The problem of big banks

Financial Express, 16 November 2009

Big banks are a source of trouble. The world faces some important questions on how to deal with them. There are three incremental paths: (a) Better mechanisms for closing down distressed banks, (b) Better banking regulation and (c) Emphasising a more market-dominated financial system. Three non-traditional paths that are gaining some traction are: (a) Breaking up big banks, (b) Forcing banks to be narrow, (c) Requiring more risk capital as a bank gets bigger. While there is a certain attraction about these non-traditional alternatives, a cost-benefit analysis is hard.

Nobel Laureate Merton Miller said that banking is a disaster-prone 19th century industry. It features a unique juxtaposition of five troublesome features:

  1. Banks borrow from a large mass of unsophisticated households, and in democracies, messy failures of banks are politically unacceptable.
  2. Banks invest in illiquid assets, where marking to market cannot be done, so it is hard to know when a bank is bankrupt.
  3. Banks have very high leverage. The typical bank is more leveraged than the typical equity derivatives trader. A loss of 10% drives the typical bank bust, but can be absorbed by the typical derivatives trader.
  4. Banks have a critical role in the payments system, which makes bankruptcy more troublesome.
  5. In places with bad governance, banks are a soft target for governments to steal from.

Banking crises have recurred for centuries, owing to the difficulty in winding up + opaque assets + high leverage. Banking regulation was invented to cope with these problems, and in some respects a lot of progress has been made. At the same time, the very powers amassed in the name of banking regulation have been abused to do things like SLR (forcing banks to finance the government), priority sector lending (forcing banks to fund favoured groups) or worse.

There are three incremental paths for improving regulation.

Incrementalism #1: Doing better on closing down banks who are in trouble

The role model for this is the US FDIC, which has efficiently closed down a full 133 banks in the crisis. More countries need this capability.

In India, this has been recommended by the RBI committee on deposit insurance (chaired by Jagdish Capoor, 1999) and by the Rajan committee, to no avail.

In the UK, the problems of Northern Rock starkly showed the lack of this capability. To their credit, there has been a rapid and high quality response. In February 2009, the UK setup a `Special Resolution Regime', and has used it to successfully close down medium-sized banks that resemble Northern Rock.

While the FDIC or the UK SRR have done well on closing down medium-sized banks, they lack the capability to close down the biggest banks. A resolution capability for the top 20 global banks is one of the biggest tasks that governments now face.

Incrementalism #2: Doing banking regulation better

The second front is to do banking regulation better. There is no magic bullet here, just the task of patiently understanding what went wrong, and fixing mistakes.

Until we regain confidence in our regulatory and supervisory process, there is a case for holding bigger buffers. One idea that has gained prominence is that of requiring banks to hold contingent capital: bonds that automatically turn into shares when the bank is in distress.

Incrementalism #3: Reducing the ability of banking to impact on GDP

The third idea involves reducing our reliance on banks. This was a lesson of the East Asian Crisis, where problems in banking destabilised the macroeconomy because banking was big relative to GDP in East Asia. Recognising that banking can be a source of trouble, it is better to evolve market-dominated financial systems, where more financial intermediation is done through securities markets and less is done through banking. With policy failures at RBI in banking, coupled with progress on the stock market, India has inadvertantly walked down this path.

Looking beyond incrementalism

These three lines of attack are reasonable, incremental, and represent mainstream wisdom. In recent weeks, radical alternatives have gained prominence. Are we better off without big banks? Should the biggest banks be forcibly broken up -- or subject to bigger equity capital requirements? Should some or all banks be forced to become payments utilities?

Eliminating big banks involves important costs. Big sophisticated banks are essential partners to big multinational corporations. Indian multinationals like Tata Steel find that Indian banks have inadequate scale and sophistication: they have outgrown the capabilities of the Indian financial system. In banking, size yields economies of scale and scope. Forcing banks to become smaller will make banking crises infrequent, but will impose costs upon the economy every year. It is not obvious, today, that the cost-benefit analysis favours radical paths.

The serious analysis and discussion of radical alternatives is the hallmark of a healthy policy process. These radical solutions certainly need to researched and debated. In my mind, they represent a fallback if incrementalism fails to deliver. Incrementalism needs to be given a few years. But if governments fail to make progress on closing down banks and particularly the biggest banks, and if progress on banking regulation is not convincing, and if the size of banking relative to GDP remains stubbornly high, then it would be time to put radical alternatives on the front burner.

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