Debunking the Myth That Bigger Banks are More Efficient and Necessary

A very good op ed by Thomas Hoenig in the New York Times, “Too Big to Succeed” provides a solid recap of why the business of reining in the too big too fail banks is crucial. It isn’t simply that this is yet another version of “Mission Accomplished”; the bailouts actually made industry concentration worse, as Hoenig indicates.

Mike Konczal sheds more light on how the rescues helped the biggest banks at the expense of their smaller bretheren. However, what astonishes me is this drive by ad hominem by Matt Yglesias that Konczal links to in his post.

While Yglesias often has sound observations, I believe in not going beyond the limits of one’s knowledge, and Yglesias is out of his depth here. Yglesias is effectively saying smaller banks are less competitive, which is bunk. Every study ever done of banking efficiency in the US over the last 20 years shows that once a certain size threshold is reached (studies vary in their conclusions due to variations in sample and methodology as to where that is, but $25 billion is) banks show an increasing cost curve, meaning they are less, not more, competitive.

So why has there been consolidation in the banking industry? Why would banks get bigger to become less efficient? Simple. It’s the bad incentives and the usual principal-agent problem. Banks are not run to suit the interests of shareholders but of top management (and in big dealer firms, the various producers, who as we describe in ECONNED, can hold the company leadership hostage).

CEO pay is highly correlated with the asset size of banks. Big banks don’t out-compete smaller banks; they simply buy them up. The acquiring bank managers get a pay increase; the managers of the purchased banks get a windfall, since the deal will trigger payouts under their golden parachutes. It’s a win for everyone except the shareholders of the acquiring bank. Typically, the pitch for these deals is cost savings, which is fallacious. The increasing cost curve suggests at least three factors are at work:

1. Many of the cost savings pushed through in the merger could have been achieved by each organization separately. The merger was an excuse for rather than necessary for cost reduction

2. Planned merger savings may not be achieved. For instance, many banks find they can’t close as many branches as they thought, or if they try, they lose customers.

3. The visible cost reductions (which operate within lines of business) are offset by diseconomies of scope (more management layers, more coordination, and of course, those more costly top executives)

Now there is yet another factor that is often overlooked, that smaller banks can do better on the revenue side. Customers will often accept slightly lower rates on deposits (in the days when deposits actually paid meaningful interest) or pay more in loans to deal with a smaller bank if they perceive they get better service. Smaller banks also have flatter hierarchies, and are thus more able to include local, qualitative information in their lending decisions, which has the potential to lead to better outcomes.

Moreover, banks now enjoy large ongoing subsidies thanks to the TBTF status. As Bank of England officer Andrew Haldane tells us:

Table 2 looks at this average ratings difference for a sample of banks and building societies in the UK, and among a sample of global banks, between 2007 and 2009. Two features are striking. First, standalone ratings are materially below support ratings, by between 1.5 and 4 notches over the sample for UK and global banks. In other words, rating agencies explicitly factor in material government support to banks.

Second, this ratings difference has increased over the sample, averaging over one notch in 2007 but over three notches by 2009. In other words, actions by government during the crisis have increased the value of government support to the banks. This should come as no surprise, given the scale of intervention. Indeed, there is evidence of an up-only escalator of state support to banks dating back over the past century.

Table 3 takes the same data and divides the sample of UK banks and building societies into “large” and “small” institutions. Unsurprisingly, the average rating difference is consistently higher for large than for small banks. The average ratings difference for large banks is up to 5 notches, for small banks up to 3 notches. This is pretty tangible evidence of a second recurring phenomenon in the financial system – the “too big to fail” problem. It is possible to go one step further and translate these average ratings differences into a monetary measure of the implied fiscal subsidy to banks. This is done by mapping from ratings to the yields paid on banks’ bonds;6 and by then scaling the yield difference by the value of each banks’ ratings-sensitive liabilities.7 The resulting money amount is an estimate of the reduction in banks’ funding costs which arises from the perceived government subsidy.

Table 4 shows the estimated value of that subsidy for the same sample of UK and global banks, again between 2007 and 2009. For UK banks, the average annual subsidy for the top five banks over these years was over £50 billion – roughly equal to UK banks’ annual profits prior to the crisis. At the height of the crisis, the subsidy was larger still. For the sample of global banks, the average annual subsidy for the top five banks was just less than $60 billion per year. These are not small sums.

There are other spurious arguments, that we “need” big sprawling international banks. There are some activities that do require international scale, such as payment and cash management platforms for big multinationals, and acting as a dealer in OTC debt markets. But overly large, overly internationalized banks is precisely what gives them leverage over nation-states. We have a very peculiar regulator arrangement in which an international bank is nominally regulated in each of the countries in which it has licensed operations, but the capital actually (in theory) sits in the home country. So if the German regulator of a US bank is unhappy with the books of the German operation, the German sub has to get more capital from the mother ship. This has the effect of making the home country responsible for overseas operations that its regulators do not supervise.

