Ultimately, Who Benefits from Too-Big-To-Fail

One possible conclusion given Columbia Professor Charles Calomiris' op-ed in the October 20, 2009 edition of the Wall Street Journal is that he slept through the 2008 crisis. If much of what Calomiris asserts was true, the financial meltdown should not have occurred and if it did, the damage should not have been concentrated amongst the largest financial institutions.

Calomiris believes that large financial institutions are worth preserving given the various perceived benefits these institutions provide. However, many of the benefits Calomiris mentions appear to be nonexistent upon closer examination. In addition, other benefits Calomiris attributes to large financial institutions and the consolidation waves that create them could be attributed to other factors such as technological advances.

Financial institutions need to be global in today's economy due to the global needs of their clients. Merged financial firms can accrue economies of scope as they can cross sell numerous products, in the process saving in terms of infrastructure costs and information cost. Calomiris asserts that economies of scope "imply economies of scale within finance suppliers, since small financial firms cannot afford the overhead costs of building platforms with many complex products."

However, economies of scale are generally realized only in mergers of smaller banks according to numerous studies. Efficiency gains really don't apply to mergers that create the megabanks Calomiris is determined to protect.

Nonetheless, Calomiris states that bank consolidation has been successful because productivity growth for the entire industry rose by more than 0.4% per year from 1991-97, the "heart of the merger wave." Did productivity grow at a high rate across other industries not experiencing a merger wave during the period? Given the technological advances that were occurring in the 1990s, it is very possible that much of the productivity experienced across all industries had more to do with a secular movement in technology as opposed to efficiencies realized by managerial acumen.

What may be the most surprising claim is Calomiris' belief that customers benefit from the creation of mega financial institutions, stating

many of the gains of consolidation accrued to customers, not banks, in the form of cheaper and better financial services. For example, my research shows that from 1980 to 1999, after controlling for changes in the mix of firms, the underwriting costs of accessing the public equity market fell by more than 20%. These declining costs encouraged an expanded use of the market particularly by young, growing firms.

Calomiris uses "cheaper and better" together but while the services provided might be cheaper and therefore better for the bank to provide, the value provided to the client may actually be very low relative to the services and products of standalone and more expensive specialty shops.

For example, a high net worth client may own a business that uses Bank X for its corporate purposes and due to the typical cross selling by Bank X is invested with this bank's private wealth management team in a number of company-owned investment vehicles. For Bank X, the cost of providing these services may be cheaper but is the customer benefiting from a possible second rate investment product? It's no surprise that many financial institutions push their own in-house products on their clients even if they are inferior to third party products those institutions can offer.

Another example would be to focus on equity issuance during the tech boom and how this "benefited" bank customers. In the tech boom, "bought deals" were not uncommon whereby an underwriter would take down the entire IPO of a company. Basically Company X is valued at $50 per share based on the bank's analysis. The bank's syndication desk knows there is significant demand for this company's shares through its contacts with large institutional buyers and offers to "help" its issuing client by doing a bought deal, assuming the nonexistent underwriting risk by offering to give Company X IPO proceeds priced at $47 per share. Due to information asymmetry, Company X accepts this while the bank can now sell those shares to its institutional clients for perhaps $52 per share, pocketing a nice spread. In this instance both customers of the bank lose out. The issuing company is short changed in terms of the proceeds it could have obtained from its IPO while institutional investors are bilked on the actual price of the IPO.

Calomiris writes that

...global financial institutions also have made stock, bond and foreign exchange markets globally integrated and more efficient. Global financial institutions are the institutions that provide the funds for arbitrage across markets, which ensure global market integration.

It's hard to believe given what happened in 2008 that Calomiris believes that global market integration amongst these colossal financial institutions is a good thing. While extreme leverage against a sliver of equity was a key problem, the deep ties and near fluid integration amongst these financial titans is what exacerbated these issues. In fact it was the notion of one domino falling that would precipitate further pressures on the economic and financial ecosystem that led to the the worldwide bailouts of these institutions.

Ultimately, Calomiris's article can be dismissed by clear examples of what has occurred in the financial industry. Even if Citigroup (C) did not implode and require massive tax payer support, Sandy Weill's vision of rolling up a number of financial institutions into a financial supermarket was a proven failure by 2005, well before the financial crisis. Moreover, with the exception of shotgun marriages, the financial crisis has resulted in increased specialization as opposed to greater integration. Firms such as Evercore (EVR) and Greenhill (GHL) have been successful as pure M&A shops, having little need for capital markets operations and still being able to secure high profile mandates.

