Financial Regulation

How Government Helped Create the Megabanks, and What to Do About Them

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Flickr user BK and EP

If you want to understand the growth of the nation's biggest banks, it helps to understand the history of bank bailouts. Writing in National Affairs, James Pethokoukis of the American Enterprise Institute traces decades of big-bank expansionism, and the government-backed financial sector safety nets that made that expansion possible. It's great piece that serves as a compact history lesson about U.S. banking intervention.

Big banks have long been business, but even still, their growth in recent decades is kind of staggering. In 1983, Pethokoukis notes, "the six biggest American banks had assets equal to 14% of the nation's GDP. Today, their assets equal a staggering 61% of GDP." Not coincidentally, that growth corresponds rather well with a series of demonstrations that the government will prop up banks that fail. That started with the precedent-setting bailout of Unity Bank and Trust, a local Boston bank, in 1971. The Unity bailout ultimately failed when the institution folded in 1982, but more bailouts were on the way in coming years. And with those bailouts, Pethokoukis says, came a domino theory of financial-market interconnectedness which operated on the premise that if one bank fell, others would follow. From there, the idea of banks too big to fail was born.

In a [1984] congressional hearing investigating the bailout, the comptroller of the currency identified 11 bank holding companies, including Continental, as too essential to the financial health of the economy to be allowed to fold. Connecticut congressman Stewart McKinney summed up the testimony by coining a now-famous term: "Let us not bandy words. We have a new kind of bank. It is called too big to fail. TBTF, and it is a wonderful bank."

In effect, large financial institutions had grown beyond the government's ability to regulate. The various measures the government had put in place to protect consumers were no longer adequate for contending with the failure of a big bank. As a result, big banks simply could not be allowed to collapse.

It did not take long for banks to adjust their behavior accordingly. They realized that the bigger and more interconnected they became, the more essential they would seem in the eyes of regulators, and thus the more insulated from failure they would become. This increased security, in turn, afforded the big banks a huge market advantage over their smaller competitors, allowing them to bloat even more — thereby perpetuating a dangerous cycle of uncontrolled growth.

Is there a clear benefit to monster-sized financial institutions? Maybe not. As Pethokoukis argues, they may be more trouble than they're worth.

Megabanks often argue that their size allows them to make use of economies of scale, which is the only way they can compete with massive foreign rivals and provide essential services to American companies working abroad. But there is little evidence that banks need multi-trillion-dollar balance sheets to realize such benefits. In fact, when a bank offers a supermarket of services, it may actually find diminishing returns from the added complexity of its operations. The financial crisis proved that banks can become both too big and too complex to function efficiently.

Former Merrill Lynch CEO John Thain noted this phenomenon in 2009, specifically with reference to the company's business in complex derivatives. "To model correctly one tranche of one [collateralized debt obligation] took about three hours on one of the fastest computers in the United States," Thain explained. "There is no chance that pretty much anybody understood what they were doing with these securities. Creating things that you don't understand is really not a good idea no matter who owns it." More recently, JPMorgan Chase — widely regarded as the best-run bank on Wall Street — suffered a loss of $6 billion when the derivatives gambling of a trader known as the "London whale" went south. The bank's CEO, Jamie Dimon, lamented that this investment strategy was "flawed, complex, poorly reviewed, poorly executed, and poorly monitored."

I'm far from sure that there's anything inherently problematic with very large financial institutions. But there does seem to be a problem with banks that have bulked up in order to help ensure that they large enough that the government will step in, with taxpayer money, to keep them from failing. That's bound to encourage irresponsible growth, and growth for its own sake, rather than the more prudent and careful growth that would be encouraged (though, of course, not guaranteed) under a less bailout-prone regime.

Is such a regime even possible? Pethokoukis argues, plausibly, that policymakers cannot be expected to stand by while megabanks fail. Even if you convince them to say they will, they won't. There's no way to tie their hands, no way to restrain them from intervention in an emergency environment, or what feels like one.

