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Making the argument against big banks

by Robert Teitelman | Published March 21, 2011 at 3:18 PM

What to do about our big banks? That's the subject of a paper by two economists, the World Bank's Asli Demirgüç-Kunt and the University of Tilburg's Harry Huizinga (pictured right), on voxeu.org (hat tip: Mark Thoma's Economist's View), which seemed to have originated as a discussion paper at the Center for Economic and Policy Research in Washington. The paper reviews the literature on bank size and wants to say something definitive about how banks have grown too large. In fact, it drifts around, citing studies that are either obvious or questionable, then tries to tie the whole thing up by that great explanatory über-argument, "governance." In the end, this modest discussion paper illuminates why economic studies on such subjects managed to miss the bank crackup in the first place and often seem beside the point today. The pair wants to show that big banks are not only dangerous but inefficient, suboptimal and lousy investments. The former is obvious. There clearly are systemically dangerous, too-big-to-fail institutions, which, if they collapsed, would plunge the economy into recession or worst--or stir the kind of political backlash that the bank rescue efforts of 2008 elicited. The pair offers research to prove that remarkably obvious point: A 2008 study suggests, as they summarize, that "saving oversized banks ... may ruin a country's public finances." But besides stating that truism, economists seem to feel they have to quantify just how bad big banks are as a class, particularly compared to small banks. In doing so, they tend to flatten out differences between banks or ignore wide divergences of regulatory regimes.

Demirgüç-Kunt and Huizinga clearly have already decided that a) the evidence is in that big banks are a danger and b) that everyone knows the direction that regulatory policy should go. But they sense a lack of empirical definitiveness. "Additional insight is useful before one passes judgment on whether systemically large banks should be regulated or taxed out of existence." Useful. Yes. That's a little different from saying, well, we don't really know whether big banks are necessary and whether they should be encouraged. They're unnecessary, inefficient and lethal; we just can't prove it yet. They then offer their own study, which succeeds in muddying the waters further. First, they look at a sample that includes banks from 80 countries from 1991 to 2009. Such a broad sample buries any effect of different regulatory regimes, historical tendencies or dynamic changes over a period that famously saw fundamental alterations in regulatory attitudes in developed economies. It's as if they are studying some Platonic "bank" that exists in isolation from its regulatory and economic context. Perhaps there are conclusions that can be drawn about efficiency, cost or funding expenses of large banks. But to compare a universal bank with extensive trading, advisory functions and global reach with a small lending and depository institution is to compare a Boeing 777 with a balsawood plane propelled by a rubber band. And even if they had proof that the balsa plane is superior, they don't offer any idea whether the Boeing performs functions the model plane cannot. That discussion lies well outside their quantitative framework.

Second, they make a distinction between absolute size and systemic size. Absolute size is exactly what it suggests: the biggest banks. Systemic size is a measure of a bank compared to the size of its national economy, and is thus a kind of measure of the risk it poses. Past this point, fog descends. The pair argues that if you look at absolute size, larger banks show better returns. "A bank's absolute return implies a trade-off between risk and reward." But systemic banks show lower return on assets. While risk rises, reward falls. This is, on the face of it, confusing. Is there a magic line that exists when absolute edges into systemic and all hell breaks loose? Can a bank be both, and what does that tell us? "In practice expanding banks see their absolute and systemic size increase simultaneously," they write, clarifying little. Banks in small countries become "systemic" more quickly and dramatically, which at least makes sense.

They then turn to systemic institutions and argue that because their interest expenses are higher by 40 basis points--compared to what, the absolutes?--the market is suggesting they are "too-big-to-save." This runs contrary to the prevalent notion that TBTF banks get a market subsidy. They then murk up the waters by citing earlier literature on absolute size, which suggests that size pays off in a variety of ways. So what happened? Instead, they veer to "earlier evidence" from U.S. banks that show absolute size reduces market discipline by debtholders. Is this the TBTF subsidy? How do you jibe this U.S. study with the broad global sweep? Why are we back to absolute banks?

Still, for all this, the real sign of a kind of quantitative floundering is how, near the end of their paper, they reach for a kind of deus ex machina. The pair ask themselves the following question: Why has the market allowed the emergence of systemically huge banks, which it knows are bad? Their answer? "A main reason for this may be that bank managers, rather than bank shareholders, in practice devise and implement bank strategies." And "bank managers may well benefit from bank asset growth through higher pay and stature." They conclude: "The phenomenal growth at individual banks that we have witnessed over the past several decades may thus be a reflection of inadequate corporate governance failing to align the interests of bank managers and bank shareholders."

Ah, the inevitable conclusion. But were shareholders fooled into investing in larger and larger banks? There's no evidence of that, except the tautological argument, beloved of economists, that shareholders cannot be "wrong," and thus when things go bad, managers (and boards) must have been doing their agency thing. The idea that shareholders and managers were locked into a self-reinforcing dynamic--and one that seemed to work for some time, at least in terms of share price--rarely gets aired. The pair ignores the fact that shareholders appeared perfectly happy to see banks press the accelerator on risk and size (indeed, they rewarded M&A in many cases), that the conventional wisdom for decades was that size was all-important, that a handful of large banks would inevitably come to dominate global finance and that only size and diversification would offer protection against predation. For many years, interests seemed to be aligned. U.S. shareholders, in particular, cheered the nifty profits from mortgages (and they had no problem with big pay either).

Not surprisingly, the pair takes this stew of murky conclusions to argue for quantitative limits on bank size, increased capital and liquidity standards or taxation on systemically important banks. Again, the reality that such large banks pose a systemic TBTF risk should be enough to nail that argument, without the quantitative sophistry. But let's not fool ourselves that we will not pay some price by deciding that all large banks are bad. If the conventional wisdom--that big banks are good--that lasted so long with nary a word of discouragement was undoubtedly oversold, the idea that all big banks are bad also reeks of a kind of fashionable certainty that will undoubtedly pass. By then, we will have new economic studies that explain new realities. - Robert Teitelman

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