The world is growing aware that some banks have simply become too complex to manage.

Many are now forcefully advancing this idea, including experts testifying before the British Parliament, the president of the Kansas City Federal Reserve Bank, Federal Deposit Insurance Corp. Chairwoman Sheila Bair at a Senate Banking Committee, and Bank of England Governor, Mervyn King, testifying before the House of Lords Economic Affairs Committee.

The problem is not so much size, as it is complexity. Citibank could be reduced to 10% of its current size and it still would be too complex to manage. See the essay, Uncontrollable Risk.

The secret of good banking is a four letter word

Sound banking requires strict adherence to the KISS principal.

That’s right, KISS stands for: “Keep It Simple Stupid!“.

Banking is a business in which you borrow money that you have to repay today (but hope you won’t have to) and lend it to someone who is supposed to repay you tomorrow (but may fail to do so). And your margin of error for this amazing feat of daring is paper thin, because you’re leveraged from seven to twenty times your capital.

Success depends upon every bank manager’s ability to know:

• The character, capacity, and collateral of every borrowing client;
• The operational and legal ramifications of every type of banking operation;
• The character and credit and operational skills of every bank officer that is in the chain of command from the CEO to the banker that deals with the borrower.

Specialization, where only a few managers are privy to certain essential knowledge, is the formula for bank failure, and the problem becomes exponentially worse as the number of products increases and fewer and fewer bank officials, at any level, can grasp, in detail, the range of activities carried out by their organization.

Sound banking practices are gone at big banks

Sound banking practices have been forgotten in today’s big international banks.

The senior management of Citicorp have no way of comprehending the hundreds (or perhaps thousands) of banking products that are dealt in daily.

They have never met 999 out of every thousand clients.

Worst yet, they don’t even know (or have even met) 99 out of every one hundred bank officers on which the success of their bank depends.

Their “control” of the bank depends entirely upon financial reports, statistics, and mathematical formula — all based on mysterious premises, dubious accounting rules, and shaky, incomplete internal audits.

Their matrix organization charts already defy comprehension, even before being overlaid by conflicting legal jurisdictions and the complexities of affiliate relationships, partial ownership side agreements, and the cultural and political nuances of over 100 countries.

When Citibankers were bankers

Once upon a time, Citibank had the admiration of the world.

Citibank wasn’t always run the way it is today.

In 1956, when Citibank was arguably one of the world’s most respected banking institutions, it followed the KISS principal rigorously. The bank knew, at the highest level, its clients, its operations, and its officers — in detail.

The Citibank advertisement in that year, shown below, reads, “How bankers ‘on the scene’ make the difference overseas”.

But what I would like to draw your attention to is the insert at the bottom of the ad that shows the international banking platform on the 7th floor of 55 Wall Street.

This ‘platform’ was the key to Citibank success, and the bank knew it.

If you could travel back to 1956 and walk around the 7th floor of 55 Wall Street, and talk to the fifty or so senior officers whose desks are arranged without walls or doors, and observe how they worked and what they knew about Citibank operations, it would be immediately clear what the problem is with Citibank today and why this once great bank has fallen so far.

The 7th floor at 55 Wall Street

Let me take you back to the 7th floor at 55 Wall Street as it was in 1956.

Here you would find the fifty or so officers of the First National City Bank of New York whose job it was to oversee (not manage) a worldwide network of commercial lending operations.

None of these officers had private offices, and very few had private secretaries.

The highest officials had the doors removed from their offices. Transparency and openness was the basic policy.

None had stock options. All were modestly paid by today’s standards. None were working for the bank in order to get rich.

The hidden wonders

But what would be startling today and could not be seen by just looking at these officers or the physical layout of the 7th floor, is what was in their heads and the overwhelming simplicity of the bank organization chart.

The organization chart ran from the bank president, to the senior vice president in charge of a geographical area, to the branch manager overseas, to the credit officers responsible for approving loans and the “accountant” who was responsible for running the branch back office.

There were no “product managers” and the staff functions were atrophied, succinct, and essential.

