U.S. Banking System Recovery After the 2008 Financial Crisis

The State of the Banking Industry at the Time of the Recession

The American banking system was in crisis from late 2007 through early 2009. The subprime mortgage crisis had left many banks with large amounts of so-called "toxic assets" on their books, mainly in the form of subprime mortgages and mortgage-backed securities that were now underwater. The mortgage-backed securities were one of the biggest problems, because they were presented as being of investment grade, which did not align with their actual risk characteristics. For a time shortly after Washington Mutual failed, there was concern that the banking system was at risk of collapse. Invoking the doctrine of "too big to fail," the Bush Administration responded with the Troubled Asset Relief Program, or TARP, wherein the federal government bought back some of the worst assets from the banks in order to stabilize the system.

Since that point, the U.S. economy has recovered, albeit slowly. The stock market recovery has been the strongest indicator, and that is largely due to successive rounds of long-range open market transactions colloquially known as quantitative easing, and the Federal Reserve holding interest rates near zero for a period of seven years. Both of these aspects of monetary policy pumped tremendous amounts of money into capital markets through the banks and enriched them considerably. Other macroeconomic indicators have not been as favorable: unemployment took the entirety of the Obama Administration to drop to a reasonable level, and GDP growth never accelerated enough to cause inflationary pressure. The latest announcement on the Fed funds rate indicated that the central bank remained concerned about the pace of economic expansion, citing rather vaguely "recent global economic and financial developments" (FOMC, 2015) — a reference widely interpreted as alluding to the slowdown of the Chinese economy and the ongoing Euro crisis involving Greece.

This paper outlines the state of the U.S. banking system since TARP was implemented. Since that point, the banking system has enjoyed a healthy recovery, based in part on the effects of expansionary monetary policy and in part on improvements in the broader U.S. economy. The Dodd-Frank Act was also passed, bringing a measure of reform to the financial system. All of these issues are discussed with particular reference to the largest U.S. banks.

The starting point for this discussion is the state of the banking industry at the time of the recession. Most U.S. banks were in peril at this time. The U.S. banking system has traditionally been fragmented, but regulatory changes brought about the emergence of major regional banks, some of which are now approaching national saturation levels. Structurally, this represents a shift toward the model followed by virtually every other major country in the world. Banks throughout Europe and all other major Western economies are typically national-scale entities. There were no trade barriers preventing Canadian banks from operating across provinces, or Australian or South African banks from operating across states. National-level banks are more diversified in terms of their customer bases, and they enjoy greater economies of scale — both of which reduce the risk they face. U.S. banks, constrained by state limitations, were at their riskiest. Even the larger banks that operated across many different states remained vulnerable, as the Washington Mutual failure demonstrated.

As a consequence of apparently favorable risk-return characteristics — though this proved false, it was widely believed at the time — mortgage-backed securities were popular globally among banks. As a result, banking systems around the world struggled mightily with the recession. European banks in particular held far too much risk on their balance sheets. There were crises in places like Iceland, but the more consequential crises were among the major British and European banks, who had followed the same path as American banks with respect to risk and were now similarly imperiled. Banking systems that fared well during this period, such as those of Canada and Australia, were limited in their exposure to toxic assets by virtue of restrictions placed on banks in those countries (Isfeld, 2012). Those countries' banks are now heavily exposed to slumping resource sectors, but that is another matter entirely (The Economist, 2015). The key point is that with few controls on investments and risk, American banks were incentivized to seek out profit and were imperiled as a result. Moreover, they knew from past experience that they would be bailed out by the government — and they continued to operate with the knowledge that they were too big to fail (Sherter, 2010).

Major banks typically operate in three main sectors: community banking, wholesale banking, and investment management. At Wells Fargo, for example, community banking accounts for 61% of the business, wholesale banking for 29%, and the remaining 10% falls within wealth and investment management (Keats, 2015). This is consistent with industry norms, as these major retail banks arose primarily in the consumer market and have only more recently made greater inroads into other banking categories.

The U.S. Banking Business Model

There are still two broad types of banks in the U.S.: the small local banks that have always existed and were once the backbone of the system, and the major "too big to fail" banks. The former category is not of particular relevance to this paper, which focuses instead on the latter group. The major banks — Citigroup, Bank of America, Wells Fargo — are all at or approaching national scale. They have grown dramatically over the past few decades since the industry was partially deregulated, and this growth has come almost exclusively through acquisitions. Evidence now suggests that this consolidation trend is only beginning to slow (Jones & Critchfield, 2006), as the industry has become sufficiently concentrated at the top, with the five largest banks holding around a 50% share of industry assets (Schaefer, 2014).

