I’ve been thinking a lot about what kinds of benefits we enjoy from having large banks. Economics of Contempt has a post arguing that the benefit comes from big banks being able to keep big books, and thus increase liquidity:
You need a very large and diverse balance sheet to be a market-maker in fixed-income products—government securities, investment grade corporate bonds, high-yield bonds, mortgage-backed securities, bank and secured loans, consumer ABS, distressed debt, emerging market bonds, etc. Dealers hold inventories of all these securities because they need to remain “ready and willing” to sell, and because when they buy a security from a client, they need to hold it in inventory until a buyer for the security appears. Dealers are exposed to price movements for the period they hold the security in inventory, and because inventories can grow large in a short amount of time, sharp price movements can result in substantial losses for dealers.
So dealers hedge. Constantly. The cheapest way for dealers to hedge is internally
A few points:
1. This is exactly the argument you would make defending Fannie Mae and the rest of the GSEs during the early and mid parts of the 2000s. I’m trying to find a good statement of this; here is Fannie critic Peter Wallison talking about arguments the GSE have made:
What, then, are the arguments advanced by the GSEs? Freddie Mac has been circulating on Capitol Hill a lobbying document that one should assume contains the best case the GSEs can make for retaining large portfolios of mortgages and MBS….1. The accumulation of large portfolios adds liquidity and stability to the secondary mortgage market.
2. As far as I understand it, and if I’m wrong I’ll take back the point, but the largest banks don’t provide much liquidity in terms of NASDAQ stocks. There’s not much profit in it, and the market does a great jobs of handling those liquidity needs itself.
One reason is that it’s a market with easy access, allowing those with market power to be dwindled away by market competition. Electronic access has helped, but so has applied finance research (that Christie/Schultz is one of my top 5 desert island empirical finance papers, fyi) and arguments arguing where market power exists, and pressures that immediately followed in making those markets more competitive.
3. What kind of market making structure should we have? Market making by its very nature should be a transitory business. As a product’s liquidity improves, the need to a third party to act as an intermediary should diminish. Natural buyers will interact with natural sellers and the market maker role is obviated. And in transparent markets with unrestricted access, you see the profitability of market making vanish. The NASDAQ market mentioned above is one case; listed options is another.
To use an analogy that EoC uses as well, these banks were supposed to be in the moving business but they ended up in the storage business. The only reason Goldman came out relatively unscathed is because they identified the crisis earlier than the others and hedged their “storage” book. This is well played on their part, but it is something that by definition not everyone can do. Every one of the biggest banks with large storage books can’t all hedge, it goes against the very idea of liquidity. There’s only so many chairs in this game of musical chairs.
4. How deep is the liquidity actually provided by big banks? I’m under the impression, through friends and friends-of-friends, that only time banks take down trades that have negative expectancy is when they know with a high degree of certainty that they are going to get paid back soon by the same client. They look at this is an “expense” to be recouped. A trading desk’s will have a “customer facilitation” book where these negatively expectancy trades get dumped, but it is segregated and rigorously monitored. When a particular firm ends up on the winning side of too many trades in this book, the bank stops trading with that client, end of story. Maybe that’s just talk, but it seems reasonable to me given what I know of the specific area.
5. So where does the big banks make their profit and provide liquidity no one else can? In the OTC market. The TBTF banks don’t want (and given the times we live in, I might even say “allow”) these products to trade openly because they make excess rents by keeping the market opaque for competitors. I would love to see a study about transaction costs of trading a US convertible issue – you can’t get a bid and offer without calling a dealer, and even these prices are not even firm, you can try to lift or hit but the dealer can fade – versus a comparable European warrant issue that is listed on an exchange (as many warrants are in Europe). Are there any?
I think all this talk about improved and graduated capital ratios is going to be nonsense when it comes to shrinking the largest banks. I don’t expect a ‘living will’ to be credible, even in the good times. The latest fad that is sweeping risk management circles is talk about Basel having risk quants “leaning against the risk curve” during cycles, being harder in good times and easier in bad times to try and counteract the dynamics described so perfectly in the first two large paragraphs by this excellent interfludity post. Good luck.
Here is probably where EoC and I are going to disagree. I think one concrete thing to do to take care of this problem is to push for the OTC market to be brought onto exchanges. This is a big source of profits for big banks, hedging and providing liquidity for this market. EoC might think it’s largely driven by returns to scale; I think it’s largely driven by market power and the drive to keep the market opaque. Let’s see if the small players can actually provide this liquidity for the market.
Here’s a recent email from a friend at a small trading firm:
About a year ago, several of my ex-[trading firm] colleagues and I had a conference call to discuss the likely future market structure when all the dust settled. We were all a bit excited because we assumed (spectacularly incorrectly as it turned out) that one of the earliest reforms would be to put many of these OTC products on an exchange, and then firms like [trading firm]–or in our case, a group of [trading firm] refugees–would be able to compete on an equal trading field. We know that the banks make huge spreads in trading OTC products and we were looking forward to performing our patriotic duty of competing these spreads away. It looks like it will never be. These products are intentionally structured to keep them off exchanges, and the TBTF firms lobby continuously to limit competition in what is a very profitably arena.
This blog is probably read as anti-finance too often, but I seriously love the field and the work that is done. And you might read the line “performing our patriotic duty of competing these spreads away” as a bit of an ironic wink, but I take it seriously. It’s a really great thing to do, and it should be very well compensated to those who can do it. But the way to do it best is to level the playing field; standardize the OTC already, and all liquidity to come from diverse corners of the world, small firms, and those that want to keep them in check, as opposed to a super-secret list of the largest few banks. Allow the small firms of finance to actually be competitive in a real manner with the largest firms, who, as basic Ronald Coase would tell us, have a lot of internal noise and transaction costs to deal with; this is how markets are supposed to work, and this is the way competition leads us to a better place by solving problems regulators can’t.