Back in the Saddle

Few people are more qualified than William (Bill) Isaac to comment on where the banking industry is at now and where it might be headed. And rest assured, the chairman of consultant LECG’s global financial services practice doesn’t like what he sees.

Isaac, 66, ran the Federal Deposit Insurance Corp. from 1981 to 1985. He’s also been general counsel for a bank, a partner with Arnold & Porter, the Washington law firm, and, for the past 24 years, a high-powered consultant.

This past spring, he advised the board of $113 billion Fifth Third Bancorp, the nation’s No. 16 bank, to split its chairman and CEO roles as part of a governance overhaul. After considering its options, the board in May asked the native of Bryan, Ohio-just north of Fifth Third’s Cincinnati headquarters-to become its chairman. Perhaps surprisingly, he accepted.

Isaac has been an outspoken critic of the government’s reaction to the financial crisis almost since it began. His disgust with how things have played out prompted him to pen a book, Senseless Panic: How Washington Failed America, which contrasts the largely successful handling of the 1980s’ financial crises with the “bungling” he says has characterized the government’s response this time around.

The book was written before Isaac took the high-profile chairmanship and before Washington passed a controversial financial reform package, Dodd-Frank, that he terms a “disaster” for the industry.

In an e-mail interview with Bank Director, the former FDIC head shares some best practices for directors and talks about how smart boards should navigate the uncertainties of turbulent regulatory waters. He also offers a prescription for reform he says would serve both industry and country better than Dodd-Frank.

Isaac isn’t happy about where things are heading for the industry. “It’s difficult for me to be optimistic right now,” he concedes. Yet he’s also confident that his new bank, Fifth Third, can thrive. So maybe there is some hope. Below is a transcript of the conversation.

This isn’t an easy time to be running a bank. What made taking the job as Fifth Third’s chairman attractive?

First, I should be clear that I am not running Fifth Third-I’m non-executive chairman. I accepted the position because I know the company and its management and board well and have a good deal of respect for them. The company has a good franchise and good future. It doesn’t hurt that the company’s headquarters is in my home state.

What advantages does being a former FDIC chairman afford a bank chairman?

I have been deeply involved in the industry for over 40 years as a lawyer, banker, regulator, consultant, and commentator. I believe that my experience in general and at the FDIC in particular gives me a good sense of what the regulators expect in terms of the condition and governance of a bank and of how to maintain proper communications and relationships with the regulators. The greatly heightened government role in banking makes this experience more important than ever.

Why don’t we see more former regulatory heads on bank boards?

Former FDIC Chairman Don Powell is on the Bank of America board. But you’re right, there are not many of us-I’m having trouble thinking of another example. My guess is that it will become more commonplace in the future because the two dominant risks in banking today are credit risk and regulatory risk. It’s critical that boards of directors have a good handle on both.

What do you see as the biggest challenges confronting bank boards in the next few years?

Understanding the risks in their institutions, making sure the risks are diversified and not all correlated with each other, and ensuring that proper control processes are in place with high-quality personnel overseeing them are the biggest challenges facing boards.

Particularly after the 2,300-page so-called “regulatory reform” bill, staying on top of regulatory compliance will be a huge undertaking for banking companies. Also, it is quite possible that the new consumer regulatory agency will limit the ability of banks to earn fee income.

Finally, most small banks have inordinately high exposure to real estate and will need to find a way to diversify. Bank officers are going to need guidance from their boards of directors in meeting these challenges.

It’s still early in your tenure at Fifth Third, but where does the strategic opportunity lie for a mid-sized bank in the industrial Midwest?

A bank of any size or location that trains its people well, places a high priority on superior customer service at reasonable prices, and maintains a strong balance sheet will be able to prosper.

Quite a number of Midwest banks have come through the latest financial trauma in good shape. They diversified their risks, maintained good underwriting standards, and found ways to add value for their customers. The Midwest economy will be back if we can get the national economy on track.

As a consultant, you recommended to Fifth Third’s board that the chairman and CEO roles be separated. Why?

I have long believed and stated publicly that separating the roles of chairman and CEO is a good practice. I have observed closely, as a regulator and as a consultant, hundreds of bank failures. There are some common threads-one of the most important is a dominant CEO accompanied by an overly compliant board of directors. I am not saying this in the context of Fifth Third, which has an active board of directors that cares a lot about proper corporate governance.

It’s easiest to split the roles when an incumbent chairman/CEO is retiring. That wasn’t the case at Fifth Third, so it was an especially forward-looking and courageous move on the part of its management and board.

I believe most major banks will ultimately adopt this model. I’m aware of boards that would like to split the roles but worry about the reaction of an incumbent. It would make it easier for those banks if the regulators would state publicly that separating the roles is the best practice.

