Do We Need Big Banks?

Yves here. I normally let VoxEU articles stand on their own, but this topic, of whether the bank PR that bigger banks are essential stands up to scrutiny, is near and dear to my heart.

Note that the authors point to a 1990s study that finds that a $25 billion in assets bank was the optimal size. There were a fair number of studies done then of bank size versus efficiency. I’m a bit surprised that this is the one that is most often cited, since it also came up with the biggest size threshold at which a negative cost curve kicked in (meaning the bank became more costly to run). One study found that the slightly negative cost curve started at $100 million in assets (!); more typical was somewhere between $1 and $5 billion. And remember, these studies were done in the days when banks returned checks, and check processing was believed to have strong scale economies (ie, if check processing was a bigger proportion of total costs then than now, it could arguably have increased scale economies).

Some academics were frustrated with these results. I recall reading a paper where the author argued that there were theoretical cost savings to being bigger (duh) and basically contended that the empirical data had to be wrong.

This article does make an important contribution in parsing out the impact of absolute versus relative size. And it mentions that bank executives have incentives to make banks bigger (an issue we have discussed) as opposed to safer.

However, a big frustration is that this piece treats all large banks as being of a muchness. There is a considerable difference between being a large and largely traditional bank, versus being one with large capital market operations (like Citibank, Goldman, Deutsche, SocGen, UBS, Barclays). The dealer banks are systemically risk due to the counterparty exposures and opaqueness (as in when one gets in trouble, others with a similar profile are assumed to be on the ropes too). For instance, Lehman, Goldman, and Morgan Stanley are not considered to be of “systemic size” in this study’s parameters.

Another methodological problem in looking at big bank efficiency is that a lot of supposedly off balance sheet exposures of large banks really aren’t. Examples include credit card securitizations (banks have stepped in repeatedly to shore up credit card deals gone sour), the famed structured investment vehicles, and to a degree, mortgage securitizations via putback liability. That means the asset of banks particularly active in these businesses, which of course are the biggest banks, are understated. Grossing them up would be precisely wrong but approximately more correct, and would also lower the size advantage of large banks.

By Asli Demirgüç-Kunt and Harry Huizinga. Cross posted from VoxEU

Today’s big banks are enormous. By 2008, 12 banks worldwide had liabilities exceeding $1 trillion. This column, using data on banks from 80 countries over the years 1991-2009, provides new evidence on how large banks differ in terms of their risk and return outcomes and investigates how market perceptions of bank risk are affected by bank size. It concludes that policies should reward bank managers for keeping their banks safe rather than for making them big.

In recent years, many banks have reached enormous size both in absolute terms and relative to their national economies. By 2008:

12 banks worldwide had liabilities exceeding $1 trillion, and
30 banks had a ratio of liabilities to national GDP higher than 0.5.

Large banks tend to be too big to fail, as their failure would have hugely negative repercussions for the overall economy.

Saving oversized banks, however, may ruin a country’s public finances (Gros and Micossi 2008).

Take the example of Ireland; this country provided extensive financial support to its large banks and subsequently had to seek financial assistance from the EU and the IMF in 2010. The public finance risks posed by systemically large banks suggest that such banks should be reduced in size.
Further evidence against big banks can be found from studies on banking technologies. Berger and Mester (1997) estimate the returns to scale in US banking using data from the 1990s, to find that a bank’s optimal size, consistent with lowest average costs, would be for a bank with around $25 billion in assets. Amel et al. (2004) similarly report that commercial banks in North America with assets in excess of $50 billion have higher operating costs than smaller banks. These findings together suggest that today’s large banks, with assets in some instances exceeding $ 1 trillion, are well beyond the technologically optimal scale.

The public finance risks of large banks and findings on banking cost structures together present a strong case against large banks. All the same, further evidence on how large banks perform relative to small banks is warranted to inform the debate on bank size. Additional insight is useful before one passes judgment on whether systemically large banks should be regulated or taxed out of existence.

Big banks vs. small banks: New evidence

In recent research (Demirgüç-Kunt and Huizinga 2011), we provide empirical evidence on two additional aspects of the debate on big banks vs. small banks.

First, we examine how large banks perform differently in terms of their risk and return outcomes.

For this, indices of bank risk and return based on accounting data are used.

Second, we investigate how market perceptions of bank risk, as reflected in a bank’s interest expenses, are affected by bank size.

