Too efficient NOT to consolidate

Sunday, December 6, 2009

Here’s yet another historical record broken in 2009:

“Only three insured institutions were chartered in the [third] quarter, the smallest quarterly total since World War II.”
This fact is from the FDIC’s latest Quarterly Banking Profile. There are probably non-economic reasons for this, i.e., the application process to qualify as a new charter institution (see the types of charters here) is likely much more stringent than in previous years; but nevertheless, this fact reiterates the trend in the number of banking institutions, most definitely down.

The FDIC is awash in problem institutions. The well reported number of bank failures jumped to 132 in 2009 (as of November 20, and you can find the data here). However, that’s just share of the much larger “problem”. According to the same quarterly profile, there are now 552 “Problem” institutions in the FDIC charter system holding $346 billion of assets on balance – that’s 2.4% of nominal GDP.

As such, it seems that consolidation is all but a foregone conclusion. But watch out, because the new 4-letter-style phrase, “too big to fail”, is heavy on the tongues of US policymakers. Senator Bernard Sanders (Vermont) introduced the “Too Big To Fail Is Too Big to Exist” bill last month, which defines such an institution as (see the bill here):
"any entity that has grown so large that its failure would have a catastrophic effect on the stability of either the financial system or the United States economy without substantial Government assistance."
Ahem, so how big is that? Peter Boone and Simon Johnson at the Baseline Scenario define “too big to fail” as bank liabilities amounting to 2% of GDP (roughly):
"So to us, 2 percent of G.D.P. seems about right. This would mean every bank in our country would have no more than about $300 billion of liabilities.

A large American corporation would still be able to do all its transactions using several banks. They would even be better off — competition would ensure that margins are low and the banks give the corporates a good deal. This would help end the situation where banks take an ever-increasing share of profits from our successful nonfinancial corporations (as seen in the rising share of bank value added in G.D.P. in recent decades)."
But there are economic efficiencies, like scale economies, that need to be considered. David C. Wheelock and Paul W. Wilson at the St. Louis Fed find statistically significant increasing returns to scale (i.e., bigger banks, lower costs) in the US banking system. They use a non-parametric estimator to estimate a model of bank costs and find the following (link to paper, and bolded font by yours truly):
"The present paper adds to a growing body of evidence that banks face increasing returns over a large range of sizes. We use nonparametric local linear estimation to evaluate both ray-scale and expansion-path scale economies for a panel data set comprised of quarterly observations on all U.S. commercial banks during 1984-2006. Using either measure, we find that most U.S. banks operated under increasing returns to scale. The fact that most banks faced increasing returns as recently as 2006 suggests that the U.S. banking industry will continue to consolidate and the average size of U.S. banks is likely to continue to grow unless impeded by regulatory intervention. Our results thus indicate that while regulatory limits on the size of banks may be justified to ensure competitive markets or to limit the number of institutions deemed too-big-to-fail, preventing banks from attaining economies of scale is a potential cost of such intervention."
Better put: the cost of consumer and firm loans will be higher in the long run if too much intervention prevents the banking system from capturing scale economies. Furthermore, they suggest that even the largest institutions experience increasing returns (i.e., these).

As a note, David Wheelock wrote a very interesting piece a while back about the inefficiencies of mortgage foreclosure moratoria during the Great Depression …interesting stuff (paper link here).

Rebecca Wilder


Kerry Hawkins December 6, 2009 at 4:32 PM  

wow, you are back to blogging!

James Salsman December 6, 2009 at 6:27 PM  

How many banks would be in trouble if bankruptcy judges had the right to modify mortgage agreement terms? A lot fewer, no?

James Salsman December 7, 2009 at 4:20 AM  

It's the model which doesn't result in in massive liquidity due to cascading bankruptcies. Davos was warning about this a year ago, if the assets aren't detoxified. They ranked asset detoxification top out of 23 economic priorities. The U.S. Treasury re-fi program reached 85% coverage for the trial modifications, but something pathetic like only 6% of those lasted more than 90 days, so technically even the primary residential assets aren't detoxified yet. There needs to be the carrot offered by Treasury to actually take the hit, price their assets affordably, and refinance. If they can't get in line with the carrot they need the stick at bankruptcy court.

Otherwise, cascading bankruptcies, low growth, and low profits. The carrot alone has been insufficient.