Most importantly, all of the people that held key positions had spent their entire working lives with Citibank and many, especially at the large branch manager level and above, knew each other.

What also would be surprising today is that the most prized positions weren’t the desks on the 7th floor at 55 Wall Street. In fact, a manager of a large branch bank overseas that might be “promoted” to a desk on the 7th floor, was often reluctant to go home to the “head office”. All the action was abroad. No one was working for a big year-end bonus (there weren’t any). The prize was to run a big branch and to have the respect of the brethren.

There was very little boot-licking or back-stabbing, because most decisions were made by consensus. A report of the international audit team could have a greater impact on your career than the opinion of your titular boss.

A band of brothers

What you might not notice at first about the bankers on the 7th floor was that they acted together as a cadre — a band of brothers, so to speak. Their role was to oversee, guide, and observe the operations of the rest of their brethren, the bank managers and accountants stationed far away in a wide network of foreign branches.

In 1956, most communication was by mail. There was no e-mail; international phone calls were expensive; and telegrams were used mainly to order the transfer of money. Power was vested mainly with the foreign branch managers, who were watched very intently, from afar.

Almost all of officials on the international banking platform had served fifteen to twenty years as branch managers overseas.

They all had come through the same inhouse management training program.

Many, at some point in their careers, had worked with the international auditors, inspecting overseas branches in detail. These auditors were extremely good, taking two or three weeks to go through each branch, at least once a year.

Officials on the 7th floor all understood and fully supported the hallowed principles of internal control. Lapses in control that brought down Barings Bank a generation later, could not have happened in Citibank in 1956.

It would be extremely rare for someone to occupy a desk on 7th floor of 55 Wall without having devoting a lifetime of faithful, proven service to Citibank. They saw themselves as guardians, custodians, fiduciaries of the institution, responsible first to their depositors, and secondarily to bank shareholders.

A simple product line and focused knowledge

Citibank in 1956 had an extremely simple and short product line.

Officials on the 7th floor understood each of these products thoroughly.

There were short-term commercial loans with various forms of collateral, demand deposits, time deposits, collections, money transfer, commercial letters of credit, travelers checks, and foreign exchange. That was about it. Nothing fancy. Nothing hard to understand.

The peculiarities of each product to each particular market were thoroughly understood by the men on the platform, because they had dealt with local conditions themselves at first hand over many years.

All loans over $25,000 anywhere in the world were reported to officers on the 7th floor overseeing that particular country. This reporting was accompanied by a financial statement, recast into the Citibank format, with comments of the three credit officials that were needed to approve each loan. There would also be memoranda describing visits to a client’s factory, results of credit checking with other banks, and details of the terms and conditions each type of credit that had been extended.

Furthermore, because the official on the 7th floor had himself worked so many years in the country or countries that he was overseeing, he often knew the borrowers from personal experience, and, if not, certainly knew the Citibank officials that had signed off on the loan, having followed their careers since they were first hired as management trainees.

Reform will not be easy

It seems to me that the attention given today to “bad assets” on big bank balance sheets is missing the point.

The “bad assets” are the symptom, not the cause of the problem.

To put it bluntly, the problem really seems to be “bad bankers”, not “bad assets”.

The world can’t go back to the grand simplicity of banking in the 1950s, mainly because big bankers today are motivated by year-end bonuses and the perks of their executive power.

How can we expect bankers to willingly don what would seem to them as the “hair shirts” that Citibankers wore in the 1950s? One wouldn’t expect Las Vegas gamblers suddenly to give up their calling to assume the role of parish prients.

Besides, financial markets have made a fetish of complexity. KISS is not the motto of today’s bankers.

The 7th floor at 55 Wall no longer houses bankers. It now houses the Ciprioni Club Residences, whose symbol seems to be a bartender shaking up a martini.

Wall Street itself now refers to a concept, rather than to a physical location.

However, the vestiges of old time banking can still be seen in small community banks. Once the big complex banks are nationalized and tougher bank regulations are put in place, perhaps these community banks will be transformed into Citibanks of the future.

Like the little mammals waiting in the underbrush, as the dinosaurs move on to extinction.

