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Creating better banks of America

Bank of America announced on June 29, 2011 that it would pay $8.5 billion to settle investor losses on mortgage-backed securities packaged with dodgy loans from Countrywide Financial ahead of the US housing collapse. (PAUL J. RICHARDS/AFP/GETTY IMAGES)

In light of Bank of America’s recent woes, this piece is part of an On Leadership roundtable exploring the root causes of the corporate ‘urge to merge’.

Last week, Bank of America CEO Brian Moynihan announced that he had decided to give up the distinction of being the largest banking company in America. What makes this story so amazing is that Moynihan’s two predecessors, Ken Lewis and Hugh McColl, had spent the past two decades doing the opposite: growing what was once a southern regional bank into the largest financial institution in the country.

McColl and Lewis, however, were not alone. The CEOs of most large banks had pursued the same dubious distinction over the past 20 years. In 1991, the largest banking company in the U.S. was Citicorp, with about $220 billion in assets; today it is Bank of America, with about $2.5 trillion. This pursuit of size has resulted in an industry dominated by four trillion-dollar firms: Bank of America, Citi, JPMorgan Chase and Wells Fargo. Together, these four companies control about half of the industry’s assets. Twenty years ago, the four largest banks controlled less than ten percent.

This raises two related questions: Why do banking CEOs prize size so highly, and why is Moynihan taking BofA in the other direction? The answer to the first question requires us to examine the governance of modern American corporations; the answer to the second requires us to see what makes BofA different.

Many observers of corporate America, including this professor, would argue that our system of corporate governance still fails us. Even after the governance reforms put in place over the last decade, the board of directors is still frequently chaired by the CEO. This enables him or her to help set the agenda for meetings and can concentrate power in the hands of one person, especially if a strong lead independent director isn’t present.

But governance problems are only part of the reason banking leaders tried to go big for so long. For one, a national franchise also means national political clout. Bank of America has branches in almost every congressional district, giving it access to virtually every single member of the U.S. Congress. In addition, boards at many companies turn to consultants to help set compensation. They typically recommend tying a CEO’s pay to what other companies in the same industry and of comparable size pay their leaders. If size is typically measured by annual revenues, is it any wonder we see CEOs pursuing growth of revenues above all else?

Finally, in banking, there is yet a third reason to grow so large. When the solvency of a bank threatens the entire financial system, it is said to be “too big to fail,” and can then pursue reckless high-risk investment strategies, knowing that it can privatize gains, and be protected against too many losses.

So what makes BofA different right now from its competitors, who continue to grow? The answer can be summarized in one word: Countrywide. In his quest for the title of the “biggest,” Ken Lewis entered into what will probably go down as the most disastrous acquisition in the history of corporate America. Countrywide was ground zero of the subprime-mortgage debacle, lending more than a trillion dollars to just about anyone with a pulse, and then selling most (but not all) of these mortgages to investors with promises that they were triple-A investments. We now know that these promises were false; a huge percentage of these mortgages have gone into default.

While not much will help turn around BofA at this point, we can make changes to reduce the likelihood of another financial meltdown like 2008. The first of these reforms would be to limit banking companies to banking activities, forcing them to divest their investment banking work. These activities were kept separate under a Depression-era law known as the Glass-Steagal Act, but that requirement was effectively abandoned during the late 1990s. Reinstating such rules would cut the size of the largest banks by almost half. That said, half of 2 trillion is still too big. There is no reason why banks need to be larger than Citicorp was back in 1991 at $220 billion.

The second area of needed reform is more changes to corporate governance. To further limit the ability of the CEO to overly influence his or her board, we should prohibit a CEO from simultaneously serving as chairman. Encouraging even more independent directors would also help. Finally, tying CEO compensation more closely to long-term performance would reduce incentives for pursuing high-risk investments.

With these two sets of reforms, we could further change the way major U.S. banks are led—improving separation of ownership from control and limiting the potential for taxpayer liabilities from the next financial crisis. Under the current system, such an event always seems to be just around the corner.

Rebel Cole is a former economist for the Federal Reserve and a finance professor at DePaul University.

Related Articles:

John Baldoni: Bank of America’s Napoleon complex



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