Urban Core

Few industries have faced calamity and scrutiny as has banking in the twenty-first century. Acts of Congress have curbed the work of financial institutions, but compliance doesn’t mean giving up on big ideas. One large player, Citigroup, is turning around its controls as well as its place at the center of urban progress.

Visit Manhattan, and there’s a good chance you’ll see a bicycle—probably, many bicycles—bearing the CitiBike logo. It is an adaptation of the Citigroup identity, so named because the global, Big Apple-based bank spent $41 million to be the lead sponsor of the program.

And while that may appear to be clever marketing, Citigroup’s executive vice president of global public affairs, Ed Skyler, positions the CitiBike program as part of something bigger. He explains it’s about the future of cities—both in the United States and internationally—and the vital role that banks play in ensuring a smoother transition into a much more urban future.

“One hundred million people are moving to cities every year, and nearly 70 percent of the world’s population is expected to be urban by 2050,” said Skyler at a “Cities for Tomorrow” conference sponsored by the New York Times in July 2015. “The top 100 cities in the world will generate 35 percent of global economic growth over the next 10 years. Massive population and economic shifts are impacting cities.”

CitiBikes were used for 15 million trips in the first 18 months of operations, and the program continues to expand. Pretty heady stuff, considering the infrastructure necessary to support that kind of growth. And also a bit concerning—given the nature of the global economy, the recent financial crisis, and the significant criticisms of the banking industry and resultant regulatory changes that have followed.

Indeed, banks have taken their lumps for all that happened before and after the 2008 economic plunge. And while politicians and pundits debate what has, can, and should be done to protect consumers, business, and the stability and strength of the economy, sweeping changes have altered the financial-services landscape.

So what is the role of financial institutions like Citigroup? How confident can we be that they can effectively serve the needs of society, of municipalities and national governments, of shareholders, homeowners, depositors, and borrowers? Skyler puts much of it in context. Banks are the lifeblood of where people live, and they can play a very large role in how they live. He claims the very future of civilization is closely tied to the strength of a short list of urban components, including financial institutions.

“There are key factors that make a city competitive, such as the strength of its government institutions, infrastructure, financial maturity, human capital, and cultural institutions,” he says. Cities, he suggests, must embrace risk-taking in order to innovate, and this presents an opportunity for the private sector. “Public-private partnerships have accomplished many great things,” continues Skyler, “but to me, the real value of private-sector involvement is not measured in the amount of dollars. It’s about having the flexibility and freedom to try new ideas.”

Those new ideas are birthed in many places, financial institutions and regulatory agencies among them.

How confident can we be that they can effectively serve the needs of society, of municipalities and national governments, of shareholders, homeowners, depositors, and borrowers?

Dodd-Frank: the Era of Increased Oversight
It’s an easy assumption that increased regulation can hamper flexibility and freedom. Skyler didn’t say that in his speech; he was actually referring to the nature of risk-taking—how cities and other government entities are restricted in how much risk they can take. Instead, private-public partnerships are what bring programs such as CitiBike and other, much more expensive, infrastructure projects to fruition.

But such regulation is indeed part of how Citigroup and other banks must go about their business. The history of banking has seen an ebb and flow of what financial institutions can and cannot do, per the will of our elected officials. The laws that are enacted very often have to do with the difficult situations that preceded them. When things go awry, the human reaction is to curb what may be at the root of the problem.

The aftermath of the 2008 financial crisis was no exception. The enactment of Dodd-Frank, the Wall Street Reform and Consumer Protection Act of 2010, is the centerpiece of how America reacted. It was the most significant change in financial regulation in the United States since the Great Depression (which itself begot the Glass-Steagall Act). Dodd-Frank contains no fewer than 243 new rules that are intended to improve accountability and transparency of the financial system. And it created a number of new regulatory agencies, including the Financial Stability Oversight Council, the Office of Financial Research, and the Bureau of Consumer Financial Protection. Additional powers in the bill were granted to existing oversight bodies, including the Federal Deposit Insurance Corporation, the Securities and Exchange Commission (SEC), and others.

