Guest Post: Why Concentration in the Banking Industry Threatens Our Economy

By George Washington of Washington’s Blog.

As everyone knows, the big banks have gotten bigger and bigger. Noted economist Mark Zandi says we have an oligopoly of banks, and that “the oligopoly has tightened”.

The TARP Inspector – Neil Barofsky – told Huffington Post yesterday that, because of the consolidation in the banking industry:

I think we may be in a far more dangerous place today than we were a year ago.


Economists and other financial experts could provide many reasons why concentration is dangerous. Certainly, their very size distorts the markets and limits the growth of smaller banks. and the economy cannot fundamentally recover while the giants continue to drag our economy down the drain.

But I would like to use an analogy from science to discuss why our current, highly-concentrated banking lineup presents a huge threat to our economy  (analogies can sometimes be useful; e.g. Taleb talks about black swans).

It has been accepted science for decades that when all the farmers in a certain region grow the same strain of the same crop – called “monoculture” – the crops become much more susceptible.


Because any bug (insect or germ) which happens to like that particular strain could take out the whole crop on pretty much all of the region’s farms.

For example, one type of grasshopper – called “differential grasshoppers” –  loves corn.  If everyone grows the same strain of corn in a town in the Midwest, and differential grasshoppers are anywhere nearby, they may come and wipe out the entire town’s crops (that’s why monoculture crops require such high levels of pesticides).

On the other hand, if farmers grow a lot of different types of crops (“polyculture”) , then a pest might get some crops, but the rest will survive.

I believe that the same principle applies to our financial system.

If power and deposits are concentrated in a handful of mega-banks, problems with those banks could bring down the whole system.  As Zandi noted, there is an oligopoly in the banking industry (and “the oligopoly has tightened”).

Moreover, the mega-banks are huge holders of derivatives, including credit default swaps. JP Morgan Chase, Bank of America, Goldman Sachs, Citigroup, and Morgan Stanley together hold 80% of the country’s derivatives risk, and 96% of the exposure to credit derivatives.

Even though JP, B of A, Goldman and Citi are separate corporations, they are so interlinked and intertwined through their derivatives holdings that an attack by a “pest” which swarmed in on their derivatives could take down this “monoculture” of overly-leveraged, securitized, derivatives-heavy banking.

Indeed, taking just one example – JP Morgan – independent analyst Reggie Middleton notes:

As of June 30, 2009, JPM had exposure of $85 billion (or 108% of its tangible equity) towards off balance sheet lending commitments and guarantees…

As of June 30, 2009, the total notional amount of derivative contracts outstanding as of June 30, 2009 was about $80 trillion (or 101,846% of its tangible equity)…

Gross fair value (before FIN 39) of the derivative receivables and derivative payables was $1,798 billion (or 2,276% of its tangible equity) and $1,749 billion (or 2,214% of its tangible equity), respectively. The, fair value of JPM’s derivative receivables (after FIN 39) was $84 billion (or 106% of its tangible equity) while the fair value of JPM’s derivative payables (after FIN 39) was $58 billion (or 73% of its tangible equity). FIN 39 allows netting of derivative receivables and derivative payables and the related cash collateral received and paid when a legally enforceable master netting agreement exists between JPM and a derivative counterparty…

About 23% of the derivative receivables (in terms of fair value after FIN 39) were below investment grade (less than BBB or equivalent) while 12% were rated BBB or equivalent…

Within the dealer/client business, JPM utilizes credit derivatives by buying and selling credit protection, predominantly on corporate debt obligations, in response to client demand for credit risk protection on the underlying reference instruments. Protection may be bought or sold by the Firm on single reference debt instruments (“single-name” credit derivatives), portfolios of referenced instruments (“portfolio” credit derivatives) or quoted indices (“indexed” credit derivatives). The risk positions are largely matched as the Firm’s exposure to a given reference entity under a contract to sell protection to a counterparty may be offset partially, or entirely, with a contract to purchase protection from another counterparty on the same underlying instrument. Any residual default exposure and spread risk is actively managed by the Firm’s various trading desks. After netting the notional amount of purchased credit derivatives where the underlying reference instrument is identical to the reference instrument on which the Firm has sold credit protection, JPM has net protection purchased of $82 billion along with other protection purchased of $77 billion.

