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.
Hogwash.
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.
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To put it into modern era sports terms; a number of athletes felt compelled to become international stars and began taking steroids and other fancy substance “innovations” that turned them into Frankenstein. The Frankensteins thus trashed the competition and began believing so much in their “natural” place at the top that they decided to change the rules of the game to suit their by now extreme and distorted tunnel vision of life, which in turn had been creatad by chemicals and by belonging to a limited sect of wackos.
Etc.
(There was a book that came out some time ago about how large corporations more or less automatically develop into “beings” with the characteristics of psychos).
“If big banks start failing again, what will replace them?”
Oooooo, can we find out? Can we can we can we?
Getting down to business: The increasing cost curve of the big (TBTF?) banks is–or ought to be, I suppose–fascinating. Google time! A search of “banking studies increasing cost curve” (drop the quotation marks, else you’ll get no results) nets us a link within the first 10 results to a 1993 Mid-Atlantic Journal of Business article by a James E. McNulty. The article’s conclusion, in part:
“The results of this paper suggest that very large size may be a disadvantage in the commercial banking industry. The estimate of the optimum sized bank differs from year to year. Nonetheless, diseconomies are clearly evident for banks above $20 billion in assets when the data are pooled and a comprehensive measure of cost is used. The estimated behavior of average costs is consistent with the continued acquisition of small banks by large banks as well as the merger of small bank equals.”
Link: http://www.allbusiness.com/management/capacity-management/386225-1.html
(Warning: This website may do funky things to your browser. It’s not a virus/trojan/worm carrier, but it messed up my Google Chrome’s history something fierce. Surfer beware.)
Full disclosure: I am not James McNulty, and I am not an expert in economics or finance. I don’t “know” if the data showing that TBTF banks have increasing cost curves is “true.” I just found it interesting that it was so easy to find studies on the Intertubes that corroborated the host’s post assertion that banks have increasing cost curve.
As always, I leave this blog better informed than less.
I should never post something at 1:46 am. Second to last sentence should read, “…corroborated the host’s [] assertion that banks have [an] increasing cost curve.”
And the last sentence should probably be rewritten. Should have said, “As always, this blog leaves me better informed than less.”
Mea culpa.
The articles and vid for 2011-2012 — Must read (4 pp.) and must see for anyone who still is clueless:
http://csper.wordpress.com/2010/08/12/monopoly-money-and-the-international-banking-cartel/
http://csper.wordpress.com/2010/08/20/global-empire-and-the-international-banking-cartel-part-2/
http://www.youtube.com/watch?v=3Va7IqJexzY&feature=player_embedded
It’s interesting to see how hard, and how urgently, they are trying to ‘rewrite’ history.
Meanwhile, the stories of fraudclosure leak out, while no perps go to jail and executive pay is a scandal.
So if it makes the bankers feel good to suppose that ‘rewriting’ history can save them, well… shrug… let ’em try. It smacks of desperation.
After all, at least one of those 50 AGs probably has a governor and mayors breathing down their necks to haul in a few perps. With that in mind, I find the bank PR efforts bizarrely entertaining.
It needs to be said that the bigger a bank gets, the better-positioned it is to accumulate patronage, influence legislation, and capture regulation.
Cost curve notwithstanding, there are major competitive advantages, and banks certainly seem to be better off when they are TBTF.
The rest of us, however…
“It needs to be said that the bigger a bank gets, the better-positioned it is to accumulate patronage, influence legislation, and capture regulation.”
Not only that. The whole critique is somewhat incoherent. What naive critics of TBTF banks does not understand is that TBTF status in essence means that they are not only commercial but also political institutions. In some cases it is really unclear when TBTF bank ends and where government starts and vise versa. In any case TBTF banks are insiders and other banks are outsiders of the political process. That has huge implications.
We also need to remember that finance is highly political activity and in many cases foreign activity of TBTF banks is such that they can be viewed as a branch of State Department. If so, naive critics of TBTF banks need honestly discuss the implications of “power sharing” of TBTF banks and government in foreign policy area for domestic TBTF banks activity.
From that point of view the economic efficiency of TBTF banks is of secondary importance. That’s why certain government rents and subsidies that will be given only to TBTF banks and often are constructed by TBTF banks lobby.
