Emmons discuss the basis of banking and why they exist and two key economic functions they perform: payments and credit. He then explores why banks have become so large and complex due to economies of scale and scope. How big do banks really need to be to capture these economies of scale?
William Emmons: So now let's back up a little bit. All right, that's what's happening. How did we get here? That's kind of the idea here. So why do we even have banks? Why are there banks at all?
So I think most economists would agree that we have banks to perform two key economic functions - to operate our payment system and to provide credit. So by payments I mean keeping track of who owns the economy's money and facilitating trade and goods, services and assets. So that payment system consists of the currency and coin in your pocket, checks, all sorts of plastic cards, as well as electronic transfers of funds, whether it's large dollar or small dollar payments.
Credit, of course, I mean by that loans. Getting together people who have excess funds. Getting those funds in the hands of people who have productive uses for them, the borrowers. That's what banks are about.
So why do we have big banks, very complex banks? Well, to try to answer that question, most economists would ask these questions. I mean, what are the efficiency gains to getting bigger or more complex? And two candidate explanations would be what we would call economies of scale and economies of scope.
So an economy of scale is when the average or unit cost of doing something is lower if you do more of it. An example would be the average per dollar fee that you pay to use an ATM, if you pay a fee, is lower if you withdraw $200 than if you withdraw $100. That's a simple example of an economy of scale. It's cheaper if you do more of it.
An economy of scope is realized when the unit or average cost of doing two different things is lower if you do them at the same time, if you do them together. And, again, using an ATM example, if you need to deposit checks and you also need to get cash out you can save gas if you do those two things on the same trip to the ATM. So there's a synergy, an economy of scope in combining those different activities. And, of course, it makes sense to be able to do those two things in the same machine or the same bank branch say.
So those are the simple concepts. And we think maybe that's what's driving banks to get bigger and more complex. So economies of scale in banking include computer systems. It doesn't cost much more to keep track of a million accounts versus a thousand accounts. Once you invest in that hardware, that software, it's relatively cheap to expand the scale. So you can reduce the average cost, the fixed cost of setting it up.
It's also the case that in clearing and settling payments there are economies of scale. If you can have a lot of customers, sometimes your customers will trade with each other, or someone would write a check on another person who has an account at your bank. So you can just offset those. You don't have to deal with any other banks. There's an efficiency there in being able to clear and settle those transactions in-house.
Another example would be banks that have loans to lots of different customers. The more different customers you have, the more diversification you get. So you can reduce the uncertainty about how large your losses will be. So by having a larger more diversified portfolio you might be better off.
And finally I'll mention in terms of raising funds. At the retail level, my favorite example is say the Bank of America branch, which looks the same everywhere. Well, there's some economy to doing the same, building the same branch and having the same procedures all over the country, so they can get some scale economies by raising deposits that way. In the wholesale markets, in capital markets, there's evidence that larger firms can develop reputations. So they maybe have access to investors at better prices. So there might be advantages to being bigger in raising funds in capital markets.
So all these are possibilities. All these are things that would say, yeah, I can see why it might make sense to be bigger. But how big do you need to be to take advantage of that? Economic research done at the St. Louis Fed by David Wheelock and other economists suggest that most scale economies are captured by banks that have no more than 30 to 50 billion dollars of assets.
Examples in that range include First Horizon National Corp., which is a bank we supervise, a bank holding company we supervise. BOK Financial in Tulsa, Zion's Bank Corp. in Salt Lake City, Comerica in Dallas, all would be in that range.
Well, these of course are just minnows compared to what—they all rank in the top 100, but they're way down the list.
The largest institutions are these listed here. The largest what are now called financial holding companies, so they have both banking operations and also lots of other financial operations inside the corporate organization. JP Morgan Chase at the end of last year had $2.3 trillion of assets. So that's quite a bit larger than $50 billion. Bank of America, also $2 trillion. Citi Group, Wells Fargo, over a trillion. And then a few more in the $9, $8, $750 trillion, or billion dollars of assets. And you can see the percent of all bank, or financial holding company assets there in the next column.
