In the annual meeting of Berkshire Hathaway 2011, Warren Buffett and Charlie Munger recommended the letter to shareholders of Robert Wilmers, chairman and CEO of M&T Bank Corporation. A lot of lessons can be learned from his most recent letter. I will cover some main important points in his letter on the regulations and banking industry in general.
First, he noted that even though the worst of the financial crisis has passed and slowly receded, the overall financial services industry keeps being characterized by attributes which contributed to the crisis, and those characteristics are different from the traditional banking. Those inclusively impose burdens on those banks which pursue traditional banking (such as M&T) and pose significant risks to long-term health of the American economy.
Wilmers is worried about several factors existing in American economy: First is the increased concentration on the financial services where most of the profits are from the trade rather than the prudent extension of the credit that further commerce. Second is the large disproportionately outsized compensation which draws the talent away from the traditional banking and other fields which are crucial for real economic growth. Third is the regulation which enables the “virtual casino,” and does not recognize the difference between Main Street and Wall Street banks. All those factors combined have basically burdened the “real economy.”
He discussed that the banking business traditionally is community and regionally based. The bank often relies on local knowledge for gathering and safeguarding the customer deposits and extending credit for enterprise and commerce. Then this intermediation ensures that those deposits are used to invest in a diversified investment portfolio and provides liquidity and return on their savings for American households. Then the financial services industry has changed quite significantly. To prove for more and more concentration, in 1990, the largest six financial institutions took 9% of all U.S. domestic deposits and 14% of banking assets. But at the end of September 2010, those six largest banks increased to 35% of deposits and 53% of banking assets. The increasing concentration is the major cause of systemic risks. The aggregation of risks in the hands of so few has had significant impact on the fortunes of many others.
The source of income has been gradually more and more different between the large banks and the small and medium community banks. The large banks rely on a much broader and more complex range of activities including trading in derivatives, CDS, MBS and other even more complex and exotic instruments, normally with the help of high leverage. Then those “exotic” positions collapsed in value, which played a major role in the financial crisis.
The largest banks rely more and more on trading revenue to generate more income for them, and they seem to carry it too far. In 2009, the six largest banks had trading revenue of $59.7 billion and pre-tax income of $51.4 billion. One year later, the revenue was $56.1 billion and pre-tax earnings of $75.7 billion. The revenue of two years represents 92.8% and 93.1% of such revenues at all U.S. banks. And for 2009, 2010, the combined trading revenues of just four out of six banks are higher than total pre-tax income of the rest of the entire U.S. banking system.
Some can argue that trading has contributed to the economic growth indirectly by facilitating more efficient financial markets. Nevertheless, the core function of trading is the redistribution of wealth from people who trade with limited knowledge of instruments being traded to the ones who have trading advantages. It is totally different with traditional commerce, where the success is accomplished through the creation of new industries and jobs through entrepreneurship and innovation. The Volker rule is to “disentangle the trading of big financial institutions from their more traditional commercial banking operations, represents a start toward disassembling this unsafe business model. But the problem is deeper and broader.”
The financial crisis has created much more burden on more downstream business, which is the traditional banking like M&T. The failure to distinguish between Wall Street and Main Street by Washington, and the public, has damage the image of Main Street banks and increased the cost of operations for those banks. “One has to question whether we haven’t created the makings of the next financial crisis or, indeed, disrupted the balance in our society between rich and poor. Is this an issue any less important than the wars in Afghanistan and Iraq, the trouble with the euro, the crises in the Middle East, the debt load of the U.S. itself, or the imbalance of trade with China?”
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