Big vs. Little: Bigger Banks Aren't Better

Yesterday, Treasury Secretary Geithner presented an outline of his approach to regulating the financial system. The four pillars of that approach seem to be:

1. Increased power and regulatory centralization to deal with the problem of systemic risk
2. Increased protections for consumers and investors buying financial products
3. Closing regulatory gaps by shifting that organizes regulation based on financial functions, not types of financial institutions
4. International coordination among regulators

This all sounds good to me, and an improvement over where we are today. But reading Geithner’s discussion of systemic risk - the topic he focused on yesterday - I kept thinking it had been too long since he read Frog and Toad to his children.

The section on systemic risk reads like this (emphasis added, feel free to skim):

To ensure appropriate focus and accountability for financial stability we need to establish a single entity with responsibility for consolidated supervision of systemically important firms and for systemically important payment and settlement systems and activities.

. . . [W]e must create higher standards for all systemically important financial firms regardless of whether they own a depository institution, to account for the risk that the distress or failure of such a firm could impose on the financial system and the economy. We will work with Congress to enact legislation that defines the characteristics of covered firms, sets objectives and principles for their oversight, and assigns responsibility for regulating these firms.

In identifying systemically important firms, we believe that the characteristics to be considered should include: the financial system’s interdependence with the firm, the firm’s size, leverage (including off-balance sheet exposures), and degree of reliance on short-term funding, and the importance of the firm as a source of credit for households, businesses, and governments and as a source of liquidity for the financial system.

Given the existence of “systemically important firms,” I agree they need careful regulation. But why does Geithner assume that they have to exist at all?

There are a few main things that made companies like AIG (AIG) and Citigroup (C) systematically important. One was interconnectedness: they did business with lots of counterparties. One was complexity: when push came to shove, the regulators were not able to assess the potential damage a failure could cause, and therefore erred on the side of bailing them out. But the big one was size, and this is why we call it Too Big To Fail. The companies in question were so big, and had so many liabilities, that they could cause a lot of damage if they suddenly defaulted on those liabilities.

Interconnectedness is not going to go away. Complexity may not go away completely, but increased supervision could give regulators a better grasp on complexity. For example, all firms could be required to provide detailed information about their positions to regulators, in a standardized format, so that it could be imported into aggregate computer models; data about positions would be kept only by the regulator and not made public. Complexity could also be reduced by limiting the number of businesses an institution is allowed to engage in (like under Glass-Steagall, but updated for today’s world). But size can definitely go away, simply by setting a cap on the volume of assets any institution is allowed to hold (and doing something about off-balance sheet entities). And if a highly interconnected, highly complex but small financial institution fails, the system as a whole would be fine.

What would such a world look like? There would be a lot of small- and medium-sized banks that collected deposits and lent money to households and businesses. There would be brokerage and asset management firms that you used to invest your savings. There would be hedge funds and private equity firms that rich people and other institutional investors used to invest their money. There would be investment banks that helped companies issue equity and debt securities. There would be boutique firms that did research and other boutiques that M&A advising. For any financial service anyone wanted, there would be a company that provided that service; it just wouldn’t necessarily provide every other service, and it wouldn’t have $2 trillion in assets. It would look something like the 1970s.

What’s wrong with this picture? Some people would argue that it would limit financial innovation. But there is no correlation (or a negative one) between the size of a firm and its degree of innovation. Nor do you need to operate a financial supermarket to innovate: mortgage-backed securities were pioneered by Salomon Brothers, an investment bank under the old definition. Finally, perhaps we could use a little less innovation.

Some would argue that costs would be higher, because smaller firms would be less able to capture economies of scale and scope. First, casual empiricism debunks this theory immediately. When I got my mortgage on my house, I got a much lower rate at a small community bank (which holds onto its mortgages rather than reselling them) than at any national bank. National banks also typically offer the lowest rates to savings customers, except when they are about to fail and desperately need cash from depositors. Second, even if this were the case, perhaps slightly higher costs are a price worth paying for reduced systemic risk.

