Obama's Banking Agenda: Insights from Kathleen Khirallah of TowerGroup's Banking Practice

Banking was a major topic in President Barack Obama's first address to the American people. What will be his administration's approach to banking in this recession, and what can we come to expect for policy and regulations throughout 2009?

In an exclusive interview, Kathleen Khirallah, managing director of TowerGroup's Banking practice, discusses:

The significance of the President's attention to banking;
Why bank nationalization is unlikely to occur;
The impact of the Heartland data breach on banks and consumers' perception of financial institutions.

Kathleen Khirallah is the Managing Director and Practice Leader of TowerGroup's Banking practice. She has over 25 years of financial services industry experience. Prior to joining TowerGroup in 1997, she was senior principal at Marketing PLUS Inc., a consulting firm that specializes in maximizing the revenue potential from marketing customer information file (MCIF) and operational customer information file (CIF) systems. She has an extensive background in the banking industry, having served in marketing and product management roles in broad spectrum of commercial banks and thrifts. Her experience spans institutions both large and small, including Amoskeag Bank, Security Pacific National Bank, Great Western Bank, and Home Savings of America.

TOM FIELD: Hi, this is Tom Field, Editorial Director with Information Security Media Group. We are talking about the state of banking. We are talking with Kathleen Khirallah, Managing Director and Practice Leader with TowersGroup's Banking practice. Kathleen thank you so much for joining me today.

KATHLEEN KHIRALLAH: It's a pleasure.

FIELD: We all listened to the President the other night, and I want to ask you up front: What is the significance of President Obama paying so much attention to banks in his first address to the American people?

KHIRALLAH: Well, I think the significance is pretty clear. The financial system in the United States and the banking system in the United States are what hold so much of the economy together. If he hadn't addressed those issues, I think it would have been a glaring oversight. As he is talking about how we are going to pull this country into an economic recovery out of a recession and how we move that forward, he has to address the basic building blocks of the economy, and that is the financial institutions that form the banking system.

So the significance is that he is focusing on the actual building blocks of the economic structure. He had to do that ,and so I think the significance is he spoke about the right topic at the right time.

FIELD: That sort of sets the tone about how banking is very much going to be on this administration's agenda, wouldn't you say?

KHIRALLAH: Well I do, and banking, in a very, very broad sense, sometimes people think of banking as being the consumer activity of going down to your local branch and taking money out of the ATM or putting something in your safe deposit box, and that is banking. But when he is addressing the American people and talking about the banking system, he is going well beyond that, and he is talking about the activities that are involved in commercial banking. Can small businesses get credit? Can they make payroll?

It is also talking about investment banking and how new projects that are important to organizations and to companies, how do they get the funding for that? In the past it has been something that has been worked through investment banking or commercial banking, so it is not just the consumer. He is looking at the whole big structure of how things get done in this country and how projects get funded and businesses expand and municipalities think about building new roads. All of that comes from the capital markets, so he is addressing that whole big picture.

FIELD: Now the administration in general and the Treasury Secretary in particular got some criticism a couple of weeks back for coming forward with an announcement that didn't have a lot of details to it, so I wanted to ask you about the Capital Assistance Program. If you compare that to the previous administration's TARP, what do you see as key differences between them?

KHIRALLAH: Well, you know Secretary Geithner did take a lot of heat and perhaps unfairly, and I say that because what they are trying to do is put together a program that has a lot of moving parts, and to not have all the details in place is probably not unrealistic. I think it was more important that he reassured people that they were working on it.

But let's get back to the question on the comparison between CAP and TARP. If you think back to those days of the early fall into mid-fall, TARP was mandated in the sense that the first wave of

TARP funding was Secretary Paulson, the Secretary of the Treasury at the time, calling the banking chiefs and saying this is something we need to talk about and you are all going to sign up for the TARP money whether you think you need it or not, and if you sign up for it today there will be repercussions if you decide that you need the capital infusion later on. So it was not voluntary, and it was very much kind of a "we're in a serious situation and we are going to do this because we need to prop up the safety and soundness of the U.S. banking system." So it was very much a top down "this is what we are going to do" and that was the first wave of TARP.

There was a second wave of TARP funding that was not so much focused on the top 10 banks, but was focused on other sized institutions going much smaller, and they were allowed to sign up for TARP funds as they thought was appropriate for their needs, after having some discussions with the regulators.

