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

Includes: AIG, BAC, C, EVR, GHL, RBS
by: Amit Chokshi, CFA
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 (NYSE: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 (NYSE:EVR) and Greenhill (NYSE: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 (NYSE:BAC), the Royal Bank of Scotland (NYSE:RBS), and AIG (NYSE: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