So that’s it. They are square, then. Of course unless the sellers of their protection default. If they do, then it may very well cause a daisy chain reaction that could get very ugly … If you thought Lehman caused problems, compare Lehman’s counterparty exposure to JPM’s.

The bottom line is that our current banking monoculture threatens not only the biggest banks, but the entire financial system. Pesticides become less effective as pests develop resistance – and, as a byproduct, we poison friendly critters.  Likewise, the giants “creatively” work their way around regulations so that the regulations are no longer effective (or at least not enforced, and regulatory capture is widespread.  And too much regulation stifles productivity,as an unintended byproduct.

Having power and deposits spread out among more, smaller banks would greatly increase the stability of the financial system. And having more power and deposits in banks using a wider variety of business models (e.g. among banks that aren’t heavily invested in derivatives and securitized assets) will create a banking “polyculture” which will lead to a much more stable financial system.

In other words, if we decentralize power and deposits and increase the variety of banking models, we will have a healthier financial system, we won’t have such an urgent need to try to micromanage every aspect of the banking system through regulation,and the regulations we do have will be more effective.

By the way, I would argue that that is one of the reasons why Glass-Steagall was so important: it enforced diversity – depository institutions on the one hand, and investment banks on the other.   When Glass-Steagall was revoked and the giants started doing both types of banking, it was like a single crop cannibalizing another crop and becoming a new super-organism.  Instead of having diversity, you’ve now got a monoculture of the new super-crop, suscecptible to being wiped out by a pest.

The kinds of things which threaten depository institutions are not necessarily the same type of things which threaten investment banks, hedge funds, etc.

The above is yet another reason we should break up the giant banks using antitrust or other laws.

Note: Wells Fargo’s derivatives holdings are substantial, but much less than the other big boys. But rumors are that Wells might be in real trouble as well due to its commercial real estate and other portfolios.

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  1. Mansoor H. Khan

    You are making this too completed.

    We simply need to separate the money storage and payment clearing aspect of deposit banking (transactional, medium of exchange)from loan making and investing.

    Depositors would then simply choose if they want their deposit to be subject to investing (they are willing to credit risk) or not take credit risk (100% reserve deposit).

    The (usually) transparent process of inter-bank lending works so well that most of the time we don’t even think about it. This process has largely weaned the public away from physical paper money. Note that most money (about 90%) now exists only as entries on bank ledgers, backed by loans (debt). Also, note that possessing physical paper dollars is like having equity in the economic output of the United States of America, and has no credit risk associated to it. Physical paper money is not anyone’s liability.

    Bank deposit money, on the other hand, does have credit risk associated to it. That risk consists of the liability of the bank in which the deposit resides. Strangely enough, most of the time the credit risk of bank deposit money is lower than the theft and physical-loss risk of physical paper money.

    That is why we use bank deposit money more than physical money. Through this (normally) transparent process of inter-bank lending, the banking system acts like a huge clearinghouse (essentially a giant ledger) which clears payments between its customers without the physical transfer of cash, and keeps track of who has how much money. Most money in the world economy is not physical (paper cash or gold) but logical (ledger entries).

    To summarize: physical paper money is equity. Bank deposit money is backed by debt (actually that’s not 100% true–reserves at the federal reserve system are also equity, essentially an electronic version of physical paper cash).

    That difference — that physical paper money = equity in the nation’s economy, and that a bank deposit = debt (a bank obligation) causes great confusion.

    We have become very comfortable with bank deposit money, without thinking much about the credit risk we are taking. Bank failures, when they happen, create confusion and chaos because the vast majority of businesses and individuals use checking accounts for convenience (they can write checks rather than handling physical paper cash) and they don’t really think much about the credit risk that is normally associated with keeping their money (their most liquid capital) in a bank in a checking account. In fact, in most cases users of checking accounts do not want to take a credit risk. But in the current banking system there are no alternatives.

