Big Bank Obesity Conundrum

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.

35 thoughts on “Big Bank Obesity Conundrum

  1. 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.

  2. 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.

  3. 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

  4. 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.

    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.

  5. It is certainly possible for very large firms to become effectively unmanageable, for reasons roughly similar to why socialist central planning must fail.

    The only serious objection I’ve heard to letting banks get big and letting big banks fail is the problem of check payment. That can be dealt with by a bond posted to cover checks outstanding. Which sounds a bit like the UK bill. Otherwise, if a bank fails the stockholders take a haircut and life goes on after reorganization: the buildings are still there, the computers are there, the people with expertise are there, and presumably at least some other assets from the balance sheet are there.

    For the time being, let FDIC limited protection of deposits continue. But eventually, once the Fed is eliminated, and with it the presumption in favor of pyramiding implicit in the fractional reserve system, it would make sense to draw a line between banks as storage for money or precious metals versus investment clubs that invest or lend out deposits. There is something rather fraudulent, is there not, about the notion of two different people having full claim to the same assets–for example, the depositor and the person to whom most of the money deposited has been lent? In a truly free market, one would expect a variety of options to develop, from pure storage with at-will checking to various levels of fractional reserve with correspondingly higher or lower interest or fees on deposits, to pure mutual funds.

  6. I’m against the Volcker Rule for the same reason I oppose drug laws. Taking illegal drugs might be a bad idea, but the decision to take them or to refrain from doing so should be left to the individual, not the State entity. The same thing is true with proprietary trading. Banks should be free to decide whether they want to trade or not. Some banks might try it, get burned, then do what UBS did.
    Prop trading was not the cause of the recession even if it exacerbated it. Chalk that up to the Fed entity in cahoots with America’s only native criminal class, the Federal agencies it spawned and the actions they took.

  7. To elaborate a bit on my opposition to the Volcker Rule, in a truly free market there is no Fed, no Treasury, and no government bond and forex markets. Corporate bonds and stocks would be traded by stock exchanges and brokerage firms, but there would probably be little if any prop trading
    by banks. By bye Mr. V, see ya later.

  8. “Surely, so protracted and widespread a trend can’t be due to mistake or chance. There must be some efficiency advantage”

    Washington Mutual grew rapidly to enormous size through regulatory advantage. The regulators gave banks with less politically correct management to banks with more politically correct management, Washington Mutual being the most politically correct – and probably the least efficient – of them all. In mergers and takeovers, the banks did not bid for the support of shareholders by promising shareholders more money, but for the support of regulators, by promising more easy money mortgages for blacks, hispanics, and the poor.

  9. Goldman and Sach’s advantage is not efficiency, but that they own governments, rather than businesses, for example the recent unelected government of Greece. Washington Mutual was horrifyingly inefficient. Its advantage was that it was more politically correct than other banks, not that it was more profitable than other banks.

  10. Ah yes, regulatory arbitrage and rent-seeking. Having friends in high places. Hi Mr. Buffett. Hi Mr. Killlinger.
    Abolish the regulatory state and free up the captured pawns within it. In a free market the ones that survived would slim down to a normal size. Whatever systemic risk they pose would evaporate.

    In a free market, perceived (pseudo-) problems A,B,C… would not be met by legislated regulatory “fixes” X,Y,Z… but by economic creative destruction shored up by the rule of law. Real law, not legislated absurdities, usurpations and crimes, which simply cause the problems–the risks, rent-seeking and regulatory capture–to compound.

  11. Jerry O’Driscoll–
    First of all, I think neo-trustbuster is a proper term to describe the position you share with others. It harkens back to the early 20th century anti-big-company folks while acknowledging that we now have a new variant on our hands.

    Second, I don’t know that the Financial Services Roundtable takes the perspective of this post. They may have other fish to fry.

    Third, your assertion, “No supposed efficiency is worth that taxpayer risk,” is unreasonable. I don’t defend bailing out any business with taxpayer money. The government should be forbidden to bail out this or that business. But that’s a problem about the government.

    GM and Chrysler were bailed out. Yet you do not advocate downsizing them. Certainly, special benefits should end. But that’s not an argument for breaking down a business.

  12. Re capital requirements:
    I have no objection to higher capital requirements for larger banks. Strangely, this useful rule is not in the thousands upon thousands of pages of regulation flowing from Dodd-Frank. Instead it’s been left to the Basel committee.

