Why size matters

Kevin Drum has nicely posed the question of whether it really is important to break up big banks. After all, he argues, even small-ish banks have proven to be too leveraged and interconnected to be permitted to really fail. He argues that maybe it’s the banking industry, rather than individual banks, whose size and reach we need to constrain.

John Hempton has been arguing for the Australo-Canadian model of an oligarchic, heavily regulated, generously profitable banking system.

James Kwak offers a very nice discussion of the “too big to fail” problem in light of the absence of structural rather than supervisory approaches in Treasury Secretary Geithner’s recent regulatory proposals. (And Drum responds.)

I think size does matter very much, but not because small banks are inherently small enough to fail. Drum is right about that: Like a dwarf with a suitcase nuke, a sufficiently levered and inter-contracted microbank could take down the world as surely as the Citimonster.

But in practice, a properly defined smallness could add a lot of safety to the banking system:

  1. Very directly, limiting size defined by total asset base plus an expansive notional value of all derivative and off-balance sheet exposures limits both interconnectedness and leverage. (Defining size limits by capitalization would suffer from the same drawback as traditional leverage constraints — they encourage bankers to scheme secret ways of levering up.)

  2. When a bank appears to be small enough to fail, creditor discipline will backstop regulatory supervision. If a bank is perceived as too big to fail, if its failure in “unthinkable”, then clients and counterparties will be lax in managing or limiting their exposures, leaving always circumventable regulation as the only bulwark against becoming too levered and interconnected to fail. (Insured depositors, of course, won’t provide discipline, and shouldn’t be expected to. But bondholders and derivative counterparties will, if a bank’s credit is potentially dodgy.)

  3. Smaller banks, even very levered and interconnected ones, can be unwound, merged, or put into receivership. We’ve managed the failures of even large-ish banks like Drexel, Bear, Wachovia, WaMu, or IndyMac, and we could have managed Lehman in a costly but orderly unwind. But once banks have gone truly mega, we’re not sure we can manage it. A bank that is too big too merge without overconsolidating the industry presents special problems. From a taxpayer perspective, we are generally able to unwind smaller banks without guaranteeing non-insured creditors, while we find haircutting the creditors of larger banks impossible, because these unsecured creditors regard failure as unthinkable and fail to adequately provision for the risk.

  4. Political economy considerations mitigate against large banks (arguably more deeply in the United States than in Australia and Canada). Particularly if financial firms are segregated by scope (e.g. investment banking distinct from commercial banking distinct from brokerage distinct from insurance), groups of small firms with distinct industry agendas are likely to be less corrupting than huge, critical institutions with a unified management that acts strategically in political circles.

  5. Scale breeds agency problems. Earning an extra five basis points on $100B in assets amounts to $50M in extra income a year, a fraction of which can make a manager very wealthy in an eat-what-you-kill bank. Making that same five basis points on a $100M portfolio earns a small bank 50K, a fraction of which amounts to a nice bonus, but not a lifestyle change. For both managers, the downside if something goes wrong is the same: they lose their jobs. The ability to leverage a large balance sheet tempts managers at larger banks to take risks that managers at smaller banks would not find at all worthwhile. (Drum points out that managers of small hedge funds earn huge sums too, but that’s really apples to oranges. Hedge fund investors, like stock investors, are generally aware of and prepared to manage investment risk, while bank creditors expect that their money is safe. Hedge funds mostly present systemic problems when their use of leverage puts bank creditors at risk. That can and should be regulated, from the bank side and perhaps by eliminating the right of hedge funds to limited liability forms of organization.)

There are very few obvious reasons why large banks are useful at all, other than supervisory convenience if you think Hempton’s regulated oligarchy is the right model. It may be annoying to have to pay other-bank ATM fees, but besides that, there are very few services or efficiencies a large bank can offer that a small bank cannot. Large banks can provide large loans more easily, which is convenient for corporate clients. But that may be a bad thing. Lending decisions can be mistakes. It’s one thing if a lending committee misdirects $300K to a bad mortgage. It is much more costly if that same flawed body channels $3B to a crappy LBO. Raising large quantities of capital should require the separate assent of multiple independent parties. Misdirection of the resources represented by billions of dollars creates social as well as private costs.

My sense is that a lot of people think large banks are here to stay for precisely the reason they should be made extinct. Large banks feel modern, important, powerful. It seems nice, somehow, when you travel across oceans and find a branch of your own bank. It’s like you are part of a winning team. There’s that ubiquitous brand, and it’s your brand. But “brand equity” is an important means by which banks build a mystique that makes their failure unthinkable, and charms bondholders and other uninsured counterparties into offering leverage on much too easy terms. Ironically, if banks felt a bit shabby and penny-ante, and if managed failures were regular events, the banking system as a whole would be much safer.

