Opinion: Making Banks Too Small to Succeed?
…His plan would limit both the size of banks and the kinds of assets they are allowed to invest in. In other words, the government would take one the most regulated industries in the country – and regulate it more.
Unfortunately, this plan, if implemented, would go against much of what economists know about the value of size. Moreover, it would do nothing to address the real problem: “moral hazard.”
As Columbia University financial economist Charles Calomiris pointed out last fall, when it comes to banks, size has its advantages. A bank that wants to deal in a large international market is better off if it’s big. Those who deal with it are also better off because, to the extent that there are economies of scale, some of the cost savings make their way to customers. Also, all other things equal, the larger the bank, the more diversified it is. The more diversified it is, the less likely it is to fail….
Because banks during the Great Depression were so small, they were undiversified. So when the agriculture sector went under, in part because of the Smoot-Hawley Act that attacked free trade, many rural banks failed. Call it “too small, so we failed.”….
Had they been allowed to be big, many fewer would have failed. It’s worth noting that in Canada, which also had a downturn in its farm sector, the banks were larger and not one failed during the Great Depression….
We can. And the best way to do that is to give those closest to banks a strong incentive to make sure the banks aren’t taking undue risks.
One way to do that would be to get rid of deposit insurance….
A bunch of things:
1) SAndrew, one of the better finance bloggers/tumblr-ers who needs to be writing more, said in comments that he didn’t believe that someone could blame FDIC for the current financial problems. There you go.
Stockholders, CEOs, board members, regulators, ratings agencies and sophisticated financial players assessing counterparty risk couldn’t make heads-or-tails of what was going on in the financial markets – looks like it’s up to you and your $12,000 savings account to discipline the financial markets grandma!
I’ll come back to this line of argument later because it is becoming more popular, but a Rothbardian friend of mine (everyone should have one) told me a while ago, which discussing the idea of a CFPA, “Mike, the best form of consumer financial protection is a good old-fashioned bank run.” wtf? It was like the exact opposite of any argument I’ve normally consider.
2) “Too small, so we failed”, ha! What idiots back then. Could you imagine a financial sector so dangerous that a single agriculture sector failure caused it to fail? It’s ridiculous – like imagining a financial sector that collapsed because 20% of the mortgage “crop” planted between 2004-2006 failed, crops used as collateral to leverage into the repo markets. Oh wait….
3) James took apart that paper that Calomiris quoted for an example of returns to scale and found it lacking. You can read his critique there.
4) I rarely see studies that propose a return to scale past the 25 billion dollar mark. See this survey of the literature. That’s way less than anyone is proposing as a size limit. Nobody would argue that a bank should be less than $100 million in assets; there’s clear evidence that there is scaling effects up to that point. Recent studies dig pretty deep into the statistical toolbox to pull up returns to scale past $100 billion, but those usually end at 2006, at the peak of a credit cycle.
5) The argument for scale usually involves saying that only with huge scale can a firm credibly “warehouse” huge portfolios of derivatives, thus making market-making more efficient since a firm can internally hedge, etc. I talked about that argument here.
6) I created this chart here, using data from the “Stress Test” results that were issued by the Federal Reserve. This is the Fed asking the 20 largest bank-like companies to estimate their losses over the next year. So this is the bank’s word, not mine. I graph the expected percent of losses against size:
I would love to see more sophisticated research done, but looking at that is there any reason to believe the optimal size of a bank is past the $1trillion dollar mark? Is this the magic “diversification” everyone is talking about? There is well-documented regression to the mean for skill in finance in terms of size (see all the mutual fund literature, for one), and the only way to keep returns higher than normal past a certain size is to take on more leverage, and that’s exactly what has gotten us in the current situation.
Also note when those four largest banks fail, what the hell do we do? The next guy down who could credible take it over is going to be 1/4th the size of that institution or much, much less. We can force it into one of the other largest firms, punting on the issue….