  13. Chidem,

    You keep asserting the banks are big because of efficiencies, and ignore a large literature to the contrary. In the February 6th Fortune magazine, Sheila Bair took up the issue. She presented the facts.

    There are some efficiencies from seize, but other inefficiencies from the complexity of managing such institutions. On net, the largest banks earn less on their capital than merely large banks (think BA and Citi vs. Wells Fargo). That is reflected in their respective stock prices.

    (For those who don’t know, Sheila Bair is the retired chairman of the FDIC.)

    The mega banks do not grow because of efficiencies. They grow to capture the benefits of too big to fail policies.

  14. The point I’m contesting, namely “The mega banks do not grow because of efficiencies. They grow to capture the benefits of too big to fail policies” (to quote from your most recent comment) applies to recent years. The growth trend goes back decades. The timeline just does not work for the story you’re telling. They were already big by the time the policies arose.

    Their bigness led to the policies in the crisis–the effect in the other direction, from the policies to the bigness, may be important, but does not explain what the makes these organizations the way they are.

    I am not defending the policies or the benefits banks receive therefrom. The issue is that the efficiency aspects are getting slighted in the discussions on this topic.

  15. Following up the above reply to Jerry O’Driscoll.

    Jerry, I realize the problem that the fear of big bank failures has led to very bad policy. Instituting an orderly way for them to fail is the solution, which Dodd-Frank was supposed to do. Instead it’s created an immense regulatory mess.

  16. “The growth trend goes back decades. The timeline just does not work for the story you’re telling. ”

    Goldman and Sach is not growing to capture the benefits of too big to fail, nor by being more efficient than its competitors, but to capture the benefits of owning governments and regulators, which has been going on for decades.

    Washington Mutual did not grow because of the benefits of too big to fail, nor by being more efficient than its competitors, but because of the benefits of being more politically correct than its competitors, which benefits have existed for decades, but became more extreme exactly when Washington Mutual began its rapid growth.

  17. Chidem,

    Unless you present some data and dates, you are just not being serious. There is a literature out there you refuse to acknowledge, much less confront.

    There are no damn efficiencies (net). You just keep asserting that. Provide citations to serious research, please.

    Too-big-to fail has been in place a long time, and in all developed countries. In the US, in modern times, it is ususally dated with Cotinental Illinois’s failure. But it was in place with Franklin National in the 60s. An argument could be made that the RFC in the 1930s was the beginning.

  18. James A. Donald–
    Re they grow “to capture the benefits of owning governments and regulators, which has been going on for decades.”
    Granted, there has to be some impact from being able to control government interventions as these become more numerous and extensive, say starting with the 1930s New Deal. I can’t imagine that’s the whole story, though. We’re talking many firms in different countries over almost a century.

  19. Jerry,
    Economic histories describe the role large banks played in various countries. This role waxes and wanes with the specific conditions. It appears to have started in Germany, circa mid-19th century. Thus Alfred Chandler described the “Grossbanken” and their changing place in the economy–Scale and Scope. The Dynamics of Industrial Capitalism, link in the post.

    As I wrote in the post, industrial companies have been the main focus in studying scale and scope economies and “We need a similar analysis for finance.”

  20. Chidem,

    My thoughts: We can’t always be “all about efficiency” as if economic stability doesn’t matter also. I think we tenured professors are particularly prone to neglecting the psychic and economic impact of a seesawing economy on our citizens (including entrepreneurs). Most non-tenured employed citizens would rather have stable, albeit lower economic growth rather than financial “innovations” that may have rocketed our economy forward but also created the seeds of its own collapse. That’s why the demand for insurance exists… we should think about slower “less efficient” banks (and associated higher interest rates) as insurance against a future economic collapse. Most of us would take that trade-off, including business people who would benefit by having more ability to plan in the future.

    By the way, I also agree with Walker and Jerry that these efficiencies were a smokescreen in any event to hide rent-seeking activities by banks.. But granting you this point, I still find it wanting.

  21. @Chidem,

    Germany was not yet a country in the mid-19th century. Do you mean Prussia? Banks were creatures of the state to finance Imperial Prussian ambitions. No market forces at work there.

  22. Craig Richardson–
    Re stability vs. innovation: yes, that’s a valid point that there may be a tradeoff and many people may prefer more stability. However, non-innovative, sluggish economies are not necessarily stable. They can have bubbles and busts — which after have a history that goes back centuries — despite (or maybe because of) slow growth.