Large banks may be perceived to be less risky on account of too-big-to-fail benefits, yielding lower funding costs for sizeable banks (see Carbó-Valverde et al. 2011 for example estimates). Alternatively, large banks are seen as more risky if they are too big to save, giving rise to higher interest rates.

These aspects of bank size are investigated for an international sample of banks from 80 countries over the years 1991-2009. These international data allow us to distinguish between a bank’s absolute size (as measured by the logarithm of its total assets) and its “systemic” size (i.e. how risky a bank is as measured by the ratio of bank liabilities to national GDP). The correlation between these proxies for a bank’s absolute and its systemic size is positive, but low at 0.1. Thus, it is meaningful to separately consider bank absolute size and systemic size.

Size matters, but is it absolute or systemic size?

The distinction between bank absolute and systemic size turns out to be important for explaining bank performance regarding bank risk and return. A bank with larger absolute size on average realizes a higher return on assets. This higher return, however, comes at a cost of higher bank riskiness. A bank’s absolute size thus implies a trade-off between bank risk and return.

The impact of systemic bank size on risk and return is very different. Systemically larger banks on average have lower returns on assets, but there is no discernible impact on bank riskiness.

Systemic size is thus a liability, as it lowers return without an offsetting reduction in risk.

In practice, expanding banks see their absolute and systemic size increase simultaneously. Banks located in smaller countries, however, see their systemic size increase relatively more, with negative implications for risk and return outcomes.

Next, we investigate how a bank’s interest expenses are affected by bank systemic size. Systemically large banks, defined as banks with a ratio of liabilities to GDP exceeding 0.1, on average are found to pay interest rates that are 40 basis points higher, suggesting a “too-big-to-save” effect. Furthermore, the interest expenses of systemically important banks are more sensitive to the bank capitalisation ratio as a proxy for bank risk. This also suggests that systemically important banks are too big to save, and that they are subject to market discipline by bank liability holders.

This new evidence of market discipline of systemically large banks contrasts with earlier evidence, mostly for the US, that absolute bank size pays off. In particular, Kane (2002) and Penas and Unal (2004) report that large bank mergers create value for bank shareholders and bond holders, respectively, as larger bank size increases too-big-to-fail subsidies. In our broader international sample, we do not find any impact of a bank’s absolute size on its interest costs, but we confirm earlier evidence that absolute size reduces market discipline by a bank’s debt holders for a sample of just US banks.

Market discipline of systemically important banks, while it exists, has been ineffective in preventing the emergence of systemically huge banks worldwide. A main reason for this may be that bank managers, rather than bank shareholders, in practice devise and implement bank growth strategies. Bank managers may well benefit from bank asset growth through higher pay and stature, even when continued bank growth is not in the interest of bank shareholders. The phenomenal growth at individual banks that we have witnessed over the last several decades may thus be a reflection of inadequate corporate governance at banks failing to align the interests of bank managers and bank shareholders.

Policy implications

In the absence of effective market discipline on bank systemic size, public policy in the form of regulation or taxation is required to bring down bank systemic size (see Goldstein and Véron 2011 for a discussion).

Regulation can take the form of quantitative limits on bank size, or of other regulations such as capital adequacy and liquidity requirements that are biased against systemically large banks.

Taxation can similarly take the form of, say, levies on bank liabilities that are especially geared towards systemically large banks.

In the US, the Wall Street Reform and Consumer Protection Act (or Dodd-Frank Act) passed in July 2010 prohibits bank mergers that result in a bank with total liabilities exceeding 10% of the aggregate consolidated liabilities of all financial companies, but an earlier proposal by the Obama administration to institute a levy on the liabilities of large bank failed to be enacted. In Europe, the European Commission (2010) is proposing bank levies to finance national bank resolution funds. Such levies could easily be slanted towards large banks, at the national or EU level.

Evidence that market discipline on bank systemic size is ineffective suggests that bank levies on oversised banks by themselves are not enough to reduce bank size.

Corporate governance reform in the banking sector is also needed to ensure that market discipline and taxation can be effective.

In particular, bank managers should be rewarded for keeping their banks safe rather than for making them systemically large.

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  1. KnotRP

    Size is a red herring.

    Any size bank is worthless if it’s giving OPM to
    those who cannot repay, after skimming off
    fees from the lender and the borrower.

    They serve no economic purpose, so they
    should be shuttered. Yesterday, already.
    Time is running out to repair this country.

    1. flatTax Cut

      Yesterday, already.
      Time is running out


      Don’t get mad, Steven. Get Even!

