The Interview: Dennis Santiago on Banks, Blockchain and the Goddess of NIM
New York | In this issue of The Institutional Risk Analyst, we talk with Dennis Santiago, co-founder of Institutional Risk Analytics and the author of the Bank Monitor safety and rating system. The Bank Monitor was acquired by Total Financial Solutions of Hackensack, NJ in 2014.
Dennis is a rare analyst who combines a high-level understanding of operations analysis and business process with an equally sophisticated understanding of technology. He is an involved public citizen and political commentator published on platforms such as the Huffington Post and America Out Loud. His personal blog at www.pickingnits.com focuses on global risk and national policy. We spoke to Dennis at his office in Los Angeles.
The IRA: Dennis thanks for taking the time to catch up. Let’s start off by talking a little about how you are using the Bank Monitor ratings engine and specifically the use case developed for the State of Ohio at TBS. How are they using the Bank Monitor to screen the risk of the banks that are participating in their state-level deposit insurance program for banks?
Dennis: The Ohio case is a fascinating study in action and reaction dynamics of federal regulation. As the market has gone beyond the 2008 crisis, new business cases for safety and soundness testing have emerged. This one stems from how the increased capital requirements at the federal level have constrained capital flexibility for local markets, reducing the amount of credit available to these communities. As a result of capital and liquidity requirements imposed at the federal level, banks are compelled to over-collateralize loans. The driving rule behind public depositor overcollateralization was the implementation of the US version of Basel III’s Liquidity Coverage Rule (LCR). It was structured such that a bank gained no operational liquidity for taking municipal deposits. Roughly, every muni deposit dollar had to be collateralized with a low yield high quality liquid asset. The net net interest margin (NIM) for the silo is zero.
The IRA: That’s very interesting and something we’ve never heard about in the financial industry media. What approach did Ohio take ultimately?
Santiago: The regulatory answer was to allow the pooling of collateral by a guarantor so as to generate headroom to engage in higher yielding assets. This created conditions for generating economical NIM’s off these exposures. Ohio enacted a law that created a way for the state to pool the collateral. They created a vehicle to guarantee a portion of the collateralization requirement at the federal level for in-state banks are deemed to be safe and sound using acceptance criteria more strenuous than federal requirements. The collateral relief is significant thus enabling banking services to Ohio municipalities. To enable this, what Ohio did was use a customized version of the Bank Monitor safety and soundness monitoring solution that not only looked beyond FDIC insured deposits regime analysis but went further and assessed the overall quality of depository institutions at the uninsured deposits layer. Municipal deposits tend to be well above FDIC insurance limits.
The IRA: We had no idea the State of Ohio was doing this. To be clear, the state is using public funds guarantee mechanisms to provide collateral cover for uninsured deposits of municipalities at prime banks? And this is being done to give capital relief to banks in Ohio?
Santiago: That is correct. Banks that operate within state lines can follow state law and are able to take advantage of this facility. The bank must have a physical branch in the state of Ohio. It’s a very innovative solution. More importantly from a fiscal policy perspective, it illustrates agency theory in action between federal and state actors.
The IRA: Talk about this dynamic between state and federal regulation. How have the new capital and liquidity rules constrained credit?
Santiago: The constraint is because of the need to put up additional capital and reserves against different types of risk exposures. The higher capital levels and the new risk weighting for different assets penalizes banks for selecting higher yielding asset types. We are essentially removing capital that the bank would use to lend from the business operating equation.
The IRA: And less effective leverage?
Santiago: Yes, yes. The banks look great and have lots of capital, but the business volumes are flat and down vs 2015-2016. The banks don’t have any capital allocation left to lend. Volume is constrained by the Dodd-Frank capital rules; that’s why investors are skittish about bank valuations today.
The IRA: Agreed. In the great continuum of risk and public policy, where are we now? Are we too restrictive on banks?
Santiago: We may have gone a bit too far in terms of restrictive policy on banks, thus causing new forms of behavior to emerge. You’re seeing regulations that are effectively encouraging the growth of non-bank companies, which are the customers of banks. The banks lend the marginal dollars out to non-bank firms at relatively high spreads compared to real estate lending, for example. If banks have to keep more funds sequestered in capital and reserves, then the growth in non-bank lending is a way to boost NIM. What you have is higher capital balanced by riskier operations to get to the same returns. It begs the question, is this really the center lane path we want to see our financial system following?
The IRA: Probably not. The banks do look better, but the pre-tax asset and equity returns are clearly lower than prior to 2008. The after-tax results look better thanks to the tax legislation last year.
Santiago: We have lots of money in the piggy bank and lots of risky stuff, creating a barbell of risk at most banks. It’s like the barbell on the cover of Nassim Taleb’s new book “Skin in the Game,” with one tiny end and one grotesquely large end. The banks look under-risked because of the huge reserves they are required to hold. And it causes problems and costs. What we are seeing years after Dodd-Frank is a reaction by proactive states like OH to adjust their own bank regulation to maintain economic activity in the face of restrictive federal regulations. States like OH eventually adapted and passed laws leading to new filtering methodologies for tracking the performance of prime banks. This was a reaction to the negative impact on the OH economy as a consequence and effect of federal regulation.
The IRA: We have a banking system that is under-levered and over-reserved. But we also have a system where the Fed has manipulated credit spreads and risk pricing. How much risk is hidden under the comfortable blanket of Fed open market operations?
Santiago: Loss rates are clearly headed higher. In order to achieve the returns that investors expect, banks have taken on increasingly more risk in terms of asset participations. NIM is not a forgiving number. You make it or you don’t.