    Is There a Better Way?
    Consider the banking industry’s contribution to society. The banking industry provides three major services to the public:

    It provides a “safe” place to hold the public’s most liquid assets (cash).
    It acts like a giant clearinghouse (settling checks without physical paper cash transfer).
    It is a source of loan money (banks evaluate the credit worthiness of borrowers). Think of “credit worthiness evaluation” as a service to society. If bankers do a poor job at evaluating credit worthiness they will end up mis-allocating economic resources.
    What I am asserting is that it is possible to have a banking system where a customer would get benefits 1 and 2 described above without taking a credit risk, if banks gave people a choice between a regular account and a special “100% reserve account.”

    These special accounts, which are not available to the public today, would have no credit risk. The money in such accounts would not be lendable. There would still be fraud risk, of course. A bank desperate for cash might be tempted to “dip” into the reserves allocated to their 100% reserve accounts. Of course we would make such “dipping” illegal. The 100% accounts would be the electronic equivalent of storing physical paper bills in a safe deposit box at the bank.

    Such accounts would have no credit risk (like physical paper cash) but would have the benefit of being used in electronic transactions and be accessible by personal checks. Of course, a 100% reserve account would not earn interest but would most likely have monthly maintenance fees associated to it (similar to a safe deposit box; it would also be very much like the reserve accounts that banks have with the Fed).

    Such accounts, if widely used, would lessen the impact of bank failures on the economy in terms of a contraction of the money supply, chaos and confusion–but would not completely eliminate them.

    Lending involves business risks (credit risks). If a customer were to choose a non-100% reserve account then he would be subject to losing his money. This would force the public to do some homework before handing money over to a bank (in essence, customers would need to consider banks’ credit ratings, quality of management, etc.).

    Of course, in this type of setup, a non-100% reserve account would probably have to pay a higher interest rate than the fractional reserve accounts do today. In fact if the public had a choice of 100% reserve accounts, there would be no need to impose legal reserve requirements on non-100% reserve accounts. There would be a clear separation between accounts that have a credit risk and accounts that don’t. The accounts with credit risk would need to set their interest rates high enough to attract depositors.

    If our banking system were set up this way, we would avoid huge systemic risks in the future, since a major part of the money supply would likely be sitting in non-lendable accounts. Many enterprises probably should not take any credit risk with their liquid capital (utility companies, municipalities, states, hospitals, etc.). In any insolvency or bankruptcy the 100% reserve accounts would receive priority, and unless the bank was fraudulently “using” these reserves the deposit owners of such accounts would never lose their money. If an electronic deposit account with no credit risk were available, then any individual or business choosing not to use such an account would be subject to losing their at-risk deposit. If such an alternative were available, then the depositor who chose the lendable money account would be warned that he or she could lose money if the bank became insolvent.

    Once this choice is given to the public, the banks can then be allowed to fail without severely impacting the payment system which is needed to conduct day-to-day commerce. The only job of the FDIC would then be to insure smooth transfer of 100% reserve accounts to another bank.

    I will go a step further and state that the availability of such accounts (non-lendable, 100% reserve accounts) should be mandated by Congress through force of law. Each business and individual should be able to choose whether they want to take a credit risk or not.

    non-100% reserve depositors would then be at-risk and there would be no need for deposit insurance.

    1. Anonymous Jones

      I am not against this option, but with all due respect, there is no such thing as elimination of credit risk. Nothing is failsafe. You can have 100 backstops and they can all fail.

      That is not to say that there are no methods that are less risky than others. There certainly are. So for your argument to appear stronger, I would start using the term “safer” rather than “no credit risk.”

      You have not explained how the 100% reserves are held. In physical paper dollars in the safe? Certainly risk there. In short term Treasuries? Certainly risk there (very little, of course). The concept of 100% reserves is more nebulous in a fiat money system that is more electronic bookkeeping than anything.

      You have also mentioned that FDIC insurance is a failure because of moral hazard. But you have actually not proven that your alternative is superior to FDIC insurance. You have simply posited it and noted a couple of problems with FDIC insurance and then said “point proven.” You have to do more than just say it. You have to prove that any problems with your system will be smaller and less costly.

      Also, insurance should not be able to cover every mass catastrophe. Certainly many property insurance companies couldn’t cover many imaginable catastrophes. That does not mean that property insurance should be eliminated. Just because the FDIC (in your opinion) could not could survive a Citibank failure (I guess you mean one in which there is a huge loss ratio) does not mean that FDIC insurance should not exist. I can certainly imagine a scenario in your proposed system where many debilitating bank runs would happen without FDIC insurance, specifically by the “yield seekers” who opted out of the 100% reserve checking account.