The largest banks are now diversified in their operations. They are not just retail banks but commercial ones as well. The industry is also moving toward a model in which banking is not a strictly local industry but a national one — a shift driven not only by regulatory changes but also by technological advances that have dramatically lowered the cost of obtaining banking services from distant providers (Wheelock, 2011). This structural change effectively expands the competitive field in any major market, where multiple large banks and many smaller institutions compete for the same customers.

The major banks compete on several bases. On the revenue side, they leverage their multitude of service offerings from diversified business lines to attract customers. Their size also likely makes them more attractive — perceived as secure in a way that small local banks can never be. On the profit side, they exploit economies of scale to increase margins. These competitive advantages are well supported by the current structure of the major banks, which at this point largely dictate the terms of competition on the basis of their vastly superior resources.

Major Bank Performance: Citigroup, Bank of America, and Wells Fargo

Citigroup

Citigroup has enjoyed strong performance in recent years. While it has experienced fluctuations in both revenue and profits, the company has earned at least $7 billion in each of the past four fiscal years (MSN Moneycentral, 2015). Citigroup has thrived since the TARP era and has rebuilt its capital position to a level exceeding what it enjoyed before the recession. As of fiscal year 2014, Citigroup held $140 billion in regulatory capital, a Tier 1 common capital ratio of 10.6%, and over $400 billion in "highly liquid assets" — all of which indicate a very strong capital position (Corbat, 2014). Citigroup has become a leaner company in the process. The quality of its assets has improved markedly, including a steep reduction in Citi Holdings and a reduction in the number of legal entities in order to simplify the company's balance sheet (Corbat, 2014).

These balance sheet improvements have accompanied steady and strong profitability over the same period. Citi has operations in other countries, notably Germany, and this international diversification has been an advantage — it is one of the more globally diversified American banks. The broader industry remains focused on the domestic market, however, and internationalization represents a departure from conventional U.S. banking strategy.

Bank of America

Where Citigroup has fared well since the recession, Bank of America's performance has been more mixed. Its revenues and profits have fluctuated considerably — Bank of America earned ten billion dollars less in 2014 than it did in 2011, though in 2011 it posted an operating loss due to a major writedown (MSN Moneycentral, 2015). That writedown left the company with a net income that was still positive at $1.446 billion, but this equated to just one cent per share in earnings per share (MSN Moneycentral, 2015).

There have also been serious issues with Bank of America's reported capital position. In 2014, the bank disclosed that it had $4 billion less in regulatory capital than it had previously been reporting. The bank would still have passed regulatory stress tests regardless of the $4 billion error, which might suggest an underlying financial resilience. The company had also increased its capital position by nearly tenfold since the recession, which is why this error was, ultimately, considered immaterial in terms of solvency.

Nevertheless, the situation raised significant concerns. The more troubling issue was that the error had gone undetected for five years. That such a major discrepancy could persist for so long raises serious questions about internal controls. Senior executives received larger bonuses on account of the misstatement, which is precisely the sort of conflict of interest that can result in fraud — as any auditor would recognize. The scandal also raised significant concerns about the competence of lead auditor PricewaterhouseCoopers. Some observers noted that the error fit within a larger pattern at the bank, which also included an inability to accurately estimate its mortgage liabilities in the run-up to the recession and a lack of clarity around legal costs — all evidence of weaknesses in the company's internal controls (Morgenson, 2014).

As a consequence of this error, Bank of America was forced to revise downward its regulatory capital ratios, with Tier 1 capital falling by 29 basis points under the Basel III advanced approach. The company was also placed at risk that the Federal Reserve might identify procedural weakness in its internal controls and take objection to the bank's revised capital plan (Vardi, 2014). While Bank of America has remained generally healthy after the recession, its financial controls have proven weak, and the company's overall performance has been considerably more volatile than Citigroup's.

Wells Fargo

Wells Fargo has enjoyed exceptional financial performance since the recession. Its revenues have fluctuated over the past four years, but its net income has increased steadily — from $15.8 billion in 2011 to $23 billion in 2014. This performance drove the company's earnings per share up to $4.17 from $2.85 in 2011. This track record has, in turn, been reflected in Wells Fargo's capital position and other measures of financial health.

The company's Tier 1 capital ratio under Basel III norms stood at 10.7%, and there has been a significant reduction in non-performing assets. Wells Fargo also reported that its credit quality remained strong during this period, an outcome related to its ongoing efforts to reduce the volume of non-performing assets (Keats, 2015).

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