Basically, this is the issue that Ronald Coase discussed in “The Nature of the Firm” (Wikipedia summary; paper). A firm’s optimal size is reached when the transaction costs of doing business in the market equal the administrative costs of managing the firm; the bigger the firm, the higher the administrative costs. Clearly some financial institutions reached a level of scale and complexity where they simply could not even understand what they were doing, let alone manage their risks appropriately; they were too big, looked at just from their own perspective (and excluding the implicit Too Big To Fail subsidy). To this equation, we now need to add the social costs (negative externalities) of being Too Big To Fail: moral hazard, socialized losses, and so on.

To some people, the idea of size caps will seem anti-capitalist (or even un-American). However, that viewpoint is based on a misunderstanding of what the modern large corporation actually looks like. In the United States, supposedly the most dynamic capitalist economy in the world, our corporations are run almost exclusively as giant bureaucracies with a rigidly hierarchical decision-making structure. When I was in the business world, I saw several of these entities from the inside or up close, and they are identical: there’s barely a trace of the free market to be found. Even in the technology industry, the biggest companies, like Cisco and Oracle, expand by buying innovation from startup companies where the innovating actually happens. (Some large technology companies expand by copying innovations made by startup companies, but that’s another subject.)

Geithner’s testimony yesterday did contain at least one important insight:

In general, the design and degree of conservatism of the prudential requirements applicable to such firms should take into account the inherent inability of regulators to predict future outcomes.

When you are designing regulation, you have to bear in mind that the world will change. But this is another reason why simpler is better, and the simplest solution is simply to prevent firms from becoming Too Big To Fail in the first place. First, you have to expect that no matter how clever your regulatory scheme, some firms will be even more clever in finding ways to evade the system and blow themselves up. You are far better off if they are small when they blow up than if they are big.

Second, one of the “future outcomes” you have to protect against is that the firms being regulated will try to change the regulations. So one prerequisite to a successful regulatory structure is limiting the political power of the firms being regulated. This is, ultimately, the most important reason why smaller is better.

Update: Paul Krugman says something similar in his op-ed today:

America emerged from the Great Depression with a tightly regulated banking system, which made finance a staid, even boring business. Banks attracted depositors by providing convenient branch locations and maybe a free toaster or two; they used the money thus attracted to make loans, and that was that.

And the financial system wasn’t just boring. It was also, by today’s standards, small. Even during the “go-go years,” the bull market of the 1960s, finance and insurance together accounted for less than 4 percent of G.D.P. The relative unimportance of finance was reflected in the list of stocks making up the Dow Jones Industrial Average, which until 1982 contained not a single financial company.

It all sounds primitive by today’s standards. Yet that boring, primitive financial system serviced an economy that doubled living standards over the course of a generation.

Update 2: Calculated Risk has this gem which I meant to include in my original post but forgot:

Imagine if the Federal Reserve had been the “systemic-risk regulator” during the bubble.

According to Greenspan in 2005 “we don’t perceive that there is a national bubble”, just “a little froth”, and even in March 2007 Bernanke said “the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained”.

How would a systemic-risk regulator help if they miss the problem?

So it’s good to have a systemic risk regulator, but it’s best to minimize the chances of systemic risk getting big in the first place.

Comments

[Mbuna:]

A must read by the former chief economist of the IMF Simon Johnson.

www.theatlantic.com/do...

Intro from the Atlantic-
The crash has laid bare many unpleasant truths about the United States. One of the most alarming, says a former chief economist of the International Monetary Fund, is that the finance industry has effectively captured our government—a state of affairs that more typically describes emerging markets, and is at the center of many emerging-market crises. If the IMF’s staff could speak freely about the U.S., it would tell us what it tells all countries in this situation: recovery will fail unless we break the financial oligarchy that is blocking essential reform. And if we are to prevent a true depression, we’re running out of time.

Mar 27 07:32 PM

[mahoney:]

Brilliant brilliant brilliant. You hit the nail on the head.

Mar 27 07:46 PM

[William Cowie:]

Totally agree. Simply break up the big boys. It's been done before, quite successfully - Standard Oil and AT&T come to mind. Then you don't need this excessive bureaucracy having to oversee things.

