Big Bank Obesity Conundrum

Is the Federal Reserve a hotbed of trustbusters? Fed officials (as well as some academics) have been calling for forcible downsizing of big banks . “I am of the belief personally that the power of the five largest banks is too concentrated,” Dallas Federal Reserve Bank president Richard Fisher said a few days ago during a visit to Mexico, according to news reports. He’s expressed similar views before, as has Thomas Hoenig, former president of the Kansas City Fed.

Here on ThinkMarkets Jerry O’Driscoll, a Federal Reserve veteran, wrote: “There is no conceivable efficiency gain that justifies the risk these gigantic, risky institutions impose on all of us,” to quote one of his comments. The main argument is that large banks, having been given access to financing from the Fed during the crisis, are now more likely to take risks because they know they’ll be bailed out.

The neo-trustbusters favor the rule, suggested by and named after former Federal Reserve chairman Paul Volcker, aiming to slim down banks by having them divest proprietary trading and hedge fund and private equity businesses. “Perhaps the financial equivalent of irreversible lap-band or gastric bypass surgery is the only way to treat the pathology of financial obesity, contain the relentless expansion of these banks, and downsize them to manageable proportions,” Mr. Fisher says.

No doubt, government backing of banks, like government backing of mortgage giants Fannie Mae and Freddie Mac, creates a nasty moral hazard. Unlike Fannie and Freddie, however, the banks were originally not creatures of the government. They grew in scale and scope for decades, long before the bailouts and the emergence of the notion that they are too big to be allowed to fail. Government-subsidized risk taking is not the reason they became big—they were already big, for reasons the neo-trustbusters do not address.

The classical objection to concentration is that the resulting monopoly or oligopolies boost prices and restrict output to make extra profits. But investment banks face competition in almost every line of business; the competition is ferocious in areas like brokerage. It is not just that big US banks compete with each other. They also compete with large banks all over the world. It would be hard to find any major financial market where the incumbent enjoys monopoly rents at the expense of customers with no threat of competition.

So the case for scaling down banks is not predicated on their monopoly power but on the menace to taxpayers in the event the government props up failing banks. But if they’re not making monopoly profits, why did these banks become large and diversified in the first place? Remarkably, this has happened everywhere, under different policies and regulatory regimes. Global financial players – not just Bank of America, JP Morgan, Goldman Sachs, Morgan Stanley, Wells Fargo but also Deutsche Bank, Credit Suisse, UBS, HSBC, Barclays – are all big entities.

Fed officials say banks don’t need to be so large to be efficient. But then why are they so large? The long-term trend of expanding scale and scope in banking goes back a century or more and is global. Surely, so protracted and widespread a trend can’t be due to mistake or chance. There must be some efficiency advantage. The great business historian Alfred Chandler explained scale and scope economies in modern industry. We need a similar analysis for finance. It is likely that there are such economies and destroying them in the name of shrinking the banks will obliterate a portion of national income.

So far, the starve-the-fat-banks Volcker Rule treatment is not going well. While regulators still try to determine how to implement the rule, unintended consequences have already shown up. Banks’ trading on their own account is intertwined with market making for clients. As the prop desks shut down, there are fewer market players to match buyers and sellers. That increases the cost of transacting in particular in the bond market, adding to the expense of mutual funds and small businesses.

Europeans complain that the Volcker Rule could discourage banks from trading European government bonds, thereby increasing the costs to those governments and aggravating credit problems.

We’d be better off if the ancient medical tenet, first do no harm, were applied by both doctors and regulators. Instead, regulators tend to behave like medieval physicians who apply leeches for bloodletting every time they confront a baffling condition.

Until there is a better understanding of why banks grow, what makes them efficient and how the loss of efficiency will affect the system, forced dieting is likely to do more harm than good.

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