Rebecca Wilder December 7, 2009 at 7:08 AM  

Hi James,

I like your verb detoxified. There are plenty of problems left in housing, and the FHA is now pushing mortgages out the door with LTVs of much higher than you would think (a colleague of mine who works on mortgages says 95%). With 1/4 homeowners underwater, there are plenty of foreclosures left in the pipeline. Modifications - at the bank or otherwise - are not going to stop the the plow, especially with the unemployment rate at 10% and income growth meager. Better to write down the assets, and move on. Households need to delever - and unfortunately, default is one way to do that.


James Salsman December 7, 2009 at 10:09 AM  

Oops, I meant "massive ILliquidity" sorry.

There must be models for mortgage cram-downs because it's not uncommon to give the power to restructure all debts to bankruptcy judges. Don't Canadian, Japanese, and Australian bancruptcy courts have that power? Are their banks in better shape than ours?

It's not like re-finance on affordable terms is going to hurt the banks anywhere near as much as foreclosure. Shelia Bair was saying that a year and three months ago, and Paulson and Bernanke initially agreed -- what changed their minds? The whole write-down project was estimated at less than $100 billion back then.

So many press releases from Treasury this morning! More than a dozen. I haven't seen more than three or four in months.

janie December 7, 2009 at 11:49 AM  

Thanks for coming back, Rebecca. You cover things that we seldom hear.
Now about the banks.... Doesn't it seem very obvious that no one in government or the banking system has thought beyond the short term? I'm still pessimistic about the "whole" as the "parts" just don't add up (like you have stated). Keep on "stating", girl!!!!

stephen saines December 7, 2009 at 3:11 PM  

Yes! Ditto the above, re your return, Rebecca

I have not had time to review your posting (I note it dated yesterday but received today).

As always, it will require a thorough read and digest to do a response justice.

I'm tempted to take you up on blogging on "another G7 nation", but will wait and see what other responses you get first.

I spend a lot of time trying to educate the Brits on why they're in such terrible shape, and as a Cdn/Brit dual, I continually harangue them to start learning from others.

This is something the US, for all her faults, is good at: Learning from others. I don't state that at all in any facetiousness, it is fact. The US, *even if she doesn't adopt other models*, at least makes herself aware of them.

The Swedish Model was looked at for bank reform, as was the Cdn model.

The UK?

I'm afraid the prevailing attitude is that they don't need to learn from anyone. The inference is that they know it all.

Evidence clearly indicates otherwise: They'd best start learning and learning soon.

Here is the forum: (and I was instrumental in setting it up, details supplied upon request)

Beware though, folks, there is no censoring, so it can get very rough and nasty, as you'll see from the comments aimed at me.

I use my real name, as I do here, it's a point of principle, but I do suggest you use a unique handle there, if for no reason than to block some of the nutcases tracing you back to this blog.

It's so good to see you back, Rebecca! A real note of sanity.

I'll comment on your specific post later, and will consider handling a Cdn comparator forum if some other Canuck will join me. (I'd love to do it, very hot on the subject, but I'd like to share as that way, responsibility is not absolute)

Canada has done surprisingly well. But that is more structural than political, this present gov being about as advanced as the Neanderthal man.

Paul Martin set the stage ten years back.

stephen saines December 7, 2009 at 3:52 PM  

[But there are economic efficiencies, like scale economies, that need to be considered. David C. Wheelock and Paul W. Wilson at the St. Louis Fed find statistically significant increasing returns to scale (i.e., bigger banks, lower costs) in the US banking system.]
Apologies if someone else has questioned this, but examinations but three federal agencies in this nation (Canada) under the aegis of Paul Martin, determined that in the case of Canada's banks (and I quote from memory, I will supply the reference later) re mergers: (gist) "the effect upon consumers will be detrimental".

Paul Martin (Chretien regime) was insistent that Canada's "big five' would not be allowed to merge, not the least because of "too big to fail" risk.

It was clearly seen back then (ten years ago), and Canada and Australia, both of whom had undergone extensive bank reform, actually *tightened* standards when the US and most of the ROW (UK especially) were "liberalizing" regs.

We clearly see the result of actions!

Neither Can nor oz has had to bailout a single bank, and both nations (for different reasons) are seeing their banks making record profits! (Oz never entered a Recession, so the details are slighlty different).

I therefore have to make a preliminary comment on that St Louis Fed report, even before reading it.