What bothers me is the suspicion that companies pay off politicians, who then instruct overseers to allow these mega-mergers. The most brazen was when Citibank bought Travelers and Sandy Weill as much as told the world he was going to do the merger because the change in the law was in the bag. No surprise which is the bank in worst shape today...

Mar 27 09:03 PM

[Speedspirit:]

We the people hold the power so lets return all those Citi,B o A, JP Morgan Chase credit cards and get ones with the smaller banks. ASAP

Mar 27 09:10 PM

[anarchist:]

This is all intellectual play. In reality the Fed and Treasury has stated that they are not going to allow the big banks to fail so thats it!!!!! Bank of America was thinking about backing out of the Merrill deal but the government MUST have forced that deal and in so doing made some guarantee that BAC would be protected from any downside risk from taking on Merrill.

Mar 27 10:51 PM

[user225084-...:]

Her's something to keep in mind: If all banks assets consist of slivers of the same CDO paper, they will still all fail at the same time.

The fact that they are all *small* banks is not going to make all that much of a difference.

Upshot: The problem is more the nature of securitization, and not so much the size of the banks.

Mar 27 11:30 PM

[Steven Hansen:]

"The fact that they are all *small* banks is not going to make all that much of a difference.

Upshot: The problem is more the nature of securitization, and not so much the size of the banks." - user225084

the reasons are different, but what user is saying is true. this failure mode runs through the system. the system is screwed up. fractional banking literally insures banking failures at times of major stress. if we want to correct the problem - we need to change the system.

and i fully agree with the author, to big to fail is unacceptable.

Mar 28 01:08 AM

[donzelion:]

Does size really make a difference? That is, do you get less "system risk" from thousands of small banks than you do from a dozen megabanks?

Turns out that all banks - large or small, Asian, Latin American, European, American - prefer to add risk rather than acknowledge losses (or lack of earnings). Small banks add risk by generally treating customers generously after a local disruption (e.g., farmers get extensions on their loans, until the bank losses cause the bank to close, at which point, someone takes over the bank and forecloses on all late farms...creating concentrated regional pain and suffering). Big banks add risk through administrative complexity.

In theory, Coase isn't suggesting that small banks are less risky than big ones - but rather, small banks would have lower insurance costs than big ones. Coase never considered that modern financial products might sell off that risk (taking advantage of the same economies of scale as factories) - because "risk" is a transaction cost, and economies of scale should only apply for production costs.

Of course, maybe Coase was right, and it is utterly irrational to think of bankers as "salesmen peddling financial products." I find that line of reasoning appealing - providing a financial service is categorically distinct from selling a product, and there is no such thing as a "financial product."

Implications: Geithner's third point - focusing on activities, rather than categories - is a starting point. But more important will be all the other means used for regulating professionals - who, by and large, are required to bill by the hour/project (or other increment), rather than being able to obtain pay through commissions.

Mar 28 04:32 AM

[Chezfrederick:]

Excellent article... We can all learn from the experience of Iceland... Banks were too big to fail, so the whole country is failing to sustain the banks... Is the US any better? Can taxpayers take such a risk? In Canada, bank mergers were rejected a few years back, and one of the justifications offered then, is that the country cannot afford to take the risk of any institution having that kind of clout.

100% on the money.

Mar 28 07:23 AM

[MarkitWacha:]

When I worked for Bank of America, their strategy was to get a foothold in each of the 50 states, and then sell out to a big Japanese bank. They have congressional support, because the congressmen don't have to extort money for their campaigns from multiple sources. It's one stop shopping!

This is political. I'll vote against any incumbent who supports these large, failed, institutions.

To date, that includes:

All members of the financial services committee.
Obama (and Bush when he was there)

Mar 28 09:47 AM

[Harry Tuttle:]

Wait! If you break up the large banks they may not be able to afford hiring former Treasure Secretaries for over $100 million. Bob Rubin for example. The implications are too obvious to mention explicitly.

