07 March 2016

The past year was another challenging one for the U.S. banking industry, testing the viability of business models and the ability of management teams at community-focused banks of all sizes across the country.
Complex, still-evolving regulatory requirements confront the industry and continue to drive heightened investment in compliance, risk and capital management infrastructure. A slow and uneven economic recovery, an unusually persistent low-rate environment, concerns abroad and rising competition from outside the regulated banking industry all placed further performance and consolidation pressures on small and mid-sized banks.
M&T’s results were impacted by such factors in 2015, as they have been over the past several years. The progress we made on our risk management infrastructure earned some measure of validation through the approval and completion of the merger with Hudson City Bancorp, Inc. (“Hudson City”). It was an arduous journey, one that validated the need for those investments as well as extraordinary regulatory compliance costs, while rearming that scale, efficiency and credit discipline remain as competitive advantages.
Using generally accepted accounting principles (“GAAP”), net income was $1.08 billion in 2015, an increase of 1% from $1.07 billion in 2014, while diluted earnings per common share registered $7.18 in 2015, a decrease of 3% from the earlier period. The impact of merger and acquisition charges incurred in connection with the consummation of the Hudson City transaction on the first day of last November dampened those 2015 results by $61 million net of tax, or 44 cents per common share.
Following our traditional practice, which helps investors better understand the impact of merger activity on M&T’s financial statements, we also provide M&T’s results on a “net operating” or “tangible” basis. Net operating results exclude the effect of intangible assets as well as the after-tax impact of merger-related expenses on both the income statement and balance sheet. Such charges are akin to the cost of entry in consummating a merger and will not continue as part of the normal, ongoing expense required to operate the new franchise. Under this measure, M&T’s net operating income was $1.16 billion last year, improved by 6% from $1.09 billion the year prior. Diluted net operating income per common share amounted to $7.74 in 2015, a 2% rise from 2014. The net operating results for 2015, expressed as a rate of return on average tangible assets and average tangible common shareholders’ equity, were 1.18% and 13.00%, respectively.
M&T’s primary source of revenue is net interest income, comprised of interest received on loans and investments, less interest paid on deposits and borrowings, which, expressed on a taxable-equivalent basis, was $2.9 billion for 2015, an increase of 6% from the prior year. Two somewhat offsetting factors combined to affect that rate of growth. First, average earning assets increased by $9.5 billion or 12%. Tempering the positive contribution from that growth, however, was a narrowing of the net interest margin, which is taxable-equivalent net interest income expressed as a percentage of average earning assets. Let’s review the details.
Average loans notched a 10% increase of $6.2 billion, rising to $70.8 billion, while average holdings of investment securities grew by $2.9 billion to nearly $14.5 billion. Those investment securities expanded M&T’s layer of high-quality liquid assets, funds which otherwise could be used to expand lending, but which are being held in reserve so that they can be readily turned into cash in times of economic stress. Total loans at December 31, 2015 were $87.5 billion, inclusive of loans acquired from Hudson City.
The net interest margin was 3.14% in 2015, a decrease of 17 basis points from 3.31% the year before. The pressure on the net interest margin continued as a result of the low interest rate environment that prevailed throughout most of the year. Those pressures began to ease in late December, when the Federal Reserve raised its benchmark interest rate by 0.25%—the first increase since June 2006, some nine and a half years ago.
As the economy continued to improve during the year, however slowly, the repayment performance of M&T’s loan portfolio remained steady. Net charge-offs expressed as a percentage of average loans outstanding were 0.19%, unchanged from the same figure in 2014 and just over half the bank’s long-term average of 0.36% since 1983. Expressed in dollar terms, net charge-offs were $134 million, compared with $121 million in the prior year. M&T’s allowance for losses on loans and leases stood at $956 million as of December 31, 2015, representing 1.09% of loans outstanding.
Non-interest income from fees and other sources totaled $1.8 billion in 2015, an increase of 3% from 2014. Revenues from mortgage banking increased by 4% over the prior year to $376 million. Trust income declined by 7% to $471 million, which reflects the April divestiture of Wilmington Trust’s trade processing business and its associated revenues. This transaction is representative of our efforts to direct resources towards services that will provide the most value to our clients over time. In connection with the divestiture, M&T realized a $45 million gain, included in other revenue from operations.
Non-interest expense increased to $2.8 billion, up from $2.7 billion in the previous year. The increase primarily reflects the impact of the Hudson City merger, which includes two months of its operating expenses as well as $76 million of pre-tax merger-related expenses. The efficiency ratio, the cost to produce a dollar of revenue expressed in percentage terms, improved from 2014 by 1.31 percentage points, to 57.98%. Adjusting for the impact of the merger and a $40 million contribution to the M&T Charitable Foundation made in the second quarter, expenses declined slightly from 2014.