The first thing I learned as a bank trainee, many years ago, was that all banks are insolvent — it is the nature of banking.

The banking business consists of borrowing money you have to repay today to lend to someone else who will pay you back tomorrow. If your creditors demand their money today, you won’t be able to pay — because you’re a bank and banks are insolvent.

Lessons of the New Deal

Throughout the 19th century and up until 1933, hundreds of banks regularly failed every six years or so, whenever there was an economic recession. During the New Deal, the Federal Deposit Insurance Company was set up to ensure depositors’ money, thereby effectively making banks “solvent” by government intervention.

In 1933, demand deposits were the major source of bank funding. With a government guarantee on deposits, bank runs became rare. The Glass-Steagall Act kept banks away from the dangers of investment banking. Strict margin requirements on securities loans dramatically reduced risks on what were the “toxic assets” of those days.

In 1950, checking deposits made up 70% of US bank liabilities, while small time and savings deposits made up most of the rest. In other words, the government guaranteed virtually all bank liabilities. US commercial banks were safe.

Just as important, banks were engaged in very few different kinds of operations; they were much, much easier to manage and understand than today.

But times change.

Not your grandfather’s bank

By Q4 2007, private checking deposits were less than 5% of total liabilities of US commercial banks. Interbank liabilities with respect to federal funds and repurchase agreements were 164% of US private checking deposits. Glass-Steagall had been repealed. Banks were engaging in blatant speculation in exotic securities on their securities trading desks. The effective safety measures that protected institutions that were — by definition — fundamentally insolvent, had been allowed to wither and become irrelevant.

Furthermore, and most importantly, most US bank liabilities today are no longer guaranteed by the US government. The safe banks of the 1950s are no more.

Although bankers are well aware of the “dirty little secret” of their insolvency, they still oppose “government intervention” and “over-regulation”. Bankers know that they rely on government to stay in business, but like to pretend that they should be allowed to operate as free-spirited entrepreneurs in the “private sector”.

The Crisis of 2008 was simply a modern reenactment of the bank runs of the 19th and early 20th century. Different liabilities, different times. Except that banking is now exponentially more complicated and has become virtually impossible to understand.

How to read a bank balance sheet

The second thing I learned as a bank trainee, back in the good old days, was that it is impossible to learn much of anything useful about a bank by reading its balance sheet. Whether a bank is strong or not, depends upon the quality of its assets — information that is woefully absent from financial statements.

Once we understand that banks are insolvent and require government guarantees to continue in business, the question becomes what percentage of liabilities have government guarantees and which assets are good, or whether the government will eventually have to step in, liquidating the bank and paying off depositors, leaving zilch for shareholders.

Accounting rules can’t make water run uphill

Now accounting rules don’t require banks to list their loans on their financial statements, nor to indicate terms and covenants of each financial asset. You’re not told the credit rating of borrowers, or even the weighted average of credit ratings (even if you put faith in credit ratings). Information in such detail is not even feasible.

Nor do accounting rules require that auditors actually evaluate the likelihood that a bank will get its money back on a particular loan, or any group of loans. Bank auditors don’t visit bank borrowers one by one and look them in the eye to see if they seem credit worthy, or whether they are drunken bums that have just blown the bank’s money at the racetrack.

Moreover, large international banks are extremely complicated, composed of thousands of subsidiaries, affiliates, side ventures, and special deals, and subject to the risk that some obscure trader in one of hundreds of countries where they do business may be hatching a scheme that will bring the bank to its knees tomorrow morning — operations of these banks are so complex that it is impossible to contrive a document that could possibly “protect investors” by supplying all relevant and material information.

Now, auditors don’t like to admit that bank balance sheets are bullsh*t, and that that the millions spent on auditing — for the benefit of “investors” — might just as well have been donated to charity. So they try to find some way to get someone else to give an opinion on how much bank assets might be worth — at least some part of the assets.

This is where the “mark-to-market” rules come in — based on belief in the Efficient Market Hypothesis. This theory suggests that market price reflects intrinsic value.

