We Need Banks To Be ‘Too Big To Fail,’ Whether We Know It Or Not

August 5, 2015 0 Comments

Regardless of how you frame the question about the popularity of banks, there are a ton of people who will tell you that they do not like banks. There are also a ton of people who can list at least 5 things they dislike about banks. The same people most likely do not understand normal banking operations and how banks facilitate the flow of capital in the banking system/economy. Considering this, it probably goes without saying that people fear what they can’t understand.

So because most people dislike banks and cannot understand banking, populist anti-banking rhetoric because rather popular, especially during an election season. You have very confused Elizabeth Warren who believes financial legislation such as Dodd-Frank just doesn’t go far enough. If it was really effective, it would have “broken the large banks into pieces.” She still isn’t going to throw her hat into the election, which probably doesn’t matter. Not when someone shares even less of the knowledge Warren possess about banking: Hillary Clinton.

Hillary Clinton really wants the Democratic Party nomination, despite being the biggest hopeful and frontrunner. However, if she wants a leg up on Socialist Bernie Sanders (I-VT), she has to step up her financial illiteracy big time. She has adopted a very tough economic plan, centered around reigning in on excessive Wall Street risk, and appointing regulators who understand that “too big to fail is too big a problem.”

No one likes institutions that are too big to fail. Nobody likes to be on the hook for someone else’s failures. Why are some of this banks ‘too big to fail?’ Is it greed or is that just an inevitable byproduct of Capitalism? If there is anything the financial crisis has taught us was that large institutions are truly ‘too big to fail’ and they must be bailed out to avoid systemic and disastrous results.

Or perhaps this lesson was learned the hard way with the failure (or inability) to rescue Lehman Brothers. What was estimated to be at least a $65 billion dollar bailout, looking back on hindsight, it could be argued that refusing to bailout Lehman Brothers cost a few trillions of dollars in damage to the nation’s economy and financial markets. The same thing happened to Wachovia, the third largest bank at the time (by deposits), and the failure of the Federal Deposit Insurance Corporation (FDIC) to categorize Wachovia as a ‘failed bank.’ While the central government did everything in their power to avoid another Lehman, the now defunct Wachovia, is merely an example of acting too little, too late.

Should this alone be a reason why financial institutions should be so large that the become ‘Too Big To Fail (TBTF)?’ The TBTF doctrine relates to rescuing financial institutions from their own mistakes by giving them taxpayer money. Majority of people disagree with this idea and it’s usually looked at from a moral perspective. The perspective who decide to examine is completely determined by the individual, but I’ve narrowed these ideas into two central themes.

Moral Hazards

Treating banks as TBTF truly does mitigate systemic risk, on the other hand, giving into something called a moral hazard has it’s vices too. Moral Hazard is like an insurance policy of its own, encouraging risk-taking, which makes the prospect of a bailout more likely. For example, a government guarantee that protects a bank’s creditors from losses enables the bank to borrow on more favorable terms and operate with greater leverage — along with a greater chance of failure — than it would if such a government guarantee never existed.

This is a classic example the FDIC, which ensures deposits of any bank failures or theft of money from up to $250,000. This may put any concerns of any bank failures of your local branch to bed; however, depending upon the size of your bank, this incentivizes banks to engage in heavy risk-taking. While there are some provisions in place to prevent a high level of risk-taking (coverage limits, risk-based insurance premiums, minimum capital requirements, etc), there is no guarantee that all of these would be able to prevent catastrophic systemic risk for sure.

Parasitic Government Relationship

The rather cynical rationale about banks was born after the financial crisis. The most popular relates to how embedded large financial institutions are in politics and central government, lobbying for special favors and favorable regulations. This is known as ‘too politically connected to fail,’ the belief that the level of bailouts depend on how politically connected these banks are.

While both of these concerns are valid (and I’m a firm believer in most of them), these perspectives fail to offer a pragmatic approach to why banks become so large, and why TBTF would be necessary, as different economies compete in an ever growing and complex financial market.

In order to understand the role of TBTF in our economy (as well as others), one must understand these basic truths, as Kenneth H. Thomas plaining lays out during his 2000 testimony on FDIC reform.

‘Too Big To Fail’ Has Existed Since 1984

Flashback to the year 1984. The government just spent $1 billion dollars to bailout Continental Illinois, the 7th largest bank by assets at the time. Because of this, Continental Illinois became the first bank to achieve TBTF status. Until this time, it was generally common practice to assume that both bondholders and shareholders would accept losses for their failing stake in financial institutions. The bailing out of Continental Illinois broke away from this practice.