One new rule in Dodd-Frank, which took effect in July 2015, after a five-year stall, restricts some large US banks from making risky, speculative bets by way of proprietary trading—i.e. using funds from their own accounts to engage in hedging that places bank customers at risk. Called the Volcker Rule (named after former Federal Reserve chairman Paul Volcker), it was largely anticipated by Citigroup and others such that they were already in compliance when it finally became effective.

Perhaps this is because attorneys and other compliance staff are in abundant supply at banks. Among its 244,000 employees, Citigroup has almost 30,000 regulatory and compliance staff, about 13 percent of the firm’s entire workforce. This is up since 2008. And it addresses the need for greater scrutiny and conservatism with regard to financial risk-taking. But does this level of caution, this reduction in risk, amount to good things in the end? It may depend on how much we need the banks to do what banks do, coupled with the regulatory environment that is now in place.

Laying Blame
Without question there was a multiplicity of factors that fostered the financial crisis and led to the economic recession. The story of how it transpired, who was at fault, and what could have been done differently is a tale abundant with characters.

There were the subprime lenders who allowed new homeowners to borrow in larger loan-to-value (LTV) ratios than ever before. In 1994, the median LTV was 1.65 when the median loan after adjusting for inflation was $120,000 and the median income of borrowers was $73,000. By 2005, median loans grew to $183,000 against roughly the same level of income as in 1994, resulting in an LTV of 2.46. What was perceived as enabling more people to become homeowners was in fact building a significant debt bomb of under-qualified, at-risk mortgage holders.

Others posit that the homeowners themselves bit off more than they could chew. Senator Elizabeth Warren’s book, The Two-Income Trap, Why Middle-Class Parents are Going Broke, posits that when both spouses work they tend to buy homes that are affordable on the combination of their incomes—leaving them quite vulnerable if either were to become unemployed. Warren argues that home prices just before the housing bubble burst were out of whack from an earlier generation; but it bears noting the size of homes, the number of bedrooms and bathrooms, and features of kitchens and bathrooms increased significantly in recent decades. The average American home in 1980 was about 1,700 square feet, but by 2010 it was closer to 2,400 square feet. Was it homebuyers’ fault they were loaned enough money to buy McMansions, which they subsequently lost in the recession years?

These so-called subprime loans were largely originated by finance companies outside the banks. Most of the larger banks, Citigroup included, did little business in selling or securitizing these loans themselves, instead being involved in that business through the acquisition of subprime lenders. Arguably, owning companies in subprime lending was the mistake Citi made while growing into a global banking empire since the beginning of the twenty-first century.

Or did the government-sponsored Freddie Mac and Fannie Mae secondary mortgage companies encourage all of this to happen? With such an increased volume of loans in the early 2000s, as well as the number and opacity of mortgage originators, underwriting standards suffered.

Going back further, to 1999, a series of changes brought about by the Graham-Leach-Bliley Act (also known as the Financial Modernization Act of 1999) removed barriers that separated investment firms from commercial banking and insurance brokerage. Citigroup’s 1998 merger with Travelers Insurance tested the limits on this rule, and Congress’s passing of Graham-Leach-Bliley, signed by President Bill Clinton, effectively endorsed Citigroup’s move. But while this is called “the repeal of Glass-Steagall,” the 1933 act, which separated commercial and investment banks, had been eroding almost since its inception. Even Senator Glass sought to change a rule regarding banks underwriting corporate debt as early as 1935, with many other legislative challenges and rule changes in the decades that followed.

The Bailout, Paybacks, Judgments, and Settlements
What unfolded in late September and early October of 2008 is, of course, historic and continues to be the subject of much debate. The Troubled Asset Relief Program (TARP), signed into law just two weeks after the failure of Lehman Brothers, halted what many considered to be a death spiral for financial institutions. There was the equivalent of a bank run on money market funds, where $144.5 billion in withdrawals happened in one week (the prior week withdrawals were only $7.1 billion). Corporations were unable to roll over their short-term debt. An indicator of perceived credit risk in the economy known as the TED spread (the difference between the interest rates on interbank loans and on short-term US government debt) reached record levels by mid-October.

TARP promoted financial market stability. It collateralized difficult-to-value assets such as debt obligations, and it encouraged banks to resume lending and effectively bolster the overall economy. Of $467 billion allotted under TARP, $427.1 billion was disbursed, and as of 2015, proceeds to the US Treasury from the banks came to $441.8 billion, a net gain of $14.1 billion.