      Put savings into bank then siphon-off most of savings from bank account but into USA-t-bonds commission-free at http://WWW.TREASURYDIRECT.GOV. Sell t-bonds for tiny commission and fat capital gain when you need cash. At time of sell, proceeds siphon straight back into same bank account. Less of your money languishing in bank-account less the cock-roaches have to chew on. But keep money out of flaky stock market. When you see a contract on derivative or a derivative on a contract, do a quick about-face then run like hell. Stay away from purchase of improved-real-estate, but buy only vacant land. Sell all improved real-estate. Use small community bank for deposit-account that is connected to your treasury-buy-direct-account. I would like to recommend to you Bob’s Bank located at the corner of the only two streets in my small city. You can’t miss it. If BB, Bob’s BAnk is victim of hostile corporate raid and take over by a joint venture of 13 too fat to fail and too swell to jail bank holding companies, I’ll let you know in time to close out account. You can now lean back, relax, and

      Rest in Peace

  2. mp

    I recall seeing a letter, dated sometime in the late ’80s (yes, late ’80s), from the president of the Richmond Fed to Greenspan concerning the move towards national banking.

    It was clear from the letter that they wanted to end up with four or five banks that would control 90% of the retail business.

    It looks like that’s how it’s going to end up.

    I’ve mentioned that letter here before, but I guess it’s old news.

      1. Tim

        Canadians are in many ways the children of Alexander Hamilton whereas Americans are the children of Andrew Jackson.

        I do I think the like of Yves and Simon Johnson are going to have to make a more direct attack on the Canadian and Australian banking systems if they want to win this battle. Having said that for a non Canadian or Australian respectively to start crictizing those banking systems very vocally is not the easiest things to do(I can imagine though Stephen Harper would love nothing better than to drape the Canadian flag over his shoulders and go into battle with what he would describe as some foreign pointy headed intellectual like Simon Johnson. Even better if Michael Ignatieff could be tied into the whole thing).

        Now to be fair while the likes of RBC, TD, NAB, and Westpac are huge in the context of their home countries from a global level I don’t think anyone in the industry considers them at all in the same tier of a JP or Goldman or even Barclays.

  3. Paul Repstock

    It seems too stupid for words to defend economies of scale in terms of systemic blackmail.

    In general, I think economies of scale are far over rated, and that they quickly reach a ceiling where the only benifit stems from regulatory manipulation.

  4. BrianSJ

    The extract doesn’t mention where these economies of scale might occur. You mentioned cheque clearing. I would have thought that if these economies ever existed, the internet has probably removed them. The ability to make informed risk assessments based on local knowledge has been largely discarded in favour of inappropriate automation, to wit:
    “With these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers. The widespread adoption of these models has reduced the costs of evaluating the creditworthiness of borrowers, and in competitive markets, cost reductions tend to be passed through to borrowers. Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending; indeed, today subprime mortgages account for roughly 10 percent of the number of all mortgages outstanding, up from just 1 or 2 percent in the early 1990s.”
    Chairman Greenspan Federal Reserve System’s Fourth Annual Community Affairs Research Conference, Washington, D.C. April 8, 2005

    1. Tom Crowl

      Thanks for this great Greenspan quote!

      (By great I mean a perfect illustration of the triumph of what I’d call idiot expertise where it serves powerful interests rather than common sense)

      I’m a great fan of automation… but the fantasy of these elitist whizbangs that they could completely automate judgment… (though expecting very personal attention themselves when their own house of cards fell) should serve to shock us all…

      Yet we keep seeing the same faces of these same experts year after year, bubble after bubble while the ranks of the poor swell and the middle-class dies.

      Hey, citizens… when you gonna realize you’ve been played for suckers by the elites of both clown shows we call political parties?

  5. Toby

    A better question is, “Do we need banks?” The answer is, “No.”

    A truly democratic money, as proposed by Austrian Professor of economics Franz Hoermann, and as currently being deployed in the so-called developing world via internet and mobile phone technology, would render the need for banks redundant. What we need is a money system which does not depend on perpetual growth for its very survival.

    Money-profits from debt-money creation is an anachronism we must transcend, if we want to experience democracy, embrace sustainability, and leave behind decadence, corruption, war and the terror(ism) of poverty.

    1. F. Beard

      What we need is a money system which does not depend on perpetual growth for its very survival.

      Money-profits from debt-money creation is an anachronism we must transcend, if we want to experience democracy, embrace sustainability, and leave behind decadence, corruption, war and the terror(ism) of poverty. Toby

      Basically we need a debt-free government money that is ONLY legal tender (in fact as well as in law) for government debt (taxes and fees) and debt-free private monies.

