Aargh, can someone please acquaint economists with the economics of banking? Consider the embarrassing premise of a piece by Floyd Norris of the New York Times:
If big banks start failing again, what will replace them?
In the United States and Europe, that is a question with unsatisfactory answers in the aftermath of the financial crisis.
To put it in sports terms, there was nobody on the bench waiting for a chance to become a star. One result is that even after a crisis in which it was every country for itself, banking is becoming more internationalized than ever….
When barriers to interstate banking fell, there were many players able to grow into major institutions…
But there is one lesson that has been overlooked: Just as big league baseball teams need a farm system to provide replacements for players who age or are injured, a banking system needs a second tier of institutions that can step in and become major league banks if necessary.
The message is that big international banks are desirable, and that little banks should properly grow up to be bigger banks.
Big banks are LESS efficient on a cost basis than small banks. Every study of banking ever done in the US has found that once a certain, not all that large size threshold has been achieved, banks exhibit an increasing cost curve, which means they are more expensive to operate per dollar of assets.
So why do banks strive to get bigger? It’s VERY simple. Bank CEO pay is strongly correlated with the size of the bank. So bank leaders find gobbling up other banks to be a very attractive activity. And the selling bank’s cooperation is assured because the sale triggers payouts to the top brass.
But don’t banks get rid of a lot of costs when they buy another bank? Go revisit the increasing cost curve. Any expenses taken out of the combined bank could have been taken out of each bank separately. The merger just provided a convenient excuse for a bit of bloodletting.
But what about funding costs? Surely big banks can borrow on the markets more cheaply that little banks. Yes, but even so, they STILL exhibit an increasing cost curve. Moreover, for the biggest banks, their cheap borrowing costs are not due to the fact that the market thinks really big banks are a swell idea, but because it knows they are government backstopped. Per Andrew Haldane of the Bank of England:
One such measure is provided by the (often implicit) fiscal subsidy provided to banks by the state to safeguard stability. Those implicit subsidies are easier to describe than measure. But one particularly simple proxy is provided by the rating agencies, a number of whom provide both “support” and “standalone” credit ratings for the banks. The difference in these ratings encompasses the agencies’ judgement of the expected government support to banks…
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….
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.
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; and by then scaling the yield difference by the value of each banks’ ratings-sensitive liabilities. 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.
So the cheaper borrowing rates that really big banks enjoy is in part due to the fact that the markets see them, correctly, as having more state support than smaller banks.
But aren’t big banks necessary to serve customers well? Don’t big international companies want really big international banks?
In a word, no. There are some activities that require international reach, such as cash management and payments processing. But big multinational companies in the 1980s, when banks were smaller and even the biggest had a narrower span of activities, were not complaining that they found it onerous to deal with different banks in different countries. Corporate treasures spread out their business among a lot of banks and are very much in the “horses for courses” business.
Unfortunately, a lot of people who ought to know better continue to promote a bloated financial system, both on the individual bank level and in aggregate, as necessary and desirable. I suppose I should not be surprised that the victors are succeeding in rewriting history.