The Big Bank Obesity Conundrum

Chidem Kurdas Think Markets March 6, 2012

A blog of the NYU Colloquium on Market Institutions and Economic Processes

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by Chidem Kurdas

Is the Federal Reserve a hotbed of trustbusters? Fed officials (as well as some academics) have been calling for forcible downsizing of big banks . "I am of the belief personally that the power of the five largest banks is too concentrated," Dallas Federal Reserve Bank president Richard Fisher said a few days ago during a visit to Mexico, according to news reports. He's expressed similar views before, as has Thomas Hoenig, former president of the Kansas City Fed.

Here on ThinkMarkets Jerry O'Driscoll, a Federal Reserve veteran, wrote: "There is no conceivable efficiency gain that justifies the risk these gigantic, risky institutions impose on all of us," to quote one of his comments. The main argument is that large banks, having been given access to financing from the Fed during the crisis, are now more likely to take risks because they know they'll be bailed out.

The neo-trustbusters favor the rule, suggested by and named after former Federal Reserve chairman Paul Volcker, aiming to slim down banks by having them divest proprietary trading and hedge fund and private equity businesses. "Perhaps the financial equivalent of irreversible lap-band or gastric bypass surgery is the only way to treat the pathology of financial obesity, contain the relentless expansion of these banks, and downsize them to manageable proportions," Mr. Fisher says.

No doubt, government backing of banks, like government backing of mortgage giants Fannie Mae and Freddie Mac, creates a nasty moral hazard. Unlike Fannie and Freddie, however, the banks were originally not creatures of the government. They grew in scale and scope for decades, long before the bailouts and the emergence of the notion that they are too big to be allowed to fail. Government-subsidized risk taking is not the reason they became big"”they were already big, for reasons the neo-trustbusters do not address.

The classical objection to concentration is that the resulting monopoly or oligopolies boost prices and restrict output to make extra profits. But investment banks face competition in almost every line of business; the competition is ferocious in areas like brokerage. It is not just that big US banks compete with each other. They also compete with large banks all over the world. It would be hard to find any major financial market where the incumbent enjoys monopoly rents at the expense of customers with no threat of competition.

So the case for scaling down banks is not predicated on their monopoly power but on the menace to taxpayers in the event the government props up failing banks. But if they're not making monopoly profits, why did these banks become large and diversified in the first place? Remarkably, this has happened everywhere, under different policies and regulatory regimes. Global financial players "“ not just Bank of America, JP Morgan, Goldman Sachs, Morgan Stanley, Wells Fargo but also Deutsche Bank, Credit Suisse, UBS, HSBC, Barclays "“ are all big entities.

Fed officials say banks don't need to be so large to be efficient. But then why are they so large? The long-term trend of expanding scale and scope in banking goes back a century or more and is global. Surely, so protracted and widespread a trend can't be due to mistake or chance. There must be some efficiency advantage. The great business historian Alfred Chandler explained scale and scope economies in modern industry. We need a similar analysis for finance. It is likely that there are such economies and destroying them in the name of shrinking the banks will obliterate a portion of national income.

So far, the starve-the-fat-banks Volcker Rule treatment is not going well. While regulators still try to determine how to implement the rule, unintended consequences have already shown up. Banks' trading on their own account is intertwined with market making for clients. As the prop desks shut down, there are fewer market players to match buyers and sellers. That increases the cost of transacting in particular in the bond market, adding to the expense of mutual funds and small businesses.

Europeans complain that the Volcker Rule could discourage banks from trading European government bonds, thereby increasing the costs to those governments and aggravating credit problems.

We'd be better off if the ancient medical tenet, first do no harm, were applied by both doctors and regulators. Instead, regulators tend to behave like medieval physicians who apply leeches for bloodletting every time they confront a baffling condition.

Until there is a better understanding of why banks grow, what makes them efficient and how the loss of efficiency will affect the system, forced dieting is likely to do more harm than good.