Size isn’t everything: Bankers are famous lemmings, and a whole lot of small banks who pile into the same poor investment can fail together like one really big bank. But a thousand little banks are at least a bit less likely to make correlated mistakes than megabanks, which can turn a bad investment idea into a firm-wide mission. One goal of bank regulation, besides restricting size and leverage, should be to encourage independent lending decisions and supervising the diversity of the aggregate banking system’s portfolio. Regulators should “lean against the wind” of booms that homogenize banks’ asset base by restricting growth of overrepresented asset classes. If there is a good economic reason for a boom, nonbank equity investors can take advantage of the opportunity.

Note: Ideally I prefer a complete separation of the depository and payments function of banks from the lending and investment function. That is I’d prefer we create “narrow banks” that invest only in government securities, and define a new kind of explicitly at-risk investment fund to serve the traditional purposes of bank lending. But this piece is written under the pessimistic assumption that we’ll leave the familiar structure of banking intact.


27 Responses to “Why size matters”

  1. SW:

    I have favored limiting bank size to 1% of total banking assets for years. Further, I would prohibit publicly held banks. If one wants to run a bank with deposits subject to FDIC insurance, it must be run as a general partnership only. Consider how conservatively a Citigroup would have been run if limited to $140 billion in size and its “officers” had unlimited liability for its acts. I also favor “small” banking, i.e., an absolute prohibition of banks holding FDIC insured deposits from making LBO loans, having mismatched maturities, engaging in stock or bond trading, providing investment advice and engaging in investment banking. I have no faith in any regulatory body doing anything to protect the public from reckless banking practices and “limited liability predation”. However, even a useless organization like the SDNY US attorneys office, might have to indict a “bankster” if his actions were clearly criminal and exposed on say page one of the New York Times. At some point, even the “captured” Justice Department can’t ignore the facts and the law with regard to the politically powerful.

  2. vlade writes:

    Me too: ).

    Seriously though, small banks with hard limits on the size of balance sheet (and not allowed to have off balance sheet vehicles) + harder limits on off-balance-sheet instruments are the way to go.

    Arguments that it’s lost efficiency is spurious, as for retail banks it clearly isn’t, and even if it is for the commercial/investmnet banking, it’s offset by much higher survivability (i.e. being a top predator with no fat is better for normal condition – you’re faster – but come catastrophe you’ll be the first to die).

    Additionally, if all the banks are smaller, it’s easier for new entrants to get in. It’s hard to compete from scratch with established giant unless a catastrophe strikes.

    We need to recreate an ever renewing pool of Darwinian struggle (wrong metaphor for US, I know but what the heck…)

  3. RueTheDay writes:

    If we took the proper steps to build firewalls into the system, I think the “size” issue would sort itself out naturally:

    1. Re-impose Glass-Steagall and the separation between commercial banks and investment bansk.

    2. Regulate insurance companies at the federal level and forbid them from entering into any other non-insurance financial service business lines.

    3. Impose capital adequacy standards on all financial service businesses (e.g., hedge funds) regardless of size.

    4. Eliminate all of the SPV and other assorted off-balance sheet nonsense for financial services companies.

    5. Wipe out the shadow banking system, especially money market mutual funds. They’re banks, call them that and regulate them as such.

    6. Implement a Tobin-esques tax on all financial transaction (sliding scale dependent on risk of transaction type) to make any future systemic-risk mitigation activities self-funding.

    7. Legislatively change the bonus structure on Wall Street so incentive comp is tied to longer term performance (say 5 years) with all short term bonuses structured as draws against the long term pool and explicitly subject to future clawback in the event of a blowup.

  4. The title of this post reminds me what I call it viagra economics, which I note also Prof. Krugman likes to refer writing always “make it bigger” to fiscal stimuli without any convincing case or cost-benefit analysis. It’s the usual “think big” approach.

    In any case there is no point in having big banks if they do not work properly and credit markets end up oligopolistic with high concentration of market and counterparts risks. With big banks risks tend to be correlated so any portfolio of activities and assets is not diversified (these days show it clearly). Moreover if you have a big bank so big that cannot be bailed it out and its depositors or other creditors cannot be guaranteed I believe that’s alone is a convincing case to “make it smaller”. My “good banks” proposal envisages also said break up.

