The too-big-to-fail debate continues

By Felix Salmon
November 13, 2009
Economics of Contempt defends too-big-to-fail banks:

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Economics of Contempt defends too-big-to-fail banks:

The point of creating CDOs was to generate a mezzanine tranche, which investors, who had a seemingly insatiable thirst for yield, would gobble up. Goldman (and other dealers) couldn’t place the super-senior tranches, so they held the super-seniors on their books and hedged all that risk by buying CDS protection from AIG (and the monolines)…

As you can imagine, all the risks that a major dealer bank has to manage on a daily basis—the constantly changing level of their exposures, how those exposures all interact, etc.—gets extraordinarily, mind-bogglingly complicated. The major banks all made huge investments to develop the technological capacity to manage those risks, and it’s pretty clear they didn’t invest enough in their risk management systems. There are only two banks that I’ve seen that clearly did make the necessary investments in risk management (Goldman and JPMorgan, not surprisingly). So there are undoubtedly economies of scale there.

There are two problems with this. Firstly, the two banks which made the necessary investments in risk management were not the two biggest banks. Neither Goldman nor JP Morgan is small, of course — but Citigroup and Bank of America, both of which had woefully insufficient risk-management systems, were bigger still, and saw none of those “economies of scale”. There’s no indication that bigger banks are better at risk management than smaller banks; in fact, bigger banks tend to have more places in which they can hide nuclear waste from senior management and the board.

EoC also implies that bigger banks are more likely to be able to mark their assets to market; again, that’s not really true, as a glance at Citigroup will tell you. The key variable here isn’t size, it’s the quantity of illiquid assets that a bank is holding. (Loans, which are the bread and butter of commercial banks if not of Goldman Sachs, are by their nature illiquid.)

And then there’s EoC’s point about Goldman holding illiquid CDOs on its balance sheet and then hedging the associated risks in the CDS market. Is that something Goldman can do because it’s big, or is it a mistake which Goldman made and which it’s unlikely to repeat? Let’s ask Goldman CEO Lloyd Blankfein, who recently gave an interview to Peter Lee of Euromoney (behind a firewall, unfortunately):

We think there should be a much, much higher return for holding illiquid assets. Right now, our asset quality is a lot higher, we’re carrying more liquidity and the bar just got higher for carrying anything else. But for the right profit opportunity, we would put more illiquid assets on our balance sheet.

Super-senior CDOs are never going to provide that kind of profit opportunity. Goldman’s shenanigans in the CDO market were an aberration, and were not something societally useful which sprang from being large. In any event, there’s really nothing in EoC’s argument which couldn’t apply to banks with only $100 billion in assets, say, as opposed to $1 trillion. As James Kwak notes, economies of scale top out long before bank size does; beyond that, it’s all moral hazard.

2 comments

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Very nicely written Felix, it’d about time someone told it as it is about the banks.

“in fact, bigger banks tend to have more places in which they can hide nuclear waste from senior management and the board”

Absolutely spot on!

I think you’re missing his point. You’re actually agreeing with EoC. He isn’t saying that the biggest banks MADE the biggest investment in risk management systems, he’s saying they NEEDED to, and the ones that did have done best.

Posted by Pete | Report as abusive