      1. Mansoor H Khan

        The reserves stored at the FED are like “digital cash”. There is zero credit risk. In a 100% reserves option my checking account money would be stored at the FED. Just like member banks have their “cash” stored at the FED (completely free of credit risk) perfectly safe since it will not be loaned out by force of law (in a 100% reserve account).

  2. micron26

    As someone who was trained in plant genetics (but now works in human genetics), the ‘monoculture’ analogy isn’t quite correct as described here. What you are really talking about here is a specific strain (a genetically distinct but homogenous subgroup) of a given crop, not separate species.

    Because pathogens and hosts have some degree of genetic specificity, if one strain of (for example) Dupont’s GM soybeans represents 80% of the crop, a strain of pathogen that can infect that strain of the crop can decimate it. If that 80% is subdivided into 10 separate strains, it’s unlikely that a given strain of a pathogen will be able to infect more than 1 or 2. With respect to the latter, this analogy is fairly accurate.

  3. Mansoor H Khan

    The reason I propose 100% reserve is because it is a very simple way to think about credit risk the depositor will be taking (100% reserve = No Credit Risk). The depositor is using the bank as a convenient electronic “piggybank”. Most individuals and banks who use checking accounts would rather not take any risk with this portion of their capital.

    Once this option is widely available FDIC protection can be removed. Consumers can be taught to associate credit risk with non-100% reserve accounts.

  4. micron26

    Well done, it reads very well now. And like I said before, an accurate and–rightfully, very frightening–analogy.

  5. Tony Lawrence

    It’s not just banks. From farming (ADM) to technology (Microsoft), being “too big” harms us.

    Fortunately, these big companies often fall from their own weight, but those tumbles hurt us yet again.

    Someday we’ll recognize that and put limits on corporate growth.

  6. Alexandra

    Very good post. I think the implications are even more extreme in highly connected environments.
    And there are several anlalogies in nature as well on of which is the behaviour of yeast:
    ‘More than 90 percent of the proteins in the network had five or fewer links, and only about one in five of these was essential to the yeast’s continued survival. With these removed, the yeast could still function by adapting its remaining network. In contrast, less than 0.7 percent of the proteins were hubs having more than fifteen links.’
    From: Nexus by Marc Buchanan 2002

  7. Siggy

    At latest count, the Federal Reserve identifies 18 banks as being primary dealers. At one time the count was forty plus. Over the past 35 years we have seen a consolidation of the banking industry that has altered its economic character from being monopolistically competitive to what we have now, an oligarchy.

    The consolidation has created banks that are now deemed too big to fail, a concept that in itself is the epitome of moral hazard. This oligarchy of banks has created incestuous trading relationships and the business model is predicated on, ‘profits we keep, losses you bear’. The repeal of Glass-Steagell is central to the assumption of excessive risk. The oligarchy that has been allowed to develop has assisted in the regulatory capture of the regulatory agencies and in great measure the Congress.

    A law that creates two banks within one house won’t work. What is needed is a law that brings the essence of Glass-Steagell back. Where institutions have both depository banking and investment banking operations, the investment banking operations will have to be spun off as separate entities with separate ownership. Such a law might require that depository institutions meet a 100% reserve requirement. That requirement will meet with very substantial resistance. It may be possible to enact a reserve requirement of say 50%. Even that will be seen as being too draconian and a restraint of trade.

    The current distress is quite clearly the result of the extension of credit to parties who are incapable of servicing the incurred debt. The resolution of this difficulty is deleveraging and that will be accomplished by any or all of the following: paying down the debt, repudiating the debt, converting the debt to equity, and a national debt forgiveness.

    The biological analogy is interesting, however, I feel that it begs the problem that the concentration in banking is the basis for the canard that any institution can become too big to fail. If it is deemed that it is possible for institutions to become too big to fail, we have then come to point where we have entirely abandoned a market driven economy in favor of a government controlled economy.