The same can be said for a number of independent research shops such as Sidoti & Company that have far more credibility than sell-side analysts within the confines of banks that tie research to banking mandates. Lastly, what's the ultimate cost and risk in attempting to preserve the mega financial institution? Ironically, the largest financial institutions such as Citibank, Bank of America (BAC), the Royal Bank of Scotland (RBS), and AIG (AIG) were the ones driven closest to the edge if not for significant government intervention.

Calomiris, however, believes that

Limiting the size, complexity and global reach of financial institutions is fraught with downsides for the international economy. We can solve the too-big-to-fail problem without destroying global finance. It certainly is worth a try.

However, with billions of taxpayer dollars directly supporting these operations along with potentially trillions in implicit guarantees/backstops, it appears that preserving these types of institutions is the real economic risk.

Disclosure: None

Comments

[JAMES CARLINI:]

"Too-big-to-fail" dilutes the concept of capitalism.

Letting an institution fail will create a vortex of growth in competitors and the market eventually takes care of itself. Keeping the weak organization on life support weakens the total market because then the next organization that starts falling has no incentive to correct itself, they will just wait for their bailout - AND their undeserved bonus checks.

Oct 21 07:10 AM

[flmortgage:]

Too big wouldn't be too big if capital requirements were high enough!

Luke

flmortgage.com

Oct 21 07:42 AM

[CautiousInv...:]

If we put aside the arguments put forth by Charles Calomiris and concentrate upon the author's headline question, it is immediately apparent in the most narrow sense its the management and the equity stakeholders of too-big-to fail institutions that most immediately benefit the doctrine. Knowing their firm is backstopped by the US Treasury, management of TBTF institutions will be inclined to take outsized risks to generate profits that will increase their bonuses and the equity values of their firms. If the risks are kept within bounds, all is well; if the risks are too great and deals fall apart, the losses will be socialized. As Volcker and Mervyn King have noted, this mentality can not be regulated away.

Oct 21 09:10 AM

[Tony Petroski:]

Good article Mr. Chokshi.

"However, with billions of taxpayer dollars directly supporting these operations along with potentially trillions in implicit guarantees/backstops, it appears that preserving these types of institutions is the real economic risk."

Let's get on with the job of breaking up the "too big to fail" institutions. Why do we hesitate?

Oct 21 09:22 AM

[whack'em:]

RE-institute the Glass-Steagal Act in it's entirety, and the problem of "too big to fail" is solved. Our grand-parents knew what amoral lying bastards bankers were, and still are, so they took the very effective step of controlling their potential maximum size. however, until we have a requirement for public financing of elections, we are doomed to repeat this fiasco.

Oct 21 10:22 AM

[chap08:]

Mr Calomiris' thesis is based on the assumption that the TBTFs are efficient - without that, his economies of scale argument falls down. What chance is there that a cabal of government protected organizations will be efficient? I'll tell you: zip. Even if he was right, I could live without the economies of scale provided by mega banks, thank you very much.

Mr Calomiris worries about "destroying global finance". A bit of creative destruction is exactly what we need.

Oct 21 10:24 AM

[tenofwands:]

It is time to invoke the principles of the presently embryonic MACRO-EVOLUTIONARY THEORY; its application to biological, ecological, and economic systems alike is valid. Relevant germinal axioms are:
1. In any emergent phenomenon, EVOLUTION OF THE INDIVIDUAL ORGANISM TRANSPIRES INDEPENDENTLY (AND POTENTIALLY CONTRARY TO) THE EVOLUTION OF THE EMERGENT ORGANIZED SYSTEM. Thus, in the Darwinian lifetime of a species, larger individuals tend to dominate and reproduce more effectively than smaller ones, and, when the species is about to become extinct, the individuals have reached their largest evolutionary size. THE SAME APPLIES IN ECONOMICS. At the end of any civilization, institutions have reached their historically greatest size and geographic scope. EXISTENTIALLY, THERE IS NOT SAFETY IN NUMBERS; THERE IS ONLY COMPANIONSHIP OF THE MOST DEGRADED AND MISERABLE SORT !!)

