If the crisis has a single lesson, it is that the too-big-to-fail problem must be solved. - Ben Bernanke, September 2, 2010
As the 2008 U.S. banking crisis demonstrated, the alleged problem with too-big-to-fail (TBTF) firms are to be found predominantly in the banking sector.1 The problem therefore really boils down to banks that are TBTF, and not firms which Bernanke referred to in his above testimony before the Financial Crisis Inquiry Commission.
Prior to the eve of the 2008 banking crisis culminating with the bankruptcy of Lehman Brothers in September 2008, there were 7,137 commercial banks in the U.S. Around the time when Bernanke made the above statement, there were 6,570 banks operating in the U.S. At the time of writing this article, the number has shrunk to 5,141, a total decline since 2008 of 1,996 banks, or 28%. During the same period, total bank assets increased from just over $11 trillion to more than $16 trillion, an increase of almost 46%. Consequently, the average U.S. bank's total assets have more than doubled since 2008.
The TBTF problem has therefore not been dealt with at all in terms average size and numbers. But it gets worse; as a share of GDP, bank balance sheets are even bigger today than they were in 2008.
The average bank is therefore more "systemically" important today than back then as the average bank's "share of GDP" has increased 60.5% from 2008 to 2016 (calculated as av. total assets per bank in the table above divided by GDP for the quarter). Whatever difficulties the banking system will experience going forward therefore will have a potentially bigger negative impact on the economy than in 2008. But despite the political rhetoric, ever fewer banks operating with ever bigger balance sheets will continue to be a trend for the foreseeable future. Banks will merge and the banking sector will continue to consolidate this year for a key reason unbeknown to most in my experience. The reason is the be found in the current monetary arrangement; fractional reserve banking.
There are obviously many good reasons why the banking industry in the U.S. has consolidated during the last 30 years (as is the case for many other industries) such as economies of scale, expanding the range of products/services, synergies, bankruptcies etc. But there is another fundamental and powerful reason banks merge and make acquisitions. This reason is directly related to fractional reserve banking which lies at the heart of the U.S. monetary system.
Simply put, a commercial bank attempts to make a profit through issuing loans, accepting deposits and by providing a range of financial services. As such, the extent to which it can create loans (credit) is an important factor deciding the level of profits. Many banks will therefore normally seek opportunities to expand their loan portfolios in order to increase the amount of earning-assets in the pursuit of increased profits.
At first glance, two banks merging will end up with a larger loan portfolio, but can only make an incremental profit from it if there is a gain from synergies. Right? The answer is no. Banks are nothing like other corporations and therefore are not as dependent on the (potential) gain from synergies in order to make an incremental profit from a merger or acquisition. The reason for this can be found in this simple formula in the book Money, Bank Credit and Economic Cycles, 2nd ed by J.H. de Soto, p. 202):
The formula shows what the maximum credit expansion possible for a single bank would be, where,
d: the money originally deposited in the bank's vault
x: the bank's maximum possible credit expansion starting from d
c: the cash or reserves ratio maintained by the bank, in keeping with the banker's experience and his careful judgement on how much money he needs to honor his commitments; and
k: the proportion of loans granted which, on average, remain unused by borrowers at any given time.
As commercial banks are able to create money "out of thin air", meaning they don't need a corresponding amount of actual savings backing the loans granted (this is what is meant by "fractional reserve banking"), the key motivator for bank mergers and acquisitions in the above formula is k. The k is the amount of the loan which, since it is not used, is just sitting on the bank balance sheet as a deposit (a deposit is created when a loan is granted). Therefore, the larger the bank's market share, the more loans and deposits it is able to create and make money from. I'll let de Soto explain:
The fewer the banks operating in the market, the higher k will be; the higher k is, the less money will leave the bank; the less money leaves the bank, the greater the bank's capacity for expanding loans. One of the strongest motivations behind the trend toward bank mergers and acquisitions which has always been obvious in fractional-reserve banking systems is precisely the desire to increase k. In fact, the more banks merge and the larger their subsequent market share, the greater the possibility that the citizens who receive the banks' fiduciary media will be their own customers. Therefore both k and the corresponding capacity to create loans and deposits from nothing will be increased and the resulting profit much greater. The value of k is also increased when monetary deposits are made in other banks, which in turn expand their loans, and their borrowers ultimately deposit in the original bank a significant portion of the new money they receive. This phenomenon also causes an increase in the bank's monetary reserves and therefore in its capacity for credit expansion.
So, there we have it: the larger the bank the less deposits leave the bank. The less deposits leave the bank, the less money and reserves leave the bank and the more the bank is able to expand its loans and deposits:
d1 = (1 - k)x
d1: the money or reserves which leave the bank as a result of loans it grants
x: loans granted
The desire to increase loans and deposits through increasing k has been a strong motivation for banks to merge and grow through acquisitions for decades. Two banks that have merged are able to expand their loan portfolios and deposits by a larger multiple than the two combined as stand alone entities. And as long as the current fractional reserve banking system survives, bank mergers and acquisitions will continue unabated in the future as any "prudent" bank would seek to increase k in order to increase profits. In theory, this could continue until there is only one bank left standing. Antitrust regulation is perhaps the only way to end it (other than unreasonably high stock prices of target banks) as long as we have a fractional reserve banking system. Finally, as the k in the above formula has increased substantially over the years, banks' fire power to expand credit has increased with it. Though the increase in k by itself perhaps makes banks less prone to bank runs, their ability to create ever more fiat money only increases the potential, and probability, for creating yet bigger and even more violent credit- and business cycles than those in the past. If credit conditions tighten this year, a very possible scenario of which we are already seeing some tentative signs (e.g. here), then this could very well trigger another bank merger wave as banks desperately seek to protect their reserves (i.e. fight off possible drops in the k).
1 It's not banks that are "too big" that is the real problem, but rather the fact that all banks have too little reserves. This state of affairs is a reflection of the banking system employed in the U.S. and most countries around the world today - fractional reserve banking. Banks therefore find themselves permanently in an illiquid position, the degree of which is under constant change and which will worsen following a period of credit expansion.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.