I'm skeptical! I must also add that available liquidity (the probable basis of the 'economy of scale' argument) was not much of a problem in Canada and Oz as it was in the US, UK and other nations that botched their regs. (Int'l sourcing was a problem, but Canada easily addressed that by buying back CMHC *guaranteed* mortgages from the banks, a device done by the US also, albeit at a much greater risk=cost due to the fragility of the FMs)

I will attempt to source my reference on why the Cdn banks were not allowed to merge. The agencies involved were the BoC, OFSI (fin reg) and the Competition Bureau. The reports were unanimous and remarkably consistent:

It would not be in the interests of consumers! Time and facts bear that out...add "taxpayers" to the list.

Whether this is directly analogous to the US or not remains a good question.

Rebecca Wilder December 7, 2009 at 9:17 PM  

Hi Stephen,

Yes, it probably is analogous. But remember, Canada's banking system was more strictly regulated than in the US (barely comparable, from what I hear).

I don't suggest that every bank grow to the capacity of 2 trillion (like some, BoA); but simply that there are efficiencies to consider. So before Congress goes barreling down, cutting off lines of short-term credit (like the commercial paper market) and deeming too big to fail anything over (let's say) 200 billion, that there are successful large-scale banking systems out there - Canada, for example.

It is very unlikely that tax payers (now and generations to come) would be paying the bill of a banking crisis had regulation been appropriate (holding the effects of Japan and China constant, of course).

Best, Rebecca

Hi Janie,

Interesting...Policymakers and regulators will mess this one up - they always do. New regulation is generally backward looking, lacking foresight. It will be interesting to see what shape the final bank bill will take (whenever that will be).


stephen saines December 7, 2009 at 11:54 PM  

Here's my reference as per earlier post.

[ Canadian Bank Mergers Decision
Finance Minister Rejects Bank Merger Proposals

Dateline: 12/14/98

It's official. Canadian Finance Minister Paul Martin has rejected the proposed mergers of the Royal Bank with the Bank of Montreal and CIBC with the Toronto-Dominion Bank.
Reasons for Bank Mergers Decision

The reasons for the bank mergers decision are no surprise. The Finance Minister concluded that the mergers are not in the public interest as they would result in

* too much concentration of economic power in Canada in the hands of too few financial institutions
* a reduction in competition in the Canadian financial services sector
* a reduction in the Canadian government's flexibility to address future concerns.

The last round of reports delivered to the Minister of Finance last week appear to have sealed the decision.
Competition Bureau

Canada's Competition Bureau concluded that the proposed bank mergers would substantially lessen competition, would result in bank branches being closed, and mean that Canadians would have to pay more for less. The Competition Bureau's conclusions on each of the mergers are provided separately in letters to the bank presidents for the Bank of Montreal and Royal Bank merger and the CIBC and TD Bank merger.
Superintendent of Financial Institutions

The Office of the Superintendent of Financial Institutions (OSFI) also weighed in with concerns. A summary letter to the Minister of Finance raised issues about the impact of mergers on the Canadian financial system as a whole. It noted that if one of the merged banks were to run into trouble, the policy options for government would be severely reduced. For example, the possibility of a sale to a domestic competitor would be less, since it would result in further reducing competition. And a sale to a competitor from outside Canada would have a negative impact on Canadian ownership and control.[...]]

This may seem a bit stale being a decade past...but it seems to have borne the test of time very well.

Martin came under huge criticism for his intransigence on the matter.

Whatever, it does substantiate Rebecca's point on needing a 'balance' of size v. being not too big to fail.

If Rebecca's agreement that there is a direct analogy of Can to the US, then does the pop ratio of ten to one apply?

stephen saines December 8, 2009 at 12:10 AM  

I'm tired, but the context of my discussing the prior post is coming back to me.

It was Dodd's proposed legislation in the Senate, greeted with mostly harsh response.

He proposed something remarkably similar to the following, which is linked from my post above at the source:
[Updated: 06/15/01

Massive legislation reforming government policy on banks, trust companies, credit unions and the insurance industry in Canada finally received Royal Assent in June 2001.

The Act is designed to encourage efficiency and growth in the financial industry, increase international competitiveness and domestic competition, and improve the regulatory environment for the sector.

There are many measures in this legislation which affect Canadians in their day-to-day personal finances, as the government tries to balance the needs and protection of consumers with those of financial service providers. Here are the main consumer elements of the legislation.

Financial Consumer Agency of Canada

The Act establishes the Financial Consumer Agency of Canada (FCAC) to enforce consumer-related provisions of the legislation, to monitor the industry's self-regulatory consumer initiatives, to promote consumer awareness and to answer consumer questions.