Upon reflection, our financial performance and condition in 2015 merit no small measure of pride. Considering the environment, our businesses have performed remarkably well. The retail banking business opened 178,119 consumer checking accounts, issued 38,001 credit cards, originated 63,665 auto loans totaling $1.5 billion and wrote 20,234 mortgages totaling $4.2 billion. On the commercial side, 17,714 loans totaling $19.4 billion were underwritten. Wilmington Trust was appointed to act as the trustee or agent on 4,149 new corporate debt, loan agency, structured finance and equipment finance transactions generating over$8 billion of average deposit and investment fund balances. The wealth advisory services group was engaged by 330 new clients to provide them with services to manage and preserve their assets.
M&T’s fundamental performance in 2015, against the backdrop of the competitive environment and the significant investment made in its risk management infrastructure, remained strong relative to the industry, as evidenced by a return on tangible common equity of 13.0%, which is above the median of the 20 largest commercial bank holding companies headquartered in the United States. Over the past year, M&T’s tangible book value per share, an important measure of value creation for investors, grew by 12.7%, significantly outpacing this entire group. Over the past five years, our compound annualized growth rate of 14.1% was exceeded by just two others.
M&T has long prided itself on a patient approach to mergers and acquisitions, entering into partnerships that made sense and which were additive to shareholder value. We are not motivated by growth for growth’s sake and, even while cognizant of gaps that may exist in our geographic footprint, prudence has always dictated that we wait for the right opportunities for expansion. Such was the case with Hudson City, in which we moved in a meaningful way into new, adjacent markets with 135 branches utilized by 217,707 consumer households with 553,067 accounts. The fact that this merger was immediately accretive to operating earnings and tangible book value per share, and brought an increase of as much as 80 basis points to our regulatory capital ratios, demonstrates our unwavering commitment to the careful stewardship of our shareholders’ capital.

In 1983, or 33 years ago, I became Chief Executive Officer of M&T Bank. During that period, the bank’s total assets have grown from $2.1 billion to $122.8 billion. Concurrently, its earnings grew from $5.3 million to $1.1 billion, its personnel complement from 2,096 to 17,476 and its branches from 59 to 811. The value of its shares grew at a compounded rate of 14.8%—the best return of the 100 largest banks that were in existence at that time—only 23 of which are still around today. M&T is among the eight banks that are able to borrow money in the public marketplace at the narrowest of spreads and is one of just seven banks out of the top 20 that have a rating of B+ or better in the S&P Stock Guide. During the financial crisis, it was one of just two commercial banks out of 20 then included in the S&P 500 that did not reduce its dividend, and at no point in the last 33 years has it had to raise additional common equity in the public markets. Within the entire universe of 586 U.S. publicly traded stocks that have traded continuously since January 1, 1980, M&T’s annualized total return through the end of 2015, including reinvested dividends, of 18.7% ranks twenty-fifth. Berkshire Hathaway, widely considered the gold standard for shareholder returns, returned 19.5%, ranking sixteenth in the same analysis.
The bank continues to maintain its headquarters in Buffalo, New York, where it was founded 160 years ago and where today almost 40% of our employees still work. Until 2003, save for a boutique operation in New York City, M&T’s franchise was essentially located in Rust Belt cities that are poorer than the national average—many in locations where people know when you are born and care when you die.
M&T has always focused on serving its communities. It has had the highest possible Community Reinvestment Act (“CRA”) rating from its federal regulator since 1983. M&T encourages its colleagues to get involved with those institutions that enhance a community’s quality of life, and it has made $190 million in charitable contributions during the past 10 years. Last year alone, M&T employees contributed 307,873 hours of their time and served on 2,115 not-for-profit boards.
The bank also spends a great deal of time recruiting and developing its colleagues. In the last 10 years it has, without interruption, continued its long-standing practice of adding young talent to its ranks, enlisting 842 recent college and business school graduates into its training programs. These young people—combined with more seasoned external hires, all of whom bring a widely varied set of backgrounds and viewpoints—engender diversity that broadens our perspective, enriches the workplace and ultimately results in better dialogue. The bank further establishes bench strength by rotating high potential colleagues into different disciplines and geographies. Today, there are more than 800 who have worked in two locations, and 84 in three.
M&T has 14 members on its Management Committee and they have been with the bank an average of 25 years. Bank-wide, the tenure of M&T’s employees averages 10.4 years—more than twice that of the financial services industry. These colleagues exhibit an intense personal responsibility to the bank and to one another. Their tenure and tenacity have meant that the bank has always gone the extra mile to correct any single mistake in its transactions or weakness in its overall systems. M&T concentrates on details—on getting things right no matter the amount of work involved—and demands the highest moral conduct of its colleagues. Fundamentally, M&T focuses on its clients and tries to do the right thing the right way. Taken together, these traits are part of the bank’s culture—overarching principles that have been essential to its success.