This entry was posted on March 5, 2012 at 10:01 am and is filed under Bailouts, Financial Markets, Regulation. Tags: Alfred Chandler, Bank of America, Barclays Capital, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, Jerry O'Driscoll, JP Morgan Chase, Morgan Stanley, Paul Volcker, Richard Fisher, UBS, Wells Fargo

My, my, where to start?

First, I never advocated “trust busting.” My preferece is to remove the special benefits provided to large financial institutions, which are summarized as the “too big to fail” policy.

Second, Chidem’s posting reads like a press release from the Financial Services Roundtable (the trade association for the largest financial services firms). Chidem writes: “Government-subsidized risk taking is not the reason they became big — they were already big, for reasons the neo-trust busters do not address.”

That is a bald assertion lacking any support. By contrast, to name just a few, Ed Kane, George Kaufman, Martin Mayer, Walker Todd and I have produced a lifetime of research showing just the opposite. Allan Meltzer has recently decried the “giganticism” that is the product of too-big-to fail policy.

It is true that policies twoard banks differ in details in different countries. But all developed countries have a de facto policy of protecting large banks from failure. Even when the consequences are devastating for taxpayers, and threaten the economic future of a country, as in Ireland, governments proetct the banks.

As Martin Mayer has observed, the liabilities of the banking sector must be added to the explicit liabilities of governments to measure the size of taxpayer liabilities. Even were the size of banks due to some efficiencies, which are often asserted but seldom measured, that would be reason enough to want to curb their size. I repeat the statement that Chidem quotes. No supposed efficiency is worth that taxpayer risk.

I happen to believe that what Chidem calls “efficiency” in financials ervices is largely the creation and trading of rents generated by risk-taking at taxpayer expense. Perhaps Paul Volcker overstated it when he said that the ATM was the last financial innovation in banking. But he wasn’t that far off the mark.

Agreed. In Chidem’s analogy, the bloodletters are by now putting leeches on their leeches.

If a patient’s illness is largely iatrogenic in the first place, adding another prescription on top of the old ones is unlikely to promote health. Let’s start by eliminating some of the snake-oil meds we know have nasty side effects–like, Fannie, Freddie, and the Fed.

It starts with Adam Smith’s analysis of the “efficiency” of large and monopolistic joint stock corporations. Alex. Hamilton laid the foundation for profit-making corporations in the USA built on that joint stock model, despite having read Smith himself. Hamilton’s corporation was a bank. Jefferson and Madison complained about what that bank was likely to become, and viewed retrospectively, their writings are prophetic on this account. Essentially, if you take a license to print money (which banks can do in a fractional reserve system), give banks state protection (who can deny that they have it?), give bankers limited personal liability (who has gone to jail or even lost his job for the recent fiasco?), and add state subsidy, you have an unbeatable combination that leads to about where we are today. I think O’Driscoll is right and that the only way out of this mess is to go back to identify the wrong turns taken on the path to the present and take a different course. The Volcker Rule is just a baby step in that right direction.–Walker Todd

I will add two pieces of additional information.

First is a link to a Kevin Dowd post on a bill in the UK that would be a radical remake of bank regulation. I recommend reading it.

http://www.cato-at-liberty.org/new-bill-to-reform-the-uk-banking-system/

Second, I observe that the Swiss are imposing capital requirements over and above the Basel rules (an irony, there). UBS is going further and setting capital standards for itself above even what the Swiss governemnt wants. UBS is also downsizing its investment banking arm, which has done nothing but lose money for the bank.

The best comment I’ve heard recently on capital is that higher capital does not reduce profitability, but reveals the true, underlying profitability of banking. For an older verity, I cite George Kaufman that there is no such thing as too much capital.

The optimist side in me says that markets are demanding higher standards than regulators. That is good. But I agree with Walker that the Volcker rule is needed.

The Big Bank Obesity Conundrum

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