There is a lot of woolly thinking about the right way to regulate banks post this crisis. The consensus is that banks should never again be allowed to grow to be “too big to fail”. The right banking system is one in which there are hundreds of banks – all sufficiently small that their failure does not cause systemic problems. The argument is that Citigroup or Bank of America or whatever is bailed out as soon as it clearly returns to solvency it should be broken up.
Indeed one of the cases cited for nationalisation is that it is much easier to break the banks up under government ownership than it is when there are private shareholders.
I think this consensus is absolutely cock-eyed wrong – and that the list of the blogging intellegentsia who are wrong on this covers pretty well every big-name economic pundit out there.
The division of American banking into thousands of banks did not help during the 1930s.
More bluntly I think the US should end this crisis with substantially fewer banks – which because they have a high degree of market power should be highly profitable. The high level of profitability will
(a). Reduce the incentive for banks to take excessive risks (if you have a goose that lays golden eggs it does not make sense to risk killing that goose), and
(b). Increases the chance that the banks can work through any problems that they do have (because the underlying franchise will generate enough profit to fill any holes).
The strategy I advocate is to put your financial system eggs in relatively few baskets and to watch those baskets.
The experience of bank collapses
I have spent a bit of time looking at how banks collapse in countries other than the US. The model I have in head is Taiwan. Taiwan until relatively recently had about 50 banks. This is in an economy about the size of a mid-ranking US State.
The banks were highly competitive and margins were sickly thin. Bank management respond to the high margins by increasing risk. Its kind of odd but banks in highly non-competitive markets (eg Australia) have returns on equity of about 18 percent. Banks in highly competitive markets seem to have equity returns of about 16 percent. The difference is that in highly competitive markets the banks take more risk to get 16% and they tend to blow up with monotonous regularity. A blow-up in Taiwan causing something looking like a local recession happens more than once a decade.
Every blow up results in the reduction of the number of banks. As this happens the level of competition goes down and the profitability goes up. At the end you wind up with a banking system like Australia – which has four super-profitable banks. These four banks can survive almost anything because the pre-tax, pre-provision operating profit is so huge. In Australia and New Zealand the numbers are almost 5 percent of GDP.
I know what I am doing is turning standard economic dogma (particularly amongst conservatives) on its head here. The standard dogma (questioned by some with financial services) is that competition is almost everywhere a good thing. But I would have the other view. My view is that competition in financial services causes massive financial crises.
Much more instructive – and much more familiar to my English speaking readership is the UK recent experience. The UK banking system was changed by massive competition in mortgages. UK mortgage margins went to 40bps. This was extraordinarily low and it was devastating to the UK banking system. Various banks responded differently to it – Northern Rock levered its mortgage book about 60 times – and then very small changes in spread and credit blew it up (see my old notes here). HBOS did similarly. Royal Bank of Scotland bought everything that moved and also levered itself up. Barclays decided to become one of the world's biggest investment banks. The problems of the UK banking market were caused by too much competition compressing margins.
Ditto – the problems in American finance were caused by massive competition from the new (and huge) shadow banking system. You had mortgage companies spring from nowhere – and start originating huge quantities of mortgages. Companies like Countrywide – which had very little capital indeed – could originate literally over a trillion dollars in mortgages.
The financial innovation spread from personal to corporate finance – with all sorts of bizarre credit securitisations. All of these things reduced margins. The banks responded to reduced margins not by accepting reduced profit (something that in retrospect would have been the right course of action) but by increasing their risk profile (and hence profitability).
It was the competition that caused things to blow up.
The counterfactual is Australia. Australia is very similar to America – except that the consumer was even more in debt. Our credit card industry was bigger (relative to GDP) as were our mortgages. Our car loans were substantially lower. But the consumer here was also fairly close to hocked out.
However our banks are solvent. There is only a remote chance that they will become insolvent despite a property boom that makes America's look modest. They are solvent despite not being well run. Indeed they are famously bureaucratic and inept. I once worked for one after having worked for the government. I can assure you the government department I worked for was far more competently run.
The banks survive because they are just so profitable. They are profitable despite being in an economy that should be sour (from indebtedness).
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.
The last thing you want to do is break up Citigroup. It would be far better if it merged with Wells Fargo.
What does a post-competition banking system look like?
First the banks are going to be huge.
They will lay enormous golden eggs for their shareholders. I hope to be one!
These golden eggs will give the shareholders very strong incentive to act to preserve the banks. Bob Dylan howled out that “when you got nothing you got nothing to lose”. Like much of Bob Dylan it is the truth. And the solution is to make sure the shareholders have something really good – so they have something to lose.
Because the goose lays golden eggs its management should be conservative. Of course there will be agency problems – with management with incentives to lever up the golden egg laying goose as they will (via cashing their options) have a big part of the golden egg laying goose when it works – and if it doesn't work then the shareholders own the carcase. So there will need to be corporate reform in such a way that shareholders can better protect their investment from managers. (Carl Icahn's blog has plenty of worthwhile suggestions.)
And – as a backstop there should be regulation – and the regulation should be stiffling. It should limit competition and increase bank profitability. Captured by the interests of shareholders (but maybe not management) is not a bad place for the regulator to be.
In the end I want this to look like a regulated utility. Highly profitable and dull as dishwater. The salaries should also look like a regulated utility (above average – but nothing special).
The losses from my anti-competitive stance
The first and obvious loss is a generally higher cost of financial services as competition is constrained. Essentially the anti-competitive strategy will reverse the benefit of cheap and widely available financial services created by the last two decades of financial innovation. Such is life – that is what the credit crisis is doing – and the benefits of that have been overstated anyway.
The second loss is far more important – you lose the driver of financial innovation. Competition isn't great because it lowers prices (although it does). Competition is great because it rewards innovation – and allows companies or individuals who do innovative (usually better) things to thrive and grow. Companies that don't innovate eventually wither. This is the “creative destruction” of competition – and it is the greatest driver of capitalism.
Well the last decade and half has rewarded financial innovation above other forms of innovation. The best and the brightest (and many of them really are very smart) have headed towards the financial sector because that is where the money is. The best and the brightest do not (with the exception of my business partner*) leave university to join an electricity utility.
If we remove competition in financial services we remove that chimera called financial innovation. I argue that is a small loss. Financial innovation is a chimera because it rewards individuals but creates massive societal risks (as this crisis demonstrates). Real economy innovation is what drove income and wealth up throughout the 20th Century – and at the moment the failure of financial innovation is stifling real economy innovation through stifling the economy. My strategy – four to six deliberately anti-competitive banks – is the death knell to financial engineering – and will sharply reduce the salaries of people in that business. It is bad for New York but it will free the best-and-brightest to do something ultimately more important.
A call for debate
This is a debate which it is important we have – because almost everybody (outside Australia) thinks differently to me. That doesn't mean that I am wrong. I come from a country that has been well served by its four banks – even though they are grotesquely incompetent and bureaucratic.
John
*The business partner did wind up as CEO of the utility.
