Does Size Matter?

2big2fail The antithesis to market capitalism is monopoly.  High market concentration has been historically a reason to use the US Justice Department to trust bust.  We’ve had laws on the books since the late 19th century.  The last real monopoly challenge was during the Clinton administration that took on Microsoft and its software bundling practices.  The Bush 2 administration promptly walked away from enforcing the suit.  The Eurozone found Microsoft guilty of monopoly behavior and are still in the process of enforcing their court’s findings.  We’ve been ignoring monopoly-creating behavior on the part of lawmakers and corporations for decades now and we’re living with the high costs of market failure as a result.

Much of the problems in the current downturn can be traced to the behavior of some of the country’s largest banks. Banks that were allowed to grow to sizes that allowed them power in the market, power in congress, and power in the setting the terms of their regulation. Several rationalizations were used to allow banks to grow from the 1980s to present time.  First, there were the arguments for economies of scale.  Big banks were more able to process huge batches of ACH transactions and checks.  These money center banks replaced the FED as the transaction processor of choice since they were generally cheaper given the various expenses of being a FED member bank that include leaving large amounts of money in reserve and on-going regulation and monitoring.

Second, there was the argument that huge money center banks were necessary to offset the power of the up and coming huge Japanese banks.  During the 1980s period, one US bank after another on the top ten largest banks in the word was knocked off the list by a Japanese bank, then later by Eurozone banks.  It was argued that in order to compete with these larger foreign institutions, US banks concentration should be looked at in a global context.  In a global context, they were ‘competitive’ and not part of a market concentration problem.   The basis of this argument was that the bank might be big in US terms, but as a global entity it was one of many.  During the 1990s, it was typical for market concentration to be defined more on a global basis which in turn led to less prosecutions based on the traditional measures.

We now know that poor regulation and  terrible understanding of the role of financial innovations in the financial system led to the current meltdown.  We also know that many of the offenders and the biggest failures have been the huge money center banks.  Many regional and small banks that continued to follow the loan and hold model of lending, rather than the loan, securitize and sell model are still thriving and did not contribute to the current crisis.  Given the global financial crisis and the role of the mega banks and the resultant demands on tax payer funds to bailout those deemed too big to fail, should we look at regulations that  limit bank size?

Many economists, liberal pundits, and I question the Geithner plan because it assumes we need the financial system to just work as it exists today.  His paradigm doesn’t really question the failure of the system in terms of the current set-up of the system itself.  Geithner’s plan blesses the poor system that was just swept off its feet by a passing oddity that surely won’t repeat itself.  James Kwak of  Baseline Scenario questions the basis of the Geithner plan that we need just need to prop up these too big to fail behemoths until they are back on their feet.  Here’s the central part of the Geithner proposition questioned by Kwak and others.

“. . . [W]e must create higher standards for all systemically important financial firms regardless of whether they own a depository institution, to account for the risk that the distress or failure of such a firm could impose on the financial system and the economy. We will work with Congress to enact legislation that defines the characteristics of covered firms, sets objectives and principles for their oversight, and assigns responsibility for regulating these firms.

In identifying systemically important firms, we believe that the characteristics to be considered should include: the financial system’s interdependence with the firm, the firm’s size, leverage (including off-balance sheet exposures), and degree of reliance on short-term funding, and the importance of the firm as a source of credit for households, businesses, and governments and as a source of liquidity for the financial system.”

Kwak questions the underlying Geithner assumption that these systematically important firms need exist.  Kwak uses the traditional bank-runmonopoly theory first discussed by Ronald Coase that argues that there is an optimal size for a firm and there are ways you can determine the optimal size.  The argument here is that these banks are way pass the size that would be efficient for transactions processing and have gone over into the ‘too big to effectively manage’ category.  Kwak argues for a size cap as part of new regulation.

There are a few main things that made companies like AIG and Citigroup systematically important. One was interconnectedness: they did business with lots of counterparties. One was complexity: when push came to shove, the regulators were not able to assess the potential damage a failure could cause, and therefore erred on the side of bailing them out. But the big one was size, and this is why we call it Too Big To Fail. The companies in question were so big, and had so many liabilities, that they could cause a lot of damage if they suddenly defaulted on those liabilities.

Interconnectedness is not going to go away. Complexity may not go away completely, but increased supervision could give regulators a better grasp on complexity. For example, all firms could be required to provide detailed information about their positions to regulators, in a standardized format, so that it could be imported into aggregate computer models; data about positions would be kept only by the regulator and not made public. Complexity could also be reduced by limiting the number of businesses an institution is allowed to engage in (like under Glass-Steagall, but updated for today’s world). But size can definitely go away, simply by setting a cap on the volume of assets any institution is allowed to hold (and doing something about off-balance sheet entities). And if a highly interconnected, highly complex but small financial institution fails, the system as a whole would be fine.