2. The rate of evolution slows with the increased size of emergent organizations increases due to the CONCOMITANT REDUCTION IN VARIATION ARISING FROM INHERENT CONFORMITY. Thus, GM is unable to evolve cars whose utilitarian value emulates that of a DYMAXION or a TUCKER. (I lament that most of you have never heard of these modalities of ground-transport technology; your ignorance of them is a demonstration of what I teach. I AM NOT INTENDING TO BE COY)

On an independent subject, I am compelled to point out that ANYONE WHO THINKS THAT BANK CONSOLIDATION HAS BENEFITED CONSUMERS HAS HIS HEAD CONFIGURED IN A POSITION THAT I COULD NEVER ACHIEVE WITH MY OWN FOR REASONS OF STRUCTURAL AND KINESTHETIC CONSTRAINTS. I would love for you to be my Yoga-instructors.

Oct 21 10:26 AM

[ebworthen:]

The farther money has to travel the less efficient and prudent is it's usage.

Look at Governments and taxes; the more centralized the dole, the more pieces are taken along the path from city to state to federal and back again. Everyone takes their cut along the circuitous path the moeny travels.

If I give $1 to a local charity or church most of it goes to those in need. If I mail a check across the country, they will likely spend .50 cents of my $1 sending out mailings and running the mail room.

The bigger the bank, the farther the money travels and the more is siphoned off or speculated with.

Remember the town in Norway that lost almost everything to CDS's.

And then their losses and the malfeasance of the financials was covered by debt on the back of the U.S. taxpayer.

That is 100% inefficiency from the standpoint of a taxpayer, but 125% efficiency on the side of the "too-big-to-fail" banks.

Brilliant.

Oct 21 10:55 AM

[John Lounsbury:]

Amit - - -Great article.

You gave an example:"...offers to "help" its issuing client by doing a bought deal, assuming the nonexistent underwriting risk by offering to give Company X IPO proceeds priced at $47 per share. Due to information asymmetry, Company X accepts this while the bank can now sell those shares to its institutional clients for perhaps $52 per share, pocketing a nice spread. In this instance both customers of the bank lose out."

This is standard operating procedure. This could not happen in a truly competitive environment. The spreads would be squeezed if all IPO transactions by the underwriter faced competition from other financial intermediaries. The underwriter should be guaranteed a small commission of 2-3% (that would be $1 to $1.50 in this case) and that cost would be shared by seller and buyer. With competition, the $5 spread illustrated might be no more than an average of $1. More important than the reduced cost (by about 1/2 in this example) would be the increased free market transparency of the entire transaction.

Of course, the argument will be made that we have reduced the compensation that the underwriter needs to motivate assumption of underwriting risk. I answer that with one question: How many underwritings have ever lost money? I have not done the research, but I expect it is a very small percentage. How about a guess of less than 1%? Someone who is more knowledgeable is welcome to provide a more correct number.

What will happen in my scenario is that billions of dollars that accrue annually to investment banks will, instead remain in what I call "the productive economy". The giant sucking sound I hear (does anyone else hear it?) will be diminished as money that has been removed from the production of goods and services by outsized bank profits (more than 40% of S&P 500 earnings at times in this decade) remain in the rest of the economy.

Imagine if the average compensation of the 20,000 plus Goldman Sachs employees would decline from more than $600,000 each to something only two or three times the national average. That would be in the range of $150,000 to $200,000 plus or minus. Would that be inadequate compensation for the value they add to the economic system? If 10% of the leaders in Goldman Sachs made over $1,000,000 each annually would that be under compensation for the value they add to the financial system? If 1% made over $5 million, would that be under compensation? It might be argued the numbers I quote still could be over compensation. But at least they would be closer to "earned" compensation. I say earned to mean compensation for value added to the financial system rather than value added to their bank accounts.

Goldman Sachs employees are being paid like athletes who have a very short viable career. And many Sachs employees do indeed act like athletes in terms of how long they stay with the firm. Some have a short (10-20 year) career and then "take the money and run" to other careers. Unlike athletes, whose careers are limited by injury and fading ability, the short careers at Goldman are by choice. Some go into politics, other government related positions and second career activities doing something they love. A spokesman for the firm would call this giving back. See www.bloomberg.com/apps...;sid=a8upOpH5Q3Tw . I would call it "taking more". In some cases more good results from the new "taking" than the original, but, in the case of government service, that can be debated. The questions about Paulson's lingering connections to Goldman Sachs are an example. See Felix Salmon's piece seekingalpha.com/artic... .

