Is Bigger Really Better In Banking?

As I mentioned in this recent post, Charles Calomiris of the Columbia Business School wrote an editorial defending 'too big to fail' banks in last Tuesday's Wall Street Journal.

Calomiris clearly states his contention thus,

"Yet the challenge of coordinating the efforts among different countries' regulators can be met through prearranged, loss-sharing arrangements that assign assets to particular subsidiaries based on clear rules. This would make it possible to transfer control over the assets and operations of a large international financial institution in an orderly fashion, in case of its failure. This process could be handled by the courts for nonbank failures and the Federal Deposit Insurance Corp. for banks. With such arrangements in place, governments will have no reason (or excuse) to bail out large, international institutions.

But is it worth the trouble to preserve large financial institutions? Emphatically, it is."

It's worth noting that Calomiris postulates an entirely new, trans-national financial regulatory and accounting structure, after and on which he then bases his contention.

Realistically, what he envisions would be a good decade away from implementation, never mind that the sorts of accounting data supporting it would be gamed to high heaven by the smart financiers who would have time to discover and exploit the inevitable loopholes.

And, ironically, last year Calomiris claimed, in the Journal piece on which I wrote a post which is linked in that recent post, that the Basel accords' risk management prescriptions were the reason for the recent meltdown!

So, prior international financial regulatory attempts were bad. But now, Calomiris believes, they will magically become good.

Remember, modestly-paid civil servants write these sorts of regulations and procedures, while much smarter, better-educated sector practitioners, with plenty of capital behind them, immediately begin working to subvert, avoid and evade these same regulations.

Calomiris' vision will never be created, much less work as planned.

"This underlying reality is the background factor that helps explain why some financial firms also need to be large.

First and foremost, they need to be large to operate on a global scale—and they need to do so because their clients are large and operate globally.

Second, there are economies of scope when financial firms combine different products within the same firm (lending and foreign-exchange swaps, for example). A financial firm able to offer multiple products to a customer means savings in marketing costs and in the costs of information production (about the creditworthiness of clients, for example). Economies of scope among products also imply economies of scale within finance suppliers, since small financial firms cannot afford the overhead costs of building platforms with many complex products."

This is a rather common fairy tale in banking. The truth is, until the mid-1970s, the business of correspondent banking was alive and well. I didn't happen to include Calomiris' cite of Ollie Williamson's recent Nobel for his work on networks among businesses, but correspondent banking was the original implementation of this notion.

Simply described, regional and local banks across the US would use New York- or California-based money center banks for various financial markets activities, such as securities lending, upstreaming loans for risk layoffs, taking part in large loans from the money center, institutional trust, letters of credit, and so forth. There was no particular need for a regional bank to be everywhere, when it could basically share customer activities with a money center bank.

However, as money centers grew more complex, there was no accompanying increase in the skills of senior management in those banks, and the increased risks began to result in heavy losses. For example, recall Chase Manhattan's Drysdale Securities fiasco in securities lending, and the Penn Square energy lending debacle in the correspondent banking division.

If anything, finance has proven to be a sector where focused execution of fewer functions tends to result in greater wealth creation per invested dollar. Old line investment banks and brokerages were partnerships which only went public when the allure of cashing out to an unwitting public proved too great a temptation for the older partners.

Third, many of the gains of consolidation accrued to customers, not banks, in the form of cheaper and better financial services. For example, my research shows that from 1980 to 1999, after controlling for changes in the mix of firms, the underwriting costs of accessing the public equity market fell by more than 20%. These declining costs encouraged an expanded use of the market particularly by young, growing firms.

One study of bank productivity growth during the heart of the merger wave (1991-1997), by Kevin Stiroh, an economist at the New York Federal Reserve, found that it rose more than 0.4% per year.

This is hilarious. I would just love to know how the Fed's economist's study defined "bank productivity." I worked at Chase Manhattan for quite a few years, in many areas of the bank, including IT. One thing which is nearly impossible to do is provide a meaningful, cross-bank measure of productivity that has any sort of functional meaning.

