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People that are struggling with the state of financial institutions today should take a look at Leo Tilman’s book, “Financial Darwinism: Create Value or Self-Destruct in a World of Risk" (John Wiley & Sons, Inc., 2009). The simple truth that the author builds on is that too many individuals still perceive of the financial industry in its static form in which institutions are simply divided into distinct sectors such as those for depository institutions, investment banks, insurance companies, pension funds, mutual funds and so on. It was a world that was described in a static “flow of funds” framework where institutional sectors could be separated from one another, both in terms of customers and products/services, and in terms of balance sheet construction. Regulators were comfortable with such a structure because each sector could be distinctly identified and regulated within its own structure.

In such a world, financial institutions lived within an institutional framework that provided them with protected markets which gave the organizations some form of monopoly power and an economic environment that was relatively stable in a sense that interest rates were relatively stable over time. As a consequence, some industry segments, like that for depository institutions, could live off of what Tilman defines as “Balance Sheet Arbitrage” and perform well, economically as well as in an accounting sense. Other segments like that for brokers, investment bankers, securities firms and life insurers could charge fees that were significant enough so that they, like the depository institutions, could perform well, economically as well as in an accounting sense. Other financial institutions, like pension funds and insurance companies could live off of a systematic risk exposure which was not pressured by a margin compression that might arise in a more competitive environment.

Unfortunately, the world has changed into one in which finance is not divided into distinct, relatively independent sectors that exist within a relatively static monetary framework. All financial institutions have become intertwined in this new world and the environment is continually in motion requiring managements to constantly re-interpret and re-position their firms as players and situations change. If firms have not adjusted to this new paradigm, then so much the worse for them.

In this review I cannot go into the book as deeply as I would like to, but let me emphasize a few major points. First, let’s look at the idea of “Balance Sheet Arbitrage” simply defined by Tilman as the ability of an institution to borrow at submarket levels. Historically, in the static model, we know that depository institutions were very limited geographically and hence had a substantial amount of monopoly/monopsony power in terms of lending and borrowing. As a consequence, banks could lend at rates that were significantly higher than their marginal costs and could gather deposits at rates that were significantly lower than marginal revenue. The resulting interest rate spread achieved was quite large.

Furthermore, the macro-economic environment was such so that interest rates varied within a relatively narrow band. The interest rate spreads lasted for years and allowed the “monopoly” banks to live an dull, but comfortable life. In essence, buy and hold was the norm in such a static environment.

Two things happened. In the 1960s commercial banks invented the Eurodollar deposit and the negotiable Certificate of Deposit. Banks obtained funds in these markets from large sources that had a multiple number of places they could put their money. The supply curves for these funds were perfectly elastic and banks had to pay market interest rates, rates that were equal to their marginal cost of funds. The idea of “Balance Sheet Arbitrage” was threatened because the banks could not raise funds at submarket levels. This was just the start, as this type of financial innovation carried into the 21st century.

Second, inflation reared its head in the 1960s. The use of deficit spending in the 1960s accompanied by the “guns and butter” budget policies of the Johnson administration resulted in rising interest rates as inflationary expectations got built into interest rates. Nixon froze wages and prices in an effort to contain inflation and Paul Volcker was brought in as Fed Chairman to put an end to rapid inflation of the late 1970s. But, short term interest rates rose and rose and rose. The existing structure of depository institutions could not exist under this strain and the next twenty years or so saw the unraveling of the thrift industry as it was known along with major resultant changes in commercial banks.

Banks had to find other means of making money. They tried fees, but the competition actually forced down what could be earned by this means as Tilman demonstrates. Consequently, commercial banks had to find other ways to make money. Tilman adroitly shows how this was done by adding facilities in which earnings were gained by assuming systematic risks (basically investments relying on the β of financial returns) and by adding facilities providing independent returns (α investments) which the author calls Principal Investments. Of course, movement in this direction made all financial firms more alike and required substantial changes in how risk was managed within the organization as well as how the riskiness of the whole organization was managed.

Further mixing and matching took place. An example of this: the federal government was instrumental in the creation of mortgage-backed securities. Depository institutions were the primary originator of mortgages back in the 1960s and the idea arose that if these mortgages could be packaged into an instrument that pension funds and insurance companies would purchase and hold, more money would be forthcoming to the housing market so that more Americans could own their own home. But, this effort began a process of breaking down the definition of what one kind of institution does relative to what other institutions do. And, once this breakdown started to happen it just grew and spread into all corners of the financial community. Thus, firms became more and more like one another.

Tilman traces the evolution of the financial markets and financial innovation into the 21st century and tells a vivid story of how the “static” model of finance broke down and evolved into the “dynamic” framework that now exists. People must adjust their perception of the world to this dynamic framework and discard the static one if they want to understand and thrive in the new environment. But, moving in this direction has substantial implications for managements and regulators. Let me just list a few.

Management must take on a different perspective. Risk management becomes a much more important part of the activities of senior management. The new understanding of how financial institutions go together and how the control of risk is maintained with the functions of Balance Sheet Arbitrage, Principal Investments, and Systematic Risk Investments is crucial to performance. But this cannot be divorced from generating fee income, controlling expenses, and minimizing the cost of capital. Managements must adjust their responsibilities for this as markets continue to open up, as computing power grows and the spread of information proceeds and as financial innovation continues at a rapid pace. The continuous re-assessing of situations and re-setting of firm priorities is a must.

This dynamic environment will also require a change of how accounting is done. More focus will be given to economic performance and not accounting results: for example, in a dynamic environment like the one described, mark-to-market is essential, one cannot hold onto historical values. Furthermore, openness and transparency is a must so that not only managements can better understand the risks that they are undertaking but so that this information on risk can be passed onto shareholders as well.

Finally, in a dynamic environment regulation must become process orientated, not outcomes orientated. The latter works only within a static environment. Hello Congress, are you listening?

Source: Making Money in the 21st Century: 'Financial Darwinism: Create Value or Self-Destruct in a World of Risk' by Leo Tilman