Financial Services Ombudsman

The Act establishes a new Canadian Financial Services Ombudsman (CFSO) to handle complaints from consumers and small businesses. The CFSO is independent of both the financial services institutions and of the federal government. Banks are required to join the CFSO.

Improved Access to Financial Services

The legislation improves access to financial services for some Canadians. Banks are required to open accounts for individuals without demanding a minimum deposit or that the individual be employed. Financial institutions are also required to cash government cheques for non-customers, with a minimum form of identification. [...]]

My apologies, I'm too tired too dig out Dodd's impressive draft bill.

Perhaps Rebecca could pick-up the loose ends and tie it back in to the prime subject?

If not, I'll add more tomorrow.

Perhaps it is easy for an outsider, esp a Cdn, to see the sense in Dodd's concept (Frank, surprisingly, was somewhat cool to it), but it certainly made sense to me, even knowing that The Establishment in the US would absolutely dread that kind of reform.

To be continued....

stephen saines December 8, 2009 at 12:26 AM  

James writes:
[Don't Canadian, Japanese, and Australian bancruptcy courts have that power? Are their banks in better shape than ours?] I can't speak for Japanese courts, but Oz and Can cases rarely go that far. Personal Bankruptcy is a much rarer course of action, and the US is the exception to many nations in allowing "walk away mortgages".

Yes, Cdn and Oz banks are in exemplary shape, both nations showing record bank profits, even with writedowns, in most cases, due to US operations.

There is no need for legislation in both to protect consumers from mortgage failures, the rate is solow.

The RBA published an excellent report on the matter some months back, detailing the Oz and Cdn examples, I'll see if I can dig it out tomorrow. Delinquency rate is about .3% in both nations, and a pretty flat line too. Meantime the US and the UK, used as comparators in the report, go up like a rocket.

There is an article in tomorrow's FT claiming that US defaults will peak next year.

We'll see.

My apologies, I must fall into bed.

It's great that you're back, Rebecca. By default, your reader comments in themselves become an excellent forum for exchange.

lol, you know you're tired when the 'word verification test' words start making sense!


James December 8, 2009 at 3:47 AM  

The opposite of "Too Big To Fail" is "Too Many To Rescue". There's no such thing as a free lunch.

Keep in mind also that Bank of United States was minuscule compared to today's banks, but that didn't prevent its failure from provoking a wave of bank failures throughout the country.

Regardless of size, I think the real problem is that U.S. law doesn't have an effective way of handling the failure of non-bank financial institutions (or the non-bank components of universal banks).

Rebecca Wilder December 8, 2009 at 6:42 AM  

Hi James,

Good point - the government couldn't touch AIG...only use arcane and untouched Fed statutes to smooth its transition (i.e., foot part (most) of the $85 billion bill).

Thank goodness banks are insured - there would have definitely been a panic (there actually was a silent one).

Oh, thanks for the link!


Tim Manni December 8, 2009 at 10:54 AM  

Welcome back!

stephen saines December 8, 2009 at 11:31 AM  

James writes:
[The opposite of "Too Big To Fail" is "Too Many To Rescue". There's no such thing as a free lunch.]

That is not a proportional inverse relationship. Think dominoes. One huge domino will undoubtedly start the chain reaction, but a multitude of smaller ones won't. The unhealthy dominos can fall and there is little impact on the greater whole.

Economy of scale is important for profitability, and ostensibly, consumer cost, so too many little dominoes is not optimal, but in the case of the US, many state and local banks are doing quite well considering, and they seem to be competing aginst the national banks in many cases.

"Too big to fail" is not just a US consideration. The UK, for instance, is making a complete mess of things by using tax-payer money to actually force conglomeration.

King, the BoE Governor, is none too pleased.The actions are of the Treasury, not Central Bank.

"Too big to fail" has become a global concern.

On AIG, the story seems some things never change.

James December 8, 2009 at 6:53 PM  

stephen saines said...
"That is not a proportional inverse relationship. Think dominoes. One huge domino will undoubtedly start the chain reaction, but a multitude of smaller ones won't. The unhealthy dominos can fall and there is little impact on the greater whole."

You appear unfamiliar with the U.S. bank failures of the Great Depression. As I already pointed out above, Bank of United States, the commercial bank that started the wave of falling dominoes in 1930, was minuscule compared to today's banks. The problem back then was that the vast majority of banks were local, geographically undiversified, community banks. (It's Christmas time, so try watching "It's a Wonderful Life" for an example.) The result was many, many, many, small bank failures throughout the United States.

