Garett Jones  

Expanding Megabanks: Is Impatience the Cause?

Henderson on Zingales... The Joy of Microwaves...
From Tuesday's Wall Street Journal:

Some, like Citigroup Inc. and Bank of America Corp. have embarked on diets of their own.  On the whole, though, the financial system is more concentrated than before the crisis. 

And Santander, the largest Euro-area bank with 32 million depositors across the Euro area, is buying up smaller banks.  Tuesday's WSJ again: 

[Spain's banking] sector is concentrating into fewer banks, with larger, healthier banks absorbing weaker ones, often with help from the government.

In the wake of the crisis the Too Big To Fail problem has grown across the rich countries.  When something happens always and everywhere we should start looking for underlying laws.  We're not at "always and everywhere" here but it's getting close: Time to theorize.  

I don't think political influence from big banks is a major reason for the recent rise in bank size.  Political influence is a constant, like gravity, so the question is what changed after 2008.  Why the rise in bank concentration just as economists, policymakers, and politicians became more worried about bank concentration?  

It sounds to me like an interaction between hyperbolic discounting (impulsivity, short term impatience in the government sector) and time inconsistency (depositors know the regulator will cave later so depositors put more money in TBTF banks today, making it even more tempting for the regulator to cave).  

When you've got a small weak bank RIGHT IN FRONT OF YOU it seems like you should make that bank as safe as possible: And the way to make it safe is to lump it together with a bank that will get a bailout if things go bad at some point in the future.  

And in the future, when things go bad, you know that you or your successor will likely cave since the suffering will be RIGHT IN FRONT OF YOU.   And part of the reason you'll cave is because the bank has grown so big.  It'd be irresponsible to create systemic risk in the name of  some abstract ideal like "market efficiency" when short-term macroeconomic stability is at stake.  Today's temptation makes tomorrow's bailout more likely than ever.  

This is just one channel, others are at work.  But I think hyperbolic discounting by bank regulators is a big problem for bank regulators.  One way to end that problem is by putting a lock on the liquor cabinet with loophole-free legislation that forbids bank acquisitions by the biggest banks.  No "unless in the judgment of FDIC the public interest would be served by such an acquisition," no "final rules implementing this legislation shall be passed no later than January 1, 2018," nothing like that.  Just a ban, now.

If legislators enact such a ban, then in the future a tiny number of well-informed policy experts will be quite grateful.  I hope legislators have a great desire for praise from such people.  

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COMMENTS (6 to date)

I think it does have to do with confidence, but not so much because of bailout expectations. Also because banks heavily rely on short-term liquidity, requiring that the bank's assets be in good shape. Many weaker banks have poorer quality assets, so the government aids in advancing bank mergers as a means of reassuring wholesale depositors. It's to avoid isolated panics that may develop into more if left unchecked.

Philo writes:

“[L]oophole-free legislation that forbids bank acquisitions by the biggest banks” is an awfully crude approach. Some such acquisitions would, indeed, “serve the public interest” (as well as the interests of the owners of both the big and the small bank), and should not be forbidden. It’s a very thin pretext for such a ban to claim that without it the regulators won’t do their job properly.

Joe Cushing writes:

Even without government market interference, healthy banks would buy up unhealthy banks during crashes. The unhealthy banks are at discount prices. Even without government interference the healthy banks could buy the part of the unhealthy bank that has value and leave the negative value stuff on the table. So we add in some government interference which helps these transactions along and there are more of them. I don't really think there is any new news here.

Ghost of Christmas Past writes:

I think it is slightly misleading to speak of "healthy" banks buying weak ones. Some of those "healthy" banks have a lot of "regulatory capital," not so much real capital-- which is both a consequence and cause of their TBTF status.

My proposed "draconian" legal cure is to forbid, not mergers, but size. If no banks are too big, none will be TBTF. I'm not sure how many dimensions need to be measured (deposits, capital, assets, liabilities, derivative exposure, etc.) but no bank (nor bank-like "non-bank" fiancial firm) should be allowed more than two percent (2%) of the US total on any of them. Period.

Ghost of Christmas Past writes:

Modern American banks have a bunch of computers, a staff of people who act as flexible I/O processors for the computers, a much smaller staff of decision-making people, and a very small superstructure of top execs, rainmakers, lobbyists, and board members.

All but the execs/rainmakers/lobbyists get their maximum marginal returns to scale by the time the bank reaches 2% of the US Total bank size on any dimension of interest. Above that size, the only advantage to be gained from sheer growth (by mergers, say) is regulatory clout, which is a problem rather than a solution.

For everything else there are diseconomies of scale. Indeed, this is true even considering stuff like the board-- as the bank grows the cost of the board declines as a portion of total costs, but the effectiveness of the board shrinks as well, so there is no gain to the bottom line-- any money you save on stipends and perqs for the board, you more than lose to unchecked management frippery or even peculation.

While I agree that "hyperbolic discounting by bank regulators is a big problem", I wonder whether banning acquisitions would solve the problem. Looking at the most recent crisis, Bank of America, Wells Fargo and JP Morgan were practically begged by regulators to acquire other large banks presumably because no better alternative existed. Had those mergers been prevented, what actions would have been taken? Speed bankruptcy is an option, but likely wasn't on the table. It seems plausible that the government and Fed would have bailed out those failed banks more explicitly.

One of the other channels, that I think may be a greater issue, is the subsidies inherent in an implicit government backing for SIFIs. My reading suggests these institutions are able to finance their operations at rates 50-100 bps below other financial institutions. This cost advantage could eliminate smaller institutions regardless of banning acquisitions.

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