What would such a world look like? There would be a lot of small- and medium-sized banks that collected deposits and lent money to households and businesses. There would be brokerage and asset management firms that you used to invest your savings. There would be hedge funds and private equity firms that rich people and other institutional investors used to invest their money. There would be investment banks that helped companies issue equity and debt securities. There would be boutique firms that did research and other boutiques that M&A advising. For any financial service anyone wanted, there would be a company that provided that service; it just wouldn’t necessarily provide every other service, and it wouldn’t have $2 trillion in assets. It would look something like the 1970s.

What’s wrong with this picture? Some people would argue that it would limit financial innovation. But there is no correlation (or a negative one) between the size of a firm and its degree of innovation. Nor do you need to operate a financial supermarket to innovate: mortgage-backed securities were pioneered by Salomon Brothers, an investment bank under the old definition. Finally, perhaps we could use a little less innovation.

Some would argue that costs would be higher, because smaller firms would be less able to capture economies of scale and scope. First, casual empiricism debunks this theory immediately. When I got my mortgage on my house, I got a much lower rate at a small community bank (which holds onto its mortgages rather than reselling them) than at any national bank. National banks also typically offer the lowest rates to savings customers, except when they are about to fail and desperately need cash from depositors. Second, even if this were the case, perhaps slightly higher costs are a price worth paying for reduced systemic risk.

Felix Salmon at Conde Naste has picked up the banner and supports the idea of a size cap.  His argument is this.

To get specific, I think that maybe $300 billion in assets would be a reasonable cap on bank size — there’s very little evidence that banks get any economies of scale beyond that in any case. If they want to be part of a global or even a national network that would be fine — I’m sure such networks would spring up quite naturally, much as they have in the airline industry. After all, the United States managed to go 200 years without any nationwide banks, it’s unclear why it desperately needs them now.

At the same time, the cap on the balance sheet of broker-dealers should be smaller still: the more interconnected you are, the lower the cap, to the point at which companies like the CME, which are far too interconnected to fail no matter how small their balance sheet, should be barred from issuing any liabilities at all.

As for what happens when lots of smallish banks overleverage themselves and collapse en masse, well, you get an S&L crisis. Which is fiscally painful, to be sure, but which can largely be avoided through good regulation and which more importantly doesn’t have anything like the systemic implications of the current meltdown. So yes, we’re better off with one of those than we would be with Citi and BofA both failing.

Even the free market supporting The Economist has gotten in on the movement.

What’s needed is a force from outside the system to commit the American government to change. Simon Johnson argues in the Atlantic that if America were a developing nation the IMF’s advice would be clear; among other things, America would need to break up the financial oligarchy that created the conditions necessary for a thousand toxic assets to bloom. Of course, the IMF can’t hold America’s feet to the fire in the way that the WTO can. But the WTO achieved that power, in part, because American leaders wanted an outside force to be able to tie their hands, so they could shrug at angry voters and say, “Sorry, them’s the rules”. I wouldn’t be surprised to see national leaders constrained in crisis response by domestic politics seeking to empower the IMF in the near term.

I find this last opinion quite telling.  It specifically says that “a force outside the system must help the American government to change.”  Isn’t that what the we were promised during the election?  We did not get a force outside the system, but of the system.  We are not seeing change in the financial system, but continuation and tax payer subsidy of the very things thatbank_crisis_03 created the meltdown from the start.  I agree that we need to question the idea of  ‘too big to fail’ but I go a step further.  I believe we need to question the system that is now allowing these things to get to that point to start with.

Will a cap on bank and financial institution do this?  Yes, of course it will.  Better question though is this:  Why isn’t the Attorney General’s office moving to prevent market concentration and enforce the laws that prevent market monopoly and oligopoly?  Have we progressed from the disfunctional Bush Justice Department to a new era of enforcement of The Sherman Anti Trust Act?  We seem to have reached a point in Washington where we are not even enforcing the laws that we have to prevent the “too big to fail” paradigm right now.  I think it’s worth looking at the size cap, but I’d much rather use the existing laws to prevent the problem.  We need to go back to trust-busting and not trust-enabling.  This may be unlikely to happen in a poltical system that thrives on bundling from the biggest corporations to their congressional indentured servants and their Presidential enablers.

2 Comments on “Does Size Matter?”

  1. 1539days says:

    Maybe George Washington was right. We should have stayed out of international entaglements.

    • dakinikat says:

      Well, sending neophytes out to work with professionals doesn’t help either. I’m still thinking both Geithner and Obama will be eaten alive there.