Since then, TBTF expanded beyond just commercial banks and eventually included hedge funds. Long-Term Capital Management (LTCM) got into risky derivatives trading by leveraging itself 53-to-1 with investments worth $125 billion and shareholders equity of just $2.3 billion. Thanks to government intervention, shareholders and managers of LCTM were made whole through a Fed-initiated plan, on the grounds that LTCM posed a ‘systemic risk.’

Since the nation has decided to prop up larger banks at the expense of smaller banks, the number of commercial banks has declined steadily throughout the years.

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‘Too Big To Fail’ Cannot Be Eliminated

If anyone believes we’re going to eliminate future bailouts with provisions such as ‘Dodd-Frank (more on this in the future) is really fooling themselves. In a perfect world, where nations can produce all of the goods and services without the need of an open market economy, there may not be a need for banks to grow at the scale that they do. Unfortunately, America (just like many other nations) relies on Free Trade to facilitate transactions. As the world economy grows, global financial needs become larger. Globalization is simply one (of many) reasons why TBTF can never be eliminated.

Critics will usually point to an out-of-control banking sector that needs to be reigned in. However, data shows that the U.S. banking sector has grown proportionately with the rest of the economy.

Foreign Domestic Investment outflows from the United States has grown from $27,081.0 to $46,815.0 million from 2011 to 2012, a 23% increase. At the same time, there are plenty of foreign countries that are heavily investing in U.S. companies. There are more than $4 Trillion of U.S. dollars in foreign exchange reserves, and exports of goods and services (especially imports) are surging to new highs.

Simply put, as the economy grows and our demand from the global marketplace increases, so does the importance, scale and size of our financial institutions. While regional and smaller banks can serve the interest of many small and mid-size businesses, global banks serve as platforms for companies that need assistance in executing financial and business strategies all over the world. Sure, there are smaller banks that can serve for this purpose as well. However, when we examine the changes in the global economy and the distribution of financial assets, the need of more larger global banks increase.

‘Too Big To Fail’ Offers An Extremely Valuable Competitive Advantage

Your first thought would be, ‘it certainly does offer a competitive advantage: to banks.’ On the other hand, there is more to the global macro ramifications of having TBTF banks other than helping the bottomline of banking executives and hedge fund managers. What exactly would happen if U.S. banks were broken up, their size reduced and financing activities limited. How exactly would multinational companies obtain the funding they need to expand?

One proposal involves gathering a ton of smaller banks, rather than using a few larger banks, to underwrite loans for multinational corporations. The other alternative would be to break up the existing larger banks into smaller banks. There is absolutely nothing smaller banks from underwriting loans to large multinational companies, through a underwriting process called ‘loan syndication.’

This is the process where an arranger brings two or more banks to jointly agree to provide a loan. The issuer pays an arranger fee for raising the capital, complexity of the services and the overall risk. It’s up to the arranger to make sure that the underwriting process has the least amount of complexity with the lowest amount of cost, which is why there is a huge incentive for companies to choose large banks with investment/commercial banking services.

For this reason, its really no secret why larger banks are the preferred funding source for loan syndication. You can still argue that a pool of smaller banks are capable of providing the necessary capital corporations need. The problem is, smaller banks do not always provide the same level of services and possess the same level of capital, which adds to the complexity of underwriting loans. Complexity increases cost; therefore, from a financial perspective, it wouldn’t make any sense for borrowers to choose smaller banks over larger ones. If anything, breaking up larger banks means that multinational companies would choose foreign banks for the loan syndication concerns, which in turn hands the loan syndication marketshare over to foreign banks.

As you can see, large U.S. multinational banking firms dominate the U.S. Syndicated Loan market. When it comes to much smaller U.S. banks, on the other hand, the market is turned over to larger foreign banks, that can easily replace domestic firms if bank break-up policies were ever adopted in the United States. This is just one of the few ways having larger, or TBTF, banks offers the United States a competitive advantage over foreign credit markets.

‘Too Big To Fail’ Institutions Pay Nothing For This Privilege

As mentioned previously, there are some notions regarding banks relationship with the government. Mostly involving how banks are able to lobby the government for special favors or favorable regulations, which in-turn increases the size of banks that wouldn’t have been able to flourish without these favors. While there is some truth regarding banking regulation and their lobbying to eliminate unfavorable regulations, this view fails to offer a balanced approach for banking in today’s society, their size and their role in today’s marketplace.

