Opening Address: How We Got Here; The Evolution of the Banking Industry
John Reed, Former CEO of Citibank/Citigroup
with Intro by Dennis Kelleher, President and CEO, Better Markets
Dodd-Frank Act 10th Anniversary Conference
Tuesday, July 21, 2020, 1-5 p.m.
TRANSCRIPT of Video
Now let’s turn to today’s program of speakers and hear what they have to say about their role, experiences and insights in finance, financial reform and the Dodd-Frank Act itself. I should mention that their full bios are linked at the event website—10yearsdoddfrank.org. Our first speaker is John Reed, who began his career at Citicorp in 1965 and retired as co-Chairman of Citigroup in 2000, after which he had several additional roles in finance. That four-decades plus long career in banking and finance provided him with a front row seat on most of the major events throughout that time.
As a recent Euromoney profile began, “John Reed is a visionary. His ideas about global banking and transformative technology put him decades ahead of his time and set him apart from his peers as one of the leading bankers of the 1970s, 1980s and 1990s.”
Among other things, he was a “tech pioneer” as Euromoney also said and he was known as innovator. I don’t know if I agree with Paul Volcker when he said in 2009 that “the only thing useful banks have invented in 20 years is the ATM,” but I do know John Reed is credited with being a leader in the worldwide use of ATMs.
In 1998, John became co-Chairman of Citigroup when Citicorp merged with Sandi Weill’s Travelers Group, de facto taking down one of the most important Main Street protections created after the Great Crash of 1929: the Glass Steagall Act. He left Citi in 2000, long before the crash. But, as everyone knows, Citigroup was at the center of causing and spreading the financial crash of 2008 and required multiple massive taxpayer bailouts.
After the financial crash of 2008, John genuinely and honestly reflected on that crash, what lead to it, and what his role might have been in it. As a result, he candidly admitted being wrong about the benefits of universal banking and about mixing the incompatible cultures of traditional banking and trading.
He became a vocal supporter of strong financial reform, including testifying in 2010 before Chris Dodd’s Senate Banking Committee in support of the Volcker rule ban on bank’s speculative proprietary trading. And, in September 2015, he discussed his broader views about banking and needed banking reforms in the Financial Times. Without further ado, let’s hear John’s decades long unique perspective on the industry and events leading up to and including the 2008 crash and Dodd-Frank.
John Reed, Former CEO, Citibank/Citigroup
Thank you very much, Dennis; thanks for the invitation. And Dean Bracey, thank you very much for including me in this lineup. I’m looking forward to this conference, and I’m glad to be able to help.
Mr. President, if you’re still watching, I’m delighted that you’re here. Senator Dodd, Representative Frank, I’m not sure if you’re in the audience; it’s somewhat unusual to give a talk simply looking at a screen that has your own picture on it.
But in any event, as we think about what’s going on in the industry today, and we think about the impact of Dodd-Frank, it’s sometimes useful—maybe even interesting—to look back and see how the industry has evolved, how it’s changed and what happened that got us where we are today.
As was mentioned, I started in the business in the ‘60s. I joined what was then the First National City Bank, FNCB as we called it. It was a different world and a different business. The focus was very much on customers; profit was something that we reported at the end of the year—it wasn’t something that was focused upon. We did not have a budget when I first joined the bank, there were few metrics. We thought that we needed about an eighth of a percent to put our name on something, so if we lent money or guaranteed something, we figured about an eighth of a percent per month, one and a half percent per year was what was needed to pay for the use of our name. Lending was 90-days fixed rate; term loans started coming into being during the 1960s, but they were rare.
The tradition was 90-day fixed rate loans we funded ourselves with deposits. If banks didn’t have the deposit base, we bought from networks of corresponding banks—typically smaller banks in the center of the country who were long on deposits and would sell them to
the so-called money center bank; but this is how we funded ourselves.
The only market instrument at the time in the banking industry were certificates of deposit, and they were used, but that was pretty much the only thing, and liquidity was a bond portfolio. We kept a fairly large U.S. government bond portfolio which cost us a lot of money when Mr. Volcker raised interest rates back in ‘79, but that was where our liquidity was—it was a bond portfolio, and we thought of capital as being about 10 percent of assets. The concept of risk assets did not at that time exist; it was simply 10 percent of your assets.