You’ve worked with a lot of boards and managements. What are some best practices-in terms of board-management relations, strategy, operations, whatever-you’ve seen that you’d like to replicate at Fifth Third?

Good chemistry and communication between the board and management is essential. A healthy atmosphere is one in which management considers the collective wisdom and experience of board members an important resource.

Directors should be encouraged to probe and express their concerns about a proposed decision or strategy. The board, for its part, needs to have faith in the integrity and competence of management and understand that management is charged with running the company.

Time should be devoted at board meetings-and perhaps in special sessions outside of board meetings-to educating directors about the bank’s business and its regulatory and competitive environments. Also, it is important that key board committees, such as audit or risk and compliance, have members who are knowledgeable about the subject matter.

Do you foresee the need for boards to change their composition or structures to respond effectively to the new environment?

Yes, particularly as banks become larger and more complex. Fifth Third devotes substantial attention to its board committee structure and composition. Some new directors have been brought in who have specific skills and expertise. In prior times, many banks sought directors primarily for their ability to attract business. That is no longer sufficient.

On a personal level, how will things change for individual directors?

Being a bank director is not for the faint of heart. It is both an honor and a lot of work. Some banks are going to need to look at their compensation practices for directors and might need to pay them more as the demands increase, particularly for the heads of active committees.

How has the role of the FDIC chairman, and the agency, changed since you had the job?

I don’t think the agency or the role of the chairman has changed much since I had the job, but my challenge was different. From 1940 to 1980, the FDIC examined relatively small state banks and resolved a handful of small bank failures each year.

When I took over as chairman, the country was facing severe economic conditions with the prime rate reaching 21.5%, followed by a serious recession and unemployment rates of 11%. We foresaw a major banking and thrift crisis, which ultimately resulted in the failure of some 3,000 banks and thrifts, including many of the largest in the country.

Our challenge was to reshape, reorient, and build the FDIC into an organization that could deal with massive problems unlike anything it had ever encountered. We also had to change the way Congress, banks, the public, and other government agencies viewed the FDIC and its role.

Would you want the job now? What would you be doing differently?

I loved my years at the FDIC and have enormous respect for the agency’s staff. They are among the most dedicated public servants I have seen. I hated to leave, but I had already served two years beyond the end of my statutory term. I suspect Thomas Wolfe had it right when he wrote You Can’t Go Home Again.

I’m sure I would be doing some things differently than Chairman [Sheila] Bair, just as she would have done some things differently in my era. That said, she is an exceptional leader who has brought great credit and distinction to the FDIC.

As you note in your book, the 1980s were treacherous times for banking, too. Did we learn anything from those experiences?

We have taken the wrong lessons from the banking and S&L crises of the 1980s and enacted the wrong policy responses. We implemented very bad accounting reforms and placed excessive reliance on the markets and highly pro-cyclical mathematical models to regulate our financial system.

When trouble hit in 2008, the Treasury, which should not have been in charge of crisis management, lurched from one crisis to another with no coherent plan. Bear Stearns was rescued, but Lehman was allowed to slide into bankruptcy. We were reassured repeatedly that Fannie Mae and Freddie Mac had plenty of capital, and then they were abruptly put into conservatorship, wiping out their common and preferred stockholders. AIG was rescued, but WaMu was allowed to fail.

The markets couldn’t figure out which firms would fail next or how the government would handle them. The markets froze, causing the Treasury to panic and rush to Capitol Hill with a horribly flawed plan (TARP) to purchase $700 billion of toxic assets from Wall Street. Extremely heated rhetoric (“financial Armageddon”) was used to sell the plan, destroying what was left of consumer confidence and sending the economy into code blue. My anger and frustration with the way we botched things compelled me to write Senseless Panic: How Washington Failed America.

You wrote the book before the passage of Dodd-Frank. Where does the bill stand relative to other historic pieces of financial legislation, like FIRREA or Gramm-Leach-Bliley?

Dead last in that it represents a lost opportunity to make critically needed reforms in the regulation of financial companies, and it imposes thousands of pages of new laws and regulations for almost no gain.

How will it affect the banking industry?

Dodd-Frank is a disaster for the financial system and the country. It does not address the major issues that led to the last crisis, and it will not prevent the next one. Fannie Mae and Freddie Mac are not addressed at all. A badly fragmented and politicized financial regulatory system is not reformed. The Systemic Risk Council was a good idea, but they made it a tool of the Treasury Department and the other agencies it should be overseeing. The Securities and Exchange Commission and the Financial Accounting Standards Board were major culprits in the crisis, and they are not reformed at all.