It is in this context, with a sense of humility, that we say it should not have required a reminder from our regulators that stronger systems, programs and infrastructure were needed for a bank of our current size and complexity. We fell behind in building our risk management processes and have come to learn—the hard way—that the task of catching up is far more costly than simply keeping pace. This is a lesson that we have embraced and will not readily forget. The experience of the past three years has been additive to our cultural DNA.
We have worked tirelessly since 2013 to put our house in order. M&T has engaged 12 consulting firms at an aggregate cost of $178 million over that time. The team handling the anti-money laundering program, consumer and corporate compliance, as well as capital planning and stress testing and other risk management areas increased from 128 to 807. Our overall cost of compliance, which peaked at $441 million in 2014, retreated somewhat to $432 million last year.
M&T has built a vast and intricate system for capturing and tracking additional information and augmenting knowledge of our customers. We have already completed reviews of 71% of our 3,558,681 M&T clients that are required to go through the new process for determining risk of money laundering or other financial crimes. Imagine the permutations of letters, emails, phone calls and meetings it took to gather the required intelligence. We are cognizant of the inconvenience to our customers and aware that it came as the result of our having to play catch-up. By our own estimate, it was necessary to contact some individuals or businesses nearly five times to successfully collect the needed material. While we regret the necessity of putting our customers through this process, we do not regret the fact that we are now closer to those customers and know them better than ever before. And given the intensity with which we have tracked down the additional data, they most assuredly know us!
In addition to updating client profiles, the bank continues to screen transactions for suspicious activity. In 2015, M&T’s automated monitoring system reviewed 768,984,034 transactions for signs of suspicious activity. Such scrutiny, along with the use of other money laundering detection tools, may help in uncovering financial crimes, money laundering or a terrorist cell by flagging transactions emanating from local establishments to notorious locations around the world.
So too has our capital governance process, put in place to ensure the bank’s capital structure is sufficiently robust, strengthened our internal planning and improved risk awareness across the bank. The publicly disclosed results of this process give the investment community more insight as to how M&T and its peers would perform in stressed economic conditions.
New capital rules provide better differentiation among the types of activities that M&T and other banks engage in by applying higher risk-weightings to assets such as equity exposures, certain trading portfolios, derivatives and securitizations, whether accounted for on or off bank balance sheets.
M&T’s risk management infrastructure is, without a doubt, broader and more comprehensive. A steadfast commitment spans the organization, including intense involvement from both executive management and the Board of Directors. The Risk Committee of the Board provides oversight of a robust risk governance structure and, last year, convened 16 times to review 5,673 pages of materials and produced 141 pages of minutes. Executive management is actively engaged through the Management Risk Committee, which serves as the central forum for the identification and escalation of key risks. Organized under that body are eight Risk Governance Committees, each of which has oversight of a specific risk category. Since the implementation of this governance regime nearly two years ago, these committees have met 222 times to discuss existing, new and emerging risks, reviewed 34,196 pages of presentations and reports and produced 1,329 pages of meeting minutes. The comprehensive reach of the risk management framework that spans 189 committees across the bank has become a catalyst for improvement. For example, the quality of data has been enhanced, as has the transparency of information. The organization is, as a matter of consequence, more vigilant and more adept at policing itself.
There is little question that the lens of time has sharpened our perspective. M&T needed to improve its foundational infrastructure in order to deal with the challenges and pace of change of the world today. The bank has reinforced its risk management in a manner designed to support an organization that aspires to grow. This is not to say that our work is done—ongoing investment in compliance, technology, systems and personnel will be needed to keep pace with the evolving financial industry landscape well into the future.

It is hardly the case that M&T and 6,174 other U.S. banks and thrifts are entirely content with the current environment in which we operate. The U.S., and indeed the global economy, suffered a financial crisis of horrific proportions—one in which a handful of banks, but not all, played a pivotal role. In its wake, public officials, reflecting the mood of the public at large, demanded change—and change, most assuredly, they have seen. Yet, from a banker’s perspective, the very word “bank” continues to be convenient political shorthand for financial shenanigans. For institutions that see local banking as both a service and a calling, convincing officials of our good intentions feels like a Sisyphean task.
Just as M&T needed to keep pace with the rapid changes that have occurred in the world since the crisis, so too must the industry, the government and the public be cognizant of the need to stay abreast of the swiftly changing environment and move forward.
Since the 1980s, government agencies, regulators and politicians, in combination with market forces, have shifted the equilibrium of the banking industry. New entrants, public policy and enhanced regulatory oversight have all contributed to this change. In this environment, just at a time when disadvantaged members of our communities are in need, regional banks find themselves playing a diminished role in their traditional activity of supporting economic growth by taking deposits, extending credit and facilitating trade and commerce. A restoration of those crucial roles will require a healthier dialogue between bankers and regulators, an appreciation of the unintended consequences of new policies, a grasp of the implications of technological change, and an understanding of the rapidly evolving financial services industry as a whole.