  23. Jerry–
    The “Grossbanken” phenomenon continued through unification and various political changes in the 19th and 20th centuries. So it persisted under different regimes. I mention this to highlight the fact that big banks are not new and not confined to the US.

  24. Bill Stepp–
    Re “In a free market the ones that survived would slim down to a normal size.” Really important point.

    Let’s remember the antitrust case against IBM, which started in 1969 and after elaborate efforts by the government to prove IBM was monopolizing the computer market ended in the 1980s with the decision that the charges were without merit. Of course by then the computer market was changing almost beyond recognition, competition was ferocious and IBM had to change just to survive.

    There is no knowing what the future will bring but markets tend to change unless government interventions freeze them in place. The big banks will face competition unless protected by government-created barriers. Making policy on the basis of what they are today is like bringing the case against IBM as if the computer industry were going to stay the way it was in 1969.

  25. Chidem,

    Sure, I agree to your point that non-innovative countries may have issues as well. But this is not between choosing starkly between say “innovative vs. non-innovative”. but rather choices at the margin.. In financial markets these innovations have only one benefit that I can see for ordinary citizens: they *may* have lowered interest rates, because of their efficient dumping of financial capital to unsuspecting buyers here and in Europe, through the capturing of rating agencies.

    Synthetic CDOs are more “efficient” in that they created a whole new market of buyers and sellers that otherwise would not have existed.. but did they improve social welfare for most of us? I don’ think so. We could have legalized gambling in North Carolina and done more for society.

    My point is that in looking backwards, I think most American citizens would have rather paid higher interest rates, and this would have incentivized all of us from making foolish speculative choices in housing.. as well as encouraging savings and a longer term, more prudent perspective. I would have taken this loss of “efficiency” gladly, as a tradeoff from Wall Street’s so called innovations that destroyed trust in the financial system.

    By the way, the Chinese now trust free markets more than we do, according to the recent poll from Globescan. The fallout from these innovations:

    Americans with incomes below $20,000 were particularly likely to have lost faith in the free market over the past year, with their support dropping from 76 per cent to 44 per cent between 2009 and 2010. American women have also become much less positive, with 52 per cent backing the free market in 2010, down from 73 per cent in 2009.

    This is the true loss of the collapse of the financial system, that will take decades to rebuild.. which is why I think these calls for efficiency have to take into account this collateral damage.

  26. Chidem,

    Re: IBM, one of the ways it adjusted to the fast changing tech market was to sell its computer division to Lenovo and to shift its focus to selling services. The first laptop I used in 1994 was an IBM Thinkpad. Ever the kidder, I referred to it as a Stinkpad.

  27. Craig Richardson–
    You make a reasonable case that certain financial innovations were misused. This often happens to new technologies and not just in finance. It happens because the hazards are not well understood–due to the novelty.

    However, re your point “most American citizens would have rather paid higher interest rates, and this would have incentivized all of us from making foolish speculative choices in housing.. as well as encouraging savings and a longer term, more prudent perspective.” I’d have thought the Exhibit Number One in assigning blame for low interest rates belongs to the Federal Reserve. Look at us now–savers are positively penalized by near-zero rates.

  28. All this talk about what would happen in a truly free market is missing the point. I suspect everyone here, Chidem and Jerry included, would like a system in which bail-outs were impossible. Sadly, that is not an option, because governments don’t have the ability to create binding constraints on their future behavior. They can pass a law now and repeal it later. Thus, the argument for limiting the size of banks is not to correct a market failure, but to correct a government failure. And yes, that is a second-best solution, but we live in the world of second-best. (That said, I’m not sure I support the bank-busting proposal. But I do think it has merit.)

  29. Yes. I am also glad to see the term “government failure” used in its accurate sense. Sometimes it is defined as the government’s “failure” to carry out someone’s statist agenda.

  30. Chidem,

    I completely agree. The Fed is attempting to “solve” a problem of excessive leverage by having people take on even more debt. Lack of transparency with these financial innovations and the Fed’s complicity are all to blame.


  31. Glen–
    Re “Thus, the argument for limiting the size of banks is not to correct a market failure, but to correct a government failure” Absolutely right.

    Taking that another step, bank busting would be an example that government failure generates more government intervention, often leading to more government failure and further intervention. Thus government failure leads to more government. .

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