As for Calomiris' finding of lower equity underwriting costs, this is precisely what my old boss at Chase, Gerry Weiss, predicted. However, Calomiris separates that cause from the effect it triggered on Wall Street, meaning investment banks. This loss of profitability in underwriting is what drove Merrill Lynch, Morgan Stanley, Bear Stearns, Lehman and the capital markets portion of Citibank to pile into mortgage banking and securitization. Thus, the causes of the ensuing bubble of poorly-originated and securitized mortgages by 'too big to fail' investment and commercial banks stemming from the ability of diversified financial institutions to move into product/markets with which they were not well acquainted. And whose risks with which they were inexperienced.

Fourth, global financial institutions also have made stock, bond and foreign exchange markets globally integrated and more efficient. Global financial institutions are the institutions that provide the funds for arbitrage across markets, which ensure global market integration.

But such "integrated and more efficient" "stock, bond and foreign exchange markets" can be accessed by smaller, single- or limited-product line firms, just as well as by financial utilities of unimaginable size and scope. That's the point of exchanges. They require counterparties to post collateral and stand between the counterparties, allowing small and large entities to safely trade with each other.

It was the old telephone markets which allowed large firms, in their day, like the old Salomon Brothers, to dominate specific markets, such as fixed income trading and origination, to the detriment of smaller rivals.

Today, we see thriving privately-owned M&A, hedge fund and private equity concerns. All primarily focused on specific niches in the financial services markets.

Until large commercial banks embarked on their buying spree, of dubious value, of standalone credit card issuers, that segment, too, had its own focused, skilled competitors.

Limiting the size, complexity and global reach of financial institutions is fraught with downsides for the international economy. We can solve the too-big-to-fail problem without destroying global finance. It certainly is worth a try."

As in his piece in October of last year, Calomiris avoids providing empirical evidence for his sweeping contentions. By contrast, merely observing which firms went under last year tells you a lot about how wrong Calomiris' positions are.

Merrill Lynch, Wachovia, WaMu, Bear Stearns and Lehman were all large financial institutions. They were either needlessly diversified, or growing into new areas at their peril. Citigroup and AIG came near dissolution, but were "saved" by government intervention. Morgan Stanley nearly failed, but found a gullible Asian savior just before the feds closed and merged them, as well.

One of the most memorable lessons I took away from my Chase Manhattan Bank experience was the manner in which executives in businesses that are part of a large, diversified financial institution lose a sense of individual risk-taking, assuming that poor performance or outright losses will be borne by the institution and its shareholders, while the near-term profits of risky and/or ill-conceived strategies will drive bonuses for the unit's management.

Financial services skills tend to be focused on and in particular products. Very few senior managers, CFOs and CEOs actually understand the intricacies of all of the businesses which report to them, and for which they are responsible and accountable. Notice how unprepared Vik Pandit was as he was given the CEO job at Citigroup, and how many months he took before claiming to have the slightest idea of what to do with the collection of businesses he inherited from Chuck Prince.

Among the most admired financial service firms, for their ability to generate consistently superior total returns, do not appear large, publicly-owned diversified banks. More often, firms such as Goldman Sachs, Blackstone, Blackrock, and a few hedge funds, are mentioned. Those firms operate in fewer, more focused collections of businesses.

As I wrote in that recent post concerning Mervyn King's and Paul Volcker's calls for the effective rebuilding of the Glass-Steagall wall between deposit-taking institutions and risk-taking investment banking institutions, it's simply unwise to allow large, diversified banking concerns to have a conduit into government-insured deposits. This allows them to essentially take risks with taxpayer-insured money, knowing that this will also prevent the firms from failing without some form of government-directed intervention or rescue.

In short, until and unless such insured activities are split from risk-taking ones, the moral hazard against which the two central bankers warn will continue to loom large.

Calomiris simply ignores this fact, provides no persuasive empirical evidence for his contentions, and then dreams up a non-existent international regulatory regime on which to base his conclusion that we need gigantic financial utilities.