WASHINGTON — Herb Allison, the former president of Merrill Lynch, was relaxing on a beach in the Virgin Islands in September 2008 when he got an urgent phone call from a senior aide to Treasury Secretary Henry Paulson.
Fannie Mae was on the verge of a government bailout, and the firm needed a new chief executive. Would Allison hop on a plane to Washington and take the job?
Allison was interested, but he had a problem, which encapsulated the frenzied atmosphere at the height of the financial crisis: he had nothing to wear except shorts and flip flops.
While that story was recounted by author Andrew Ross Sorkin in "Too Big To Fail," what goes unmentioned is that Allison, an immensely successful Wall Street executive, had just written a manuscript that contained a radical, ahead-of-its-time prescription for what ailed the financial industry: he wanted to break up the largest U.S. banks.
After less than a year at Fannie Mae, Allison became an assistant secretary of the Treasury, where he ran the Troubled Asset Relief Program, until he stepped down last September. Today Allison is out of government — he currently serves as a director of the Atlantic Council, a Washington-based think tank — and he now feels liberated to share his own opinions. After updating his 2008 manuscript, he recently published it as an e-book titled "The Megabanks Mess."
Allison spoke with American Banker about how Wall Street has changed over the last 40 years, how big banks put their own profits ahead of their clients, and why he believes the financial conglomerate model is obsolete:
Q: How would you define a megabank? Are we talking about essentially six banks in the United States — JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs, and Morgan Stanley?
Allison: In effect, yes. And if you look at the structure of the industry today, you'll see that those six institutions handle about half of banking and investment banking activity. So these are mammoth, highly diversified, extremely complex financial institutions.
Q: You started at Merrill Lynch in the early 1970s. What are the biggest ways that the culture of Wall Street has changed in those last 40 years?
Allison: In the early 70s the financial industry was much simpler and slower changing. There was much less competition for business. Regulations prevented companies from competing with firms outside their product segment. In Wall Street's culture back then, investment bankers considered it impolite or even crass to compete for each other's clients.
The forces of change began building in the mid-70s. New kinds of institutional investors, like mutual funds, were growing fast and gaining market power to force reductions in trading commissions. Securities firms started looking for new ways of making money.
All of that was accompanied by major innovations in finance that could offset the declines in profit. The later innovations have been increasingly extreme product extensions like derivatives of derivatives, securitizations of securitizations and funds of funds, accompanied by much higher leverage in order to generate greater return on equity.
Q: You describe the megabanks as rife with conflicts of interest, and you call for them to be broken up into smaller independent companies, each of which is focused on serving a set of clients with distinctive needs. Explain why this is necessary.
Allison: I think it's in the interests of the institutions' own shareholders, not to mention their customers and the general public. I think there's plenty of evidence that their business model - the diversified financial services company - has become obsolete.
There's no truth to the assumption that the diverse businesses of a financial conglomerate reduce overall risk and require less capital than those businesses would need if they were separate from each other. They don't benefit financially from being combined within megabanks. And if you looked at the groupings of the megabanks' subsidiaries that serve individuals or corporations or investment companies, you'd see they could be just as competitive, if not more competitive, by operating independently from the other groups.
Today, one of the mantras of the megabanks is cross-selling — distributing products of each subsidiary through the others. But if, say, their retail businesses really put the interests of their customers first, they might select products from other companies rather than from their affiliates. Cross-selling is the epitome of a corporate-centered, self-centered approach to doing the business, not a client-centered approach.
If you look at satisfaction surveys of financial firms, you see that the megabanks score very low in trust among their own clients and the general public. Other, more focused, client-centered financial firms have much higher trust levels.
Q: Your public persona is not that of a rabble-rouser or a flame-thrower. Have people been surprised that you're calling for breaking up the mega-banks?
Allison: Well, I think the people who know me well probably aren't terribly surprised. Even though I had a great career at Merrill and am very proud of what my colleagues and I accomplished there, my views of what needed to be done were often out of the mainstream.
But the tendency is to frame stories of the financial crisis around personalities and colorful conflicts. So I can see why it's kind of interesting that I was a leader in the industry and now am criticizing the structure and business models of the industry that I was part of building years ago. But the real story isn't about me or leaders who later ran the megabanks during the boom and crash. It's about what's in the interests of the American public, what's needed to help stabilize and make more efficient the financial system in the United States.
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