The arguments about the value of oligarchy are largely self serving. Once you create a monopoly, of course that monopoly and their accomplices will argue that disruption would be dangerous. They are entirely correct – it would be dangerous for them. What about the other 99% + of us? In your concluding statement, you state, “…it appears that preserving these types of institutions is the real economic risk.” Point, set, match.

Oct 21 03:48 PM

[Kinabalu:]

"Given the technological advances that were occurring in the 1990s, it is very possible that much of the productivity experienced across all industries had more to do with a secular movement in technology as opposed to efficiencies realized by managerial acumen."

We have a winner!! Give the man a Kewpie Doll. The FDIC promoted bank mergers for 2 decades because they thought that larger banks had lower loss ratios. They never tried to claim that larger banks were more efficient because all of American industry was experiencing productivity improvement.

TooBigToFail has refuted the loss ratio concept but now someone is trying to ascribe broad productivity gains to merger activity? Except for monopolistic situations, mergers have traditionally been shown to have ineffective results across industries. Banking is no exception.

Oct 21 03:59 PM

[tripleblack:]

I loved reading this article, and its responses. Its the sort of insight I come to SA to find. I am humbled before the financial knowledge represented here, but I do have some knowledge of productivity gains (I was once an industrial engineer, with a company that went through a series of takeovers and reorganizations), whether from new processes or the oh-so-elusive "synergy" buzzword once the rage of conglomerates everywhere. I will contribute what little I can in favor of the stands taken here:

Kinabalu is correct, mergers of these disparate giants are near-universally NOT productive - particularly when they immediately lose whatever customer loyalty, regional advantage, or institutional knowledge the seperate companies once possessed. Any efficiency gained by reducing headquarter staff is frittered away with the massive cost of write-offs, lay-offs, damaged morale, and disruptions to business relationships. Best case the net productivity of the organizations, once merged, are about the same as they once were, perhaps just a little better, though recovering the costs of achieving this landmark condition from any productivity increase might take years. In business terms, these sorts of productivity gains are rarely worth the price and risk, though in the case where you have immense net assets that can be had for a fraction of the price, THAT becomes the motive, and talk of synergy and worker productivity are just camouflage.

The accuratge term in the end is not "synergy" in the case of these odd marriages, but when the taxpayer is the one taking the risk, while the 2bigs are getting all the assets and rewards, the term is "looters". Given this, the fact that many of them can claim that the government coerced them into this condition is all the more surreal.

Oct 21 04:43 PM

[derryl:]

Calomiris wrote, "Limiting the size, complexity and global reach of financial institutions is fraught with downsides for the international economy. We can solve the too-big-to-fail problem without destroying global finance."

Is he talking about the same "international economy" that has seen all the benefits for the past 3 decades flow to corporate profits and zero to US workers? And the resultant overconcentration of wealth in the top 10% and overconcentration of debt among the middle class? The same international economy that saw China sell $2 trillion more goods to the US than it bought from the US creating a debt fueled US consumer bubble whose ongoing collapse is still threatening to bring down the very global finance that Calomiris defends? The global finance that securitized unpayable US mortgages on bubble priced houses and sold them to suckers across the planet to earn fees and commissions? The same MBSs that the Fed is now buying en masse to prevent a Depression?

If that's the "international economy" and "global finance" that Calomiris seeks to defend then I suggest this man is our enemy, not our ally.

Oct 21 10:04 PM

[MarvinMBA:]

The problem is not oversized banks with its various financial offerings....example B of A....lets call a spade a spade and our problems go right back to the USA Fed and Treasury which failed to rein in the Housing Boom before it became a bubble. If it did its job of raising interest rates and not allowing those that have zero income or next to zero income to qualify, most of the problems we are now facing would never have happened, big banks or small banks..it all would have adjusted to the tightening...perhaps we would have had a few problems that could have been easily handled but now the wolves are on the loose...MarvinMBA

Oct 21 11:09 PM

[Kinabalu:]

A review of FRB staff studies reveals a 1994 review of Merger Performance Studies in Banking, 1980-93, and an Assessment of whether bank mergers actually yielded any effeciency gains.

www.federalreserve.gov...

Conclusions? "findings indicate consistently that bank mergers do not generally result in gains in efficiency or general operating performance."

Oct 26 03:47 PM