The 70s was a different period. The 70s was a period of interstate banking, the banks that today have nationwide chains were formed at that time. The North Carolina, NCNB, bank started out, became the nation’s bank, acquired the Bank of America; it took on that name and is today still known as the Bank of America. But it was the North Carolina National Bank, NCNB, that started building that process, that set of branches across the country.
Bank One in Columbus, Ohio, the McCall family built up a similar network across the country; they merged with First National and then J.P. Morgan, and they today constitute the backbone of the branch system that J.P. Morgan has. J.P. Morgan Chase, they tend to use Chase for their retail banking and J.P. Morgan for their corporate activities.
It also is a period of time when banks first went to Washington to try to influence legislation because the legislation that led up to nationwide banking came out of Washington, and it was the southern banks that started out and first got permission for regional banking and then national banking. At the time, somebody like Citibank (was) contained within the city of New York. We had to fight to get permission to go to Long Island or to Westchester, and it took a long time before the money center banks were allowed to branch across the country.
But the ‘70s was also a period when credit cards came into existence. ATMs, which have been mentioned, first had a broad sort of spread during the 70s, and frankly it was the first time that banks began to focus on the American consumer as a customer as opposed to simply a source of deposits.
The ‘80s, which came pretty quickly, were focused on cross-border problems. The major banks around the world, not only in the United States but in Canada and Europe and Japan, were significantly exposed to developing countries, and, of course, the ‘73 oil crisis led to a disturbance of economies and interest rates. And all of a sudden in 1982, Mexico suspended payments on their foreign loans. And that kicked off a process that engaged quite a few of the emerging markets, and the banks discovered, myself included—I became chairman in ‘84—we didn’t have the capital to support the risks that we had taken on. We had greater exposure to these countries than our capital would have permitted.
This was generally true, and the industry, that is the major banks around the world, were basically bailed out because of the cooperation between the U.S. Federal Reserve and the IMF, led by Jacques de Larosiere at the time. So, it was Mr. Volcker and Mr. de Larosiere who led these two institutions together with the banks to work out this problem. It took the better part of the ‘80s. If you stuck with it, you got all your money and interest back; you could bail out along the way—various possibilities for that came into existence and some banks did—but it was a period of time when we realized that risk was important and our capital was insufficient for the cause.
The ‘90s probably was a more important period particularly for the purposes today; it was during the ‘90s that values changed substantially. The stock market had not done particularly well during the ‘70s and ‘80s even going back into the ‘60s, and the people who had large sums of money invested in the stock markets, particularly pension funds, insurance companies and so forth, were not earning much of a return, and they were unhappy. Because in order to provide for their needs, they were having to add money to the reserve so as to have the money to pay pensions or meet life insurance claims or what have you. So, there was a lot of pressure on the investors to improve returns. Somebody during the ‘90s got the idea that gee, wouldn’t it be interesting if we bought a little bit of a company, and then we went and talked to the management and said you know what, you’re not running this company very well; why don’t you get rid of your inefficiencies, quit playing golf all the time, and let’s settle down to business.
It was called greenmail, and it came into being. It hit the private sector broadly; it included banks, it included industrial companies, but there was tremendous pressure from investors to the management of companies, saying we want you to focus on financial returns, and it was successful. It did scare companies into performing better, and it did cause some companies that couldn’t perform to merge and to look for ways to provide for their stockholders because they couldn’t do so as standalone entities.
But it also brought into the value system of the banking industry, but also of the private sector more broadly, this idea of stockholder value, and basically the management was told look, what we want you to do is to focus on your stockholders; forget all this stuff about your customers; focus on your stockholders. And by the way, we don’t care particularly if you focus on the stockholders, you do well for the stockholders, we don’t care particularly if you become highly paid. And so, all of a sudden, compensation became tied to stockholder return. And to the extent that there had been any general sort of limitations on compensation that just stemmed from the general public, that sort of went away. And management sort of said, hey we gotta focus on stockholder return.