  8. hidflect

    The problem is the narrowing down of markets to mono-industries is also that it reduces employment to the best ten players in the room with a

    million unwanted on the sidelines. Like NBA wanna-be’s or Hollywierd’s struggling actor market. Like blogs. There may be 10,000 out there but I

    only have 4 hours in the day to dedicate. So me and everyone will just gravitate to the top 10. And then there will ONLY BE 10 after a while. So

    mono-production, like everyone buying an i-Pod, will result in one factory with reasonably paid workers to churn out the killer-prod and a

    million unemployed unable to buy the damn thing. And that’s the flaw with meritocracy. You end up with a very small pool of big earners. That’s

    what fragmented cottage industries prevent. The Balkanization of a giant economy into many small pieces allows for many market leaders and their

    entrained following of people employed in support. It’s less efficient than a mega-provider, but at least everyone has a job.

  9. Matt


    Your system sounds like an ideal setup for the mythical “economic man” who has complete information (and understanding) of the entities he deals with. Unfortunately, real people are quite far from that ideal – or do you truly think that the average consumer could evaluate the financial risks associated to a “non-reserve” account in a large bank? If I dropped the last 4 annual reports at Goldman Sachs on *your* desk, could you figure out why they collapsed?

    More importantly, we already have a system like you describe, except the “non-reserve” accounts are embodied as trading accounts at brokerage firms. The difference is that losses to a trading account are clearly the responsibility of the account holder, whereas the losses here are caused by the (invisible) action of an intermediary.

    1. mansoor h khan


      You are correct most people are not in a position to or want to worry about evaluating financial risks when it comes to depositing money in a commercial bank. That is all the more reason they need a “worry-free”, 100% safe option to store their most liquid capital (money in their checking accounts).

      Yes. We have FDIC insurance. But this insurance scheme is not working out. Please see my comment below in response to comment by “ComparedToWhat”.

  10. Keating Willcox

    I like the idea of safety deposit boxes loaded with
    cash, and I like the idea of banks offering some
    accounts that had no, or extremely low risk.

    I thought that was what FDIC insurance was all about.

    This derivative mess scares the pants off me. If it
    goes south, we are all in a mess. Thee will be folks
    owed literally billions of dollars and nothing to
    show for it. What can be done to insulate from
    these quadrillion dollars time bombs?

  11. Keating Willcox

    I like the idea of safety deposit boxes loaded with
    cash, and I like the idea of banks offering some
    accounts that had no, or extremely low risk.

    I thought that was what FDIC insurance was all about.

    This derivative mess scares the pants off me. If it
    goes south, we are all in a mess. There will be folks
    owed literally billions of dollars and nothing to
    show for it. What can be done to insulate from
    these quadrillion dollar time bombs?

    1. mansoor h khan

      @Keating Willcox

      Yes. The idea of FDIC insurance is to remove risk. But because of moral hazard reasons and cost of premiums FDIC insurance is not working out. Just a failure of one single bank like Citibank would wipe out the FDIC insurance fund by 10 times. Citibank was backstopped by government guarantees. The “cost” of these guarantees were not “charged” to the FDIC fund. Also, there are limits on FDIC insurance.

  12. ComparedToWhat?

    @MHK, your first comment above is a good argument for making an “Islamic banking” option available to all. I hope someone from NC will ask you to polish it up a bit and make it a full post on the site. I’m all for distinguishing “utility banking” from “hedge-fund banking”. Thanks for contributing!

    @GW, while I’m sympathetic to the drift of your argument I believe we must consider our neighbor to the north. My understanding is that Canada has a small number of large banks that are in pretty good shape, especially considering how closely Canada’s economy is tied to the US.

    1. mansoor h khan

      Yves Smith of Naked Capitalism has pointed out that Irwing Fisher had proposed something similar in his book, 100% Money (Published in 1935).

      Here is how my proposal is different:

      Irving Fisher in his book 100% Money (1935) proposed that all banks be required to hold 100% reserves for money deposits payable on demand. In other words the government should outlaw fractional reserve banking. Fisher believed that booms and busts are a result of credit created by fractional reserve banking.