IMPROVING THE DIALOGUE: Though small and mid-sized banks played little, if any, role in the crisis, they have been swept into this vast change, and the resulting disproportionate burden is distracting them from their traditional focus on servicing local families, businesses and farmers. Despite a shared objective of maintaining the safety and soundness of the financial system, today’s banking environment is typified by a relationship between institutions and governing agencies that is less than collaborative—a product, it seems, of a political atmosphere where pressure remains upon banks to prove themselves reformed.
There is sometimes a lack of coordination among different agencies. Post-crisis regulation conferred new powers and created new governing bodies. Each agency is attempting to administer and exercise its granted authority. However, various regulatory organizations can have different criteria for assessing the same issue. For example, M&T had three different agencies analyze its mortgage portfolio, and each required a unique sample of mortgages that the other two had not seen. In 2015, M&T underwent 36 different inspections across 10 agencies. Each review brought as many as 15 regulators to the bank and, at one point last year, eight exams were being conducted simultaneously. In the past, some of the supervisory bodies conducted their examinations together, compiled their findings, and then made a joint presentation to an organization’s board of directors. More recently, such reviews have been conducted separately and accompanied by individual written reports and presentations to a bank’s board. This inevitably results in fragmented assessments of banks and makes it difficult for banks in defining priorities to facilitate necessary change.
A measure of improved coordination could help in reducing some of the unnecessary duplicative work needed to fulfill regulatory requests, and free up resources to make faster progress in reforming the system, allowing for a rebalancing of our responsibilities toward serving our customers.
Dodd-Frank created the Consumer Financial Protection Bureau (“CFPB”)—an agency whose mandate is as simple as it is broad: consumer protection. For 72 years, the Federal Trade Commission was tasked with protecting consumers from “unfair” or “deceptive” business practices. With its inception, Dodd-Frank added the term “abusive.” Although the CFPB has power under the law to promulgate regulations to ensure clarity, no further definition of this term has been published, creating a “you’ll know it—when I see it” atmosphere, leaving banks uncertain about what is required to remain above reproach.
While these are but a few examples, the recurring theme is that banks have been working with new regulations that are constantly evolving, sometimes with a lack of clarity, but always with a certain degree of urgency. In that regard, M&T is no different from regional banks that have always endeavored to provide banking services in a manner that governing agencies, shareholders, clients and communities would find exemplary. However, that task becomes increasingly difficult when the rules of the game and the supervisory process are, at times, managed in a conflicting manner. Amidst the uncertainty and angst that this engenders, it is difficult for traditional banks to use their renewed culture, fortified by heightened risk management and compliance discipline, in the service of their core mission.
APPRECIATING CONSEQUENCES OF PUBLIC POLICY: History has demonstrated that thoughtful legislation can accelerate and even pivot the direction in which our country’s economy moves. However, we are reminded frequently that unintended consequences can arise out of the best of intentions. Not only do the benefits often not reach their intended recipients but, at times, previously unforeseen issues emerge as a result.
The Federal National Mortgage Association (“Fannie Mae”) and The Federal Home Loan Mortgage Corporation (“Freddie Mac”) were created with the laudable goal of increasing home ownership. These institutions were granted regulatory and capital advantages that, combined with their implicit U.S. government guarantee, allowed them to dominate competition from the private market. Fannie Mae and Freddie Mac began pursuing non-traditional mortgage loan programs—moving into the subprime and Alt-A market segments characterized by lower credit quality. By the eve of the financial crisis, they had extended 39% of the $4.6 trillion of those mortgages then in existence—loans that subsequently resulted in large scale defaults and borrowers losing their homes.
In 2010, the government eliminated the federal guarantee program and began exclusively originating loans directly to students, with the promise of reducing the cost of the program to taxpayers. College education debt outstanding at that time was $811 billion. By the end of 2015, that figure had grown to $1.3 trillion. In fact, student loans are the fastest growing category of consumer debt, now ranking as the second largest, after mortgage loans. The average student debt at graduation has risen by 56% over the past 10 years, from $18,550 to $28,950. Ninety-day delinquency rates have risen sharply from 6.4% to 11.6% over the past decade—a harbinger of higher losses, whose cost will ultimately be borne by taxpayers. At the same time, increased debt burdens are contributing to lower rates of household formation and home ownership as well as reduced business start-ups among the generation of recent college graduates.
Beyond these unintended results, there are other areas in which it is difficult to understand whether the benefits of public policy have reached the intended recipients.