When you look at the Capital Assistance Program, it is very different. It is still very mandated in that regard, but this is more of a program where the stress testing comes into play. The regulators are saying 'We're going to take a look at your capital positions, and we are going to make sure that you have sufficient capital under a number of different scenarios, and if it looks like you are not going to have what you need, then we think that you should definitely apply for these CAP funds and not delay, and there is a cut-off point for doing that.'

So it is a little bit different in the sense that institutions will not have to be guessing whether or not they need the funds, which was kind of the way TARP started. This was the stress testing piece where they will be looking at different financial scenarios, different economic scenarios, and trying to determine whether or not the banks have sufficient capital to carry on their daily operations, if not, then CAP kicks in.

So I think it is just a very different way of looking at the circumstances. In the early fall, the banking system needed to have that happen, and this is more of a matter of the individual banks being able to see what they need and having it based on a set of metrics that have been set up by Treasury.

FIELD: You mentioned the stress testing there, which has started. What should banks expect in their examinations this year? Is it all going to be about fiscal safety and soundness? Is there going to be a lot of emphasis on information security and risk management as well? What is your sense?

KHIRALLAH: You know, I think that the examinations are going to be, and I don't want to imply that they haven't been rigorous in the past, I wouldn't want to insinuate that at all. I do think that they have been rigorous in the past, but I think that they are going to go the extra mile in this case. I think that the examiners will be coming in looking at a broad array of issues, and they will perhaps scratch a little deeper than they have in the past.

They have always asked for a broad set of information to try to understand what is going on in terms of the institution. This time I think that they will dig down to a deeper level and look for more back up data or more data that explains the financial position of the institution or that looks at the policies and how those policies are being carried out, operational policies.

I do think that there will be a more intense focus on the financial performance of the institution, but given what has been going on in terms of financial information security, there have been some very interesting and noteworthy breaches over the past couple of months and it is a trend that is concerning. When you start talking about the big picture, which is 'let's establish and reinforce the safety and soundness of the U.S. banking system,' if there continue to be data breaches, that is going to undermine that, so I do think that information security it going to be a large part of all of this. It is almost as though the mental image I have is the little Dutch boy putting his fingers in the dike; I think that is pretty much what is going to happen. I think regulators are going to try to look at the entire wall that has been built to hold back problems in the financial system, and they are going to be looking at all of the possible points of leakage. So I think it is going to be a more intense examination than it has been in the past. It is not going to be just one point of weakness that they are worried about, there are going to be several out there.

FIELD: They also might find out that a lot of Dutch boys have been laid off in recent months.

KHIRALLAH: Well, yeah.

FIELD: Kathleen, from your perspective, what would you say? I mean you see large institutions, community institutions, what is the state of banking right now in the U.S.?

KHIRALLAH: Well, I think that what we are going to see is a lot of conservatism in the banking industry. I think that I've heard a lot of bankers across the spectrum of size talking about going back to basics and making sure that we are doing the right things at the right time for customers, whether they be corporates or consumers. And, I think that there is a good sense of moving in the right direction by doing that. It allows organizations to think about what their basic business model is and how can they execute it more competently, more professionally, with more responsiveness to customers. So I think that there is going to be this back to basics mentality that is going on.

At the same time, I think that there are going to be handful of institutions that start to rethink what they are doing and why, and they may actually make some significant changes in their operations as a result. You are going to find some institutions that think about perhaps moving away from some of their lines of business or initiatives that they have had in the past that no longer work for them. That happens probably more in the bigger institutions that are looking at shedding some of their lines of business. But I think we are going to see conservatism for the most part. Kind of a back to the basics of let's focus on the banking and do it and execute against that business model as competently, professionally as possible.

One of the things that may be, I think that will keep that sense of conservatism going, is the fact that there is far more oversight. There is oversight from the government, there is oversight from regulators, and then there is also a lot more oversight and sensitivity coming from the general press. I think that banks are really, really very, very self-conscious right now, which is another reason why they will continue to be somewhat conservative in what they do and how they do it.

So I guess what I expect is that we are not going to see major, major new product announcements. I don't think we are going to see organizations betting the ranch on some new initiatives. I just don't think that is going to happen. I think we are going to see kind of a low-key mode. I think that banks are going to try to stay under the radar as much as possible.

FIELD: Do you think we will see a wave of bank failures as we have seen in earlier economic downturns, or are we going to keep sort of the lower pace that we are at right now?

KHIRALLAH: Well we are on pace. We have seen quite a few in the past; if you go back to maybe July of 2008, the pace has picked up significantly, and in 2009 we have also seen quite a few banks that have been taken over by the FDIC. Every Friday afternoon it is always interesting to see how much activity there has been--

FIELD: Friday at 5:05 eastern time [laughter].