The bottom line is that we fixed almost nothing that needed to be fixed, and we have created thousands of pages of new regulations and burdens that will increase costs to bank customers and likely impede the economic recovery. When the next crisis hits, it will be harder to contain because Dodd-Frank further ties the hands of the FDIC and the Fed in using their crisis management tools and clearly puts Treasury in charge of crisis management.

There seems to be a consensus that the finer points of the law will be reworked. What stands out to you as being in need of repair?

If I were President, I would propose a sweeping financial reform package, an essential ingredient of which would be the repeal of Dodd-Frank. In short, we need to start over. If repeal is not possible, Dodd-Frank needs to be reformed in major ways.

For starters, the Systemic Risk Council should be independent of the Treasury and other agencies it should be overseeing. The future of Fannie Mae and Freddie Mac needs to be resolved. A badly fragmented and politicized regulatory structure should be reformed. The mission of the SEC should be revamped, and pronouncements by the Financial Accounting Standards Board should be subjected to systemic risk oversight.

I doubt the wisdom of preventing bank regulators from using ratings by the credit rating agencies in their supervision of banks. The limitations imposed on the FDIC’s and Fed’s use of their emergency authorities are dangerous and will likely haunt us during the next crisis.

What sort of actions is Fifth Third’s board taking in response to the new law?

Most banks are waiting to see what the regulators come up with in implementing the regulations, which will likely take years to put in place.

What do bank boards need to be thinking about with regard to the new Consumer Protection Act?

It is impossible to know what is going to happen, as the agency’s leadership has not been selected. In the meantime, I would be looking closely at fees and other charges for services, as the new agency will likely do so. I worry about the possibility of new restrictions on prepayment penalties on loans.

With all of these new laws and restrictions, how will a smart bank make money going forward?

It will not be easy, but I believe it will be by creating and retaining a well-trained staff, providing very good customer service, controlling risks, and maintaining a strong balance sheet. While pricing needs to be reasonable, I would not worry about being the low-cost provider.

Banks, particularly smaller ones, have placed too much emphasis on real estate lending in recent decades. They will need to find ways to reduce their relative exposure to real estate, probably by increasing their lending and fee-based services to small and mid-sized businesses. This will likely require adding more lending and marketing expertise and stronger controls.

More banks chasing after C&I and small-business loans, especially in this environment, sounds like a recipe for consolidation.

Banks continuing to overload on real estate loans is not an acceptable alternative. But you are correct that we are likely to see more consolidation among the smaller and mid-sized banks. I hope we are not going to see more consolidation at the megabank end of the spectrum. I’m not comfortable with the five largest companies controlling more than half the banking system.

Some people say that the compliance costs of these new laws will drive smaller banks out of business. Agree or not?

I worry about it. I hope the increased compliance costs will be largely offset by the fact that big banks will need to carry more capital vis-u00e0-vis smaller banks. This should help level the playing field. Despite the political rhetoric, the markets clearly don’t believe we have ended too big to fail, as they continue to give the large banks greater and less-expensive access to funding.

Ten years from now, what will the banking landscape in America look like?

I’m still reeling from what transpired the past 30 years. I knew there would be consolidation, but not on the scale we experienced. Only a handful of the 50 largest banks in 1980 remain in existence. I could not have guessed that little North Carolina National Bank would swallow Bank of America on the path to assembling the most attractive retail banking franchise in the world. Who could have predicted that Manufacturers Hanover, Chemical Bank, Chase Manhattan, and Morgan Guarantee would merge?

I think the future is even more unpredictable because the government will likely have a huge influence in determining the winners and losers. If we do not repeal Dodd-Frank and adopt meaningful regulatory reforms, I fear we are doomed to more boom/bust cycles that result in an even more consolidated and more heavily regulated financial system to the great detriment of our economy and nation.

Putting the government and Dodd-Frank aside, I suspect we will see consolidation at the megabank level remain relatively static, continued consolidation among the banks below $1 billion in assets, and growth in market share among the regional banks, which will likely be accompanied by further consolidation among those firms.

We’ve been through a very rough period for the industry. What’s the good news about banking and its future?

It’s difficult for me to be optimistic right now. The financial system and the economy are interdependent, and both require responsible political leadership. I have not seen much evidence of that from either party for more than a decade.

I take comfort from a couple of things. First, our country has been through far worse times-the Civil War, several financial panics and economic depressions, world wars, and natural disasters-and we have always found a way to regroup and build a better life for our children. Second, the American public does not have infinite patience with a dysfunctional government.

It’s my hope that voters will exhibit a high level of impatience in November. There is nothing wrong with America that cannot be fixed if we have the will.