Bigger Safer Banks May Be The Way To Go

The blogosphere has been preoccupied this weekend by the WaPo article about the big banks getting bigger in the wake of the financial crisis. The predominant sentiment seems to be that this is a bad thing. All of the talk reminded me of a post that John Hempton who writes the excellent Bronte Capital blog put up about six months ago.

In that post, John pointed out that Australia has only four banks and that those banks make an unconscionable amount of money because they have no competition. In his view it was competition, or put another way excessive risk taking in the pursuit of financial returns, that caused so many of the world’s developed country banks to come close to oblivion.

His solution is to eliminate competition by merging the big banks and making them huge, then you regulate them with an iron hand. What you end up with are a bunch of big, boring, bureaucratic banks that make tons of money and are impervious to failure. Shareholders reap rich returns and as a consequence keep a rein on the banks’ risk taking lest it endanger the annuity stream from their investment.

John is not being facetious. He points out rightly that Australia has as many problems with leverage and property markets as does the US but it has zero problems with the solvency of its banks. Though not mentioned by John, Canada is another example of a banking system that is somewhat hidebound and certainly controlled by only a few players. Once again, they’re coming through all of this stuff quite nicely. Take a look at John’s entire post, it’s worth your time.

But while we’re on the subject of banks, let’s turn the discussion on its head and ask the question of what should be done with all of the small banks. Consider this also from the WaPo article:

Large banks with more than $100 billion in assets are borrowing at interest rates 0.34 percentage points lower than the rest of the industry. Back in 2007, that advantage was only 0.08 percentage points, according to the FDIC. Such differences can cause huge variance in borrowing costs given the massive amount of money that flows through banks.

Folks, I can assure you that with that sort of cost of money spread there is no way on earth for a small bank to compete with a large bank. It can’t be done. The combined effects of size, leverage and funding costs of this magnitude make it a simple exercise for large banks to snuff out small banks whenever they choose.

Even before the credit meltdown, smaller community type banks had seen most of their profitable business siphoned off by the large banks. Virtually that was left on the plate for them was loans to the smallest of the small businesses in their markets and local commercial real estate lending. As we’re coming to find out, the degree of loan concentration in CRE grew like Topsy and is now crashing down around their heads. Looking past this phase one has to ask how, if they are to be prudently run, are these banks going to make money. Literally, what purpose do they serve.

If put on a short leash when it comes to future real estate related loans, I find it hard to answer those questions in any manner that suggests we need 8200 banks. I just can’t figure out how they can accumulate earning assets that will provide any sort of meaningful return to shareholders absent piling on unacceptable risk once more.

So, If market forces are pushing us towards more concentration of banking assets anyway, maybe we need to pay some attention to Hempton’s ideas. Big and boring might be the wave of the future and it might also be the way to avoid a repeat of this disaster.

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