KHIRALLAH: Exactly. What hasn't the FDIC been up to? But the institutions there are typically rather small, and that is I think a good thing. We haven't seen really large institutions being involved. The last really large institution I would say that has been involved with the FDIC was Indy Mac, and we haven't seen anything like that since. That was taken over in I think August of 2008. So that is a good sign that it is not the larger institutions, but the smaller institutions. It is smaller institutions that are on the FDIC watch list. I do think that we will continue to see away with those throughout the year.

It just makes sense that institutions that have been poorly capitalized or that have been in risky lines of business will find that they have gotten themselves into trouble, and they are going to need assistance to get out of that trouble, so I do think that we will continue to see that in 2009.

FIELD: Now the term that has come up an awful lot in the last couple of weeks and has been debated back and forth is this term of nationalization of banks. If you've got the government investing more capital in banks and taking more ownership, that you are going closer to a nationalized model. I want to get your thoughts on this. One, are we headed there? What are some of the pros and cons to this and what do you see happening? Are we going to get to a degree of nationalized banks?

KHIRALLAH: Well you know, I guess it all depends on how you define nationalization. Under TARP there were injections of capital into those institutions, and in return preferred shares of the institutions were sold to the government to Treasury, but those were non-voting shares. So I guess you could say that because those were non-voting shares, that in essence it was not a nationalization under TARP. Under CAP it also appears that the initial banks, any banks that sign up for the Capital Assistance Program, will be issuing preferred non-voting shares as well. There is an option to convert those to common shares, but initially it looks like they are going to be preferred non-voting shares.

So nationalization is a tough sale in the United States. If you look at other countries around the world, nationalization is not seen as being quite as fearsome as it is in the United States. So the U.K. has had some serious nationalization of their banks going on, and it has been a pretty aggressive move by their government and by their financial services authority to really prop up their banking system. But you look at the United States, and we have 8,000 banks in the Untied States, or something like that give or take a couple -- it would be impossible for the United States to really nationalize a grand swap of the U.S. banking system.

It would just be impossible to manage, so I think that what we are seeing in terms of CAP and as a follow on to TARP is let's inject capital, let's take preferential shares that will give the U.S. taxpayers some upside as we move into a recovery, but let's try to stay away from nationalization as much as possible because it is not necessarily practical for the U.S. government to be so deeply involved in the financial and operational details of running some of these larger institutions. It would be really hard to do, and I think that from a con, if you will, I would think that the con would be that it would be very difficult to truly nationalize a large number of especially large banks.

The other challenge that we have is that if you start talking about smaller banks, they are geographically disbursed all over the country, and that complicates the whole management issue somewhat. So I think that for those reasons and the fact that from a political point of view, we really in this country, don't like the idea of nationalization. It is really something that will be avoided at all costs. But at the same time I think what we are seeing is that with CAP as a follow on to TARP Treasury is trying to thread the needle and to find a happy medium where they can inject capital into these institutions, provide some upside for the U.S. taxpayer and have a degree of influence over the financial institutions without necessarily having a direct voting management responsibility for the institutions. I think they are really just trying to thread the needle and just to walk the line between nationalization and being completely hands-off.

FIELD: Do you think ultimately the U.S. government doesn't want to get into the banking business?

KHIRALLAH: Oh yeah, definitely. It is a very complex business and in this country we have so many institutions. If we were to do any nationalization, even if it were just one or two banks, it would take an enormous amount of management talent that we don't necessarily have on staff in government today. So in essence the government, if you think it is big today it would definitely get bigger if we were to go the nationalization route.

FIELD: Now a few minutes ago Kathleen, you talked about some of the well publicized data breaches, and I think the name that we all know better than any these days is Heartland Payment Systems. What would you say is the impact of this breach because I guess it kind of surprises me in some ways how people have picked up on this and really rallied behind it. This has become probably the most publicized breach that I have seen. Is it timing as much as anything? What is the impact to this breach? And I guess my follow up would be, are banks finally mad as hell and not going to take it anymore when breaches like these happen outside their institutions and yet they are left having to contact their customers and replace their cards and take the heat for it?

KHIRALLAH: Right. Well there is definitely, if you think about it, the processors just like Heartland involved, there are the banks and then ultimately there are the consumers and the impact is different for each of those constituencies within the payments world.

You know if you were to focus on the banks, they probably are mad as hell in the sense that it forces them to do things that they would really rather not do at a time when consumer confidence in the banks is not high to begin with. With all the talk that is going on about everything from executive compensation to how did we get into these situations in the first place and how did lenders make so many bad loans and how were so many bad decisions made by banks?

