The financial crisis and the credit freeze resulting from the Lehman collapse shifted the focus on the "too big to fail" banks in the United States. Subsequently, more than 8,800 pages of legislation have been proposed, and the process is still not complete. Amid all this, the too big to fail banks have become too bigger to fail. This article discusses the current structure and concentration of the U.S. banking system, and the probable solutions to the too big to fail problem.
To put things into perspective, the chart below gives the U.S. banking sector concentration for 1970, 2010 and the third quarter of 2012.
There has been a significant change in the U.S. banking concentration from 1970 to 2010. My emphasis is, however, on the change in the banking sector concentration after the crisis. In 2010, the top 100 banks in the U.S. had an 84% market share. In the third quarter of 2012, the top 82 banks in the U.S. had an 88% market share. Clearly, the too big to fail are getting too bigger to fail, and if this trend continues, the next banking crisis will be bigger than the 2008-09 crisis, which almost lead to the collapse of the financial system.
The extent of financial and economic system damage in any future crisis can be understood from the data below. As of its 10-K regulatory filing in 2007, Lehman operated a mere 209 subsidiaries across only 21 countries and had total liabilities of $619 billion. We all know the problem created by the Lehman collapse.
Coming to the current scenario, the data below show the non deposit liabilities, subsidiaries and number of countries of operation of the big five banks as of the second quarter of 2012. Considering these metrics, Lehman was a small player in the industry. If Lehman's decline almost resulted in the collapse of the financial system, investors can imagine the impact on the economy or the financial system if any of these banks were to fail.
Considering the above two charts and factors, I am sure that most investors would agree that something needs to change in order to prevent a bigger crisis. Market participants have already discounted the complexity and too big to fail factor in the respective stock prices of the banks. The chart below (as of October 2012), gives the average price-to-tangible book value ratio for the big and complex banks compared with relatively smaller and not so complex banks. The market has been rewarding reduced complexity, giving an indication of what investors are looking at in terms of investing in the banking sector.
Coming to the probable solution to the too big to fail problem, the first step should be market discipline. The Federal Reserve Bank of Dallas defines market discipline as "market‐based forces that restrain a firm's stakeholders (stockholders, creditors, and management) from excessive risk‐taking due to the belief that they are exposed to sharing the firm's losses."
For the too big to fail institutions, the market discipline is very limited, as shown by the matrix below, as they know that they would not be allowed to fail. As a result, excessive risk taking is predominant in such institutions. This needs to change in order to restrain the big banks from indulging in risky activities other than core banking activities.
One of the ways to enforce market discipline is to clearly define where the safety net would begin and end for banks. Only commercial banks should be allowed to have access to the FDIC and discount window provided by the Federal Reserve. The safety net should exclude shadow banking affiliates, special investment vehicles of the commercial banks or any obligations of the parent holding company. According to the Federal Reserve Bank of Dallas, this is the current case -- but in theory, not in practice. Therefore, instead of adding on volumes of legislation, the regulators need to enforce the current regulations more strictly. The chart below clearly defines the safety net for commercial banks.
If this rule were to be strictly enforced, it is very likely that commercial banks would take steps to reduce their complexity by selling innumerable subsidiaries or separately listing those entities as financial institutions. The important message to banks here would be that excessive risk taking through subsidiaries would be punished, and not defended with taxpayers' money. The banking system should largely stick to its core activity of lending and deposits rather than engaging in trading exotic instruments.
If this simple rule is strictly enforced, market discipline will return to big banks, and policymakers will not need to work on voluminous legislation. Less complexity in banks and legislation is the solution to the problem, not more complexity.
In conclusion, regulators need to take immediate action in order to prevent a bigger financial crisis in the future. The U.S. banking system will offer an attractive investment opportunity if market discipline is restored. As shown in the chart above, market participants do reward reduced complexity. In terms of specific investment opportunities, I am not really fond of the banking sector. However, Wells Fargo & Company (WFC) does look interesting, even at these levels, with a dividend yield of 2.5%, five year forward PEG ratio of 1.03 and a relatively attractive forward PE of 9.01. Among the bigger banks, JPMorgan Chase & Co. (JPM) also has an attractive dividend yield of 2.6%, and has upside potential if the market discipline is enforced in the foreseeable future. JPMorgan also trades at an attractive forward PE of 8.09. However, it has a relatively high five year forward PEG of 1.45.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.