many of the risky assets and operations it owns — assets that nearly toppled the American economy. With over $1 trillion in deposits, 5,000 locations, and over 200,000 employees, society depends on Bank of America's survival. Participating in risky behavior that does not benefit the bank's constituents is a recipe for financial disaster.

To better accommodate the needs of society while reducing risk and enhancing shareholder returns, the following is proposed. Bank of America should spin off non-core assets when adequate value can be obtained for them. "Non-core" assets are defined as operations that are not essential to the bank's core customers or mandate. Derivative financing, for example, is not critical to the bank's mandate of taking deposits and lending money to individuals. Aspects of the bank's trading operations should also be eliminated, as they are predicated on greed rather than on actually helping society.

Further, lending and underwriting standards should be strengthened to better protect the bank from the economic downturns that will inevitably occur. Through stronger underwriting standards, losses in economic downturns will be less severe than in previous business cycles. The primary reason Bank of America found itself in its troubled position was faulty underwriting standards. The bank lent money to individuals without appropriate documentation or collateral, and it participated heavily in the subprime market — lending to individuals with questionable credit histories and, in some cases, credit scores below 500. The company subsequently experienced heavy financial losses during the crisis and required government assistance.

Finally, this report proposes that the company maintain strong liquidity and loan loss reserves in the event that mass defaults occur. Due to faulty underwriting standards, the bank has paid over $100 billion in fines to individuals, governments, and municipalities. Although higher lending standards will make the bank less profitable in the short term, they will save far more money over time and reduce reputational risk for the firm.

The financial crisis of 2008 created a wide range of economic problems throughout the world. Nearly eight years after the initial crisis, many firms and economies continued to struggle. Bank of America in particular engaged in a number of harmful practices during the crisis. Robo-lending, misaligned incentives, and outright fraud contributed to the near-demise of the firm. As a result, Bank of America should use its past experiences to downsize and eliminate risky operations. By shrinking the balance sheet of the bank, both society and Bank of America shareholders stand to benefit (Pitt, 2005).

Introduction and Scope

The purpose of this report is to outline the reasons why corporate downsizing and restructuring are recommended. Both the advantages and disadvantages of this initiative are analyzed and discussed. Recommendations are supported by thorough analysis and due diligence. The report first documents the need for banks within a market economy, with particular emphasis on their unique role in capital allocation within society. A discussion of the risks embedded in the banking industry follows. This section addresses why the elimination of non-core assets will help Bank of America become a more viable franchise. The firm must take two steps back in order to move three steps forward.

Data for this report comes primarily from financial publications and resources, including corporate filings with the Securities and Exchange Commission (10-K, 10-Q, and similar documents), as well as reputable publications such as the Wall Street Journal and Barron's.

The report first establishes the need for eliminating non-core business operations, emphasizing both the advantages and disadvantages of this course of action. It then analyzes the qualitative factors that contribute to severe bank losses and explores how the frequency and severity of such losses can be mitigated.

As noted in the introduction, Bank of America plays a vital role within the American economy. Bank of America is, in a very real sense, "America's Bank." It should therefore conduct its operations with a mindful focus on customers first. If the bank delivers what customers need, profits will follow. As recent history has shown, when a bank deviates from its core customers, the initial increase in profits ultimately gives way to a severe decline in profitability. Why earn profits in good years only to give far more back in fines, ill-will, and negative publicity?

Advantages of Eliminating Risky Banking Operations

Litigation expenses represent a critical dimension of this problem. Data provided by SNL Financial indicates that Bank of America had, by far, the largest legal settlements among its large-bank peers. These litigation costs not only hurt profitability — they also damage the overall reputation and standing of the bank. By eliminating the more risky areas of the bank's operations, including derivative trading and proprietary trading, the bank will be better positioned to reduce these costs in future years (Peter, 2007).

The efficiency ratio is another important metric. This ratio measures how well a bank controls its expenses. The lower the ratio, the better: a ratio of 0.60 means that 60 cents of expense generates one dollar of revenue, which is more efficient than a ratio of 0.70. Bank of America has carried the largest expense ratio among its peer group, driven primarily by litigation expenses stemming from faulty underwriting standards.

It is instructive to compare Bank of America with peers such as U.S. Bank and Fifth Third Bancorp, which did not have significant exposure to subprime lending. Neither institution appears among the top 25 subprime lenders, yet both rank among the most profitable banks in America. Their profitability stems from a focus on core operations and core customers — without manufacturing short-term profits through high-risk behavior.

The argument for eliminating risky lending standards and operations is compelling. Bank of America was profitable in the years leading up to the financial crisis, but subsequently surrendered those gains and more after 2008. The bank has paid over $100 billion in fines and continues to suffer reputational damage. These losses were sparked by high-risk activities that, this report argues, should be eliminated entirely. Sub-prime lending cost the bank billions of dollars and provided no meaningful benefit to society. Lending money to individuals who cannot afford to repay it is a recipe for disaster. By eliminating these operations, the bank can reduce costs, improve its efficiency ratio, write better loans, and ultimately achieve greater long-term profitability — even if near-term earnings are somewhat reduced (Yuliya, 2007).

Conclusion and Recommendations

The positive attributes of Bank of America are being overshadowed by the terrible operations of recent years. The elimination of trading operations, subprime lending, and proprietary trading serves two main purposes. First, the bank can better focus on its core customers, delivering improved experiences and more relevant products. Second, the company can eliminate the risky behavior — predicated on short-term greed — that cost it so dearly in the past. In essence, by becoming less risky, the company can become more profitable while also providing a vital service to society.