Why Break Up the Big Banks? Here's Why

Earlier this week, my fellow Fool Morgan Housel ran down some of the highlights and lowlights of Alan Greenspan's letter addressing the causes of the financial meltdown.

Among Greenspan's "great points" that Morgan highlighted was the following regarding "too big to fail": "Federal Reserve research had been unable to find economies of scale in banking beyond a modest-sized institution."

Come again? No economies of scale for megabanks like Citigroup (NYSE: C  ) , JPMorgan Chase (NYSE: JPM  ) , and Bank of America (NYSE: BAC  ) ? That sounds blasphemous to me. Surely the empire-building efforts of folks like Jamie Dimon and Ken Lewis weren't for naught. Right?

Not content with taking Greenspan at his word, I figured I'd see what evidence I could come up with.

Bigger may be better, but huge may be worse
Back in 2002, Federal Reserve Board economist Dean Amel, along with Colleen Barnes of Canada's Department of Finance, and Fabio Panetta and Carmelo Salleo of the Bank of Italy, authored a paper called "Consolidation and Efficiency in the Financial Sector: A Review of International Evidence."

The paper gathered research that had been conducted in the U.S. and abroad on the impact of mergers within the financial services industry. The idea was to bring all the evidence together to come to a conclusion about whether mergers in the sector really created the hoped-for efficiencies.

The result? The group concluded the following:

In conclusion, the empirical evidence suggests that commercial bank M&As do not significantly improve cost and profit efficiency and, on average, do not generate significant shareholder value. There is evidence in favor of exploiting scale economies, but only up to a size well below that of the most recent large deals. Economies of scope are harder to pin down; there is no clear-cut evidence of their existence.

Ouch. In other words, building a bank to a certain size can improve efficiency, but beyond a certain size -- they suggest assets of $50 billion -- you don't gain anything. In fact, as the group presciently pointed out, banking mergers give rise to social costs, among them:

... consolidation can increase the risk of the operators involved, both at the individual level (by generating large and complex institutions that may suffer from diseconomies of scale) and at the systemic level.

Oh, you mean like near-failure of massive banks that threaten the whole financial system? I can't imagine that ever happening.

The little guy is onto something!
Roughly four years before the paper cited above, Craig Collette, president of Marathon National Bank (which is now part of PacWest Bancorp (Nasdaq: PACW  ) ), spoke at the Federal Reserve Bank of San Francisco about the merger of Nationsbank and Bank of America.

Defending the Davids of the banking industry against the intrusion of Goliaths like B of A, Collette had this to say about economies of scale:

One recent study indicates that, except below a relatively low threshold in terms of combined assets, bank mergers do not in fact result in the realization of increased efficiency through economies of scale ... Several other studies ... found no significant cost savings or profit improvement (measured as return on assets or gross operating income) as a result of mergers. ... An analysis of the largest 100 banks in the May 1998 issue of USBanker shows that as a general rule the largest banks have poorer asset quality, lower profitability, less efficiency and weaker capitalization than the smaller banks on the list.

Meanwhile, he came to a similar -- if not even more accurate -- conclusion as the paper from Amel:

The trend toward mega mergers, and this includes this merger, is not healthy for Main Street where I come from, it is very risky for Wall Street, and it is bad for the Federal Reserve and other regulators who will have to bail out these mega giants when they are mismanaged, over speculate or reach too far in risk taking. These banks are the new super sized "too big to fail" varieties.

Well, we can't say that Collette didn't warn us.

Yet they continue
So why in the world would these megamergers continue, despite the evidence against efficiencies created by them? The Amel paper throws out a few ideas, some of them exploring reasons why the research may not have picked up on merger efficiencies. The explanation that jumped out at me, however, was this: "non-value maximizing motives (such as managerial hubris)."

You don't say.

And why exactly would managers be incented to press forward with empire-building? It's quite simple, whether you're Goldman Sachs (NYSE: GS  ) putting the pedal to the metal on leverage and trading growth, or Wells Fargo (NYSE: WFC  ) making hefty acquisitions, CEOs of larger banks get larger paychecks. In 2007, Wells Fargo had $575 billion in total assets, and its chairman took home $23 million in total compensation. M&T Bank (NYSE: MTB  ) had $65 billion in assets, and its top dog was paid $1.2 million.

So if we connect the dots, we've got managers pushing to build massive banks to score massive paychecks, while shareholders are left with a bigger bank that may actually be less efficient, and the rest of us bear the systemic risk that the massive bank creates.

How is it not time to end too big to fail?