We need to recognize that we live in a sophisticated, large, modern economy and its going to require the need of large, interconnected firms that are capable of managing complex financial instruments. To meet these demands, firms would need to expand. Some firms may expand faster than others. That’s is mutually beneficial. If banks have very good and prominent investment banking presence, its going to have a better advantage and people/businesses are going to want to do business with these banks anyway.

The fact of the matter is, size matters when it comes to global financial markets. JP Morgan Chase is the only American bank that is ranked within the Top 10 of largest global banks (by assets). Among that list, China has 4 banks that are in the Top 5 and 5 banks listed within the Top 10. Furthermore, as the Chinese economy continues to grow, the among of assets that Chinese banks accumulate will grow substantially.

Rank Company Name Country Assets ($)
1 Industrial & Commercial Bank of China (ICBC) China 3,328.48
2 China Constrcution Bank Corporation China 2,704.16
3 HSBC Holdings U.K. 2,634.14
4 Agricultural Bank of China China 2,579.81
5 JP Morgan Chase & Co U.S. 2,573.13
6 BNP Paribas France 2,526.98
7 Bank of China China 2,463.08
8 Mitsubishi UFJ Financial Group Japan 2,337.04
9 Credit Agricole Group France 2,143.88
10 Barclays PLC U.K. 2,114.13
11 Bank of America U.S. 2,104.53
12 Deutche Bank Germany 2,078.13
13 Citigroup Inc U.S. 1,842.53
14 Japan Post Bank Japan 1,736.34
15 Wells Fargo U.S. 1,687.16
16 Mizuho Financial Group Japan 1,640.71
17 Royal Bank of Scotland Group U.K. 1,635.93
18 China Development Bank China 1,614.99
19 Societe Generale France 1,591
20 Banco Santander Spain 1,540.08

U.S. banks do not only have to compete with Foreign banks domestically, but they must compete with foreign banks abroad. They play a large part in helping to finance U.S. multinational corporations with a sufficient international business presence. Considering the financial involvement in U.S. companies, and the ever expanding nature of American economic growth, it’s no wonder why many foreign banks are much larger U.S. banks, in relative and absolute terms.

Most European banks have assets more than 100% of their home based nation’s GDP, while a few are more than 200% more than their size in GDP. The simple fact of the matter is U.S. banks don’t have the same size or concentration that is associated with European banks. However, because foreign banks are significantly much larger, they pose significantly more risk considering that Foreign banks have less capital on hand than U.S. banks.

The U.S. Needs TBTF, Even If It Thinks It Doesn’t…

Conducting business is very costly and very complex. It requires the assistance of firms that can handle a costly and complex business atmosphere. Even if you believe your money is safer with smaller banks, when it comes to performing large funding operations, most firms seek larger banks, for good reason.

While our political leaders debate over what should be done about our financial institutions and coming up with clever ways of limiting their size, they will only be looking at this debate from one point of view. In the short run, the largest foreign banks will fill the gap left by large U.S. banks. In the long run, banks that exhibit the most growth in financial assets will fill those roles as the global financial leader. Whether or not that will still be the United States has yet to be determined, but by recent trends, it is looking unlikely.

While smaller banks may be great for people who live in smaller communities, larger banks offers society with a great deal of advantages. Larger banks have the ability to invest more in a product development, which produces product innovation such as check imaging, identity theft prevention and mobile banking tools. Not to mention, larger banks tend to be more diversified in their activities, which posses less risk of failure.

Are there some negative drawbacks when it comes to having larger banks? As I have already outlined earlier, there certainly is. Propping up larger banks at the expense of smaller banks also provides an unfair funding advantage in our nations capital markets, which encourages them to take more risk.

Even if you do accept that larger banks enjoy higher degree of bailouts and subsidies, it may be because the markets recognize that larger, more diversified banks, pose a lower risk of failure than smaller, less diversified banks. This doesn’t mean that larger banks aren’t enaged in risk financial activity. They most certantly are; however, risky financial activities and larger banks are not mutually exclusive. As the financial crisis has shown, there were plenty of risk taking all around.

Considering this, policymakers shouldn’t be debating on how to break up large banks or prevent them from growing, nor should be limit the scope of their financial services. If anything, we should be finding ways to ensure there is fair competition in the financial sector (as well as its global presence), while ensuring that banks cannot pose a risk for the overall economy. For this to work, policymakers (politicians, regulators, etc) need a greater understanding of our financial institutions, how they work and their overall role in our global marketplace.

This may seem like too much homework for our elected officials to ever want to pursue, but as long as we are substituting soundbites for credible financial policy reforms/ideas, the financial sector will keep getting rich off our ignorance, as the rest of us will keep scratching our heads as to why this is occurring.

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