The Small Business Administration’s (“SBA”) 7(a) guaranteed loan program is intended to expand access to capital for small businesses, yet only about a third of the country’s commercial banks participate in it and the number declined by 13% between 2012 and 2015. Since the recession, the SBA has attempted to simplify program requirements and streamline processes in order to boost borrower participation. Commercial loans under $1 million are deemed by the government to be “small business” in nature. Despite program improvements, SBA-backed loans under $1 million are 40,047 units or 41.3% below their 2007 pre-recession levels. The SBA program remains too cumbersome for many banks to use in extending credit to small businesses. It is hardly surprising that credit availability as measured by CRA data for loans under $1 million remains 34.9% below 2007 levels, a decline of nearly $115 billion.
The Durbin Amendment, included in the Dodd-Frank legislation, imposed price controls on the interchange fees that banks could charge retailers, with the expectation that annual savings—which a recent academic study estimated at up to $8 billion per year—would be passed on to consumers and smaller merchants. Researchers found that, despite the creation of such “savings,” there was no evidence that consumers and small businesses saw any of it. Instead, the study concluded, big-box retailers were the real winners.
The collective goal of all stakeholders in the financial system—the banking industry, the regulators, the legislators, and the public—should be to foster a safer and more productive environment in order to create a fair, equitable, growth-oriented, yet transparent system that promotes the expansion of the overall economy and the betterment of businesses and consumers alike. As we do this, we must also be keenly cognizant of the absolute imperative that the most disadvantaged members of society not be left behind in the wake of these efforts.
TECHNOLOGY AND ITS IMPLICATIONS: Rapidly changing technology in combination with the need for continued expenditure on compliance infrastructure is creating a dual challenge for regional banks. Consumers demand the ability to seamlessly interact with banks from anywhere and on any number of devices. Traditional banks are increasingly caught in a vise—they cannot afford to shortchange investment in the mobile and online banking technologies that their clients want, as well as in the cybersecurity that will keep their customers’ information and assets safe from global criminals. Yet banks also have to simultaneously bear the higher regulatory and compliance expenses and decreased revenues brought about by legislation and regulation meant to address the ills of the last crisis. The largest banks, on the other hand, are able to take advantage of their massive size to shrug o. the impact of compliance costs, fines and penalties, and still have the wherewithal to invest in the latest technologies. As a result, they are increasingly gaining a competitive advantage over these smaller banks. For instance, five of the largest banks were able to grow their aggregate same-store retail deposit balances at a rate nearly twice that of the rest of the industry over the last three years.
A recent J.D. Power and Associates® survey noted that mid-sized and regional banks were seeing their long-held customer satisfaction advantage over large banks erode, a development attributable primarily to the large banks’ ability to meet customers’ quickly evolving preferences in mobile and Internet banking. It would seem that a legislative canon that purports to better regulate those institutions deemed “too big to fail” is unwittingly creating a class of banks that may be “too small to succeed.”
THE CHANGING LENDING LANDSCAPE: For centuries, banks have been the principal source of financing for commerce and industry—bolstering this country’s economy since before it was constituted a nation—and operating under charters to gather deposits and make loans to businesses as well as individuals. Forty years ago, nearly 70% of all private sector loans were made by 19,372 banks and thrifts across the United States. Today, just 48% of loans are made by one-third as many banks.
Lending standards have loosened over the last several years; the markets across our regional footprint are intensely competitive, almost frothy, with both pricing and loan structure coming under pressure. Loan features such as interest-only payments for the life of the loan and fixed rates for long periods of 10 to 15 years have re-emerged while pricing is being pushed downward, sometimes below minimum sustainable levels of profitability. Banks of all sizes remain engaged, aggressively competing for a limited number of high-quality opportunities that satisfy increasingly stringent regulatory standards, while at times reaching beyond their natural geographic footprint.
In recent years, players from outside the industry have stepped in to capitalize on a more restrained banking system. A variety of non-banks— hedge funds, private equity firms, business development companies, direct lending funds, non-bank mortgage originators, online platforms, peer-to- peer lenders, real estate investment trusts and a host of others—o.er loans to businesses of every description, conduct mortgage banking and commercial real estate lending, and make other consumer loans. A recent survey commissioned by a leading independent market research firm found that approximately one-quarter of U.S. small and mid-sized companies have reportedly obtained credit from non-bank lenders, with 79% saying it is easier than working with a bank and 94% indicating they would do so again.
The International Monetary Fund noted in a research paper that “the interplay of different regulations (capital, liquidity, activity restrictions and governance) and increased compliance costs and legal risks may be affecting banks’ willingness to support certain activities.” A 2015 survey conducted by the Federal Reserve in partnership with state banking regulators found that compliance costs for community banks represented 22% of their net income. While indicating that it was too soon to weigh such expenses against their systemic benefits, the report still noted that the costs are “sufficient to frustrate bankers.”