Everything became metrics, became numbers, earnings per share, dividend, stock buybacks and so forth and so on—all as a result of this pressure that came from investors. And that is still with us today. That started in the ‘90s; I watched it happen; I watched the transformation. I remember the chairman of one of my big competitors in New York called and said, John, I’m going to merge with another bank in New York. I said, why are you doing that. He said, look I’ve got stockholders who are driving me crazy; I can’t respond to them, and so I’m going to merge with this other bank, and it will be good for my stockholders, and I’ll retire; and he did in fact do that.
So, it became a big change. And I think something that happened in 1995 is indicative of this change. People may remember there was a lawsuit from a big customer of the Bankers Trust Company alleging that their traders had knowingly sold them instruments that would not work out for the customer but would result in good profits for the bank.
Now in the old days, if you focused on customers that simply didn’t happen. If somebody did that, they would have gotten fired, and it just wasn’t part of the culture; it wasn’t acceptable. In this case, there were tapes that came out in the court case that indicated that the traders very knowingly had what they called an ROF, a rip-off factor where they were making money on the back of their customers, and the customers were not getting full value from the services. And this became something that wasn’t limited to Bankers Trust; it wasn’t limited to banks alone, but the financial sector began to have the profitability of the sector as being more important than the banks themselves.
As this developed and the mathematics of finance developed, black shoals had come into being, and there’s a lot of mathematics and finance you could argue, or at least I used to argue, that basically your traders were trading future probabilities, and so you better understand exactly what the instruments were and what sort of probabilities of payment or lack of payment were built into them. And, of course, people sliced and diced as it was said, and we could provide derivatives and so forth, and markets took over.
It started out with mortgage-backed securities. These investors who were looking for returns said to themselves, hey selves, you could have a package of mortgages, which is a very, you know, well-known product and usually pretty good in terms of credit characteristics, and we’ll get a package of these, and banks who keep mortgages on their balance sheet have to have reserves against them, and that’s, you know, expensive; you’ve got to set money aside against potential losses. We could buy these, and we’ll cover the potential losses in terms of a diminishing of earnings, and we don’t have to put money against them. And so pretty soon it became impossible for banks to hold mortgages on their balance sheet, and they became traded instruments. And, as I say, once you start trading instruments like this, you could slice and dice and so forth.
And so this became during the ‘90s a period of fundamental change in terms of values, looking at shareholder return is the dominant value, a fundamental change in terms of compensation philosophy, all of a sudden the industry which traditionally had not been a high-paying industry became an extremely high-paying industry, and markets became the cornerstone of much of everything. Now there was an event at the end of the ‘90s, after the merger of Citicorp and Travelers, that should have warned us, Long-Term Capital.
You may recall that Long-Term Capital got into financial difficulties, and it was sort of a precursor of what happened in 2007-08, basically extremely complex business that was not understood by the creditors to the company. There was concern as to whether the company was in trouble or not; no one was smart enough to understand exactly what was going on and so credit froze up. And the Fed came in and organized basically a refinancing for Long-Term Capital and eventually a liquidation. But the point is this was a precursor from what we encountered in ‘07.
Complexity that couldn’t be understood—funding that depends on having some concept of what kind of risks the company you’re lending to runs—and of course complexity makes that difficult. We failed to grasp what had happened there and to learn what might have precluded the problems of ‘07/08.
The problems of ‘07/08 were basically a continuation of that. The industry was deeply involved in trading, and when I say the industry, I’m talking about the major banks—the so-called money center banks—the banks that in fact turned out to be too-big-to-fail, too-big-to-be-allowed-to-fail—and these banks were heavily engaged in trading. And it wasn’t solely because they were driven for profits; it was because customers, our large corporate customers, American customers, European customers, even some Brazilian customers, I remember put a lot of pressure on the banks to have the banks take them to market, i.e., to help them finance themselves in the market.
We had gotten into the habit of having large syndicated loans with multiple banks providing substantial capital to our customers, and by capital, I don’t mean working capital which traditionally banks have always financed. I was talking about the equivalent of bonds. And these customers wanted the banks to be able to introduce them to the market, allow them to issue securities that people would find attractive to buy, and reduce what they thought their cost of financing might be. And so, the banking industry really started getting pushed into the idea of breaking down Glass-Steagall and introducing customers to the market and occupying the space that, prior to the breakdown of Glass-Steagall, had been reserved for what were called investment banks.