Aside from government loans, there were charges levied by the US Justice Department—working under the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA)—against banks that included Citigroup. The charges cited federal and state civil claims related to Citigroup’s conduct in the packaging, securitization, marketing, sale, and issuance of residential mortgage-backed securities in the lead up to the meltdown. Citigroup paid out $7 billion ($4.5 billion of which is being paid to settle Justice Department claims under FIRREA, $208.25 million to the Federal Deposit Insurance Corporation, and multimillion-dollar claims of varying amounts have been made to the states of California, Delaware, Illinois, Massachusetts, and New York).

Relief to aid consumers harmed by the crisis (and tied specifically to Citigroup) will be funded by $2.5 billion in the settlement. This includes loan modifications to homeowners whose properties are underwater, refinancing for distressed borrowers, down payment closing costs for qualified home-buyers, and donations to community organizations that work in redevelopment and affordable rental housing for low-income families in high-cost areas.

The legal scenario for bank executives in the aftermath remains uncertain. The Justice Department issued a public statement in 2014 that said, “the agreement does not release individuals from civil charges, nor does it release Citigroup or any individuals from potential criminal prosecution.” The bank agreed to fully cooperate in any investigations related to the conduct covered by the agreement. What is noteworthy is that the SEC concluded two key cases in 2015 against executives at Freddie Mac and Ernst & Young (for its role as auditor for Lehman Brothers) with a muddled resolution that found no actual wrongdoing on the part of individuals who were centrally involved in the 2008 crisis.

Compliance in the Aftermath
Dodd-Frank and the post-2008-crisis era have chastened financial institutions, even while the industry remains a popular kicking post for those who proclaim the banks remain “too big to fail.”

“There’s a huge demand for infrastructure in the world’s cities,” Skyler said in his speech to the “Cities for Tomorrow” symposium. “The need has been estimated at $57 trillion over the next 15 years.” Included in that infrastructure is the renovation of LaGuardia Airport, announced mid-2015 and expected to cost $4 billion. The bank is also committed to lend, invest, and facilitate $100 billion to reduce the impacts of climate change and to finance sustainable growth.

Those kinds of investments—not philanthropy, Skyler is quick to clarify—require deep pockets. And to win work in the private-public sector, at a minimum, the bank has to be compliant with laws, rules, and regulations that have arisen to correct the mistakes of the past. The requirements of the Bank Secrecy Act (BSA) and the Patriot Act make that no small task.

Compliance officers on Wall Street are the new power brokers who arguably eclipse the influence of traders and investment bankers.

Congress enacted the BSA in 1970 as a means to fight money laundering. It’s the law that kicks in, for example, when both cash-in and cash-out transactions in currency total $10,000 or more on the same day by, or on behalf of, one person. It applies to banks, savings and loans institutions, credit unions, and all other financial institutions and money-services businesses. Initially designed to limit the activities of illegal-drug kingpins, it also found utility in detecting and restraining operatives in international terrorism. The law also identified former US House Speaker Dennis Hastert in an alleged hush-money scandal in 2015.

Citigroup’s Mexican subsidiary (Banamex USA) was charged with allegedly lax compliance controls in 2012. The bank was accused of lacking appropriate internal controls on legal, compliance, and reputational risks related to money laundering (a particular concern for remote and international deposit operations). The bank responded vigorously, providing a written report on the standards and structure that underpins its compliance program. This includes documentation of its training of staff, investigations, and compliance-monitoring standards. The bank also provides lists of staff in charge of compliance-related functions in different business units, as well as how they are coordinated across different subsidiaries.

Compliance efforts by Citigroup and all other financial institutions and corporations were already ramped up almost a decade earlier in the wake of the Enron and WorldCom debacles. Those events provided impetus to the enactment of the Sarbanes-Oxley Act of 2002, which added new layers of rules and guidelines to corporations. Financial institutions such as Citigroup, however, were less affected by the act because its underpinnings were modeled after the Federal Deposit Insurance Corporation Improvement Act, adhered to by banks since the 1990s following the savings and loan crisis of the 1980s.