Mar 28 11:55 AM

[aarc:]

During the boom years. So many analysts favor bigger corporations in order for them to be able to compete effectively in a rapidly expanding globalized marketplace. The bigger, the better.

Sounds good, sounds right. Until they blew up themselves.

During this economic recession. Now, we are asking them to downsize and to decentralize and to break them up into manageable pieces in order to be able to survive the current crisis.

Sound good too, sounds right too.

What happens when the whole world got it's act right? When the good times comes back again and economies start booming again while the US is still in the process of downsizing and decentralizing?

No worries, plenty of time? What made you sure? The US and Europe had been downsizing and decentralizing for more than 8 years already starting with the technology and manufacturing companies in year 2001.

We start another round of downsizing and decentralizing with the banking and finance sectors this time around?

Great! US and Europe were so successful downsizing and decentralizing manufacturing and technology when they got into trouble starting year 2001. Manufacturing and technology go hand in hand, don't they? Likewise, banking and finance and brokers too go hand in hand. They are now in trouble, lets downsize and decentralize them all. Get rid of those troubled assets as fast as possible.

Now, China and India got the better handle of the situation by upsizing and centralizing their manufacturing and technology sectors while the US and Europe were doing the opposite during the early 2000's.

US and Europe are not yet starting to downsize and decentralize their banking and finance and China is already getting busy buying banks in Europe that are on the brink of insolvency.

They must be stupid paying considerable amount of money for those troubled assets Europeans are so willing to get rid of. What are the Chinese going do with so many banks on their hands? Consolidate them and centralize them so that they will have the knowledge, experience, capacity, and capability competing in a global marketplace of the future?

Global marketplace is dead, is'nt it. There is no longer a global marketplace now and there will never be in the future, right? Global economy is going to remain in crisis mode for decades to come, is that what you mean?

I don't think so.

I still believe in the benefits of long-term planning and short to medium term strategic executions - rather than the exclusively short-term perspective so pervasive now in America after decades of constantly chasing short-term happiness as a constitutional right and must be exercised at all costs.

Mar 28 12:21 PM

[John Lounsbury:]

This article is one of the best discussions of the "too big to fail" problem I have read. It is clear that there is a structural problem in the financial system (not just in the U.S., but globally - with a few exceptions like Canada). Because of the precarious position at the moment, structural problems are not being addressed.

However, the cost of stabilizing the existing structure before rebuilding a better one is going to be high. If the structureal problems and the stabilization could be addressed simultaneously the cost savings could be significant.

Mar 28 12:29 PM

[fbcx:]

There is much to recommend this article. Probably too much to ever see the light of day in terms of encactment. Size does matter and, size kills, if only because the drive to continue growing and taking risk beyond ones ability to understand and self regulate that risk is unlimited by any personal risk in the result by corporate entities. Recent history is all the proof needed. Innovation without personal, equity responsbility is irresponsible at best. The best example is what has transpired and the fact that it could never have happened in the old Wall St. where Partners would have paled at such craziness and risk. When Wall St. Partnerships became public companies all responsibility flew out the window, all the possible evils of unfettered, selfish and unlimited capitalism were unleashed. Then, when product could be created out of thin air without a formal real world issuer and an equity interest in the product was finally eliminated (sold off), the printing presses could run 24/7/365 without limit, especially since raw material could be self created through outright fraud. The result is the incredible melt-down we are living though. The bottom line, and this should be the focus of regulation going forward, is if you are going to create crap, you should be forced to eat a portion of it daily and your compensation should be paid in a large dose of that same pile you sold to others.

Mar 28 04:02 PM

[Kinabalu:]

Too big to fail, i.e. “systemically important firm" isn't a Geithner revelation. The reason we have big banks is because the FDIC, an independent corporation not a part of the Treasury Department or the Federal Reserve, has been pushing bank consolidation for 2 decades. Their way of avoiding costly, to them, bank liquidations has been to encourage the takeover of "weak" banks by larger ones. Even in this crisis they have put WaMu into JPM and would have put Wachovia into Citibank. What a disaster that would have been.

Mar 29 01:30 AM