Mark-to-market nonsense

Historically, banks haven’t been in the business of selling their loans to others. Instead they hold loans until they come due and then credit the proceeds to cash, interest earned, or loan losses. Accountants were not able to impose mark-to-market rules on ordinary loans for the simple reason that there was no market to serve as a benchmark.

But with modern, complicated banking, some assets actually do have markets that might be used as a measure of value. Surely, some assert, it would be in “investors’ interests” to adjust the value of bank assets to changes in market price. So accountants came up with a “mark-to-market” rule that says that, unless a bank intends to hold an asset until maturity, it must indicate the value of the asset in terms of market value.

Why mark-to-market accounting is misleading

Mark-to-market accounting is misleading for many reasons, but perhaps the most important is that market prices are not the value at which all assets of a certain type could be liquidated tomorrow, but merely the price at which a very small number of securities in circulation happen to have been sold yesterday.

Furthermore, unless a bank is obligated to sell asset by a certain time in the immediate future, but instead has the option to hold assets to maturity or until market prices get better, the current value of assets may be irrelevant both to bank investors and creditors.

If a bank holds $50 million in bonds that had $5,000 traded at 100 yesterday, it doesn’t follow that the bank will be able to sell all its bonds tomorrow at this price. All securities markets — even the deepest and most liquid — only trade a small portion of securities outstanding on any one day. No security market on earth is able to liquidate all holdings of securities outstanding today, at yesterday’s price. If all securities are liquidated at the same time, and there are no buyers, the market value is zero!

Now, in some cases, mark-to-market accounting is useful, although still misleading. For example, mutual funds that promise to redeem shares on any day based on the market value of the portfolio as of the close of business, obviously must use mark-to-market accounting because they have a legal obligation to redeem shares at that price.

However, banks are not required to pay creditors based on the market value of bank assets, nor do bank shareholders have any claim on the bank based on the current market value of bank assets.

Furthermore, evaluating some bank assets on the basis of mark-to-market, and others on the basis of historical costs, means that total value of bank assets (apples plus oranges) is a gobbledygook number that defies comprehension.

If we start by admitting that all banks are, by their nature, insolvent, the key question we should be asking is “How much of bank liabilities are guaranteed by the government?”

In the 1950s, the answer was, “Almost all”.

Today, the answer is “Very little”.

Mr. Gaithner’s Stress Tests

Timothy Gaithner, the US Secretary of the Treasury and point man of the Obama administration’s efforts of resolving the economic crisis, has announced that he is getting ready to analyze the finances of US banks by subject them to some kind of “stress test”.

There is less said about these stress tests recently; perhaps Secretary Gaithner has given up on the idea.

Now, I can save the American taxpayers a lot of money by pre-releasing the results of this test at no cost:

1. All banks are insolvent, although some have assets of lower quality than others.
2. All banks fail the “stress test” unless the government guarantees liabilities.
3. Banks that have the largest portion of liabilities (i.e., deposits) guaranteed by the government are the strongest. (Mainly, small community banks.)
4. Banks that have the simplest, smallest “product line” are the least likely to fail. (Mainly, small community banks)
5. Most major international banks are not “too big to fail” — they are “too big to manage”.

Learning from the past

In other words, the way to save the banking system and reduce “systemic risk” is to require the big banks to split up and drastically simplify their operations, with the government providing guarantees for virtually all liabilities.

Liabilities which can’t be guaranteed by the government should be eliminated.

Too strong, you say?

Well it worked in 1933 and the fundamentals of bank safety haven’t really changed that much. What is different is that the government has allowed too much of the bank balance sheet to avoid regulation.

Of course, if the government guarantees virtually all bank liabilities, as in the distant (but safer) past, there will be pressure on banks to eliminate the absurd salaries and bonuses paid to bank executives.

Impossible, you say? Can’t get experienced bankers without paying a fortune?

Well consider this: In May 1970, Walter Wriston became chairman of Citicorp — arguably the world’s premier banker.

His compensation was just $257,820 a year, just $585 more than he had earned as president and CEO (Wriston: Walter Wriston, Citibank, and the Rise and Fall of American Financial Supremacy. page 307.).