  5. beezer writes:

    We had a decent system, but we dismantled it. Go back to “divide and regulate.” Commercial bank depositors get the FDIC insurance to mitigate “runs.” Investment banks get no insurance whatsoever. Insurance companies cannot have any financial intermediaries and have no federal guarantees. Investment firms such as hedge funds shall be registered and have to meet all capital and leverage standards imposed by regulators.

    Enforce strict capital and leverage standards for all financial firms. As Geithner said Thursday, the answer to our problems is “Capital, Capital, Capital.”

    All securities should be standardized, easily understandable by all parties, and shall be traded on public exchanges. No “Shadow Banking.”

    Re-install the uptick rule. Prohibit naked short selling and make short positions public weekly, if not daily.

    Coordinate with the international financial community so that these standards apply globally.

    Finally, as national policy, “mirror” other countries’ domestic policies re: competition. If they do not honor trademark or patent laws, we shall not either for their businesses. If they limit foreign investment and ownership, than so should we.

  6. JKH writes:

    “Narrow banking” seems like an effective broadening of the central bank mandate. Deposit gathering and payment processing functions appear to be a branching utility extension of it. The use of the deposit base to buy government securities extends the reach of the normal central bank conduit for funding the government deficit. Full consolidation with the central bank balance sheet seems like a natural option, given the rudimentary functions performed by such a system. The monetary base expands to include all such narrow banking deposits. In full consolidation mode, commercial bank clearing balances now held at the central bank increase to include the entire narrow banking deposit base. The asset liability configuration effectively eliminates maturity mismatching against the deposit base – the nominal maturity profile of the asset portfolio becomes irrelevant to the degree that it characterizes an intra-sovereign transfer of funds. The government may as well agree to designate a maturity profile for the transfer of funds that matches that of the deposit base, pricing it at an MZM transfer rate.

  7. JKH writes:

    Nothing jumps out at me here to explain why the Canadian system, which is concentrated, would be a relative outperformer, or why the rest of the world (including Australia btw) would be a relative underperformer. My guess is that the root answer lies in regulation and supervision.

  8. RueTheDay writes:

    JKH – I’ve searched high and low for an explanation of the Canadian system escaping unscathed, and all I can come up with is 1. regulatory capital requirements are higher and culturally, they like to keep an additional buffer of capital on top of even that and 2. the regulators keep them from funding risky loans (the Canadian bankers were actually complaining about this a few years ago, today not so much). Ordinarily, this would lead to lower rates of profits, but by allowing a much greater degree of concentration and preventing the entry of foreign players, they are able to bring the profit rate back to otherwise normal levels.

  9. JKH writes:


    That sounds about right to me. I like your take on Canada more than Hempton’s on Australia. I think his anti-competitive paradigm is wrong; although it’s consistent with his personal insight into large bank efficiency.

    Very interesting and critical that Canada’s Prime Minister (via the finance minister) made a strategic decision ten years ago not to allow Canada’s banks to merge. Four of the five had super serious merger proposals on the table. Ironically, it was also rumoured around that time that one of them had designs on Lehman, a misstep that was dealt with internally.

  10. The motivation for mergers has always been to increase top management salaries, which vary with asset size, while claiming efficiencies of scale. But The Economist’s 2006 survey of banking cites research showing that such economies top out at about $25 billion in assets.

    I posted my soundbite-sized program a few threads ago. As I recall it included:

    1. Redo Glass-Steagal (isn’t it comforting that Larry Summers, the architect of undoing Glass-Steagal, is going to “fix” now?)

    2. Limit banks to $250 billion in assets size

    3. Get everything on the balance sheet (as IA points out, we could blame the accounting profession for the whole mess…)

    But I tend to think we’re looking at correlations here, not the deeper causations, that probably have to do with moral and econophysical dimensions of society that we don’t have good models for yet.

    Like, maybe once a ruling elite becomes entrenched to a certain degree, controlling the scope of acceptable political discourse and representation, that the implied result is a singularity (“tending toward infinite inequality”) implying a phase change. I’ve collected some of the recent articles on systemic failure at my site.

    So, Canada, with less inequality than the U.S. and lower mortality rates as a probable partial result, has the social cohesion to administer a highly concentrated banking system effectively, because people trust the system and the regulators actually do right.

    Thus, John Hempton’s recommendations are not appropriate for the American system at all. We don’t trust Hank Paulson or Larry Summers or Tim Geithner, or even poor Ben Bernanke, I’m afraid. They’re going to have to prove their mettle to us, with full transparancy of what they’re doing.

    Unfortunately, to the extent they’re being transparent, a lot of people are losing confidence in their motivations and judgment.