All the best for everybody in 2011.
Nothing new in this justification. In the book of Jobe, one of Jobe’s friend states: We are a people, once we die wisdom will die as well. All we have to do is replace people with TBTF banks and wisdom with the economy.
Size is an odd criteria EXCEPT when it comes to fractional reserve lending; then it is important that banks be small and many to increase competition and to make leverage more dangerous.
Still, if we had an honest banking and money system, then size would be irrelevant.
Bigger is not better for the whole economy, it’s only better for the controller of the thing that’s growing bigger. The great reforms of the nineteenth and early twentieth centuries were to ensure that nobody had less than a certain basic share of power (i.e. at least one vote). Is it too much to hope that the great reform of the twenty-first century will be to ensure that nobody has *more* than a certain share of power (i.e. no more than a fraction of all the banks/newspapers/tv-stations/dollars/share-of-the-software-market under the control of a single CEO at once)?
RE: “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.”
This is of course true and directly analogous to Tainter’s work regarding complexity and collapse which has a more general applicability. (http://en.wikipedia.org/wiki/Joseph_Tainter)
However, I suggest that the complexity issue is somewhat mis-characterized (and/or its genesis is misunderstood).
Which is why my work focuses on WHY that complexity leads to failure and ways to address it.
Much of the added complexity he refers to arises with costs associated with loss of trust… legal, political and administrative costs essentially used to substitute for peer-to-peer mechanisms which fail with scale.
This is why a “Jimmy Stewart” approach to banking is actually MORE profitable for the society as a whole… but depended on a social and cultural proximity between the ‘banker’ and his customer… which is lost with loss with ‘mega-banks’.
Scaling without pragmatically directly addressing these issues makes control fraud INEVITABLE. Rhetoric alone isn’t going to fix these problems.
But… inertia is so easy… and arguing is so much fun… let’s not think about doing anything about it.
I’m sure the pro’s will fix it for us.
Becoming bigger by purchasing other companies also presents opportunities to artificially improve the corporations books by the subterfuge of booking “Good will”. Better books, better bonuses.
Your point is flawed past usefulness. The primary function of banks is to intermediate capital – to get money from savers to productive investments. You could make a case that megabanks are much more “efficient” at creating profits from derivatives and at the same time demonstrate that they are pathologically diseased when it comes to getting the new infrastructure funded that we so desperately need. But hey! That’s not as profitable.
Oh, and let’s not forget the wonderful “efficiencies” of political influence that are a side effect of bank giantism. Or perhaps you see that as a good thing.
The ONLY way to bring banks to heel, from the society’s POV, is to make the CEO’s and traders of financial institutions partners in the long term interests of America’s well being. I’m talking twenty years out. Only when the Lloyd BankFiends and Jamie Diamonds truly desire that America flourish will the problem will be successfully treated. Don’t hold your breath.
What we are seeing unfold is the culmination of thirty years of concerted effort from the rich to take over the country. And it sure looks like they’ve won the battle if not the war.
What we suffer from now is the sight revealed as the veil is lifted and in horror we watch as our new (old) masters swagger and strut the world stage.
In the meantime all you can wonder about is some abstract and hypothetical lost efficiency. Sad comment really. I’m sure you intend to show your “skeptical” nature but that’s not what I see. I just see foolishness.
Jim,
Apologies here. My response was to a comment that somehow got deleted. Your point is well taken. The comment I was responding to suggested that large banks really do have significant economies of scale. Wish I had quoted it now. But it disappeared.
Again, sorry for the confusion.
LJR
LJR, “Lloyd BlankFiend” made me laugh.
This sentence of yours is a bit vague: “The ONLY way to bring banks to heel, from the society’s POV, is to make the CEO’s and traders of financial institutions partners in the long term interests of America’s well being.”
I suggest two specific measures, namely to ban two of the basic activities carried out by banks: fractional reserve and maturity transformation. I set out my reasons, for what they are worth, here:
http://ralphanomics.blogspot.com/2010/01/full-reserve-banking-helps-stability.html
http://ralphanomics.blogspot.com/2010/09/flaw-in-maturity-transformation.html
“Any expenses taken out of the combined bank could have been taken out of each bank separately.”