Consumers are really questioning the capabilities of banks just in terms of being able to manage the business. So at a time when consumers are feeling uneasy about the capabilities of bankers in general, these breaches--and whether it is something like Heartland, which happened within the payment system outside of the bank itself, or whether it is a data breach that happens inside the bank, either way it is all bad news. So I do think that the banks are mad as hell, but I also think that they are concerned as hell about making sure that these situations don't come back up or don't come up, or just don't occur.

You know I think that there is a lot of concern within the banks around information security and PCI, and that is a good thing. But if you were to ask a banker what do these breaches mean for your business, they are going to tell you it just makes their job harder day in and day out to re-establish confidence with consumers.

So I think if you were to give a banker a wish list for 2009, one of the things he would say for 2009 is 'I want to fly under the radar. I don't want to be in the newspapers because I am having to lay people off. I don't want to be in the newspapers because I am taking huge losses. I don't want to be in the newspapers because I have a data breach internally or I have a data breach in the payments environment that I am associated with.' They just want to fly under the radar as much as possible. So I think that that's more the issue, trying to just manage bad news so that there is a lot less bad news that is going to be rolling across people's desktops as they are reading their news online or watching it on television or if they are reading it in the newspaper. They just want to stay away from having their names associated with those types of things, any type of a misstep.

FIELD: Well it is interesting because in two months so far this year banks have been anything but under the radar. We have had Heartland certainly; we have had the new administration come in with banking recovery a big part of the agenda. Just based on what we have seen so far Kathleen, what would you say the top two or three storylines for banking are as we go through 2009?

KHIRALLAH: Well, if I were to look at it from the big picture of everything that goes on within banks, I would say that there is--the major story from the consumer aspect is winning back consumer trust and confidence. I think that that's really what the larger banks, actually banks of all sizes, are going to be working on in 2009, trying to avoid bad news.

I happen to live in Los Angeles, Northern Trust sponsored a golf tournament over the past weekend and there were lavish parties that were part of the sponsorship that they did for their corporate clients and for their top tier clients. It really caused a backlash that they were having these lavish parties. It is as simple as that sometimes, it really means for a lot of institutions being a lot smarter about what happens and how they do things so that they can restore that sense of consumer trust and confidence.

At the same time, I think one of the second things that they will be focused on is bringing back the credit market. I think that that's going to be very important. All of the institutions that have been involved in TARP up to this point and that have been involved and probably will be involved with CAP have been lending to small business. They have been lending to corporate and they have been willing to lend to consumers. Part of the challenge I think is that if you looked at the credit systems in the U.S. prior to this recession/meltdown or whatever you want to call it, a lot of credit was extended by specialty lenders and a lot of those, especially in the mortgage world, have simply gone out of business.

So I think that what we will be seeing as well is from the credit perspective, institutions trying to really figure out how they can step up and provide the levels of credit that small businesses need, that consumers need and that corporates need. So I think that's a second major story--bringing back the credit market.

And the third for banking, I think is what happens or what are the needs of consumers and small business and corporate if this recession drags on longer than we think it might. I believe that Mr. Bernanke stated the other day that he thought that this could wrap up in 2009 and 2010 could be a year of recovery. That would be great, but if for some reason it doesn't, and through no necessarily "fault" of an institution or the new administration, it could be something that happens in the global system that has a negative impact, but if the things drag on further I think that that's going to be part of what we talked about in 2009.

I think that there will be a lot of watchful waiting. I think there will be a lot of stories that have to do with people holding their breath, waiting, hopefully trying to get through this so that we can hopefully "get back to normal." And so I think a lot of what we will be talking about in 2009 is are there bright spots that tell us we are going to be back to normal in 2010 or that we will be in a recovery 2010, or are we are going to be seeing signs that perhaps this is going to drag on longer? I think that is going to be the other story for 2009. A constant taking the temperature of the system and looking for bright lights or negative news and reacting accordingly.

FIELD: Well, Kathleen, I look forward to checking back in with you this year to see where we are headed. We've been talking with Kathleen Khirallah, Managing Director and Practice Leader with TowerGroup's Banking practice. For Information Security Media Group, I'm Tom Field. Thank you very much.


About the Author

Tom Field

Tom Field

Senior Vice President, Editorial, ISMG

Field is responsible for all of ISMG's 28 global media properties and its team of journalists. He also helped to develop and lead ISMG's award-winning summit series that has brought together security practitioners and industry influencers from around the world, as well as ISMG's series of exclusive executive roundtables.




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