Clearly, bank compliance doesn’t only serve economic interests but also those of law enforcement. Industry observers working for Thomson Reuters wrote in 2013 that compliance officers on Wall Street are the new power brokers who arguably eclipse the influence of traders and investment bankers. Reporters Aruna Viswanatha and Brett Wolf wrote, “the demand for compliance expertise exceeds the pool of qualified professionals, forcing banks to poach from each other—sometimes by offering to double salaries and other perks like flexible work schedules.” The writers continue with an example of a new compliance director, who after interviewing with “a very big bank” was offered a salary of $1 million—which the candidate rejected.

While that may seem like a hefty salary for what was once a secondary function, the economics are understandable. With increased government enforcement of anti-money-laundering provisions of the Patriot Act, fines levied against the banking industry rose from $26.6 million in 2011 to $3.5 billion a year later ($1.9 billion of that came from the Mexican unit of UK-based HSBC, which was found to have handled millions of dollars of drug money).

Who fills these now-well-compensated compliance positions? Lawyers from top schools, say the Thomson Reuters columnists. “There are no specialized degrees required for compliance officials who were typically repurposed from other divisions of a bank,” they write. “But as demand picked up, candidates with degrees from reputable law schools started moving into the field, recruiters say.” Starting salaries might be between $65,000 and $85,000, with $150,000 salaries common after five to ten years experience—on up to seven figures for top professionals. Compliance positions with hedge funds are said to scale even higher. With smaller banks, the opposite is the case as the most talented compliance professionals leave them for higher-paying positions.

John Gerspach, Citigroup’s chief financial officer, spoke at an institutional investors conference in early 2015, lauding the benefits of its own beefed-up compliance function. “Today, we operate global risk, finance, and compliance functions with common standards and systems, consolidating disparate functions from our businesses and regions and establishing a disciplined firm-wide, risk-appetite framework,” he told colleagues. “At the same time, we have further invested in our regulatory and compliance staff, with these control functions nearly doubling since 2008. Improved information systems, reporting, and risk management have served us well in recent years, as we successfully navigated events, such as the sovereign debt crisis in Europe and Arab Spring as examples, and as we manage today through the impact of geopolitical risks and the recent declines in energy prices on our businesses.”

Risks still need to be taken, even under the rules and dictates of legislation that has adopted a very wary view of financial institutions.

If earnings reports are any indication, the bank’s efforts seem to be working. Citigroup’s 2015 midyear adjusted net income exceeded expectations ($4.7 billion versus $4.1 billion) and earnings per share in the second quarter followed a very profitable first quarter ($1.45 versus the $1.34 predicted by analysts), boosting the stock price when announced in July 2015. Gerspach told the Financial Times, “I never want to predict future performance … but we are committed to hitting our targets. We are certainly well on our way.” An industry analyst put it more strongly, describing Citi’s results as the “biggest and most noteworthy turnaround story in banking.”

Which gets us back to CitiBikes and what Ed Skyler says about the relationship between banks and the development of future-looking cities. Risks still need to be taken, even under the rules and dictates of legislation that has adopted a very wary view of financial institutions.

“In the private sector, risk-taking and innovation is expected by the public,” Skyler says. “But government is rarely a leader when it comes to experimentation and trying new ideas. The scrutiny on tax dollars makes governments reluctant to take risks. But that doesn’t mean this is how it has to be. Risk-taking by cities needs to be catalyzed, not constrained.”

In other words, the broad-based changes of such things as infrastructure, global trade, sustainable building, and innovative companies each happen because investors identified a tolerable level of risk. Those investors, individuals as well as companies and institutions, are assured that the enterprise is honest and adherent to laws and regulations that serve important social and economic needs.

Skyler emphasizes these points relative to the needs and opportunities in the mass trending toward increased urban populations. Affordable housing and energy efficiency will make new mega-cities more livable. “In the U.S., aside from being the leading lender for affordable housing, we’re helping households become more energy-efficient by providing low-cost loans for energy improvements such as installing more efficient boilers and smart thermostats,” he says.

Because in the end, all that compliance, all the risk management, and certainly the resurgent profitability of Citigroup does boil down to how it affects people where they live. If that includes providing homes for low-income individuals and ensuring they can responsibly manage their utility costs—and maybe ride a CitiBike to work—then so be it. That’s what well-managed banks make happen.