      Debt-free government money is easy; just let the US Treasury spend it into circulation and tax it out of circulation and NOTHING ELSE (no borrowing, lending, buying other money or buying PMs to back it with).

      For debt-free private monies, common stock is ideal for many reasons (just ask me!).

      Bye, bye usury class!! Your days are over.

      1. F. Beard

        And lest I seem arrogant, that solution comes from Matthew 22:16-22, it’s not my idea.

      2. fajensen

        But, But, But … then taxes would have to be raised every time we go to war for oil. That would be insustainable ;-)

  6. jake chase

    Economics, shmekonomics. Can we afford the political consequences of big banks? Obviously not. Our country is now run by mendacious idiots running around with their hands out. Yesterday, Phil Gramm, Bob Rubin. These days I don’t even track the names. One would think that the insolvency of 90+% of the population would have some impact in discussions of “efficiency”, but apparently toadyism continues to pay. Why is anyone bothering to read this ridiculous nonsense?

  7. Phil Koop

    It is not necessary for banks to be large in order to achieve economies of scale in check processing. Canadian banks are not allowed to merge, but they are allowed to share service providers. Consequently, they amicably share several back-office functions, check processing (or rather, cheque-processing) among them.

    1. Tim

      In the US context the operations that Canadian banks share through the Canadian Payments Association such as check clearing are things that would typically be handled by the US regional Fed banks. In many ways the Bank of Canada is a much weaker central bank than the Fed it doesn’t have any regulatory oversight, it doesn’t run the payments system, and it doesn’t impose required reserves. In theory it is the federal governments fiscal agent but even in that role the Recevier General, Treasury Board, and Finance Canada deal with commercial banks directly for many of GOC operations.

      One note I’ll will make is that unlike in the US it is longstanding practice for the Bank of Canada to engage in Repo/PRA transactions with investment banks/securities dealers who are not part of the Canadian Payments Association.

  8. readerOfTeaLeaves

    However, a big frustration is that this piece treats all large banks as being of a muchness. There is a considerable difference between being a large and largely traditional bank, versus being one with large capital market operations (like Citibank, Goldman, Deutsche, SocGen, UBS, Barclays). The dealer banks are systemically risk due to the counterparty exposures and opaqueness (as in when one gets in trouble, others with a similar profile are assumed to be on the ropes too). For instance, Lehman, Goldman, and Morgan Stanley are not considered to be of “systemic size” in this study’s parameters.

    And the confusion about what a ‘bank’ is plays right into the hands of the PR interests of Goldman, et al. It allows the wolf to pass itself off as Little Red Riding Hood, which causes no end of confusion and makes it impossible to expose these fraudsters.

    We need more precise terms for ‘banks’; mistaking dealer banks for
    traditional banks complicates and confounds sane and meaningful public discussion of the problems.

    This is a real problem contributing to muddled policy and public conversations, IMVHO.

  9. monday1929

    If large banks were vastly more “efficient”, it would still be irrelevant to the question at hand. Assuming anyone wanted to reign in bank criminality, (or reduce systemic risk), a smaller criminal organization is always preferable to a larger criminal organization.
    And as Toby says, the real question is- Do we need banks at all?

    1. F. Beard

      And as Toby says, the real question is- Do we need banks at all? monday1929

      The short answer is no. Conventional money is an unnecessary intermediary between real capital. Common stock can serve as a store of value and medium of exchange. It requires no borrowing or lending much less fractional reserves or usury. It requires no PMs but could easily accommodate them. It shares wealth at the same time it consolidates for economies of scale. It is democratic. It is decentralized. It cheats no one via inflation.

  10. Main Street Muse

    For me, the question is less about whether we need big banks, but whether we can afford to bail them out again. And that answer is a big NO.

    We have a dangerously interconnected banking system that failed dramatically in 2008. I don’t see how it can be characterized any differently, given that our entire financial system exists today thank to a massive federal rescue.

    The big question for me – are we doing enough to protect our country from additional failures from our financial sector? Doesn’t really seem like it….

    1. jeff in indy

      having just spent 18 years in mortgage banking, i’m fairly confident that there is neither a ‘left’ or ‘right’ in banking/finance. it’s all about the benjamins. by the way, was ben a lefty or a righty?

    2. zadoofkaflorida

      To answer your big question: Our financial system is a house of cards……….just in case you weren’t looking.

