The size of a bank doesn’t matter: Big banks vs. small banks

Felix Salmon believes small banks make the best . Many people agree with this statement. The Move Your Money campaign is an attempt to convince people to switch their money from large banks to smaller ones. The Archbishop Of Canterbury suggested that one the UK’s major banks should be dismantled to make way for a system regional banks. The German Finance Minister defends Volksbanken, Sparkassen and Landesbanken from EU attempts to include them in the European system of bank regulation. This is because only large banks with cross-border liabilities require international regulation.

The economy benefits from small banks: they offer safe savings options and provide essential financing for businesses and households. With some reason, small local banks are more likely to provide finance to local businesses that large international or national banks. This is because their staff has greater local knowledge, which allows them to better assess risk and helps them manage relationships.

Small banks can be just as bad as big ones. They may become dependent on insecure wholesale funds, and they might lend too much at too high risk. They can also be fraudulent and corrupt. It is not true that “small banks are good and big banks are bad”. Americans seem to have forgotten about the massive bank runs that forced FDR in 1933 to declare the “bank holiday”. They should also remember the Savings & Loan Crisis of 1973-05. This was when hundreds of thrifts collapsed due to a combination of rising interest rates and unstable funding. The Federal Savings & Loan Insurance Corporation was forced to be rescued by the Government. The Secondary Banking Crisis of 1973-5 in the UK was a devastating wholesale run on unregulated property lenders. The Bank of England saved them because they were putting at risk the UK’s large clearing banks, which threatened the financial system. Interconnectedness was the main cause of systemic risks, and not size.

In the wake of the financial crisis, thousands of small banks have failed in the US. Many of the UK’s banks and building societies got in trouble and were purchased out by other institutions. Credit unions and small banks are also failing at a rate of one per month. The German Landesbanken, which suffered severe damage in the financial crisis of 2008, are still weak and under-capitalized, despite the sovereign bailout. Many of Spain’s regional banks were bankrupted by the collapse of the construction and property bubbles.

Small banks are not safer than large ones. They are less likely to fail than larger banks. Individual small banks can fail, but not large banks. However, if the US has an FDIC, the EU could benefit from its effective resolution authority. However, a number of small banks failing together can pose as much risk to the system as a single large bank. Small banks have been historically bailed out. Even if they’re small, if they’re interconnected or systemically important due to market concentration they will be bailed. Large banks are not the only ones that “too big to fail”.

The German Sparkassen are too large to fail. They have never failed, but they are honest about that. They are still connected to the damaged Landesbanken. If the German government had allowed the Landesbanken failure, it is likely that large swathes Sparkassen would have also failed. They are also very interrelated: they lend to each others and guarantee each other’s loans. German regulators permit these loans to be accounted as loans between subsidiaries within a holding company. This means they don’t require capital allocation, a practice the IMF has criticised. They also benefit from explicit and implicit sovereign backing. They are majority publicly owned and enjoy strong political support.

Individually, the small banks in the US aren’t too big to fail. They are, however, large enough to fail in the aggregate. But in aggregate, they are. Hardly. Felix Salmon claims that small banks are safer because FDIC regulates them closely (my emphasis).

“… Because small banks have operations that are simple and easy to understand, it is possible for the FDIC to step in when they get into trouble. Small banks can choose between two management teams: either the FDIC or their in-house one. The FDIC is well-versed in its business.

But if the safety of small banks can only be ensured by what is in effect a publicly-owned holding company managing them at arm’s length, can they really be considered as anything but a simply enormous “too big to fail” government-controlled bank?

The truth is that no matter what form the banking system takes, it is too big to fail. Individual components of a system that is dominated by small banks can fail but the whole system must have public support or it will end up in a state of chaos. This can take many forms: In the USA it’s deposit insurance, lender of last-resort liquidity insurance, and the FDIC. In Germany it’s public ownership and explicit sovereign guaranteed. The individual components of large-bank-dominated systems are housed within large, diversified banks that may be too big to fail and thus benefit from implicit sovereign guaranteed. Financial stability doesn’t care if the components are integrated or disintermediated as in the US. Although integrated systems are generally more resilient, it doesn’t necessarily mean that small-bank-dominated systems can’t be as robust with the right regulation and support.

A poorly regulated banking system, with no public support (e.g. a lender last resort), is the most dangerous. It doesn’t matter if the banks are large, small or a combination of both. The system is a time bomb because it lacks support and has inadequate regulation. This is what happened in the US in 1983; it’s what happened in the UK in 1974; it’s also what led to the financial crisis. We still believe that certain forms of banking should not be supported by the public (shadow banks, large, too big-to-fail banks) and that some banking forms don’t require regulation (small banks, specialist lender). This is absurd. Financial crises do not come from well-regulated, publically supported sectors. They are caused by poorly regulated, unsupported sectors that are connected to those sectors via normal commercial relationships. We can put the whole system at risk by cherry-picking which sectors to support or regulate.

A stable financial system cannot be created by regulation alone. Regulators are imperfect, and no system of regulation can be perfect. The creation of a regulatory industry that acts as an umbrella for bank management removes the responsibility. We risk creating a situation where regulators are held accountable for bank failures while bank managers move on to higher-paying jobs with their reputations intact. New Zealand has a large-bank-dominated banking system without deposit insurance. It has never experienced a bank run. Senior executives of banks in New Zealand are held accountable for making mandatory disclosures. There are both civil and criminal penalties for not complying. This could go a long way in improving bank management quality. It will not eliminate the need for public support as an option. Failures will always occur, which can put the system at serious risk.

It doesn’t matter how big banks are. It is a nonsense to argue that small banks are better than larger ones. It is important to ensure systemic stability as well as customer service. Banks of any size can put these at risk through bad behavior. If systemic stability requires not only strict supervision of individual banks but also public support for all the systems, shouldn’t we recognize that banking is in fact a public service that is just as important to our economy and society as the National Grid?

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