The core problem is not bank size, it's that loans were made against bad collateral. Think of it this way. Imagine there's $10 trillion of bank deposits throughout the country. The banks collectively lend out $9 trillion as mortgage loans and hold $1 trillion as bank reserves. Then, one day after a massive asset bubble collapses, everyone realizes that the homes used as collateral are only worth $6 trillion in aggregate. Homeowners who are underwater on their mortgages start going into foreclosure left and right. The banks learn that even though they collectively lent out $9 trillion, the loans are now only worth $6 trillion. Combine that with the $1 trillion of bank reserves and the banks have $7 trillion in assets, but owe $10 trillion to their depositors.

Now, I ask you, does it really matter if those $7 trillion of assets and $10 trillion of liabilities are divided by 5 banks or 50,000 banks?

Rather than focusing on bank size, legislators' primary focus should be on requiring sizable down payments for all home purchases. Larger down payments would make it harder for housing bubbles to form in the first place (because rising prices would make it harder to save up for the down payment, thus reducing demand) and would also reduce the damage caused by any housing bubble collapse that did occur.

James Salsman December 9, 2009 at 1:02 AM  

The size of the down payment doesn't help a bit when an income earner loses a job or becomes injured. Crystal ball schemes for trying to price credit like FICA scores or any other form of evaluation, discriminatory or otherwise can only go so far. And make no mistake, large down payments discriminate against the younger buyers who are otherwise just as credit-worthy but simply unable to clear that hurdle.

The solution is exactly as Davos says: grow the middle class by letting families in trouble get a write-down, protect the bank by letting them offset the loss on their bottom line, or even better (less regressively) have the Treasury pay directly.

Like Sheila Bair says, you pay now a little, or you pay a whole hell of a lot more when credit crunches up again. So what will it be? Slower growth now or a bigger credit crash than last year's later? (Hint: later isn't very long given the situation in commercial real estate at present.)

James December 11, 2009 at 11:04 PM  

James Salsman said...
"The size of the down payment doesn't help a bit when an income earner loses a job or becomes injured."

Requiring down payments will help prevent housing bubbles from forming in the first place -- even during periods of low interest rates -- because as the price of the house rises, the down payment rises with it. The reason we're in the trouble we're in today is entirely because of a housing bubble. Growing the middle class won't do a damn thing to prevent housing bubbles. The reason people are losing their jobs today is entirely because of a housing bubble.

James Salsman December 12, 2009 at 7:31 PM  

Bubbles are caused by speculation and leverage, not down payments. To say otherwise is absurd.

If you want an un-muddled view of exactly what's wrong with the finance sector at present, read "How To Make The World's Easiest $1 Billion" by Henry Blodget. Even the guys directly profiting from the inefficiencies are getting ready to start turning things around because they want to limit the size of their inevitable haircuts.

stephen saines December 13, 2009 at 2:35 PM  

James writes:
[You appear unfamiliar with the U.S. bank failures of the Great Depression.]
I may appear so, but I'm not.

The Great Depression did not have banking as the cause of the collapse. Somehow, this has become popular lore of late (That it wasa bank failure).

The failure of the banks as a secondary factor would have happened whether they were large or small. The lesson for today is that then, as now, US bnak regulation was very poor.

The Great Depression hit Canada much harder than it did the US or the UK, and yet not a single Cdn bank failed in that era, large or small. (Smaller local banks were far more popular then than now, albeit regulation cut across Provincial jurisdiction. )

The subject is a tad more complex than your claim would allow.

Since Rebecca's original post on criticality of size, the FT and WSJ have both carried excellent articles on thye matter.

The 9000 or so US bank failures during the Great Depression are indicative of lack of regulation, not necessarily size.

A lot of the problem was addressed at the time by legislation, since relaxed. The FHA and Fannie came out of the same era, and the same need for action, Fannie now being in very poor shape (and much owned by foreign investors, mostly China), and the FHA, which has weathered events remarkably well, is now expected to pick-up the slack of the private FMs, and just doesn't have the backbone to lift such a heavy demand.

The CMHC, which was modelled on the US' FHA, is in excellent shape.

It is not the model in the US that is failing. It is the tendency to "liberalize" (a bastardization of the term) and deregulate that is at the base of it all.

Without effective regulation, banks will continue to fail in great numbers in the US,(and elsewhere) large or small.

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