One way to make the TBTF banks somewhat less influential is to put them on an “every tub on its own bottom” footing and require banks in foreign countries to be separately capitalized. That would have the effect of compartmentalizing the operations of each bank further than they are now. That would also mean that a German regulator could shut down the German operations of a US bank and not need much coordination with the US regulators. The resulting greater national compartmentalization would presumably make resolution less difficult (bankruptcies are national; thus forcing international banks to limit all but the most important elements of international integration would be a step forward).

The large banks would of course complain bitterly, since this sort of change, which would have to be implemented over a period of years, would increase their operational costs and require them to hold more equity or shrink their balance sheets (they would presumably not be able to “share” capital as readily across operations). But with a bloated, heavily subsidized, and value destroying financial system, measures to increase safety will inevitably reduce efficiency and shrink the industry. These outcomes would be features, not bugs, and should be celebrated.

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  1. Paul Repstock

    OT; but relevant.
    From the telegraph: QE European

    “Jean-Claude Trichet, the ECB’s president, said emergency lending support for eurozone banks would be extended until at least April next year, citing “acute tensions” in the market. The delay removes the risk that Frankurt might soon pull away the prop holding up the Irish and Greek banking systems, as well as the Spanish cajas – or savings banks – and the sovereign states behind them. Traders say the ECB intervened directly in the weakest bond markets on Thursday to drive down yields and calm nerves. However, Mr Trichet said there had been no decision to step up purchases of peripheral bonds to a whole new level – the so-called “nuclear option”

  2. Toby

    “Below $60,000 a year people are unhappy, and they get progressively unhappier the poorer they get. Above that we get an absolutely flat line, I mean I’ve rarely seen a line so flat.” Daniel Kahneman discussing happiness on

    I strongly suspect the dynamic described in Yves’ piece applies to businesses generally, not just to banks, since it cannot be the case that ever larger means ever better. This logic must likewise apply (roughly) to the economy generally, though for a different complex of reasons. And yet our debt-based system necessitates forced growth on businesses and the economy, come what may.

    GDP growth should not be an economy’s raison d’etre. In my opinion something subtler and harder to win consensus on should take growth’s place; a fluid and unreachable set of goals including literacy, environmental health, human dignity, falling crime rates, and so on.

    This seems a no-brainer to me in terms of common sense and setting wiser priorities, but redirecting something as cumbersome and slippery as an entire culture is inescapably difficult or even impossible. The process is slow, shifting, volatile, intractable, unpredictable, baffling and uncontrollable. And yet we should all apply our best efforts and noblest intentions to this task, because the current paradigm is out of date and causing untold amounts unnecessary suffering and damage.

      1. Skippy

        Ye speak of the Schwarzschild radius…lol…but, the end is inevitable either way, its just a matter of how soon one recognizes it.

        skippy…BTW methinks common stock is the way to go…all other gristle can be chewed until digestion permits.

        1. F. Beard

          BTW methinks common stock is the way to go… skippy

          I’m honored that you agree.

          <i<all other gristle can be chewed until digestion permits.

          Skip, I’m mostly concerned about doing capitalism correctly. Perhaps the rest of my message is indigestible because I don’t serve those other dishes gracefully. At best, I’m the least, I would guess.

          1. Skippy

            Honor…me thinks not, that’s something I work towards, but am not…the final arbitrator of….

            Any who…common stock…too me, represents the sum total of everyone’s toil and as you have portrayed, values could be affixed to individual effort out side the needs of the commons by usage of different modes of exchange.

            Skippy…capitalism is a word…we all as individuals give life too…how is one to have discourse…when our language fails to convey all the possibility’s we could explore, with out running afoul of dogma.

  3. F. Beard

    Nice arguments against bigger is better. However, I did not see the argument that a fractional reserve banking system REQUIRES competition to keep leverage in check. I guess that is a mute point though since the Fed allows unlimited leverage via the discount window, so never mind.

    Yes smaller banks would be much better. What would be best though would be fundamental liberty in private money creation. In that case, we might expect usury to almost disappear since common stock is a superior money form that requires no borrowing or lending.

  4. jake chase

    Yves, you have the wrong idea of efficiency. What matters is the efficiency of systemic manipulation on behalf of those whose welfare matters. Banks must be big enough to rig the game, finance political payoffs, engineer coups, lubricate defense boondoggles, create think tanks and academic synecures, maintain media monopolies, cuddle oceans of speculative money, keep wealth in the hands of those who can be trusted to force the non wealthy to keep humping until the end of time. How exactly would a bunch of tiny weenie banks accomplish all that?