If you put those seven companies together, that's over $10 trillion, which is about 70 percent of all the assets in U.S. financial holding companies. So compared to other countries this isn't all that unusual, but it is somewhat different than what we have seen in the United States in the past. And in fact, if you go back 20 years, this starts in 1990, and then '95, 2000, 2005, and then single year increments. You can see that the share—this is now a slightly different metric. These are bank holding companies, not financial holding companies. There's some overlap, but it's a slightly different way to categorize.
In 1990 the top 10 had 28 percent. A decade later they had 52 percent. A decade later they had 66 percent. So on this metric, similar to the previous one, 66 percent of total consolidated assets, in this case in the top 10. So a very concentrated system even relative to our own past.
So is it the case, and we'll come back to this, is it the case that we have these giant banks because they're exploiting those economies of scale? Some evidence suggests that's maybe not what's going on because those gains really start weighing after about $50 billion in assets.
Okay, the other thing that I mentioned is economies of scope. Certainly we can think about payments and credit being performed more efficiently if they're done together. There's a lot of credit used in the payment system. It's—Float, for example, is credit. That makes the whole payments operation sometimes more convenient.
There's also, over the years there have been arguments that consumers want a single financial provider, so-called one-stop financial shopping. Actually, that hasn't panned out. There are very, very few examples of financial firms that have provided a very wide array of services and been successful in retaining customers. In fact, many of the big so-called financial supermarkets have broken themselves up over time because they were not terribly successful.
What about the merger of commercial and investment banking? That also has mixed reviews. Some companies believe they've been successful; others less so. Combining banking and insurance, in particular insurance underwriting, but even insurance agency also, haven't been convincing instances of real strong economies of scope. And what about market making that is providing liquidity for other traders and trading on the bank's own account? Again, it's not clear that there are huge benefits in combining those activities.
So now I'm going to fill in the table. One measure of complexity is just how many separate legal entities are in these companies. So measure that by the number of subsidiaries in financial holding companies. And that's listed in the third column here. JP Morgan Chase has 3,391 subsidiaries. That's a fairly complex organization. They operate in almost 100 countries. That, again, is a measure of complexity.
There are others that have over 1,000. Here Goldman Sachs has over 3,000 subsidiaries. If you put those seven companies together, they have 14,583 subsidiaries. So about as much share of the total as they did in terms of assets. So, again, lots of big, big banks with lots of complexity.
So does a bank need to be complex to succeed? Going back to economic research, as I kind of summarized before, most of the research suggests there are few, if any, significant efficiency gains associated with combining traditional banking, payments and credit, with other financial services.
So why do banks become complex? According to some very interesting research done at the New York Fed, some of the things that seem to point in the direction of why banks become complex, the first one is, maybe it seems obvious, size. Size breeds complexity. So as banks become larger they do tend to become more complex. There also appear to be reasons, some of the reasons are that subsidiaries are created to mitigate or avoid regulation, sometimes going across borders, sometimes within the United States. It may be easier using separate legal entities to reduce tax liabilities. And it may be possible to create some protection from risks in bankruptcy.
So each of those four you could see why they might be attractive to an individual firm, but as an economist would say, none of them increase the general welfare of society. There's no total benefit created, for example, by shifting risks from one entity to another within the economy. There's no economy-wide gain for one party to reduce its tax liabilities, because someone else will have to pay those.
So how have banks done in the stock market, for example? Here's a chart that shows from 2000 going through last Friday. First the overall U.S. stock market, that's the red line, the S&P 500. And then the blue line is an index of 24 banking companies, stocks. And you can see that from about 2007, the beginning of the financial crisis, to the worst point in the crisis, there was about a 90 percent decline. Much, much more severe than the overall stock market. There's been some recovery, but trailing the market. And so whether you use 2000 as a beginning point or 2007, bank stocks have vastly underperformed the rest of the market. So you might say that the structures that the banks put in place certainly didn't help them, at least obviously, it wasn't obvious that it helped them in this regard.
So summing up this evidence. Banks don't appear to grow very large and complex purely for reasons of economic efficiency. It's very hard to make the argument that the $2 trillion or $1 trillion banks are that size, or with 3,000 subsidiaries, are designed to maximize efficiency, certainly not from a global social welfare perspective. Because scale economies appear to be fairly insignificant at a very large scale, scope economies aren't very easy to identify. And in fact, there's some evidence of inefficiencies, as not just banks but other companies also become very large and very complex.