So "the only way to solve the problem of 'too big to fail'", he says, "may be to solve the problem of big banks, period — by taking pre-emptive action to make banks smaller, simpler, and safer." That's tough, and as he admits in his discussion of various policy alternatives designed with that goal in mind, inevitably there will be problems with any policy designed to keep banks down to a manageable size. But given the potentially expensive and/or catastrophic alternatives, it may be worth doing anyway. Certainly it's worth considering. 

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  1. I’m far from sure that there’s anything inherently problematic with very large financial institutions.

    There is nothing inherently wrong with very large financial institutions. Just stop the bailouts. Ban Congress.

    1. Hear, hear!

  2. Ending the bailouts would lead to smaller banks as customers/lenders would be skittish about putting too much of their money in a single institution.

    The issue/challenge is how to convince people that this time we’re serious, that there will be no bailouts.

  3. I think we’re to the point now where it’s impossible to give a ballpark estimate of how big financial institutions would be absent decades of government meddling (this goes for numerous other industries as well).

    Even when trying to craft a sensible approach to shrinking banks’ balance sheets and separating commercial from investment banking, there’s the perennial problem of regulatory capture (RC).

    Would it be too risky to let the megabanks fail next time, or would the risk of RC outweigh this more market-driven method?

    SLD: I’d prefer free banking, naturally, since it would approach risk most effectively, but I wonder what would happen if the big banks, which got so big because of gov. help, were to collapse.

    1. Only one way to find out. ::spends tuppence to feed birds::

    2. Some years back, I remember seeing a study that put optimal bank size at about $25 billion in assets. That was based on costs. Now, honestly, I don’t remember if it was costs excluding interest (which would be subsidized by the implicit guarantee). Still, if you accept this (and excluding the interest subsidy would only drive the number down), our top fifty banks are too large.

      1. The optimum size is lower now, probably much lower, because technology, and networks, have lowered the saturation point of economies of scale after which diseconomies of scale predominate.

  4. Well, if the banks are too big to fail, then they are obviously in violation of the Sherman Anti-trust Act.

    1. Yeah, I’ve always wondered about the seemingly haphazard way that statute is enforced (not that I necessarily favor anti-trust efforts vis a vis a naturally-occurring monopoly/oligopoly).

      1. Banks are the one of the few true oligopolies* in the US economy – and of course are de facto exempt from the Sherman Anti-Trust Act.

  5. It is amazing that a typical prog will just claim that this is the natural course of free market capitalism and will completely disregard the massive government meddling and financial support that keep these banks from shrinking during slow economic times. There is a complete disconnect which astonishes me.

    1. I know.

      It’s the cognitive dissonance: On the one hand, “big corporations are the result of the free market,” and on the other: “we can’t let companies shed jobs or sell off assets! That would bring about a crisis!”

    2. At what point do you stop seeing it as a disconnect and realize that its deliberate? Its not so astonishing then.

  6. The government is ridiculous on this. They were complaining about the banks being too big to fail, out of one side of their mouths–even as they were forcing mergers between Merrill Lynch and B of A! …even as they seized Washington Mutual and sold it to JP Morgan Chase for a song!

    The fact of the matter is that the desirability of having extremely large financial institutions waxes and wanes depending on where we are in the credit cycle, and where we are, exactly, in the credit cycle at any moment is unknown–until we’re actually falling off the credit cycle cliff.

    If how stupid someone is depends on the magnitude of their stupidity, then the stupidest people on the planet are politicians who imagine that their laws or regulations will somehow banish the economic cycle. The people who ran the USSR thought they could banish the economic cycle with rules and regulations, and the economic cycle threw them in the dustbin of history.

    The very best way to make sure large financial institutions don’t disrupt the economy, too badly, when the credit cycle invariably takes a nose dive–is to let them fail–when they take on more risk than they can handle and it blows up in their faces. Say what you want about Bear Stearns and Lehman Brothers–but make sure you also mention along the way somewhere that they aren’t a threat to our economic stability anymore.

    1. All excellent points. I would add that, concerning the “market-failure” schtick, even the way big companies word their guidance for investors often includes what they believe governments might do in the regulatory policy sphere. How in the world anyone honestly believes the “free market” causes financial meltdowns is beyond me.