      I propose that the government require commercial banks to provide 100% reserve account as one of the options. I do NOT propose that the government should outlaw fractional reserve banking.


      a) The 100% reserve accounts would just be another option that a public would have. I am in no way saying that banks should be forced to offer 100% reserve deposit accounts only just that they must provide it as one of the choices.

      b) I also propose that many institutions absolutely necessary to maintain law and order must not take any credit risk with their liquid capital (utility companies, municipalities, states, hospitals, etc). The idea here is that civil law and order should not be disrupted even if several very large financial institutions fail at the same time.

      c) I would also remove the protection of FDIC insurance for moral hazard reasons. But I would still have an FDIC like institution to facilitate a quick and smooth transfer of 100% reserve accounts to another bank from the failing bank. The idea here is to keep the payment system running smoothly so day-to-day commerce can continue to function even if a very large deposit taking institution fails.

      d) The main objective is to preserve Adam Smith’s invisible hand in disciplining and destroying poorly managed very large financial institutions. I am not proposing that we write a more stringent Glass-Steagall Act or keep anyone from creating complex financials products (securitization, derivatives, etc.) or keep any bank from investing non-100% reserve bank deposits in risky and/or complex financial products. In fact, I would want most banking regulations repealed, as they are unable to protect us from systemic meltdown. Doing this will greatly lower regulatory compliance costs for banks.

      e) I strongly believe that if we don’t let very large financial institutions die then they will eventually economically destroy us by mis-allocating huge amounts of capital. There should be no such bank that is too big to fail. But we also don’t want to descend into total chaos after a meltdown and not be able to maintain a basic payment system to conduct day-to-day commerce.

      f) In short, our basic electronic ledger based payment system should function even if several very large deposit taking financial institutions fail at the same time without resorting to physical paper cash to conduct day-to-day transactions. Deposits in 100% reserve accounts will provide a basis to build new viable financial institutions if a meltdown occurs.

      g) My proposal is a variation on what is sometimes called “Free Banking” with the 100% reserve deposit account as a required option for the public.


    Purification of the Species
    By Dwight Baker
    September 26, 2009

    Those in the G 20 meeting have an agenda not far removed from that of Adolph Hitler.

    Obama is black but he has blood on his hands from killing the innocent in Afghanistan — so he is just one more of the puppets for the Predator Beast. Obama was hand picked after graduating from Harvard by Henry Kissinger so he went on the Payroll of the Biggest Beast right then —- Older than hell itself David Rockefeller. So in the G 20 he plays like he does not have black genes. So when his own suffers he could give a hoot in hell.

    He has learned the lesson well from the Predator Beast you get yours and the hell with the REST.

    In fact all of the earths Bankers see it that way too. They hold the key to the biggest commodity in the world MONEY.

    Oh yes they shuck and jive and smile a bit sometimes but beneath that facade rages a killing machine. They have been schooled by family friends and kin how to go after the riches in the earth and to hell with the GOD peoples.

    What makes matters worse they know what they want but few have enough sense to go get it?

    Yep we can take back control right away from these Beast or they will end up screwing UP real bad and blow up the entire earth.

    They are not to be revered or looked upon as any thing other than hyper greedy banksters and crookmasters in every area of their lives.

    And beware to any that might think or perceive that any in that group has the light and lamp of our God in them for they have NOT. What they do is try their best to trick and deceive for that is the vile and evil essence of the Predator Beast a human being gone wrong as old as time. Some call them Lucifer.

    Take heed
    Beware of all who prove they have the
    Need for Greed
    Do not be a fool
    Judge each man woman boy or girl by
    Their words and each deed done?

    Birds Eye View brought to you by We the People Advocates

  14. Hugh

    I’m with Siggy. We need to bring back Glass-Steagall or something even stronger, like adding in Volcker’s suggestion that investment banks can not trade on their own account. These things are of course not all that needs to be done but they are a good start. I agree too that debt repudiation is a major pre-condition to any sustainable recovery.

    I view this TBTF argument within the context of the need to dismantle the paper economy. It contains huge amounts of money and risk just sort of floating out there or chasing itself but capable of massively distorting and wreaking enormous havoc on the real world economy. TBTF is a manifestation of it.

  15. Rdan

    How do WTO rules contradict and override attempts at regulating the big banks? Eventhough the Doha rounds stalled on certain issues, de-regulating international and national accounting rules is proceeding full speed ahead spurred from the last decade. Any thoughts?

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