Big banks aren’t bad banks
— Mark T. Williams, a former Federal Reserve Bank examiner who teaches finance at Boston University School of Management, is the author of the soon to be published “Uncontrolled Risk” about the fall of Lehman Brothers. The views expressed are his own. –
Too big to fail has become nothing more than a political sound bite and the title of a best-selling book. Unfortunately, in the process big banks have gotten a bad rap. The proposed Obama administration plan to limit bank size is just another example of big-bank bashing by high-level politicians.
Policy that simply focuses on downsizing big banks overlooks an important point. The problem is not that banks are too big; it is that banks are taking excessive risk. This includes big and small banks. Since 2008, more than 170 banks have failed, including big banks such as Lehman Brothers, Wachovia, and IndyMac. But most on this list – such as Citizens State Bank, Republic Federal Bank, and First State Bank — are smallish. They didn’t make big headlines. No books were written about them or movies made.
The fact that a bank is big should not automatically mean they are a threat to the financial system. It’s true that Citigroup, once our nation’s biggest bank, needed a massive government bailout. But this singular sample size is not large enough on which to base far-reaching policy changes.
Big banks offer many advantages over smaller ones. They provide consumers with a greater array of desired services and economies of scale allow them to deliver more for less, and they tend to have greater capital to protect them against unexpected losses. In many countries in Europe and elsewhere, the universal banking system (another phrase for big banks) dominates the market. In these countries, a universal big-bank system works.
In Canada, the top five banks represent 90 percent of the market. During the Great Credit Crisis of 2008, not a single bank failed in Canada (nor did any fall during the Great Depression). A decade ago, no Canadian bank made the North American top-ten list. Today, four are Canadian. The lesson from our northern neighbors is simply that they had tighter lending standards, lower leverage ratios, and better regulatory oversight. They also taught us that slow and steady is a better risk strategy than fast and wobbly.
Using Canada as an example, the real concern should not be bank size but the level of risk taking. Banks make money only three ways — providing loans, proprietary trading, and/or charging fees for services. The main driver of the recent financial crisis was neither proprietary trading nor fee charges, but risky lending practices.
In theory, big banks armed with greater capital should have the ability to take on greater risk. They are also better positioned to compete globally. The problem comes when these banks do not have proper risk-management oversight and focus. The administration’s bank reform should stop obsessing on size and look at risk taking relative to capital position held.
Any meaningful financial reform should address lending standards while tightening regulatory oversight and policing. Proprietary trading, with the exception of Goldman Sachs, the thorn in Obama’s side, is a sideshow not the main show. Bank minimum capital levels should be increased. Any bank (big or small) that wants to engage in increased risk should be required to raise more capital. Leverage ratios should also be reduced.
In the end, it is not big or small that matters but the level of risk taking and the ability of banks and their regulators to adequately measure and control risk. A policy of simply bashing big banks will cost consumers and our nation’s competitive banking position. A country made up of ten well-capitalized big banks is much stronger than one with over 7,000 small banks taking dangerously big bets.