As regulators build higher walls around the banking sector, and lending and other traditional banking activities continue to migrate out of the regulated portion of the financial system, we have to be concerned that a false sense of security is being created. The world of non-bank financial participants is intimately linked with that of the regulated sector. No better example of this linkage exists than the interdependency between the largest U.S. banks and hedge funds and private equity firms.
Designed as private investments for high-net-worth and institutional investors, modern hedge funds employ a variety of strategies. Some are market-neutral funds aimed at hedging market risk using offsetting positions, while others engage in short-selling securities in anticipation that the fund will be able to buy them back in the future at a lower price.
Private equity firms were originally created to pool money to acquire stakes in companies, either partial or full ownership. Today, the reach of these firms is extensive—they own hotels, Manhattan apartments, distressed loans, water utilities in California, sewer systems, school bus services, a natural gas export facility and a hydropower dam in Uganda. The largest operator of rental homes in America is owned by a private equity firm.
These firms have grown rapidly in both size and number. From 2000 to 2015, assets managed by hedge funds grew from $237 billion to $2.7 trillion, more money than the individual economic outputs of all but the world’s five wealthiest nations. The rapid expansion of the private equity industry is comparable to that of the hedge fund industry—there are 3,300 private equity firms headquartered in the United States. Since 2000, the number rose 143% while their assets under management grew nearly six-fold to $4.2 trillion.
Five of the largest banks, which account for 93.6% of derivative exposures and 90.5% of U.S. banking industry trading revenue, have an interdependent relationship with their hedge fund and private equity clients. Such firms and their funds depend on large banks’ balance sheets to increase leverage and enhance returns, and large banks in turn earn substantial fees from these clients. As one market participant noted, “Without hedge funds, there wouldn’t be prime brokers, and without prime brokers, there wouldn’t be hedge funds.”
Those five banks service 41% of all hedge funds. Just one of these banks services 20% of the 10,268 hedge funds in the United States. The funds borrow money from these banks to expand returns through the use of repurchase agreements (“repos”), a form of short-term secured lending that can be used to finance long-term investments. Such vehicles became notorious during the financial crisis when lenders had to sell mortgage-backed securities at fire sale prices and credit markets froze up. A sudden pullback in repo funding was blamed for the collapse of Lehman Brothers. One recent estimate suggests that repurchase agreements account for 47% of hedge fund financing.
Banking regulators are well aware of the risk posed by these securities financing transactions and have enacted significant regulation to limit their potential to cause harm. One Federal Reserve official noted that such transactions, “…create sizable macro-prudential risks, including large negative externalities from dealer defaults and from asset fire sales.” Said differently, when repos go wrong they can pose great risk to the system.
While the repo business itself generates very low returns, by providing this type of financing to hedge funds, large banks cement their symbiotic relationship with these non-bank players and garner their more profitable trading and advisory business. Then there are the fees paid to large banks by private equity clients, which alone accounted for an estimated 14% of all investment banking fees in 2014, compared with 2-3% in the mid-1990s. Financial institution clients, which include private equity firms and hedge funds, provide 45% of the largest banks’ revenue and utilize 56% of their balance sheets.
Since the end of the financial crisis, non-banks—particularly hedge funds and private equity firms—have benefited from increased regulation and capital requirements placed on banks, providing leveraged loans and credit to both small and mid-sized companies while operating with limited governmental oversight. These firms grew their loan portfolios by 13.2%, compared with 0.5% growth within the commercially chartered U.S. banking industry. Banking regulators, concerned with managing the risks posed to banks when their clients take on high levels of indebtedness, have restricted the amount of capital that they can provide to highly leveraged companies. Free from these restrictions, non-bank lenders have filled the gap and, as of 2013, represented 85% of the $596 billion leveraged loan market, up from just 37% in 1998. In fact, one private equity firm’s credit assets under management grew from inception in 2005 to over $80 billion in 2015, a feat which took M&T 33 years to achieve.
Following the implementation of new bank capital and liquidity standards, the business of mortgage servicing rights has subsequently been forced to migrate to non-bank servicers who are not bound by those rules— or the same banking relationship to the homeowner. In 2010, none of the top five and only one of the top 10 mortgage servicers were non-banks. By 2015, five of the top 10 servicers were non-banks, with servicing balances amounting to $1.3 trillion, or about a 13.6% market share. Notably, the fourth largest servicer is controlled by a private equity firm.
The rapid growth of hedge funds and private equity firms has been driven, in part, by an incentive compensation structure that differs dramatically from that extended to lenders at traditional banks. Hedge funds, private equity firms and other non-bank players have no restrictions on size or type of compensation. The pay formulae for managers of hedge funds—who can earn 2% in management fees and up to 20% of the gains in their funds (“2-and-20”), as well as private equity management fees and so-called “carried interest”—are all tied to the size of assets managed as well as performance of their fund. So significant are these fees that had Berkshire Hathaway charged 2-and-20 starting in 1965 for a $1,000 investment, the investor would have ended up with $527,000 instead of the $7.5 million that would have been earned through 2014.
