Monday, January 18, 2010

Breaking the Banks

The following expresses my personal views, not those of the SEC or its staff.

A few months ago I wrote a post entitled “Why do bankers make so much money?” A corollary question is, “Why do the largest banks make so much more than other banks?”

Addressing this question can help us solve the problem the largest banks pose for systemic risk, and open a channel for demands to curb their outsized profits. Profits that, by the way, are not exactly coming from producing real goods like steel or flat screen TVs. Goldman Sachs might stand foremost in Matt Taibbi’s view as a “great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money”, but all of the largest banks are increasingly seen as machines of wealth transfer, devising ways of pulling money from your pocket into theirs.


The largest banks are different from the rest, and different in ways that make them seem to be bad citizens. Compare them to the banks that are down the line in size, say regional banks, by any of these standards:
  • Amount of risk taking
  • Supplying and pushing of derivatives and other “innovative products”
  • Complexity and opaqueness of operation
  • Incentive structure and level of compensation
  • Ability to call on government support (too-big-to-fail coupled with political weight)
It is not the case that the largest banks are the same as other banks, just bigger. The regional banks are not baby JP Morgans or Goldman Sachs. What sort of trading desks do the regional banks have? How many product specialists/salesmen/modelers designing, pumping out and trading innovative products? What type of proprietary trading desks do they have that piggyback on the bank capital, customer desk trading flow and back-up from the Fed? How many of them are paying out over fifty percent of earnings in compensation? How many have a bee-line to the Fed and Treasury when things get rough?
In the movie Sabrina the title character said, “More isn’t always better... sometimes it’s just more”. But sometimes more is more than just more.The largest banks do things the smaller banks cannot do. They behave differently. They are a separate species, qualitatively different in ways that make them problematic. In fact they aren’t even banks. They are no more like Zion’s National Bank than they are like Fox Pitt, NASDAQ, Tudor Capital or Vanguard.

Another way the largest banks are different is that they have something close to monopoly power. You might be wondering how I can assert this when we all know that there are at least six large banks. (If you want to call it oligopoly power instead, that is fine).

Well, first of all, they are not open to outside competition because there are huge barriers to entry. Second, there are limits to the supply that any one bank can provide, limits to production, so to speak, because as big as these banks are, they cannot operate efficiently if they get much bigger. And third, they promote a noncompetitive industrial organization. They do that by, among other things, creating informational asymmetries. The innovative products they promote -- both derivatives and consumer products -- give them an informational edge over their customers. The trading operations they run do the same.

So if we want to curb the risk taking, too-big-to-fail conflicts, opacity, and the creation of informational asymmetries and complexity, we need to move them down to the scope and scale of the smaller banks. We need to break them up.

If the large banks are broken up into smaller banks, the risk taking, incentive distortions, lack of transparency and too-big-to-fail mentality will drop, and drop more than proportionately. If you buy the argument that the banks can exert something like monopoly power – and with the count of large banks down from a year ago, whatever monopoly power they could exert then, it has got to be worse now – then breaking up the banks will eliminate that power. And it will reduce the barriers to entry that stifle competition.

We did something along these lines before: the Glass-Steagall Act, a.k.a. the Banking Act of 1933. But reinstating Glass-Steagall is not enough, because we will still have a small set of large banks on the one hand, and a small set of large investment banks on the other, with both groups raining down negative externalities. In addition to again separating commercial banking from trading and proprietary risk taking we need to reduce the size of the largest banks and investment banks.

1 comment:

  1. Hi Rick,

    I guess you’re a supporter of the Volcker plan and beyond (Volcker + plan?).

    But may I ask what about the non-bank financial firms that are big enough to be considered systemic? If you break the big banks, won’t traders just move around to the non-regulated entities? And if we regulate those too, won’t they go overseas to less regulated jurisdictions?

    Point being:
    - It has to be controlled system-wide, not just regulated firms; regulation implemented through substance over form paradigm.
    - it has to be coordinated and implemented globally and monitored for compliance (IMF? Financial Stability Board?). too bad there’s not enough political will around the world to enforce this.

    How are things at the SEC?

    All the best,
    -Eran

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