Do Big and Complex Banks Create Any Special Problems?

September 30, 2012

Large and complex banks create systemic risk, and economist Bill Emmons explains why such risk increases the potential for major shocks throughout the financial system, which, and in turn, can harm the broader economy. He also explores the question of why even more systemically important financial institutions (SIFIs) have been created in the aftermath of the financial crisis.

Presentation (PDF)


William Emmons: So you sort of got this puzzle. If they're not being created for these positive reasons, they're not obviously more efficient. Are there any—But you might say, well, that's the, everybody should be free to create whatever kind of organization they want. Yes, unless there might be some other considerations. And so that's why I raise the question, do big and complex banks create any special problems? And the answer, I think, has to be yes. They create systemic risk.

The definition of a global systemically important financial institution, and there is a domestic counterpart to that, which is very similar, is an internationally active financial institution, the failure or impairment of which could send shocks through the financial system, which in turn could harm the real economy. So that's what economists would call an externality, a negative externality. The failure of one of these institutions is not simply the matter of the owners of the company or the creditors, but it affects potentially the whole financial system and the economy.

Here is a, sort of a schematic, giving you just a little hint of what the Basel Committee has identified as the 29 financial institutions worldwide that they consider to be in this category. You can see the Americans are here on the left. And there are British banks. There are French, Italian, German, Japanese, Spanish. So there are these large institutions, the failure or impairment of any one of which could potentially destabilize the financial system or the broader economy.

Are there any other things you don't like? I'll bring back Phil Angelides. Again, speaking as a private citizen, he said, "In the course of our commission's work and thereafter, I was taken aback at the immense political power of the financial industry. I have been stunned at the raw and crude exercise of power by Wall Street to achieve its means over the public interest." I think you would have to add that to some of the other, the negative externality problem. So why do we have trillion dollar banks that combine virtually every conceivable financial activity while operating in dozens of countries? Here are some of the largest in the United States. And why did we bail most of them out during the financial crisis, in some cases twice? Why did we approve emergency over-the-week convergence of investment banks to bank holding company status, which normally would have taken weeks or months? And why did we allow some of them to become even bigger and more complex during the crisis? Examples of which would be Bank of America acquiring Merrill Lynch and also acquiring Countrywide. So Bank of America already was a large, complex institution, and through these transactions during the crisis became larger and more complex.

Good questions.


So we'll come back to that. What do the big banks say? The bank supporters, the big bank supporters would say the academic research that finds no or limited benefits to large size and complexity may be flawed. There are too few mega-banks or data points from these very large banks to really measure their effectiveness. You can't compare them to a small community bank. They're just different animals. And it could be the case that the studies economists are using are simply measuring the wrong things, such as short-run profitability, or simplistic measures of operating efficiency. Indeed, companies like Bank of America for years have said that their goal was over a long period of time to establish a nationwide franchise that would pay off only over years. And so by looking at their quarter by quarter profitability you're missing the whole point of their strategy.

I would say more importantly, the big bank argument would be that these big and complex banks have passed a market test. Multi-national companies need multi-national banks. That was the thought expressed by Mr. Harrison at the very beginning. And if shareholders and these companies didn't like the way these companies were run, they would change them. It's a free market. And so if there's a problem, if they're not creating value then the shareholders would change them.

So these are my own personal responses, not necessarily those of the Fed or anybody else.

On the fallibility of the research, I would give, I would grant that critique. I think that there is something fundamentally different about the mega-banks and a community bank. And so much of the research that we have may be limited in its applicability to these very, very large institutions. So I would say case not proven that they're not creating value in any way.

However, on the passing the market test argument, I am not convinced, for these reasons. Most, if not all of the mega-banks would have failed without government support during the financial crisis. In other words, in a truly free market, most or all of those banks would have exited. The returns to big banks' shareholders have been very poor, not only the periods that I showed you, but over longer periods of time. And large companies, as far as I can tell, are lukewarm supporters of big banks. An example of that is this thought given by Jeff Glenzer, who works for a trade association representing corporate financial executives in non-bank firms. He says, "Is it going to have a material detrimental impact on corporate America if they were broken up?" I doubt that. I have not heard any support for big banks. Nor any demand for a break-up for that matter.

So what about this shareholder discipline? Why haven't shareholders acted if they're a problem? Again, these are my views. I think bank shareholders haven't downsized or simplified mega-banks because what economists call the market for corporate control doesn't operate very well among mega-banks.

So think about it. Who would discipline these banks? Who would sort of light the fire under the feet of the board members? What about another U.S. bank? Well, the banks that would be big enough to provide a credible takeover threat are themselves already in this category. And in some cases they wouldn't be allowed to merge because we do have some limits on how large banks can be after an acquisition.

So they're too big to merge. What about a non-bank financial company? Most non-bank financial companies, insurance companies, for example, don't want to be regulated the same way a bank is. And our laws say that as soon as you take over a bank you must become a bank holding company and you're subject to Steve's oversight.

What about a foreign bank? Well, that doesn't really solve the problem either because most of the banks that would be in this category are on that list of G-SIFIs. So you might transfer some of the problem somewhere else, but you don't crack this nut really.

And then most promising, I think, would be some more entrepreneurial financial firms, like private equity firms or hedge funds. But we have seen throughout the financial crisis that there are real limits to that. One is the size, just the huge size of the large banks. So it would probably require a consortium of firms, which may have difficulty coordinating. But it's also true that the regulators have not been very welcoming. At least that's the interpretation that the private equity and hedge funds take. Because we still require anyone who takes over a bank to become a bank holding company and be regulated like that, by the Fed.

So I think it's not obvious that the fact that the big and complex banks still exist that that's truly what everybody wants, what investors, shareholders, board members wants. It could be simply a failure to be able to restructure or downsize these institutions effectively.

This popular lecture series addresses key issues and provides the opportunity to ask questions of Fed experts. Views expressed are not necessarily those of the St. Louis Fed or Federal Reserve System.

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