  5. The PolyCapitalist

    It’s important to remember that with all of capitalism’s many shortcomings the marketplace still has the power to achieve what D.C. can’t and Wall Street won’t.

    We can either complain about the lack of political will and leadership, which will probably get us nowhere, or we can each take it upon ourselves to do something small that will drive a stake through the heart of Too Big to Fail.

    I’m doing my part — will you?

    1. ScottS

      Move Your Money Day is coming up! Switch to a community bank or credit union on December 7th.

      I’ve been using a local credit union since high school for savings and checking, but I’ll be canceling my BofA credit card on the 7th to join in the fun. Spread the word!

  6. Steve Layman

    “Big banks don’t out-compete smaller banks; they simply buy them up. The acquiring bank managers get a pay increase; the managers of the purchased banks get a windfall, since the deal will trigger payouts under their golden parachutes. It’s a win for everyone except the shareholders of the acquiring bank.”

    It is also usually a loss for the community that loses the small bank and gains a branch of a TBTF bank. In our town of 45,000 friendly folks, the acquiring TBTF banks have shown about zero interest in lending money locally or in supporting the local community. It hurts.

    Thanks for the post.

  7. Siggy

    Portfolio size is the enemy of performance. The bigger the portfolio, the more difficult it becomes to achieve above average performance.

    We once had forty plus primary dealer banks, we now have fewer than 20. That’s indicative of the concentration of financial power that leads to very bad financial performance. Were it not for accounting tricks and outright misrepresentation, it would become very clear that very large banks do not really achieve outstanding, no less good, performance. In fact one begins to see that individual bank performance is poorer than what an index fund would have delivered.

    When banks seek to become very big, think of the incentive to be a monopoly. It’s a delusion to think that by being very big you can control the market to the extent that you are able to extract outsized returns. You can only do that if you commit substantial fraud. And fraud is very much a component of the current distress.

    This is a time to consider what the outcome would be if we were to fractionate such institutions as Citi and B of A. They are bigger than they need to be and quite probably they exist and operate in the furtherance of the restraint of trade.

    Reinstate mark to market and you’ll see the rationale for initiating a conservatorship and the removal and quite probably the prosecution of current management. This business of QE2 doing something to help a recovery is the biggest lie since Joe Goebbels plied the propaganda trade.

    It is not a myth that bigger banks or more efficient, it’s a damm lie!

  8. monday1929

    Are studies really needed to prove the damage done by large, criminally inclined banks? The fact that there is such a debate leaves one feeling morose- so much for “lessons learned”.
    But, the dumb money on the other side of that debate are willing to give away January 2012 bearish Options in VIX, SKF, SRS. Any profits earned from those, if any, will be used to offer rewards for information leading to the arrest and conviction of criminal financial executives.

  9. jay22

    This post is spot on. Except for the random shot at a Matt Yglesias tweet. The guy doesnt seem to say what you think he says. He’s just reminding us of what the Fed is, not taking a shot at small banks.

  10. Tom Hickey

    The question is not just competitiveness, which boils down to efficiency of scale and which at some point runs up against the law of diminishing returns as the scale becomes increasingly unmanageable.

    The question that people like Hoenig are asking is an engineering question. At what point is it dangerous to reduce redundancy to increase efficiency? It is more efficient to produce cars without emergency brakes, but but it greatly increases the danger hen an emergency arises owing to primary brake failure.

    One solution to systemic risk is increasing redundancy in order to minimize the risk of the system freezing up when a major player gets into trouble. There is also good reasons that there are anti-trust laws. Why are banks exempt from them?

  11. European

    The compartementalizing you describe as one of the solution is actually already happening in Europe as we speak. Working on liquidity and funding from within an international bank with operations in many countries, I see that national regulators are actively seeking to reduce intercountry exposure within international banking groups. Apart from being separately capitalized, banks need to have national liquidity buffers. (The EU may e.g. decide to apply the Basel 3 Liquidity Coverage Ratio on a legal entity level instead of only on group level)

  12. El Snarko

    This is an honest proposal form a true amateur. For about three years I have been thinking that many of the functions of the banks could/should be automated and done by expert systems. There could be world wide and/or national algorithms written for this. It would solve insider trading, executive compensation, potentially cross border capital flows and end tax evasion if the invlved governments we so willing. The remaining ceos would be paid max bonuses of 5 million once in a career, and have three year mandatory turnovers. Instead of flash trading this would be called flash compensation.

  13. b.

    Yglesias is a dishonest tool, drive-by out-of-depth ad hominem sounds like par for the course. He is like a failed version of Klein, who at least made Washed Post almost-tenure.

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