Is Greece too big to fail? Fool Alex Dumortier explains why the situation in Greece matters to smart investors.

Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or on his RSS feed. The Fool's disclosure policy assures you no Wookiees were harmed in the making of this article.


Read/Post Comments (16) | Recommend This Article (18)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 25, 2010, at 2:57 PM, PhulishMortal wrote:

    You're preaching to the choir here -- on my account, anyway. I have been convinced for quite a while now that inhibiting growth of banks (and other kinds of financial institutions) beyond a certain point is crucial for minimizing damage to the financial system as a whole.

    The question is how? And I'm not just asking what would be a good system of regulation/policing/whatever; I mean: what can we do to get this sort of action taken given the armies of lobbyists and the seemingly never-ending skulk* of foxes guarding the henhouse.

    Letter-writing campaigns are one way, but they seem of limited usefulness. What are some other ideas? (I think maybe I'll ask in CAPS, but posts move so quickly in there I doubt anyone will see it.)

    Suggestions, Matt?

    *True fact:** A skulk of foxes is the correct venereal term for a group of foxes.

    **Re "true fact:" is there any other kind? Is a false fact really a fact?

  • Report this Comment On March 25, 2010, at 2:58 PM, PhulishMortal wrote:

    You're preaching to the choir here -- on my account, anyway. I have been convinced for quite a while now that inhibiting growth of banks (and other kinds of financial institutions) beyond a certain point is crucial for minimizing damage to the financial system as a whole.

    The question is how? And I'm not just asking what would be a good system of regulation/policing/whatever; I mean: what can we do to get this sort of action taken given the armies of lobbyists and the seemingly never-ending skulk* of foxes guarding the henhouse.

    Letter-writing campaigns are one way, but they seem of limited usefulness. What are some other ideas? (I think maybe I'll ask in CAPS, but posts move so quickly in there I doubt anyone will see it.)

    Suggestions, Matt?

    *True fact:** A skulk of foxes is the correct venereal term for a group of foxes.

    **Re "true fact:" is there any other kind? Is a false fact really a fact?

  • Report this Comment On March 25, 2010, at 4:47 PM, BanditZeroThree wrote:

    Can't disagree more.

    When the bottom fell out of the markets in 2008 and SecTreas was looking into the abyss, their weren't many financial institutions on firm-footing. If it weren't for colossis' like BAC, Merrill Lynch would have folded like a cheap tent. Country wide Mortgage would have forfeited unless they received a huge capital infusion AND had professionals with the ability & capicity to take over and run the busines. Would State Regional Bank of Cospus Christie have had the capicity and skills to manage THOSE rescues?

    Now we have a move to down size the financial institutions. Hereagain, governemnt wants to meddle. The same beureaucrats that put the gun to the head of CEO Ken Lewis to purchase Merrill Lynch and it's blossoming black hole; as well as countrywide, now want to disgourge those businesses from BAC AFTER all companies involved have worked heroically to make these mergers / aquisitions successful.

    Nice....

    B3

    Out

  • Report this Comment On March 25, 2010, at 5:56 PM, TMFHousel wrote:

    Banditzerothree,

    The question here is whether the bottom would have fallen out at all if banks were allowed to become so big and interconnected in the first place. The bottom fell out because Lehman went under. I think what Matt's proposing is that Lehman-like monstrosities shouldn't be allowed to exist.

  • Report this Comment On March 25, 2010, at 6:30 PM, MyDonkey wrote:
  • Report this Comment On March 25, 2010, at 6:36 PM, stan8331 wrote:

    The folks who claim that too big to fail is nonsense and that we should just let ANY bank fail, no matter how large it is and no matter what the social and economic cost, are the new century's Herbert Hoovers in-waiting.

    Claiming that we've ended too big to fail when the banks involved only continue to get larger is pure rubbish. The only way for a bank to not be too big to fail is if it's actually NOT too big to fail without creating a cascade of destruction in the economy. Fancy words and good intentions are worthless when one is staring into an abyss.

    I don't claim to know the best way to make it happen, but if we can't find some practical way to reduce the size of our big banks, history will continue to repeat itself.

  • Report this Comment On March 25, 2010, at 6:58 PM, catoismymotor wrote:

    Oh, what the heck?! They are half nationalized anyway.

  • Report this Comment On March 25, 2010, at 6:58 PM, catoismymotor wrote:

    Oh, what the heck?! They are half nationalized anyway.

  • Report this Comment On March 25, 2010, at 8:45 PM, jesse2159 wrote:

    If banks were required to be 100% transparant, we wouldn't have too big to fail because they wouldn't get too big in the first place. It's when investors don't know the facts and invest blindly, banker can gamble to their little black hearts content.

