Is too big to fail a good thing?
I read this blog post a couple of days and it really got me thinking. This guy John Hempton from Australia is advocating the too big to fail model- in fact he things we should merge more big banks together (Citigroup and Wells Fargo) because we haven’t gone far enough!
His overall thesis is that competition in finance increases as a function of how many banks there are out there and is a bad thing for stockholders and for society, because it makes people desperate for profit, and in particular people increase their risk profiles in pursuit of profit and they blow up:
What I am advocating is – that as a matter of policy – you should deliberately give up competition in financial services – and that you should do this by hide-bound regulation and by deliberately inducing financial service firms to merge to create stronger, larger and (most importantly) more anti-competitive entities.
He acknowledges that the remaining banks will be hugely profitable, and perhaps also extremely lazy, but claims this is a good thing: we would, as a culture, essentially be paying a fee for stability. It’s something we do all the time in some sense, when we buy insurance. Insurance is a fee we pay so that disruptions and small disasters in our lives don’t completely wipe us out. So perhaps, as a culture, this would be a price worth paying?
The biggest evidence he has that this setup works well is that it works in Australia- they have four huge incompetent yet profitable banks there, and they don’t blow up. People who work there are sitting pretty, I guess, because they really are just living in a money press. There is no financial innovation because there’s no competition.
I guess I have a few different reactions to this scenario. First, it’s kind of an interesting twist on the too-big-to-fail debate, in that it’s combined with the idea I already talked about here of having a system of banks that are utilities. John is saying that, really, we don’t need to make that official, that as soon as banks are this huge, we are already done, they are essentially going to act like utilities. This is super interesting to me, but I’m not convinced it’s a necessary or even natural result of huge banks.
Second, I don’t buy that what happened in Australia will happen here- perhaps Australia squelched financial innovation through regulations and the existing boring system, but maybe the people who would have been financial innovators all just moved to the U.S. and became innovators here (there are plenty of examples of that!). In other words Australia may have made it just a bit too difficult to be competitive relative to what else is out there- if everyone tried to be that repressive to financial innovation, we may see people moving back into Australia’s financial waters (like sharks).
Third, I think what John is talking about is an example of a general phenomenon, namely that, in the limit as regulations go to infinity, there is only one bank left standing. This is because every additional regulation requires a lawyer to go over the requirements and a compliance person to make sure the rules are being followed continuously. So the more regulation, the more it behooves banks to merge so that they can share those lawyers and compliance officers to save costs. In the end the regulations have defined the environment to such an extent that there’s only one bank that can possibly follow all the rules, and knows how to because of historical reasons. And that one, last bank may as well be a government institution, albeit with better pay, especially for its managers.
But we don’t have that kind of regulatory environment, and hedge funds are alive and well. They have to follow some rules, it’s absolutely true, but it’s still possible to start a smallish hedge fund without a million lawyers.
I guess what I’m concluding is that if we had formed our very few, very huge banks because of a stifling regulatory environment, then maybe we would have an environment that is sufficiently anti-competitive to think that our banks would serve us as slightly overpaid utilities. However, that’s not why we have them – it was because of the credit crisis, and the rules and regulations haven’t changed that much since then.
At the same time, I don’t totally disagree that huge banks do become anti-competitive, just by dint of how long it takes them to make decisions and do things. But I’m not sure anti-competitive is the same thing as low-risk.