Size Matters in Banking, and Big is Worse

Columbia University finance professor Charles Calomiris makes a case in yesterday’s WSJ about why the world needs giant banks.

“There are sizable gains from retaining large, complex, global financial institutions,” says Calomiris, an economist and the former co-director of the American Enterprise Institute’s “Financial Deregulation Project.”

His arguments can be summarized as follows:

• Big banks must operate globally to meet the needs of their increasingly vast corporate clientele
• Huge financial companies provide economies of scale, such as offering a wide range of services, benefiting consumers and the financial system
• Global financial institutions help developing market economies by extending them credit
• Big banks enable global trade by knitting together stock, bond and other markets

Let’s examine these claims one at a time.

Banks must be big enough to meet the needs of large clients. As James Kwak recently explained, major corporations don’t do business with a single bank. Quite the contrary — the bigger they are, the more financial institutions they tend to use. When a large company issues debt, say, they hire a slew of underwriters, not a single firm. Similarly, companies that operate worldwide typically do business with top banks in their respective countries, rather than retaining a given firm at home to handle all of its needs.

Huge financial companies provide economies of scale. The evidence for these supposed economies is very thin. For one, mergers of the kind that have spawned mega-banks are notorious for failing to deliver value (not only in financial services).

Besides, the real question is who profits from those economies, and at what cost? Big banks may be more efficient than smaller players, but those savings rarely trickle down to consumers. Take service fees. As financial companies have expanded, charges for overdrafts, late-payment penalties on credit cards and merchant processing have soared. And if adding scale requires imbuing a commercial bank with an investment bank’s soul, with all of the risks that entrails, the gains may be temporary, or downright illusory.

True, the growth of banks has yielded some benefits. Eliminating barriers to branch banking in the 1990s brought competition to underserved markets, just to name one. But runaway industry consolidation, coupled with the growing dominance of larger banks, is now tilting the see-saw too far in the other direction, reducing competition.

That’s a particular problem for small businesses, which continue to create the vast majority of new jobs in the U.S. Community banks represent about 12 percent of all bank assets, but they make 20 percent of all small business loans. These lenders also make fully half of all small business loans under $100,000. Yet community banks are today falling in droves in large part because of the recklessness of the mega-banks and because of government guarantees for the “too big to fail” set.

It’s time to recognize that this nation’s economic health depends as much (or more) on its small banks as it does on the industry’s leviathans.

Big banks enable global trade by knitting together stock, bond and other markets. The trouble here is that the size and complexity of large financial companies makes it difficult to know how they really work. One rule of thumb is that chasing profit typically supersedes managing risk. Banks also like to keep their operations secret, making financial markets opaque. That forces investors and creditors to stumble around in the dark, heightening the danger when panic strikes.

Let other specialized financial players, whose collapse wouldn’t jeopardize the entire financial system, roll the dice. Rather than engaging in financial chicanery, such as securitization, to gin up profits, banks should focus on their traditional business of taking deposits and making loans. That provides the added benefit of diversifying capital, along with risk.

Global financial institutions benefit developing market economies by extending them credit. In American football, this is what’s known as a “misdirection play.” Macroeconomic factors, such as inflation, unemployment, trade balances and currency rates — not the fate of giant financial companies — have the greatest impact on developing countries. And their economies hinge less on the welfare of global banks than on the health of local financial institutions.

More generally, although there’s a connection between credit flows and economic development, these effects are not entirely understood. What is clear, however, is that they’re not necessarily (or even chiefly) benign (see the Asian financial crisis in 1997, Russia in 1998 and Argentina in 2002). In 2007-08, which capped a period of enormous investment in developing countries, equity growth in industrialized economies fell 45 percent — in emerging economies it fell 51 percent.

As has been the pattern with previous financial crises, big banks reacted to the bubble bursting by liquidating their foreign assets and shipping the money home (click on chart below to expand). Lenders froze credit and refused to extend loans. Capital flows pouring from developed economies into emerging ones suddenly reversed course.

So the claim that global finance, let alone the biggest institutions, always and forever works to the benefit of developing countries is specious. The picture is much more mixed.

Finally, Calomiris omits any discussion of the most pressing problem with big banks — their political clout. A principal cause of the financial crisis was the banking industry’s expertise over the years at bending lawmakers to its will, especially in knocking down inconvenient government regulations.

When U.S. financial companies grow too powerful, their influence on government replicates the kind of oligarchical alliance between big business and political leaders that is commonly found in developing countries. As I’ve written before, this is an old and recurring story here, too.

The “sizable gains” that purportedly come from having big banks, as Calomiris would have it, turn out to be rather small change.

Graph courtesy of McKinsey Global Institute.