In 2014, the top 25 individuals in the hedge fund industry together earned $11.6 billion and the top seven private equity partners made a total of $2.3 billion. The nation’s highest paid hedge fund manager earned $1.3 billion—or, put another way, nearly 47 times the compensation of the highest paid bank CEO and 18,288 times that of the average commercial bank employee in the United States.
Traditional banks that have withstood the test of time understand that as markets become more ebullient, they must step back and remain disciplined even at the expense of short-term gains. At M&T, our objective has always been to deliver consistently for our clients, irrespective of market volatility, and to cultivate new relationships during market downturns, when others are constrained by the after-effects of imbibing too freely during boom times. A 2015 study conducted by banking regulators noted that while non-banks had 23% of the $3.9 trillion large syndicated loan market, a share that has nearly doubled over the past 10 years, they held 72.8% of the non-performing exposures. As nonbanks make new forays into the lending space, one wonders if the proper mechanisms are in place to balance their desire to increase the size of their portfolios with the level of institutional restraint required to pull back from the extension of credit to businesses whenever conditions, terms and risk reach the inevitable peak of the cycle. Nor can one imagine that these new entrants, who reside far from the communities where they lend, will be there to provide leadership and support local businesses during difficult times.
EMPOWERING SMALL BUSINESS: Increased regulation of the banking sector has made it difficult for banks to serve certain market segments profitably, while making customers’ borrowing experience more burdensome. While the economy as a whole appears to be expanding, small businesses, once a significant source of job creation and a leading indicator of the economy’s health, have not fully recovered from the recession. Employment at these businesses remains 1.5% below their 2007 peak and their sentiments are further dampened by sluggish sales growth since the recession. Sales at small firms are still 10% below pre-crisis levels.
At the same time, access to capital remains elusive. The Federal Reserve’s Joint Small Business Credit Survey conducted in 2014 showed that 20% of respondents felt too discouraged to apply for credit. Those small businesses that did apply were denied needed financing 44% of the time. The denial rate increased to 50% when the applicant had revenues of less than $1 million. Traditional banks, with their sharply-increased infrastructure costs, find it difficult to earn an adequate return as these small loans require the same level of initial review and ongoing monitoring, yet produce much less revenue to cover those costs.
To some extent, non-bank lenders have stepped into this credit void to provide small business loans, typically those under $250,000, offering convenience through web and mobile credit application portals coupled with shortened decision and funding timelines. The Federal Reserve estimates that non-bank financing to small businesses has doubled every year since mid-2000. While non-banks o.er convenience, speed and expanded access to capital, borrowers often pay a substantial premium for that access. One of the largest non-bank lenders to small business reported in its disclosures that it originated $1.2 billion in loans during 2014 at an average annual percentage rate of 54.4%.
The decline of small business activity is hastened at both ends of the generational spectrum. Many small business owners from the Baby Boomer generation are reaching retirement age and choosing to sell their businesses. On the other hand, Millennials—today’s would-be entrepreneurs—are ill-equipped to secure the capital needed for business formation. The net worth of those under 30 has fallen by nearly half since 2007. Millennials today have nearly twice the amount of student debt compared with the same demographic 20 years ago.
The post-recession period has yielded the lowest average pace of new business formation in the 22 years the Bureau of Labor Statistics has tracked such data. Start-ups peaked at 715,734 in 2006, creating 3.6 million new jobs. Since 2009 and the beginning of the recovery, the average number of new start-ups per year has fallen to 620,668 creating only 2.8 million new jobs annually. When companies do form, they are employing 0.6 fewer workers than a similar start-up in 2006. The drop-off in new business formation means that the population of businesses with less than 100 employees is contracting as well.
Small business lending has long been the province of banks. There is a higher calling to banking—a mission to support community development and the collective betterment that accompanies it. In the wake of the crisis, the industry has perhaps been distracted from that mission and, despite the influx of new players in the lending space, the small business engine continues to sputter. While the fundamental lack of small business start-ups is worrisome, perhaps more troubling is the contraction in the number of those companies that have long been community bulwarks. When a small business owner sells his or her business—sometimes to a firm that is distant from the community—and retires, a leadership vacuum is created; a local leader is lost. If the next generation of potential leaders is not financially capable of stepping in, the cycle will perpetuate. This is a problem the banking industry can help to solve provided it gets back to doing what it does best and endeavors to remove barriers to small business entry while reinvigorating the American entrepreneurial spirit.