  11. Taunter writes:

    There are plenty of economies of scale in finance; in fact, the existence of so many of them is why the financial institutions got together in the first place.

    ATM fees are the least of them. Think of the entire cost structure of a firm – its controllable expenses are personnel and infrastructure (IT/bookkeeping, processing, etc). The infrastructure necessary to run a moderate-sized business can handle a far larger one for modest expense, which means the industry is pretty close to having a declining average total cost curve.

    Furthermore, the capital markets functions (eg debt underwriting) that are far more lucrative in the good times than traditional banking require a very large national – if not international – presence.

    I like the idea of separating investment banking from commercial banking, as you suggest, but bear in mind that the problem here is political will. There was no will to allow AIG to threaten the survival of Goldman Sachs, and Goldman has no depositors. AIG itself could be dismembered and the regulated insurance business protected, but there is no desire to allow the CDS counterparties to take a hit. An independent investment shop will, in ordinary times, be extremely profitable, and that wealth brings with it significant influence.

    More here:


  12. Norm Matthew writes:

    The Canadian model has its own problems. Canadian banks lack real competition and are restrictive in their lending practice. Canadian banks are very balance sheet oriented with loans; i.e. what collateral does the borrower have? As a result, established asset rich business and individuals have ready access to bank cash but start ups and smaller firms have difficulty obtaining bank loans, credit lines and such. This impairs the Canadian economy in general and leads to business concentration in all industries. It still doesn’t stop Canadian banks from making bonehead moves e.g Dome Petroleum in the early 1980’s and Olympia &York in the early 1990’s.

  13. RueTheDay writes:

    Taunter – You are overstating the value of infrastructure with regard to economies of scale. I have personally consulted to some of the largest financial institutions out there on the technology side, and with a few exceptions, they are not getting economies of scale here. What has happened is that most large banks have grown by acquisition, and every business unit is still using their own legacy systems, disconnected from the rest of the organization. They may all be operating under the same brand, but they are effectively run as separate companies.

  14. babar writes:

    i have a question about all of this. if the problem was bad loan underwriting and loose credit leading to a credit bubble and asset price bubble, leading to an asset price crash and huge credit losses, isn’t that going to seriously stress your intermediaries no matter how they are set up? ie shouldn’t we try more not to have a bubble than to handle it with absolute grace?

  15. BearRoast writes:

    Canadian banks lack real competition and are restrictive in their lending practice. Canadian banks are very balance sheet oriented with loans; i.e. what collateral does the borrower have? As a result, established asset rich business and individuals have ready access to bank cash but start ups and smaller firms have difficulty obtaining bank loans, credit lines and such.

    Is this really such a drawback of the Canadian system? I would think that it is desirable for venture-stage companies to be funded by equity, not debt.

  16. joebhed writes:

    Full Reserve Banking.

    It’s more important than limiting size.

    Banks lend out REAL money.

    Risk matters.

    Risks matter.

    If MY bank is lending out MY money, then I care about the amount of risk that is being taken.

    It’s not the bankers’ money.

    It’s the depositors’.

    Banks will either become prudent and risk-averse lenders, or they will cease to be.

    We don’t need no regulation!

    Or, was that education?

  17. RueTheDay writes:

    joebhed – Under a full reserve banking system, banks do not “lend out real money”, they do not lend out any money period. Full reserve bank = warehouse for currency + check clearinghouse. A full reserve bank can not and does not make loans.

  18. John Doe writes:

    One issue that has not been mentioned is that the risk of ruin is smaller for large banks (due to the law of large numbers) *if* all else is equal. A loss which would hobble a small bank is more likely to be survivable in a large one. Furthermore, large banks are involved in liquidity-arbitrage (between when they get deposits and the loans they make) and size has an advantage here.

    IOW I suspect that large banks are ceteris paribus *less* likely to fail and more stable although the failures of large banks are likely to be more catastrophic. This is similar to having a modern electricity grid versus a third world one. This obviously induces a tradeoff in bank size although given risk averseness I suspect that the public will prefer limited size.

    Now the question of whether things are indeed ceteris paribus I leave to others.

  19. reason writes:

    I don’t think you are right and for a completely different reason than the in my view phony one that Kevin Drum gave.

    The problem is that banking is a competitive industry, dealing with an unknowable future. The least prudent tends to set the price and risks are correlated between banks.

  20. reason writes:

    In other words, I think you are overunderestimating the extent to which this problem is a management problem as against a systemic problem.

  21. crack writes:

    I looked at your anti LL proposal for hedge funds. Sounds interesting. What’s to prevent a fund from purchasing an LL entity and then running all it’s leverage through that?


