You're Missing the Point on Too Big to Fail -- It's Not the Size That Matters

Photo: Jukka Zitting

New data shows that the top five banks in the nation -- most already considered too big to fail, or TBTF -- are still growing.

There's been plenty of opposition to the current state of the nation's banks, but the debate over TBTF is far more complex than the sheer size of a bank. In fact, the debate often misses the one critical ingredient that could make TBTF a favorable status for banks in the future.

How big did you say?
By now, everyone is familiar with the TBTF concept: Our nation's biggest banks are now so large and intertwined that their collapse would be beyond catastrophic to the economy -- so much so, that the government would have to step in to avoid their failure.

A new report from SNL Financial shows that the top five banks in the US -- JPMorgan Chase (JPM 1.44%), Bank of America (BAC 1.70%), Citigroup (C 2.82%), Wells Fargo (WFC -0.26%), and US Bancorp (USB -0.20%) -- now own 44%, or $6.46 trillion, of the industry's total assets. And that's just the beginning.

Compared to 1990, when the predecessors to today's top five only owned 9.67% of the total assets, the share seems excessive. But there are positives to having a concentrated banking industry.

Photo: Tim Green

Big, friendly giants
Highly concentrated banking systems within developed countries mean a more stable industry that can spread stability out into the larger economy.

The instances of bank failure drop dramatically with a 72% or higher concentration of assets owned by the top banks according to the National Bureau of Economic Research. Because of the concentration of assets in the nation's top five banks, the World Bank ranks the U.S. financial industry within the top 75th percentile for stability.

With the industry stability, banks have fewer constraints on their lending, leading to growth in other industries. The availability of lending leads to the creation of more start-up companies and expansions. This type of growth often leads to job creation and overall economic growth. On top of that, higher concentration leads to long-term profitability for the banks themselves, a great thing for investors.

Even some of the negatives with large banks can create positive outcomes: Tighter regulations may be a headache to the banks, but for credit markets, it implies a safer bank, so they're willing to lower their rates for insuring against defaults. Essentially,  credit markets determine the cost of a bank's borrowing and, right now, the biggest banks are getting low, low rates because they're considered so safe.

Runt of the litter
At first glance, the 44% share of assets by just five banks might seem huge, but once you expand your scope a bit, you get a very different sense.

A research paper from Brunel University in the U.K. explored the concentrations of the top banks in each country during the span of 2001 to 2010. Even with the researchers averaging the concentration during that span, a surprising result occurred: the U.S. was one of the least-concentrated banking industries in the world.

Looking at the Group of Eight countries, the U.S. was at the bottom of the list in terms of concentration:

Source: Lui and Mirzaei; Industrial Growth: Does Bank Competition, Concentration and Stability Constraint Matter? Evidence from developed and emerging economies, Sept. 2013

The rates of concentration within the global banking industry reached above 95% for four countries, and the highest concentration of rankings fell between 70% and 80%. The updated 2014 figure for the U.S. banks -- 44% -- still only outranks Germany and Japan within the G8 group for the 2001-2010 period, and remains far below the 67.6% average of the 48 countries surveyed within the Brunel paper.

Everything's bigger in the U.S.
One other reason the TBTF debate needs a little bit of refreshing is that the scope of the U.S. banking industry should be compared to more than just itself. If you compare the size of our nation's financial industry (by total assets) to the rest of the globe, there's a very clear statement to make: we're HUGE.

Source: World Bank. 2012. Global Financial Development Report 2013: Rethinking the Role of the State in Finance. Washington, DC: World Bank. doi:10.1596/978-0-8213-9503-5. License: Creative Commons Attribution CC BY 3.0

With the U.S. on such a larger scale than rest of the globe, is it really that shocking that our banks' sizes would mimic the overall industry's?

It's not the size that counts
There's an inherent problem with the TBTF banks: there's little incentive to be truly competitive. The size and concentration of a banking industry is only part of its ability to promote growth -- the other half of the equation is competition.

When rival banks try to win the same business, there are better opportunities for borrowers, and competition spreads throughout other industries, as well. According to the Brunel paper, the financial industry that has a high concentration of competitive banks will promote growth and job creation, while the non-competitive industry with the same concentration will have a negative effect on industrial growth.

Since the largest banks in the U.S. were largely created through mergers and emergency buyouts, there's evidence that the U.S. banking industry lacks the essential competition needed for economic growth. So the problem with the TBTF banks is not their size, as the label would suggest, but the interconnectedness that they enjoy.

Sure, undercutting each other in order to get new loan business, or raising their savings interest rates, would incur more expenses and eat into the record profitability that the Big Five have been enjoying over the past few quarters. But taking that hit might actually propel the lagging economic recovery to a healthier place that would result in long-term benefits for everyone.