While I support your overall premise and argument, this is too broad to stand. It’s saying that there are _no_ economies of scale, and that can’t be true. There are threshold costs for establishing an HR or IT department, for example, that don’t increase arithmetically with the size of the business.
Any economies of scale are more than offset by diseconomies of both scale and scope. Many activities are subject to economies of scale. Start with lending. Score-based impersonal systems explicitly reject knowledge gained by branch managers living in a local community.
So you are suggesting that regional banks have oversized HR and IT departments, so that some of those employees are padding their time sheets.
And after the merger with a MegaBank none of those employees will be padding their time sheets? And this will result in the savings of tens of millions of dollars?
Voodoo economics!
Perhaps you have a better example?
So you are suggesting that regional banks have oversized HR and IT departments, so that some of those employees are padding their time sheets.
That’s a very strained reading of what I wrote. The claim is made that _any_ economies that could be gained by merger could be wrung from the components without a merger. I say that’s an overly broad claim, equivalent to saying that economies of scale don’t exist.
If you want to argue the point, don’t just make up stuff you wish I’d said — refute what I actually did say.
How did we ever survive all of those years in the 20th century without “Big Banks”?
I would say big banks do cut costs in one area that smaller banks don’t; in their labor costs on the lowest rung of the employee ladder. I bet that the bank teller at my local bank makes more, is treated better, receives better benefits, has more opportunity for movement up the corporate ladder, and will remain loyally employed with that bank longer than employees at chase or b of a.
Now I must say I have no proof. I am basing my guesstimation on employment at other large multinationals that have the same type of big vs small argument (walmart, target, mcdonalds, home depot). Everyone says how great it is that walmart provides such great deals and employs so many people. But a register person at walmart in Lansing Michigan will generally make the same as the same person in toledo Ohio. The only real change in wages will be for standard of living, and that will b minimal. The register person won’t be hired for her years of experience or her knowledge of the new computer system. There isn’t the opportunity for the store manager to say ” u deserve a large raise for your dedication” because the corporate overlords place such a large squeeze on the bottom line.
Entry level employees become a commodity that is sold to the lower bidder.
So you genuinely believe Norris is just naive? Come on, Yves. Norris is on the other team – the one that’s smaller but very much richer. And they feed him the script. Rewatch “Network” if you have any questions.
What’s scarier is that he could be a true believer.
What though will have when big banks start failing again? Most assume that in one way or another the government will bail them out. Let us disabuse ourselves of this assumption and ask the question again. Few seem to grasp that the Austrian critique of fractional reserve banking, i.e. that your demand deposit is a fraud (and, incidentally, that the now pitiful interest you receive on it is fraudulent conveyance), leads straight to the concept of utility banking.
What will cause the powers that be to embrace this concept? Remember, in the last four years, beginning with the 2006 Congressional elections, both parties have suffered near death experiences. Sure that might suggest catatonic paralysis is likely in the next crisis. It might though suggest that “Start a Revolution” Ron Paul will break into the mainstream. This guy is not going away.
http://www.youtube.com/watch?v=QiKh9Ko3mw4&NR=1
Are you ready?
In order to understand the U.S. banking system at a serious level, I forced myself to read The Creature from Jykell Island by G. Edward Griffin. Then one begins to see what money actually is and how it is created. If this Floyd Norris dullard does not comprehend “”fiat money”, “”fractional reserves,” and the fact that “money is debt,” then he writes fish wrapping material for the NY Times. But, this does not surprise me, because the Times published timid, obfuscating articles in the 1960s regarding the horror of Viet Nam.
If the Federal Reserve System is not taken into account, it would be impossible for me to accept any article that considers itself seriously deep with respect to contemporary banking in the US. And, likewise, with global banking, one must understand the role of global central banks and pay heed to the Bank of Iternational Settlements, the World Bank, and the IMF.
YS sez: “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.
Maybe NC could add another pictorial element if only on an occasional basis, for the sake of “Auld Lang Syne”? I’m thinking of tombstones published in The Economist circa, what, mid-80s? High time to revive syndication seems to me.
Cheers YS & NC for a great 2010, best to you going forward.