  • Report this Comment On March 25, 2010, at 9:08 PM, TMFKopp wrote:

    @BanditZeroThree

    Wow, I'm in such opposition to what you've said that I don't even know where to start....

    First of all, there's little that gets me going like the "big banks as white knights / good corporate citizens" card. It's ludicrous.

    But as to your contention, you're basically saying that large financial institutions shouldn't be broken up because then they wouldn't be able to save large, failing financial institutions... rather circular.

    Or else you're assuming that I'm all for breaking up banks like BoA, but I'm happy to see non-banking financials like Morgan Stanley grow to unsustainable sizes. If that's the case then let me allay your fears -- I don't think participants in the financial industry should be sizable enough to pose critical systemic risk. Period. So it wouldn't matter that there wouldn't be a massive BoA because there wouldn't be a massive, failing Merrill to save.

    As for the argument that Lewis and BoA were forced into the purchases of MER and CWide, well that's just silly. BoA made a big investment in CW long before the major cracks started showing, and Lewis thought he was getting an absolutely smoking deal when they bought the whole thing.

    Same goes for MER -- at the time of the acquisition announcement, Lewis thought that he was making a very savvy purchase. Heck, why in the world would he have paid a premium? If he wasn't excited about the deal why not just wait until it was on its last legs like Bear and get a rock-bottom deal a la JPM?

    It was only when Lewis realized that a) his diligence might have been half-assed and b) he could squeeze out some more government dollars by waving around the termination clause that allegations of government intervention begin.

    Yeah, sorry, I'm just not on board with the idea that Ken Lewis is the Good Samaritan of the U.S. financial system.

    Matt

  • Report this Comment On March 25, 2010, at 9:56 PM, xetn wrote:

    Stan8331

    "The folks who claim that too big to fail is nonsense and that we should just let ANY bank fail, no matter how large it is and no matter what the social and economic cost, are the new century's Herbert Hoovers in-waiting."

    Herbert Hoover was no free-market advocate and used his powers as president to force large companies into maintaining high wages instead of allowing wages to adjust to the conditions. His efforts were the real start of what became known as the new deal. As a matter of fact, Roosevelt campaigned on the promise to reverse Hoover's programs, but once in office, reversed himself and, not only continued, but greatly expanded them.

    As for this article, there never should have been any "too big to fail" bailouts. If a company can prosper, it should be allowed to earn profits, but if it does not prosper, it should also be allowed to fail.

  • Report this Comment On March 26, 2010, at 3:16 PM, jfrankh57 wrote:

    TMFKopp---Yeah, agreed---you can sure bet that Ken Lewis was altruistic in his efforts to "save" CW and MER...like I own the moon:) What happened to the FDIC??? Any bank deposits are supposedly covered by this institution which was created from the debacle of the Great Depression. Tell me that the failure of the "huge" banking institutions would have caused the same conditions and BanditZeroThree may have been right, but no one was allowed to test the "safety belt" put in place back in the 1930's. Yeah, the investment banks would have died and the investors would have lost out there, but those banks have been generating outrageous profits for a number of years...so much so, that any normal investor looking under the hood would have dumped them for what they were. Just so long as you were doing your due diligence and not being a greedy little blind lemming.

  • Report this Comment On March 27, 2010, at 12:54 PM, mountain8 wrote:

    Dear Bandit,

    True comment but it seems you are not mentioning anything about economy of scale. You are talking about Government intervention and future Government intervention. And we know the scale of the Government and the economic failure of same.

  • Report this Comment On March 27, 2010, at 12:59 PM, mountain8 wrote:

    Taking it to the nth degree, what if the world had one bank, Just one bank after a bazillion mergers. Then when it failed, as it also would have under the situation of 2007 and 08, The whole world economy would have failed with it and nobody could have bailed it out. Economies of scale do tend to peak at a certain point with banks and then it just gets too complicated to manage.

  • Report this Comment On March 27, 2010, at 1:07 PM, mountain8 wrote:

    I am no economist but I believe economies of scale refer to tangible item, ie. better materials costs, elimination of duplication, easier distribution, etc.

    I don't believe economies of scale can work with intangibles, ie. investment, protection of principle, greed, bonuses, etc.

    Too big to fail means to me, too complex and convoluted to understand.

  • Report this Comment On March 27, 2010, at 1:08 PM, mountain8 wrote:

    TMFKopp,

    Excellent retort up there. Knowledgible and understandible.

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