And that, in fact, happened. I mean there was a consensus when we merged with Travelers. It wasn’t as if we were the first people to think of this; there already was a political consensus and sort of an intellectual consensus that Glass-Steagall was an antiquated rule and need not describe the world as it then existed. And it didn’t—because to the extent that markets were going to play the role that we were talking about, then either you were going to have to have a much more robust sort of investment banking sector or you’re going to have to allow those of us who had customers who were demanding access to the markets to get into them. The merger with Travelers got us into that business because Travelers had a very strong sort of presence in the markets, but very quickly all of the major banks developed trading activities.
Actually, one of the reasons that J.P Morgan Chase did so well during the crisis of 07/08 was that they had not had a major presence in Wall Street, and it wasn’t until they acquired Bear Stearns during that crisis that they had a presence. But most of the other banks were wildly exposed, and we were way out over the skis. There were not management in place. Most of the management of banks were traditional bankers who came out of the customer side of the business. They were culturally totally different than the traders, and they certainly did not understand the complexity of slicing and dicing and derivatives and so forth and so on, and you would have to spend an awful lot of time to go through portfolios to understand, even assuming you knew all the math, to understand exactly what was in a given portfolio.
So, the industry was out there pressing liquidity to the end, if you will. There were 40 to 1 kind of ratios, capital was not sufficient for the risks that were taken; we had the ‘07 and ‘08 problem, and that of course, brought the system down—had it not been bailed out by the government, as was indicated before, it most certainly would have collapsed, and the general feeling was that the economy couldn’t afford that collapse. And too-big-to-fail became too-big-to-fail, and the industry was bailed out.
Lots of explanations as to why, and there were lots of reasons that one might have thought contributed to the problem. But, ultimately, it’s the management of a company, the board and the management of a company, that’s responsible to run a company in such a way as to not get out over your skis where you can’t get back in. And so, ultimately, you have to assume that the management of these companies and the boards of these companies—the board doesn’t have to understand derivatives, liquidity is dividing one number by another, it’s not very difficult to understand, and capital is a number you can put your mind around pretty quickly. And so, I have always felt that we, the people who are running these companies, had the responsibility not to get into the position that we did and to therefore require the kind of government bailout.
This is where we are. Dodd-Frank came along to correct for the mistakes. It was, as all things are, political. You could argue about was it perfect or not perfect, but it was designed to get away from where we found ourselves, and I think it substantially has done so. As a practitioner, as a banker, I would say that having a living will is an exercise which is well worth going through; not many management sit and think about just how would we be able to take this company through a potential bankruptcy or bankruptcy, and it was something that the management was forced to think about seriously. You couldn’t just go out and hire a lawyer and say, hey would you fill out these forms and send them in to the Fed? The management had to be engaged as did the board.
The stress tests that are now part of the industry clearly are important, and they alert management to what the risks of their business may be, although I assure you that the things that we’re stressing for are not the things that are going to be the next problem, you never do. But the fact that you have to think about how you are going to go through a crisis is important.
The Volcker rule I felt was very important. Mr. Volcker and I didn’t agree on everything, but we certainly agreed on that. And I think there’s a fundamental conflict of interest between trading for your own account and trading for customers. And you know, the banking industry is designed to serve customers. And you know, I liked it the way it used to be where profits were what was left over after a good year of working for your customers, and by the way, the business was adequately profitable. Our stockholders were appropriately returned. It was not an exciting business, but it was a solid and pretty decent business.
So that’s sort of my sense of what’s happened over the last 40 to 50 years in the industry. I think we’re better off today than we were during the heydays of 07/08, but that doesn’t mean that the industry isn’t taking a lot of risks, and that some of these risks are very difficult to quantify and get your mind around. But I think it’s worth thinking how we got here, and just saying it wasn’t inevitable, there were mistakes made, and hopefully we won’t make any in the future.
Thanks so much.