    2. The fact of the matter is that the desirability of having extremely large financial institutions waxes and wanes depending on where we are in the credit cycle

      Nope, there is absolutely no benefit to having extremely large financial institutions.

      None, at all.

      The people who ran the USSR thought they could banish the economic cycle with rules and regulations, and the economic cycle threw them in the dustbin of history.

      Communism fails because it is at odds with human nature, not because its rulers failed to manage a business cycle.

  7. Occupy!!!!

  8. As soon as the government made it clear that they will save the megabanks from failure, it pretty much became every large bank’s Board’s responsibility to become mega.

    Say the Board of a large bank rejects the merger with another bank that would have made the bank mega and, two years later, the bank is wiped out due to circumstances beyond their control (i.e., no negligence on the part of the Board or management)? The shareholders will still sue the Board members personally for that decision because being a megabank would have saved the shares’ value.

    The government created this monster. Too bad it seems completely incapable of killing it.

  9. The size of the banks doesn’t matter, since the real problem is that we have what ultimately amounts to a single-payer banking system. If banks issued and were responsible for their own notes then mega-banks would be a boon. As it stands, banks (large or small) have an incentive to engage in excessive risk since they (or their depositors) keep all of their profits but their losses are borne either by taxpayers (bailouts) or depositors in other banks (inflation). Complaining about mega banks is a canard by anti-capitalists who don’t know or more likely don’t care that big bank mergers are a symptom, not a cause, of financial volatility brought on by the state controlled currency. Free banking is the only solution.

  10. The size of the banks doesn’t matter, since the real problem is that we have what ultimately amounts to a single-payer banking system. If banks issued and were responsible for their own notes then mega-banks would be a boon. As it stands, banks (large or small) have an incentive to engage in excessive risk since they (or their depositors) keep all of their profits but their losses are borne either by taxpayers (bailouts) or depositors in other banks (inflation). Complaining about mega banks is a canard by anti-capitalists who don’t know or more likely don’t care that big bank mergers are a symptom, not a cause, of financial volatility brought on by the state controlled currency. Free banking is the only solution.

  11. Thats one mean looking bull dude.

    http://www.Tactical-Anon.tk

  12. Seems like the right solution would be a simple rule that scaled up reserve requirements with market share, such that if all banks merged into a single bank, it would effectively be banned from fractional reserve lending.

  13. Yes! We need more regulation to solve a problem caused by layers upon layers of existing regulation! Just a few more tweaks and we’ll get there. Utopia is just around the corner.

    Is this a fucking joke?

    In a real market where risk is borne fully by the institution taking it on, there is zero incentive to grow beyond capacity or to risk total failure, and absent a madman with controlling interest in the institution, there is every incentive in the world to behave responsibly. Let a bank get as big as it wants. Just make it real clear to the bank and its depositors that they’re working without a net. Accepting the author’s premise requires a presumption of irrationality on the part of every actor in the banking system, necessitating the regulatory structure that made and makes mega-banking so attractive in the first place. But that premise is bullshit.

    1. Better yet, prevent banks from having a corporate structure. Make them full liability partnerships or sole props.

  14. Too big to fail = too big to exist.

    1. Exactly. I’ve been saying the same thing for years. If there truly is “systemic risk” from a megabank’s failure (and I’m not convinced that there is; I believe that’s mostly rationalizations by rich bankers and ambitious politicians) then that bank needs to be broken apart into smaller pieces.

      Part of the problem (perhaps the whole of the problem) is simply that the megabanks are too huge to be managed properly. If Jamie Dimon doesn’t know (and understand) what is going on in a division of JPMorgan Chase that division needs to be divested. This isn’t to say that those activities aren’t useful or profitable, just that they need to be useful and profitable in someone else’s portfolio.

      Citibank (in its various incarnations) has now been bailed out by the government three times (once under Walter Wriston, once under John Reed, and most recently under Win Bischoff). That’s three times too many, and is proof positive that the institution is unmanageable, even in that hands of executives as skilled as those three. No human being is capable of properly managing Citigroup, and the risks it presents shouldn’t be foisted off on the taxpayers.

  15. “Even if you convince to say they will, they won’t. ”

    Er, say what?

    Otherwise, great article.

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