  11. steelhead23

    Is it that the banks were too large, or is it that the profit motive in banking does not provide public benefit? The job of CEOs is to maximize profits. As the higher the risks, the higher the potential profits – and salaries – risk management at the largest banks has taken a back seat. If you want to shrink the big banks (and there’s every reason to do so), here is a simple solution. Offer FDIC depositor insurance only to deposits held in not-for-profit institutions (ala credit unions). The behemoths would shrink like a raisin in the sun as they became investment banks. Oh, and because much of their backstop would be gone, risk management would instantly become more important.

    I am deeply disappointed that there is virtually no “left” voice in finance and that the popular perception of leftist finance is support for deficit spending, welfare and the like. Indeed, the left has even been associated with welfare for the elite in the form of the bank bailouts. Ridiculous. Commercial banking is a utility function in the economy. As such, serving the public interest must exceed profit maximization as a goal. Hello? Are there any leftist out there?

    1. Steve

      I’m no leftist, but I agree with you, as do most Libertarians.

      FDIC insurance is a massive subsidy; ending it will shrink these behemoths quickly.

      Also, bringing back Glass-Steagal and/or enforcing the Volcker Rule would properly separate high-risk activities from basic banking.

      We nedd only look at Ireland to see our fate: if one of these behemoths goes bust, the Government will guarantee its debts. This implicit subsidy is used against us; the banks buy more political power, raise fees, increase profits and starve the economy of capital that could be used more productively.

      Wash. Rinse. Repeat.

    2. monday1929

      How about a bumper sticker:


      Good for Large SUV’s and Priuses.

      1. Toby

        I want that bumper sticker. Heck, it might make a cool tattoo, done tastefully of course. Only, on which body part? Hmmm…

  12. MyLessThanPrimeBeef

    Do we need banks?

    Not big banks. Just banks.

    Why open an account @ 0.3%? Everyday, I am tempted to speculate in the markets.

  13. Hu Flung Pu

    I’ve worked with small banks for 15 years so I’ll weigh in here. (I’m going to leave the politics of banking, the Federal Reserve, etc. out of this and focus purely operating issues.)

    Prior to recent years, in which regulation has increased dramatically (not saying this is bad, just pointing it out as a fact), a bank of $250 million could make a pretty good profit. Today, because of increased regulation and the need to spread the related costs out over a larger revenue base, that number has probably increased to about $400 million. (Importantly, probably two-thirds of the banks in the US are under $400 million in size. Ours is a very highly fragmented industry.)

    So, the typical bank probably needs to get to about $400 million these days to get to a reasonable level of efficiency. I’d say that efficiencies really accelerate around $1 billion and top out around $2 billion in assets. Some argue that number is $5 billion, and I can live with that. But, the point is, it isn’t $100 billion or $20 billion or whathaveyou. The problem is that as a bank reaches a certain point, economies of operational scale are offset by dis-economies of bureaucracy.

    The ONE argument for larger banks – and I’m not talking about TBTF banks, but rather some of the regionals (think $10 billion – $30 billion in size) – is that they have regulatory loan limits that allow them to service large customers. If a customer needs a $250 million loan, the bank’s gotta have at LEAST $1 billion in capital (and likely much more than that amount due to internal policies), so you’re looking at a $10 billion+ asset size bank. (And, yes, you can participate the loan out, but participations tend not to perform as well as those kept entirely on the originator’s balance sheet.) So, my point is that there is some justification for “smaller” larger banks… but there is little economic rationale for the TBTF banks.

    I, personally, don’t have a problem with the TBTF banks’ very existence. My problem is with their capital requirements, which seem WAY too low for me. So, rather than split them up (which is an almost impossible political task), my preference would be to strictly enforce the new regulations (incomplete though the are) AND require these banks to carry perhaps double the capital they are currently required to carry. But that’s just me.

    1. Toby

      The answer to the question you moniker implies is this: The Banking System.

      It’s way out of date, a dead man walking, is poisoning everything, and is about to explode. The Pu is about to hit the fan.

      1. Hu Flung Pu

        You’re assuming it’s a question. Perhaps Hu is an irritable gentleman and my moniker is a statement, as in, “They got in an argument and Hu flung Poo [Pu].” Your vantagepoint influences your perception; where you stand depends upon where you sit.

        As always, the variance of possible outcomes is considerable.

        1. Toby

          I can do pedantry too. I assumed nothing, I merely played on a possible implication. The moniker can be interpreted in multiple ways, I merely chose one of them.

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