    But the least prudent are those spending the money, hence setting the price. So wouldn’t the least prudent also always end up the biggest?

  22. reason writes:


    Not necessarily, there are different ways to compete, one of which is to have a lower price. But you can expect retaliation if you adopt that strategy so you can also expect low profits.

  23. reason writes:

    As regards LL, I personally think the Argument that Steve used should apply to ALL financial enterprises – I can’t see any reason to single out hedge funds.

  24. reason — at the time i wrote that piece, i was mostly concerned with hedge and private equity funds. i had thought, back then, that regulated commercial banks actually had distributed the risks they originated (largely to said funds), and wouldn’t be the problem (although i was concerned about structured products like cpdos that looked to circumvent bank capital requirements).

    anyway, if i had it to do over again, i’d apply the argument as you suggest, to all financial enterprises. i think the rule should be one limited liability boundary between a real economy, current goods and services enterprise, and investors. obviously the boundaries between a “real economy” firm and a financial are fuzzy and would have to be policed, but that should be the principle. if the principles or investors of a bank or investment fund wants LL protection, they can hold debt claims or equity claims in LL real economy companies. they can also negotiate explicit nonrecourse terms on financing, if they can persuade counterparties to assume that risk. but by default, if they enter into contracts that impose obligations upon them beyond an initial payment, the legal form of a financial firm should not shield them from the requirement to perform. like all the rest of us, those who join together in financial firms can shield themselves from poor fortune or their own recklessness via personal bankruptcy.

    John Doe — you are right, big firms fail less frequently (although this may be complicated by management incentives to take on more risks). but small firm failures are manageable. we’ve adopted a model of long periods of stability that tend to hide underlying errors and imbalances, followed by large collapses when even the error-absorption capacity of the mega financial system is exhausted. a frequent pulse of prompt failures would let us observe problems in real time, and be a problem primarily for tose involved with the failed institution, rather than a terrifying systemic crisis. in other words, exchanging a system with low frequency, high amplitude failures for one with high frequency, low amplitude failures may be a very good trade.

    babar — while i think we should try to avoid bubbles, i don’t think we can entirely succeed. enthusiasms are not bad things, and we cannot know ex ante whether an enthuasiasm is justified. this is not to say that i support the Greenspan “mop up” view — “leaning against the wind” strikes me as a good way to test enthusiasm, and ensuring asset price volatility (to shake out momentum participants rather than considered enthusiasts) also strikes me as wise. but all that aside, there will be times when we make large macroeconomic bets that are reasonable ex ante but fail to pan out ex post. even in the best of all possible worlds, we need to ensure that when widespread failures occur, our institutions of financial intermediation fail gracefully rather than unnecessary magnifying the costs of a mistake into a catastrophe.

  25. raivo pommer-eesti writes:

    raivo pommer-www.google.ee



    Die Internationale Energieagentur (IEA) hat ihre Prognose für die weltweite Ölnachfrage wegen der Wirtschaftskrise erneut um eine Million Fass (je 159 Liter) pro Tag gesenkt. Die Nachfrage werde im laufenden Jahr mit 83,4 Millionen Fass pro Tag um 2,4 Millionen niedriger sein als 2008.

    Das schreibt die IEA in ihrem jetzt veröffentlichten Ölmarktbericht. Erstmals seit vier Monaten hat der Ölpreis Anfang April die Marke von 50 Dollar je Fass wieder überschritten. Die IEA erwartet aber wegen der Nachfrageschwäche keine nachhaltige Preissteigerung.

    Die Tagesproduktion sank im März um 400 000 auf 83,4 Millionen Fass. Gleichzeitig wachsen die Ölvorräte. Im Februar hatten die westlichen Industriestaaten mit 2,74 Milliarden Fass rund 7,2 Prozent mehr Öl auf Lager als ein Jahr zuvor, weil in Asien stark gebunkert wurde.

  26. raivo pommer-eesti writes:

    raivo pommer-www.google.ee


    Luftfahrt in der Krise

    Weil Ostern 2009 im Gegensatz zum Vorjahr in den April fällt, schrumpften im März die Ticketverkäufe vieler Konkurrenten – die Kranichlinie jedoch profitierte. Denn von ihr besonders umworbenen Geschäftsreisenden sind vornehmlich außerhalb von Ferien und Feiertagen unterwegs.

    Air France-KLM, British Airways, easyJet und Air Berlin verbuchten unterdessen weiter kräftige Rückgänge. Der irische Billigflieger Ryanair zählte dagegen deutlich mehr Fluggäste.

  27. Swoggewsmus writes:

    nice, really nice!