So much—indeed, too much—of our public discussion about banks and banking today looks back in anger. Neither fines nor sanctions nor—even more consequentially—regulatory change have restored public trust. Today we face a turning point. Will we continue to look for villains to punish or will we take steps that will enable banks to serve again as agents of an expanding prosperity? Those of us at regional banks such as M&T feel this need most keenly. As matters stand, our dialogue with government officials is sometimes difficult, marked by a cloud of mistrust and suspicion that continues to hang over banks, large and small. The expansion of regulation has affected those of us not among the ranks of giants. We have witnessed, through the rise of non-bank players, a subtle but steady shift in which regional banks are playing an ever-diminished role in the financial leadership of the communities and small towns of America that they have traditionally served so well. Such is the collateral damage of far-reaching regulation inspired by the misdeeds of a few but affecting the whole of the banking industry.
This is not a complaint about the state of our business, which remains healthy, nor even about our prospects, which remain robust. It is an expression of concern that the kinds of communities and customers we serve will not have access to the credit and capital they need—notwithstanding so much regulation enacted in the name of their protection. In many respects, the business model of traditional banks is more relevant than ever before—their role in growing and improving their communities is essential to helping disadvantaged citizens in an era when government programs do not seem to have the desired impact. We know with certainty—because we have done so, historically—that regional banks such as ours, when not disproportionately burdened by the costs and complexity of government action, can play an even more positive role for our communities.
The reach of public policy and regulation is extensive—much of it constructive but some of which has missed the mark, failing to help its intended beneficiaries. One can think here, for instance, of student loans; in the five years since the government eliminated the federal guarantee program, it has come to dominate that market while student debt outstanding has increased by more than half, becoming second in size only to that of mortgage loans. This has made it difficult for young people to start entrepreneurial ventures and afford their first homes. Similarly, the past forays by Fannie Mae and Freddie Mac into subprime lending, with the assistance of Wall Street, have put these agencies in a structural limbo. This leaves unanswered the question of how to serve an entire segment of would-be homeowners. The exigencies of the Federal Housing Administration have led some banks to limit their participation in its insurance program for loans to low-to-moderate income borrowers, raising the question as to how people of modest means will be served. Likewise, the complexities of SBA programs have reduced the number of small banks participating while small businesses with revenues of less than $1 million experience reduced access to needed capital. The Durbin Amendment, in the name of bringing lower costs to the public, has given big-box retailers a windfall with no savings to the person on the street, yet raised the cost of providing banking services to underserved consumers. The unrestricted compensation of non-bank lenders and their inherent remoteness from borrowers raise concerns about how these customers and communities will fare when the economic cycle turns.
All of which is to say that public policy is not science; past action can require future adjustment. Indeed, a fixation with the past—with the view that banks are, inherently, somehow a threat to the economy rather than a pillar of the financial system—itself poses risks. One can only hope that, working together, elected and appointed officials and industry leaders will seek to avoid a grim scenario in which capital is concentrated among a handful of banks even as lending and risk is dispersed to the barely-regulated shadow banking sector. There, where the transparency required of M&T and our peer banks is nowhere to be found, lie the risks for the larger economy of the same type which blindsided us in 2008. That underscores how paramount it is that regional banks are not so diminished that they are unable to continue to wear the mantle of leadership in their communities that they have traditionally borne.
The stakes are high. We simply cannot help but acknowledge that our economy is not the source of job creation it once was. Small businesses, formerly a leading force of economic growth, play a much diminished role today, not least because it is more difficult for lenders to provide the credit that realizing business dreams requires. It is past time for government and the banking industry to turn the page and begin to work together—not to serve the narrow interests of lenders or investors but to advance the broader goal of reinvigorating the American economy.
The best cultures are seldom the most insular. Over the past few years, M&T has learned an expensive lesson on the perils of not keeping pace with change. It is crucial, however, to emphasize that we have learned. At its best, our culture is one open to suggestion and criticism from all quarters. From this, we gain wisdom for tomorrow, not merely a lesson for the moment. In that respect, we are not unlike our country or our economy, both of which have, over time, demonstrated the resiliency to endure change and the humility to learn from it. At the heart of our nation’s innovative, entrepreneurial spirit is its willingness to overcome adversity and drive toward ends that, while new and different, are unquestionably better. Now, having endured the last financial crisis, it is time to direct our full attention to identifying and pursuing a constructive way forward.
The progress we at M&T have made in the last 12 months—a year that was challenging, yet rewarding—is in large measure the result of the determination, dedication and toil of our colleagues. Their integrity and character, their unwavering commitment to doing the right thing the right way, and their willingness—indeed, eagerness—to go above and beyond the call of duty, is the reason I am confident in our ability to thrive and prosper in service of our communities in the years to come. To the employees and directors of M&T Bank, my friends and colleagues, I extend my sincere thanks.
Robert G. Wilmers
Chairman of the Board
and Chief Executive Officer
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