Eugene Ludwig Speaks on the Changing Banking Sector

The following is a speech given at the recent AGI Symposium “Fueling the Recovery: The Role of Capital Markets and Banks” in Frankfurt, Germany by Eugene A. Ludwig, Founder and Chief Executive Officer of Promontory Financial Group. The Symposium featured two panel discussions focused on analyzing the impacts of economic and financial policies in Germany and the United States in order to increase cooperation and understanding in the transatlantic relationship.  Mr. Ludwig was a member of the second panel, “The Changing Banking Sector: What Kind of Banks Do We Need?” during which panelists discussed the changing banking industry, evolving banking regulations, and  differences between the U.S. and European banking climates. 

Thank you.  As Jack said, it is an honor to be here.  I would like to thank Alexander Privitera for his kind invitation, and Martin Blessing, Roger Blisset, Stephan Leither, and Gerhard Hoffmann for the opportunity to speak with them today.

This is a particularly appropriate time to be discussing the role of banking in the economic recovery.  The ECB’s unprecedented decision last week shows how, six years later, the legacy of 2008 still looms large over financial policy and markets.

The same is true in the United States, where, as many of today’s speakers have pointed out, the capital markets have roared ahead in growth, while the banking sector has, by comparison, lagged behind.  However, the merits of this trend are the subject of much debate, and the question of banking itself—of what traditional, chartered banks should do, and on whose behalf they should work—is still very much unresolved.

The financial crisis itself put major constraints on the banking sector, as consumers looked to shed debt and save money in tough times.  But post-crisis reforms, designed to ensure that taxpayers never again have to bail out a financial institution, constrained traditional, chartered banks even further.

The key to these reforms is the Dodd-Frank Act, which clearly envisions a heavily regulated banking sector, holding higher capital and offering a narrower set of financial products.  But even four years since the passage of the act, its implementation—and the implementation of Basel III, and of day-to-day banking supervision—is not a settled issue.

Some believe the formal banking system is similar, in many ways, to a public utility with public support—perhaps even too much public support.  They favor tough restrictions on the activities that take place inside it, restrictions that bar all but the simplest lending and deposit-taking activity.  So far, the strict interpretation of prudential measures like the Volcker Rule and the Federal Reserve’s “FBO” rule has reflected this vision.

Others, however, are concerned that these strictures simply drive activity away from banks and into the “shadow banks.”  In the last five years, nonbank companies—particularly in the capital markets—have moved into areas recently dominated by banks.  Hedge funds have built massive credit operations, matching plain-vanilla lending opportunities with pools of relatively risk-averse investors.  Dedicated servicing firms have bought bank loan-servicing rights by the hundreds of thousands.  Technological innovation has created new consumer products, like “peer-to-peer” lending, mobile payments, and virtual currency companies.  And perhaps most importantly, much talent has fled from the regulated sector to the unregulated or less-regulated sectors of the financial industry.

Regulators have begun to respond to these trends, and they will continue to do so in the years ahead.  The Financial Stability Oversight Council, created by Dodd-Frank, has stepped up its supervisory efforts surrounding “systemically important activities,” including large asset managers and money-market mutual funds.  State regulators are investigating servicing companies and payday lenders with bank funding lines.  And at long last, many are discussing regulatory relief for small community banks, which pose no threat to the U.S. or global financial system, and without which many consumers and businesses seek credit from alternate, less safe sources.

Ultimately, though, the balance between the banking sector and the capital markets is a question of culture.  There has been a sea-change—in the US and globally—about what practices are considered acceptable in financial markets.  Since the crisis, every time a cultural problem has turned into a public scandal, regulatory scrutiny has quickly followed.  And this scrutiny fundamentally constrains not only the way institutions behave, but also the market for their services, from derivatives to correspondent and retail banking.

For the moment, those constraints are falling squarely on U.S. banks, and the capital markets have picked up the slack.  But the post-crisis regulatory landscape is still taking shape—and in the next one to three years, America could still produce a more level playing field.