The IRA: And NIM is extremely unforgiving when the cost of funds for banks is rising 3x the rate of asset returns. In the most recent earnings cycle, Goldman Sachs (GS) was the only large bank that actually grew interest income faster than interest expense. The great rubber band has clearly snapped. But you won’t hear anybody in the economics profession talking about this on CNBC. The narrative still says higher rates are good for banks.
Santiago: Correct. And in the world of bank balance sheets, we have a capital squeeze in addition to a NIM squeeze. The rate of adjustment in terms of NIM is going to depend upon the inflation rate and how fast the Fed adjusts. Banks are already being forced to stretch in terms of asset returns and credit risk. Basically the Fed has flooded the room with liquidity for the past eight years. Banks have to keep their head above water in terms of earning positive returns. But the abundance of liquidity makes finding acceptable returns very challenging. In order to survive, the banks move their asset allocation decisions to less safe, especially when volumes are constrained by capital rules.
The IRA: Bankers want bonuses. Where is your big worry bead for the future of the US banking industry?
Santiago: Clearly the big transition in the banking industry in terms of asset-liability management (ALM) is going to be managing the shift from liability sensitive strategies to asset focused strategies. One of the big aspects of the 2008 crisis and the recovery was liability management by banks…
The IRA: And by the Federal Open Market Committee, which protected bank NIM from 2009 onward by killing depositors and bond holders.
Santiago: Now the focus is going to shift over the managing asset returns and related risks. How do you manage yield? In an environment where prices are constrained by the Fed and volumes are constrained by capital regulation, how do you placate the Goddess of NIM? I repeat, NIM is a unforgiving goddess. She does not care how. So if you are short on price and volumes, you turn up the risk on credit participations. All NIM wants to know is that you made your nut last quarter.
The IRA: Speaking of assorted nuts, you’ve had some prescient things to say about bitcoin and the so-called blockchain tech that enables it. Haven’t we seen this movie before??
Santiago: Crypto is a really interesting phenomenon. It’s not the tech, it’s how the tech affects the landscape of money. It has grayed the line between people who live on the network and people who don’t. The blending of the two worlds of barter and above board enterprises is like oil and water. As a rule, they do not mix. The way a barter community exchanges value is totally antithetical to the tax paying world. The world of “Hawala” with two sets of books allows for the transfer of value without money actually changing hands. We note the exchanges in a “cross-ledger.” This stuff has been going on for hundred of years in parallel with other forms of finance.
The IRA: So crypto has enabled the ancient barter system and outside of the established network. The barter participants don’t pay taxes. OK, we get it. Is that all there is, to paraphrase Peggy Lee?
Santiago: We have not really thought through the implications of enabling barter via electronic multiple ledger bookkeeping on a global scale.
The IRA: The true participants in the barter world would never trade bitcoin via an exchange. They exchange the numbers and report the transaction to the collective. Our friends in places like Russia and Lebanon use crypto to live, pay bills, outside of the formal system. It is a binary choice.
Santiago: Exactly. Trading cryptos via electronic means defeats the point of trust in the barter world. The compact in the barter world is that your net value trade is zero. There’s no taxes or excise or fees. It’s currency-free economics. Crypto imposes itself upon this barter market. The thing about this is that taxes, excise and fees attempting to extract their due won’t be far behind. That’s just the way of things.
The IRA: Fair enough on cryptos, but how about blockchain? This is definitely a movie we’ve seen before. It was an electric KoolAid XML taxonomy building party hosted by Chairman Chris Cox at the Securities and Exchange Commission. Eventually led to public companies filing their financials in a dialect of XML. Is there anything here with blockchain?
Santiago: As a technologist, I have to admit that there are moments when blockchain bemuses me. If you listen to the pundits, about half say it is a solution in search of a problem and the other half says it’s the greatest thing since sliced bread. I’m a bit more pragmatic about tech having been around since before people started calling it FinTech. To me, the shared ledger technology that seems to get everybody exited is just the latest version of SOAP XML, which is also the basis of a ledgering system. This technology was designed about 30 years ago and eventually trickled down into areas like financial reporting at the SEC as you noted. The FDIC CALL Report data warehouse is another massive implementation of XML based technology to gather, screen and publish bank financial statement data. The transfer of data between banks and other financial institutions is based upon APIs that sit atop XML constructs that are ancient in technology terms. The growth of global trade, manufacturing and logistics is a massive and universal example of XML-based ledgering technology.
The IRA: So there is nothing really new here in terms of basic functionality?
Santiago: Blockchain is an alternative ledgering system architecture. It is replacing something that is working well. More non-ICO solutions are presently deployed than blockchain ones. Don’t get me wrong. For some use cases, it’s the perfect fit. As with all tools, knowing when and where it’s the best option, and when it’s not, is the key. But people also confuse blockchain as a ledgering system with blockchain as a cyber security system, which it is not. The cases of theft of bitcoin and derivative cryptos have shown the technology still has vulnerability as manifested by incidents of cyber theft poking holes in the tech. We have nerds stealing money from the other nerds in scenarios lifted right out of movies and novels, which is pretty funny.
The IRA: Ha. How does this end up?
Santiago: What I think is going to happen with blockchain is that people will eventually realize that it is first a foremost a ledgering system that competes with existing systems, some of which are technical, others structural. The question becomes, why is a blockchain-based solution the more efficient solution? When is cost and latency attractive because it provides improved trust or transparency? In a flat internet where everyone is a stranger and are trying to hack you all the time the answer may go one way. In closed universes of known senders where per message mechanistic send/receive confirmation is mitigated, the most efficient transmission and ledgering systems will win out. The pragmatic odds probably favor innovative hybrids still hatching in laboratories. In the end, once we are done with falling in love with the toys, then we will wake up. And people are already starting to wake up to the reality that there’s more than one use-case and implementation design solution in this phenomenon. It’s not a one size fits all discovery. These are savvy folks. They are asking the obvious